Solution Manual Management Accounting

Solution Manual: Management Accounting

Management Accounting Intermediate (Universiteit van Amsterdam)

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Instructor’s Manual Management and Cost Accounting Fifth edition

Alnoor Bhimani Charles T. Horngren Srikant M. Datar Madhav V. Rajan Farah Ahamed

For further instructor material please visit:

www.pearsoned.co.uk/bhimani ISBN: 978-0-273-75986-7

 Pearson Education Limited 2012 Lecturers adopting the main text are permitted to download and photocopy the manual as required.

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Pearson Education Limited Edinburgh Gate Harlow Essex CM20 2JE England and Associated Companies around the world Visit us on the World Wide Web at: www.pearson.com/uk This edition published 2012 © Pearson Education Limited 2012 The rights of Alnoor Bhimani, Charles T. Horngren, Srikant M. Datar, Madhav V. Rajan, Farah Ahamed to be identified as the authors of this Work have been asserted by them in accordance with the Copyright, Designs and Patents Act 1988. Pearson Education is not responsible for the content of third-party internet sites. ISBN: 978-0-273-75986-7 All rights reserved. Permission is hereby given for the material in this publication to be reproduced for OHP transparencies and student handouts, without express permission of the Publishers, for educational purposes only. In all other cases, no part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise without either the prior written permission of the Publishers or a licence permitting restricted copying in the United Kingdom issued by the Copyright Licensing Agency Ltd. Saffron House, 6-10 Kirby Street, London EC1N 8TS. This book may not be lent, resold, hired out or otherwise disposed of by way of trade in any form of binding or cover other than that in which it is published, without the prior consent of the Publishers.

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Contents Chapters

Pages

Part I – Management and cost accounting fundamentals 1. The accountant’s role in the organisation 2. An introduction to cost terms and purposes 3. Job-costing systems 4. Process-costing systems 5. Cost allocation 6. Cost allocation: joint-cost situations 7. Income effects of alternative stock-costing methods

6 15 28 42 66 81 98

Part II – Accounting Information for decision making 8. Cost–volume–profit relationships 9. Determining how costs behave 10. Relevant information for decision making 11. Activity-based costing 12. Pricing, target costing and customer profitability analysis 13. Capital investment decisions

114 131 144 155 166 179

Part III – Planning and budgetary control systems 14. Motivation, budgets and responsibility accounting 15. Flexible budgets, variances and management control: I 16. Flexible budgets, variances and management control: II 17. Measuring yield, mix and quantity effects

200 213 230 248

Part IV – Management control systems and performance issues 18. Control systems and transfer pricing 19. Control systems and performance measurement

268 281

Part V – Quality, time and the strategic management of costs 20. Quality and throughput concerns in managing costs 21. Accounting for just-in-time systems 22. Strategic management accounting and emerging issues

298 309 326

Guide to case study solutions

334

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Preface This manual is intended to assist lecturers’ discussion of assignments and lecture topics. ‘Points to stress and teaching tips’ are provided for each chapter to give broad guidance on relevant issues or potential areas of difficulty to students. Solutions are offered for end-of-chapter ‘assessment material’ in the text. Case notes prepared (in most cases) by the case writer to all cases included in the text are also provided. The assistance of Pauline Gleadle, Laurence Habib, Imran Malik, Rishi Zaveri and Marvish Shami with reviewing and checking many of the problems and their solutions is gratefully acknowledged. A. Bhimani C. Horngren S. Datar M. Rajan F. Ahamed

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PART I

MANAGEMENT AND COST ACCOUNTING FUNDAMENTALS

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CHAPTER 1

The accountant’s role in the organisation Teaching tips and points to stress Modern management accounting While the accounting system provides information (e.g. product costs, downtime) for management decisions, cost management refers to active use of this information to plan and control costs. Cost management requires managers to actively seek ways to reduce costs. Much cost management occurs well before the accounting system recognises costs. (The product design stage often offers more cost management opportunities than controlling manufacturing operations.) Cost management is integrated throughout the text. To reinforce the value-chain concept, ask a student to illustrate activities/costs in each function in the context of his/her work experience. Students are often confused about the difference between R&D and Design. The distinctions are not always clear-cut, but R&D is basic research and idea generation, whereas design turns those ideas into reality. Design encompasses development of prototype products and the manufacturing process by which the products are produced.

Elements of management control Planning and control are distinct activities, but they go hand in hand. To maximise the benefits from planning (e.g. budgeting), the manager should use that plan as a benchmark for controlling (i.e. assessing the effectiveness and efficiency of implementation). Conversely, it is difficult to control activities without a plan or budget. To help students understand how accounting numbers can affect employees’ behaviour and hence firm’s performance, ask questions, such as if a materials procurement officer’s annual bonus depends on the difference between budgeted price and actual price paid, how will the officer behave? The officer may be tempted to purchase cheap, perhaps low-quality materials that may not be delivered on a reliable, timely basis; he or she may refuse to order materials for rush orders if there will be an extra delivery charge, etc. Although it is difficult to quantify the costs and benefits of accounting systems, a decision about the system will be made. The question is whether costs and benefits are considered implicitly (as part of a ‘gut feeling’) or explicitly, where effects of different estimates can be examined. Product cost information permeates all three functions. In the scorekeeping function, accountants accumulate product cost information for both external and internal reportings. Product cost information can help identify cost management opportunities (i.e. attention directing) and it is used in make-or-buy decisions, where managers compare the cost of making the product or component with the cost of buying it from an external supplier (i.e. problem solving).

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Costs, benefits and context The ‘best’ information system depends on both technical and human aspects of the specific situation. This is a major difference between financial accounting, where firms generally need to comply with external reporting requirements where they exist, and management accounting, where choices are based on an explicit or implicit cost–benefit analysis. Management accounting students must do more than memorising rules. They must evaluate the situation and context, decide which technique or information system is most appropriate and implement it.

Themes in the design of management accounting systems Customer satisfaction is the dominant theme. All other themes are directed toward attracting and retaining profitable customers who remain satisfied. These themes can also be applied to functions within a business. For example, management accountants (MAs) must satisfy their customers (managers) by satisfying key success factors. MAs must provide high-quality information on a timely basis for a reasonable cost. MAs can develop innovative formats and analyses to facilitate management decisions. They should provide information regarding all elements of the value chain and must prepare information for internal decisions as well as external financial reporting. MAs should continually strive to provide better quality information, faster, at a lower cost.

Solutions to review questions 1.1

The five broad purposes are: Purpose 1: Formulating overall strategies and long-range plans. Purpose 2: Resource allocation decisions such as product and customer emphasis and pricing. Purpose 3: Cost planning and cost control of operations and activities. Purpose 4: Performance measurement and evaluation of people. Purpose 5: Meeting external regulatory and legal reporting requirements where they exist.

1.2

Management accounting measures and reports financial as well as other types of information that may be useful to managers in fulfilling the goals of the organisation. Financial accounting focuses on external reporting that is guided by generally accepted accounting principles.

1.3

The business functions in the value chain are: •

Research and development – the generation of, and experimentation with, ideas related to new products, services or processes.

•

Design of products, services and processes – the detailed planning and engineering of products, services or processes.

•

Production – the coordination and assembly of resources to produce a product or deliver a service.

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•

Marketing – the process by which individuals or groups (a) learn about and value the attributes of products or services and (b) purchase those products or services.

•

Distribution – the mechanism by which products or services are delivered to a customer.

•

Customer service – the support activities provided to the customers.

1.4

Cost management refers to actions that managers undertake to satisfy customers while continuously reducing and controlling costs.

1.5

A successful accountant requires general business skills (such as understanding the strategy of an organisation) and people skills (such as motivating other team members) as well as technical skills (such as computer knowledge).

1.6

Yes. Drucker is advocating that accountants do more than scorekeeping, which is often interpreted as being a ‘bobby on the beat’ or a watchdog. It is also essential that accountants emphasise their attention-directing and problem-solving functions.

1.7

The new accountant could reply in one or more of several ways: a

Demonstrate to the plant manager how he or she could make better decisions, if the plant accountant was viewed as a resource rather than a dead weight. In a related way, the plant accountant could show how the plant manager’s time and resources could be saved by viewing the new plant accountant as a team member.

b

Demonstrate to the plant manager a good knowledge of technical aspects at the plant. This approach may involve doing background reading. It certainly will involve spending much time on the plant floor speaking to plant personnel.

c

Show the plant manager’s examples of the new plant accountant’s past successes in working with line managers in other plants. Examples could include

d

1.8

1.9

•

assistance in preparing the budget,

•

assistance in analysing problem situations and

•

assistance in submitting capital budget requests.

Seek assistance from the corporate accountant to highlight to the plant manager the importance of many tasks undertaken by the new plant accountant. This approach is a last resort but may be necessary in some cases.

A customer-driven management accountant function would a

approach its customers (such as managers in different parts of the value chain) to determine how it can facilitate those managers making better decisions, and

b

solicit regular and systematic feedback from those customers about its performance.

Yes, management accountants have customers just as companies have customers who purchase their products or services. Management accountants provide information and advice to many line and staff people in the organisation and to various external parties. It is essential that they provide information and advice that line and staff customers and external parties view as timely and relevant.

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1.10

Five themes that affect the way managers operate and have prompted developments in management accounting are the following: •

Customer satisfaction is priority one

•

Key success factors (cost, quality, time, and innovative products and services)

•

Total value-chain analysis

•

Continuous improvement

•

Dual external/internal focus.

Solutions to exercises 1.13

Value chain and classification of costs, computer company. (15 min) Cost item

1.14

Value-chain business function

a

Production

b

Distribution

c

Design

d

Research and development

E

Customer service

F

Design (or research and development)

G

Marketing

H

Production

Value chain and classification of costs, pharmaceutical company. (15 min) Cost item

Value-chain business function

a

Design

b

Marketing

c

Customer service

d

Research and development

e

Marketing

f

Production

g

Marketing

h

Distribution

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1.15

Uses of feedback. (10 min) Item

1.16

Use of feedback

a

2

b

6

c

4

d

3

e

5

f

1

Scorekeeping, attention directing and problem solving. (15 min) Because the accountant's duties are often not sharply defined, some of these answers might be challenged. Activity

1.17

Function

a

Scorekeeping

b

Attention directing

c

Scorekeeping

d

Problem solving

e

Attention directing

f

Attention directing

g

Problem solving

h

Scorekeeping, depending on the extent of the report

i

This question is intentionally vague. The give-and-take of the budgetary process usually encompasses all three functions, but it emphasises scorekeeping the least. The main function is attention directing, but problem solving is also involved.

j

Problem solving

Scorekeeping, attention directing and problem solving. (15 min) The accountant’s duties are often not sharply defined, so some of these answers might be challenged. Activity

Function

a

Attention directing

b

Problem solving

c

Scorekeeping

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Activity

1.18

1.19

Function

d

Scorekeeping

e

Scorekeeping

f

Attention directing

g

Problem solving

h

Scorekeeping

i

Problem solving

j

Attention directing

Changes in management and changes in management accounting. (15 min) Change in management accounting

Key theme in newly management approach

evolving

a

Total value-chain analysis

b

Key success factors (quality) or total value-chain analysis

c

Dual external/internal focus

d

Continuous improvement

e

Customer satisfaction is priority one

Planning and control, feedback. (15–20 min) 1

Planning is choosing goals, predicting results under various ways of achieving those goals and then deciding how to attain the desired goals. One goal of the European Starting News (ESN) is to increase operating income. Increasing revenues is potentially one way to achieve this if the increase in revenues exceeds any associated increase in costs. ESN expects daily circulation to increase from 250,000 per day in April to 400,000 per day in May. This budgeted circulation gain is expected to increase newspaper revenues from €5,250,000 in April to a budgeted €6,200,000 in May. Control covers both the actions that implement the planning decision and the performance evaluation of the personnel and operations. At ESN, the price drop would be announced to its sales force and probably to customers. Requirement 2 illustrates a performance report for May 2003.

2. Actual results Newspapers sold Price per paper Newspaper revenue

Budgeted amounts

Variance

13,600,000

12,400,000

1,200,000 fav

€0.50

€0.50

€0.00 fav

€6,800,000

€6,200,000

€600,000 fav

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3

1.20

Based on the €600,000 favourable variance for circulation revenue, Saunier might take the following actions: a

Change predictions. ESN underestimated the daily circulation gain by 40,000 copies per day. It might examine the procedures it uses to estimate the response of circulation to price changes.

b

Change operations. ESN might now change its advertising rates to reflect that circulation in May is 76% above that of April. This gives advertisers a much larger audience they can reach with each advertisement in the ESN.

Professional ethics and reporting divisional performance. (10–15 min) 1

Devallois’s ethical responsibilities are well summarised in Ethical Guidelines. Areas of ethical responsibility include •

competence,

•

confidentiality,

•

integrity and

•

objectivity.

The key area related to Devallois’s current dilemma is integrity. Devallois should refuse to book the €200,000 of sales until the goods are shipped. Both financial accounting and management accounting principles maintain that the sales are not complete until the title is transferred to the buyer. 2

1.21

Devallois should refuse to follow Clément’s orders. If Clément persists, the incident should be reported to the corporate accountant. Support for line management should be wholehearted, but it should not require unethical conduct.

Responsibility for analysis of performance. (20–30 min) This problem raises plenty of thought-provoking questions. Unfortunately, there are no pat answers. The generalisations about these relationships are difficult to formulate. 1

Apparently, the accountant’s performance-analysis staff have not won the confidence or respect of Hedby and other line officers. Hedby regards these accountants as interlopers who are unqualified for their analytical tasks on two counts: (a) the task is Hedby’s, not the accountants’ and (b) Hedby understands his own problems best. It is unlikely that the accountant’s performance-analysis staff have maintained a day-to-day relationship with line personnel in Division C.

2

Nedregotten should point out that her performance-analysis staff are doing the work in order to enable Hedby to better concentrate on his other work. The detached analyses by her staff should help Hedby better understand and improve his own performance.

Furthermore, Nedgrotten should point out that Hedby would need his own divisional accounting staff in order to prepare the necessary analysis of performance, if Hedby’s group did not support him. More uniform reporting formats and procedures and more objective appraisals could potentially occur if the performance-analysis staff remain as part of the corporate accountant’s group.

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3

Two approaches within the existing organisation reporting relationships are the following: a

Placing higher priority on having her performance-analysis staff view the division personnel as important customers and actively seeking out ways to increase customer satisfaction.

b

Encouraging greater use of teams in which division personnel and corporate control personnel are members. Hopefully, mutual respect will increase by this close interaction. A more extreme approach would be to change the organisation’s reporting relationships and staff assignments. For example, each division manager could have his or her own performance-analysis staff member as part of the plant accountant’s group.

1.23

Planning and control decisions: Internet company. (30 min) 1. Planning decisions at WebNews.co.uk focus on organisational goals, predicting results under various alternative ways of achieving those goals and then deciding on how to attain the desired goals. For example, WebNews.co.uk could have the objective of revenue growth to gain critical mass or it could have the objective of increasing operating income. Many Internet companies in their formative years make revenue growth (and subscriber growth) their primary goal. Control focuses on (a) deciding on and taking actions that implement the planning decisions and (b) deciding on performance evaluation and the related feedback that will help future decision making. 2. Planning decisions a

Decision to raise monthly subscription fee.

c

Decision to upgrade content of online services.

e

Decision to decrease monthly subscription fee. Control decisions

1.24

b

Decision to inform existing subscribers about the rate of increase – an implementation part of control decisions.

d

Demotion of VP of Marketing – performance evaluation and feedback aspect of control decisions.

Problem solving, scorekeeping and attention directing: Internet company. (30 min) 1. Problem solving – comparative analysis for decision making. Scorekeeping – accumulating data and reporting reliable results to all levels of management. Attention directing – helping managers to properly focus their attention.

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2

a and e Decisions to change subscription fee. Problem solving – report outlining expected revenues from subscribers and advertising with different monthly fee amounts. Scorekeeping – report with monthly subscribers and their revenues in prior months. Attention directing – report showing the change in the number of subscribers of Internet companies at the time they change their monthly fees. b

Decision in June 2005 to inform existing subscribers about rate increase in July. Problem solving – report showing the cost of different ways of informing subscribers of the rate increase. Scorekeeping – report showing how many subscribers immediately paid the new subscription fee when past fee increases occurred. Attention directing – report showing the number of subscribers to the service that have not logged on for two months or more.

c

Decision to upgrade the content of online services. Problem solving – report showing the expected cost of alternative ways to upgrade content. Scorekeeping – labour cost tracking of software developers who work on content. Attention directing – report on cost overruns relative to budget for ongoing content upgrades.

d

Demotion of VP of Marketing Problem solving – budgeted cost of marketing department with alternative management teams. Scorekeeping – report showing breakdown of subscribers into renewals and new subscribers. Attention directing – report highlighting subscriber growth and rates of competing Internet news services.

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CHAPTER 2

An introduction to cost terms and purposes Teaching tips and points to stress Costs in general Cost assignment is a general term for attaching either direct or indirect costs to cost objects. The distinction between direct and indirect costs is important because direct costs are directly traced to the cost object, whereas indirect costs are often pooled and then allocated to the cost object with less precision. Management, therefore, has more confidence in the accuracy of direct costs. The text uses the term ‘cost tracing’ to refer specifically to assigning direct costs to cost objects. Cost allocation is reserved for assigning indirect costs to cost objects. Cost objects include (1) activities or processes; (2) outputs of processes, such as products, services and projects; (3) parts of the organisation (e.g. departments or programmes) and (4) customers. Information on costs associated with these cost objects facilitates decisions such as (1) which manufacturing process is most economical, (2) what price should be charged for the service, (3) which department uses its resources most efficiently and (4) which customers contribute most to the company’s profits. There is more to cost accounting than product costing.

Direct costs and indirect costs Students have trouble with the distinctions between direct/indirect costs and cost tracing/cost allocation. Familiar examples can help. Public accounting firms directly trace direct professional labour costs to each audit engagement (through time sheets). In contrast, rent on the firm’s office and depreciation on its computers cannot be traced to individual engagements. These are indirect costs that must be allocated to the different engagements. Allocation of indirect costs is a difficult but important topic that is covered in more detail in later chapters. Example: Is photocopying a direct or an indirect cost with respect to department cost objects? In the past, it was difficult to keep track of the amount of copying done by different departments. Moreover, there was generally less copying. Photocopying was typically considered an indirect cost because it was often an immaterial amount and hard to trace. Today, businesses are making more photocopies than ever before. Counters inserted into copiers (copy keys) easily keep track of the number of copies made by each user. Because copying costs are now higher and easier to trace, they are more often directly traced. (An additional benefit of the counters is that they may induce employees to make fewer copies because the number of copies is now more observable.)

Cost drivers and cost management Cost management occurs when managers actively strive to reduce costs. Two major avenues for cost management are focusing on value-added activities (and eliminating non-value-added activities such as stock handling) and reducing consumption of cost drivers in value-added activities. Reduced consumption of cost drivers reduces costs only if managers actively squeeze

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costs down. As more managers do their own word processing, typing by secretaries declines. But unless management reduces the number of secretaries in response to the reduced workload, secretarial costs will not reduce.

Two types of cost behaviour pattern: variable costs and fixed costs The distinction between variable costs (VCs) and fixed costs (FCs) is necessary to address basic questions such as how much manufacturing costs change if the level of output increases by 5%. For example, many fast-food restaurants guarantee workers only an hour or two of work per shift. If sales are less than expected, workers can be dismissed for the shift after their guaranteed hour (or two). In this case, direct-labour cost varies directly with output (sales). In contrast, many government workers are salaried and cannot be dismissed except under extreme circumstances. Here, direct-labour costs for a government department are relatively fixed. Students are often confused about when VCs are variable and when FCs are fixed. Variable costs vary in total and FCs are fixed in total. However, VCs per unit are consistent and FCs per unit decline as more units are produced.

Total costs and unit costs Students often treat ‘unitised’ fixed costs as if they were variable costs, forgetting that fixed costs are fixed in total. They attempt to calculate total costs by multiplying the cost per unit by the number of units. Because of this misleading nature of unitised fixed costs, it is better to base projections and comparisons on total costs. When estimating total costs, students should consider variable costs as an amount per unit and fixed costs as a lump sum total amount.

Financial statements and cost terminology The basic concepts of assigning costs to cost objects (and using this information for planning and control) apply to service, merchandising and manufacturing companies. Students find it easier to grasp the basic concepts by starting with service companies, which are the simplest as they have no stocks. Merchandisers add the complications of purchases and stocks. The final step is manufacturers, which are more difficult due to the complexities of cost of good manufactured (CGM), and the three types of stock.

Solutions to review questions 2.1

A cost object is anything for which a separate measurement of costs is desired. Examples include a product, a service, a project, a customer, a brand category, an activity, a department and a programme.

2.2

Costs are not direct or indirect in isolation. A cost object (such as a product, service or project) must be specified. •

Direct costs of a cost object are those costs that are related to the particular cost object and that can be traced to it in an economically feasible (cost-effective) way.

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•

Indirect costs of a cost object are those costs that are related to the particular cost object but cannot be traced to it in an economically feasible (cost-effective) way.

Assume that the cost object is a Macintosh computer product. Apple assembles multiple products in each of its plants. The computer screen is a direct cost of the Macintosh. In contrast, the salary of the security guard at the plant where the Macintosh is assembled would be an indirect cost of the Macintosh. 2.3

Consider a supervisor’s salary in a maintenance department of a telephone company. If the cost object is the department, the salary is a direct cost. If the cost object is a telephone call by a customer, the salary is an indirect cost.

2.4

Factors affecting the classification of a cost as direct or indirect include

2.5

1

the materiality of the cost in question

2

available information-gathering technology

3

design of operations

4

contractual arrangements.

A cost driver is any factor that affects total costs. Examples include: Business function

Example of cost driver

Research and development

Number of research projects

Design

Number of products in design

Production

Number of units produced

Marketing

Number of advertisements run

Distribution

Number of items distributed

Customer service

Number of service calls

2.6

The relevant range is the range of the cost driver in which a specific relationship between cost and driver is valid. This concept enables the use of linear cost functions when examining cost–volume–profit (CVP) relationships as long as the volume levels are within that relevant range.

2.7

A unit cost is calculated by dividing some total cost (the numerator) by some number of units (the denominator). In many cases the numerator will include a fixed cost that will not change despite changes in the number of units to be assembled. It is erroneous in those cases to multiply the unit cost by volume changes to predict changes in total costs at different volume levels.

2.8

Descriptions of the three sectors are: •

Service-sector companies provide services or intangible products to their customers – for example, legal advice or an audit. These companies do not have any stock of intangible products at the end of an accounting period.

•

Merchandising-sector companies provide tangible products they have previously purchased in the same basic form from suppliers. Merchandise purchased from suppliers but not sold at the end of an accounting period is held as stock.

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•

Manufacturing-sector companies provide tangible products that have been converted to a different form from the products purchased from suppliers. At the end of an accounting period, stock of a manufacturer can include direct materials, work in progress and finished goods.

Thus, manufacturing and merchandising companies have stock while service companies do not. Manufacturing companies have direct materials, work in progress and finished goods stock, whereas merchandising companies have only goods purchased for resale stock (merchandise stock). 2.9

2.10

The three major categories of the stockable costs of a manufactured product are: 1

direct materials costs

2

direct manufacturing labour costs

3

indirect manufacturing costs.

Direct materials costs are the acquisition costs of all materials that eventually become part of the cost object (say, units finished or in progress) and that can be traced to that cost object in an economically feasible way. Acquisition costs of direct materials include freight-in (inward delivery) charges, sales taxes and customs duties. Direct manufacturing labour costs include the compensation of all manufacturing labour that is specifically identified with the cost object (say, units finished or in progress) and that can be traced to the cost object in an economically feasible way. Examples include wages and fringe benefits paid to machine operators and assembly-line workers. Indirect manufacturing costs are all manufacturing costs considered to be part of the cost object (say, units finished or in progress), but that cannot be individually traced to that cost object in an economically feasible way. Examples include power supplies, indirect materials, indirect manufacturing labour, plant rent, plant insurance, property taxes on plants, plant depreciation and the compensation of plant managers. Prime costs are all direct manufacturing costs. In the two-part classification of manufacturing costs, prime costs would comprise direct materials costs. In the threepart classification, prime costs would comprise direct materials costs and direct manufacturing labour costs. Conversion costs are all manufacturing costs other than direct materials costs.

Solutions to exercises 2.11

Total costs and unit costs. (10 min) 1

Total cost, €40,000. Unit cost per person, €40,000 ÷ 500 = €80.00.

2

Total cost, €40,000. Unit cost per person, €40,000 ÷ 2000 = €20.00.

3

The main lesson of this problem is to alert the student early in the course to the desirability of thinking in terms of total costs rather than unit costs wherever feasible. Changes in the number of cost driver units will affect total variable costs but not total fixed costs. In our example, it would be perilous to use either the €80.00 or the €20.00 unit cost to predict the total cost, because the total costs are not affected by the attendance. Instead, the student association should use the €40,000 total cost. Obviously, if the musical group agreed to work for, say €40.00 per person, such a unit variable cost could be used to predict the total cost.

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2.13

Total costs and unit costs. (10 min) 1

2

2.14

Unit cost = Total costs ÷ Number of units. Total costs (€)

Number of units

Unit cost (€)

a

60,000

200

300

b

60,000

250

240

c

60,000

300

200

The unit-cost figures per passenger calculated in requirement 1 should play no role in predicting the total air-flight costs to be paid next month. Weltferien pays SaxonAir on a per round-trip flight basis, but not on a per passenger basis. Hence, the cost driver for next month is the number of round-trip flights and not the number of passengers.

Classification of costs, service sector. (15–20 min) Cost object: Each individual focus group. Cost variability: With respect to changes in the number of focus groups. There may be some debate over classifications of individual items. Debate is more likely as regards cost variability. Cost item

D or I

V or F

A

D

V

B

I

F

C

I

Va

D

I

F

E

D

V

F

I

F

G

D

V

H

I

Vb

a

Some students will note that phone call costs are variable when each call has a separate charge. It may be a fixed cost if Presta-Serviços has a flat monthly charge for a line, irrespective of the amount of usage.

b

Petrol costs are likely to vary with the number of focus groups. However, vehicles likely serve multiple purposes and detailed records may be required to examine how costs vary with changes in one of the many purposes served.

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2.15

Classification of costs, merchandising sector. (15–20 min) Cost object: Film section of store. Cost variability: With respect to changes in the number of films sold, assumptions may be made over classifications of individual items. This is mainly in relation to cost variability. Whether DVDs and videos cost the same is another matter.

2.16

Cost item

D or I

V or F

A B C D E F G H

I I D D I I I D

F V V F F V F V

Cost drivers and the value chain. (15 [AQ1]min) 1 Business function area

Representative cost driver

A

Research and development

Number of patents filed with government agency

B

Design products/processes

Hours spent designing cars

C

Production

Hours assembly line in operation

D

Marketing

Minutes of television advertising time

E

Distribution

Number of cars shipped

F

Customer service

Number of calls to free customer services

of

2 Business function area

Representative cost driver

A

Research and development

• •

Hours of design and testing work Number of new models in development

B

Design of products/processes

• •

Number of focus groups on alternative models and designs Hours of engineering and retooling

C

Production

• •

Number of units coming off assembly line Number of models manufactured

D

Marketing

• •

Number of promotion packages mailed Number of sales

E

Distribution

• •

Number of cars shipped overseas Number of cars delivered to showrooms

F

Customer service

• •

Number of cars recalled Number of personnel on free customer phone lines

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2.17

Calculating cost of goods manufactured and cost of goods sold. (20–25 min) Schedule of cost of goods manufactured for the year ended 31 December 2011 (in €million) €m

Direct materials used Direct manufacturing labour costs Indirect manufacturing costs: Property tax on plant building Plant utilities Depreciation of plant building Depreciation of plant equipment Plant repairs and maintenance Indirect manufacturing labour costs Indirect materials used Miscellaneous plant overhead Manufacturing costs incurred during 2011 Add opening work in progress stock, 1 January 2011 Total manufacturing costs to account for Deduct closing work in progress stock, 31 December 2011 Cost of goods manufactured

€m 13.05 15.10

0.45 2.56 1.35 1.65 2.40 3.45 1.65 0.60

14.10 32.25 3.00 35.25 3.90 31.35

Schedule of cost of goods sold for the year ended 31 December 2011 (in €million) €m Opening finished goods, 1 January 2011 4.05 Cost of goods manufactured (above) 31.35 Cost of goods available for sale 35.40 Closing finished goods, 31 December 2011 5.10 Cost of goods sold 30.30

2.18

Income statement and schedule of cost of goods manufactured. (25–30 min) Howell Ltd Income Statement for the Year Ended 31 December 2011 (in £millions) £m

Revenues Cost of goods sold: Opening finished goods, 1 January 2011 Cost of goods manufactured (below) Cost of goods available for sale Closing finished goods, 31 December 2011 Gross margin Marketing, distribution and customer-service costs Operating income

70 645 715 55

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£m 950

660 290 240 50

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Howell Ltd Schedule of cost of goods manufactured for the year ended 31 December 2011 (in £millions) £ Direct materials costs: Opening stock, 1 January 2011 Purchases of direct materials Cost of direct materials available for use Closing stock, 31 December 2011 Direct materials used Direct manufacturing labour costs Indirect manufacturing costs: Indirect manufacturing labour Plant supplies used Plant utilities Depreciation – plant, building and equipment Plant supervisory salaries Miscellaneous plant overhead Manufacturing costs incurred during 2011 Add opening work in progress stock, 1 January 2011 Total manufacturing costs to account for Deduct closing work in progress, 31 December 2011 Cost of goods manufactured

2.19

£

15 325 340 20 320 100 60 10 30 80 5 35

220 640 10 650 5 £645

Interpretation of statements. (20–25 min) 1

The schedule in 2.18 can become a schedule of cost of goods manufactured and sold simply by including the opening and closing finished goods stock figures in the supporting schedule, rather than directly in the body of the income statement. Note that the term cost of goods manufactured refers to the cost of goods brought to completion (finished) during the accounting period, whether they were started before or during the current accounting period. Some of the manufacturing costs incurred are held back as costs of the closing work in progress; similarly, the costs of the opening work in progress stock become a part of the cost of goods manufactured for 2005.

2

The sales manager’s salary would be charged as a marketing cost as incurred by both manufacturing and merchandising companies. It is basically an operating cost that appears below the gross margin line on an income statement. In contrast, an assembler’s wages would be assigned to the products worked on. Thus, the wages cost would be charged to work in progress and would not be expensed until the product is transferred from finished goods stock to cost of goods sold as the product is sold.

3

The direct–indirect distinction can be resolved only with respect to a particular cost object. For example, in defence contracting, the cost object may be defined as a contract. Then, a plant supervisor’s salary may be charged directly and wholly to that single contract.

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4

Direct materials used = £320,000,000 ÷ 1,000,000 units = £320 per unit. Depreciation = £80,000,000 ÷ 1,000,000 units = £80 per unit.

2.20

5

Direct materials unit cost would be unchanged at £320. Depreciation unit cost would be £80,000,000 ÷ 1,200,000 = £66.67 per unit. Total direct materials costs would rise by 20% to £384,000,000, whereas total depreciation would be unaffected at £80,000,000.

6

Unit costs are averages and they must be interpreted with caution. The £320 direct materials unit cost is valid for predicting total costs because direct materials is a variable cost; total direct materials costs indeed change as output levels change. However, fixed costs like depreciation must be interpreted quite differently from variable costs. A common error in cost analysis is to regard all unit costs as one – as if all the total costs to which they are related are variable costs. Changes in output levels (the denominator) will affect total variable costs, but not total fixed costs. Graphs of the two costs may clarify this point; it is safer to think in terms of total costs than in terms of unit costs.

Finding unknown balances. (20–25 min)

Let G = given, I = inferred. Step 1:

Use gross margin formula

Case 1

Case 2

Revenues

£32,000G

£31,800G

Cost of goods sold

A 20,700I

Gross margin Step 2:

11,300G

Use schedule of cost of goods manufactured formula Direct materials used

Case 1

C 11,800I Case 2

£8,000G

£2,000G

Direct manufacturing labour costs

3,000G

5,000G

Indirect manufacturing costs

7,000G

Manufacturing costs incurred

18,000I

Add opening work in progress, 1 January Total manufacturing costs to account for

0G 18,000I

Deduct closing work in progress, 31 December Cost of goods manufactured Step 3:

20,000G

Use cost of goods sold formula

0G 18,000I Case 1

D 6,500I 23,500I 800G 24,300I 3,000G 21,300I Case 2

Opening finished goods stock, 1 January

£4,000G

£4,000G

Cost of goods manufactured

18,000I

21,300I

Cost of goods available for sale

22,000I

25,300I

Closing finished goods stock, 31 December Cost of goods sold

B 1,300I

5,300G

20,700I

20,000G

For case 1, do steps 1, 2 and 3 in order. For case 2, do steps 1, 3 and then 2.

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2.21

Fire loss, computing stock costs. (30–40 min) 1

€50,000

2

€28,000

3

€62,000

This problem is not as easy as it first appears. These answers are obtained by working from the known figures to the unknowns in the schedule below. The basic relationships between categories of costs are: Prime costs (given)

= €294,000

Direct materials used

= €294,000

Direct manufacturing labour costs = €294,000 – €180,000 = €114,000 Conversion costs

= Direct manufacturing labour costs ÷ 0.6 €180,000 ÷ 0.6 = €300,000

Indirect manufacturing costs

= €300,000 – €180,000 = €120,000 (or 0.40 = €300,000)

Schedule of Calculations € Direct materials, 1 January 2011

16,000

Direct materials purchased

160,000

Direct materials available for use

176,000

Direct materials, 26 February 2011

3

=

Direct materials used (€294,000 – €180,000)

114,000

Direct manufacturing labour costs

180,000

Prime costs

294,000

Indirect manufacturing costs

120,000

Manufacturing costs incurred during the current period

414,000

Add work in progress, 1 January 2011

34,000

Manufacturing costs to account for Deduct work in progress, 26 February 2011

448,000 2

=

Cost of goods manufactured

30,000

Cost of goods available for sale (given) Deduct finished goods, 26 February 2011

28,000 420,000

Add finished goods, 1 January 2011

450,000 1

Cost of goods sold (80% of €500,000)

2.22

62,000

=

50,000 €400,000

Comprehensive problem on unit costs, product costs. (30 min) 1

If 2 kg of direct materials are used to make each unit of finished product, 100,000 units × 2 kg or 200,000 kg were used at €l0.70 per kg of direct materials (€140,000 ÷ 200,000 kg). Therefore, the closing stock of direct materials is 2000 kg × €0.70 = €1,400.

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2

Manufacturing costs for 100,000 units Variable Direct materials costs

Fixed

Total

€140,000

€

€140,000

30,000

–

30,000

5,000

–

5,000

Direct manufacturing labour costs Plant energy costs Indirect manufacturing labour costs

10,000

16,000

26,000

Other indirect manufacturing costs

8,000

24,000

32,000

€193,000

€40,000

€233,000

Cost of goods manufactured Average unit manufacturing cost:

€233,000 ÷ 100,000 units = €2.33 per unit

Finished goods stock in units:

=

€20,970 (given) €2.33 per unit

= 9000 units

3

Units sold in 2011 = Opening stock + Production – Closing stock = 0 + 100,000 – 9000 = 91,000 units Selling price per unit in 2011 = €436,800 ÷ 91,000 = €4.80 per unit

4

Revenues (91,000 units sold × €4.80) Cost of units sold: Opening finished goods, 1 January 2011 Cost of goods manufactured Cost of goods available for sale Closing finished goods, 31 December 2011 Gross margin

€436,800 € 233,000 233,000 20,970

Operating costs: Marketing, distribution and customer-service costs 162,850 Administrative costs 50,000 Operating income

0

212,030 224,770

212,850 € 11,920

Note: Although not required, the full set of unit variable costs are: Direct materials costs €1.40 Direct manufacturing labour costs 0.30 Plant energy costs 0.05 per unit manufactured Indirect manufacturing labour costs 0.10 Other direct manufacturing costs 0.08 Marketing, distribution and customer-service costs 1.35 per unit sold

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2.25

Revenue and cost recording and classifications, ethics. (25–30 min) 1

Concerns include: a

Total payments made by Aran Sweaters do not ‘appear’ to be adequately described. Elements of ‘total compensation’ appear to be: •

€12 million payment to O’Neil in Achill Island

•

€4.8 million payment to O’Neil subsidiary in Switzerland

•

Assistance with life insurance plans for ‘O’Neil executives at rates much more favourable than those available in Achill Island’.

One possible motivation for restricting the payment in Achill Island to €12 million is to avoid showing higher profits in Achill Island. A second motivation could be that the Swiss subsidiary is siphoning off revenues to O’Neil senior executives that should be paid to O’Neil. This could arise if the O’Neil Swiss subsidiary is ‘owned’ by the senior executives of O’Neil rather than being a 100% subsidiary of O’Neil. The assistance with the insurance plans is in the grey area. If O’Neil is willing to accept a lower price in return for Aran Sweaters assisting with the insurance plans, it may be a judicious economic decision by Aran Sweaters. Aran Sweaters is not hurt economically in this scenario. The concern is whether Aran Sweaters is assisting the senior executives to divert ‘de facto’ payments to themselves. b

Product design costs of Aran Sweaters include €4.8 million for ‘own product design’. It is stated that the director of product design views it ‘as an “offstatement” item that historically he has neither responsibility for nor any say about’ and that ‘to his knowledge, O’Neil uses only Aran Sweaters designs with either zero or minimal changes’. It may be that the €4.8 million payment is a hidden payment made to avoid Achill Island taxation. However, the result is incorrect classification of product design costs at Aran Sweaters.

c

O’Neil receives from Aran Sweaters the margin between €16.8 million (€12 million + €4.8 million) and the €3 million payment for wool, i.e. €13.8 million. Note that Aran Sweaters can assist O’Neil to meet the 25% ratio of ‘domestic labour costs to total costs’. Charging €6.00 million for wool and receiving €19.8 million for sweaters will result in the same €13.8 million margin, but will mean O’Neil will not meet the 25% test as total costs will now be €13 million instead of €10 million. Aran Sweaters has to ensure it takes an arm’s length in its approach to supply contracts and purchase contracts or else it may be accused by the Achill Island government of assisting O’Neil to avoid local taxes.

Note: Some students will ask whether O’Neil should be able to classify labour fringe benefits as a domestic labour cost. This is not Sheridan’s domain given that she is controller of Aran Sweaters. Her concern with the Achill Island tax rebate is whether Aran Sweaters is being ‘pressured’ to adjust its billing amounts to facilitate O’Neil to have a ratio of ‘domestic labour costs to total costs’ exceeding 25%. If you want to discuss this issue, point out that labour-fringe benefits are typically an integral part of labour costs. Hence, if they can be traced, O’Neil is justified in including them in domestic labour costs.

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2

There are a variety of ethical issues relating primarily to competence and integrity that Sheridan faces: a

3

Is Aran Sweaters assisting O’Neil to avoid income taxes in Achill Island either: •

by funnelling €4.8 million to a Swiss company rather than to O’Neil in Achill Island or

•

by understating both the €3 million wool supply cost and the €16.8 total revenue amount?

b

Is Aran Sweaters assisting senior executives of O’Neil to enrich themselves at the expense of the shareholders of O’Neil?

c

Are the accounting records of Aran Sweaters properly reflecting the underlying activities?

Steps Sheridan could take include: a

Seeking further information on why the €4.8 million payment is being made to the Swiss subsidiary. This should be done first internally and then by speaking to O’Neil executives.

b

Ensure product design costs at Aran Sweaters reflect actual product design work. So-called ‘off-statement’ items should be eliminated if no adequate explanation can be given for them.

c

Ensure Aran Sweaters personnel follow any company guidelines about supply relations or customer relations. There is nothing inherently wrong with assisting O’Neil negotiate a better insurance package for its executives. The concern is whether developing a ‘too cosy’ relationship will lead to more questionable practices being overlooked.

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CHAPTER 3

Job-costing systems Teaching tips and points to stress Building block concept of costing systems Emphasise that students must master the building block concept of costing systems. This concept is equally applicable to service, merchandising and manufacturing sectors. It is relatively easy to determine ‘accurate’ costs for a company with only a few services/products. However, many companies have increased the diversity of their product lines over the past 30 years. These different products/services use differential amounts of common resources (e.g. electricity) and this makes it harder to determine accurate costs. This is one reason for companies’ renewed interest in their costing systems.

Job-costing and process-costing systems To focus on the ‘big picture’, emphasise that management accounting provides information for: 1

Planning and control – management accounting systems accumulate costs by department to compare with budgeted costs for performance evaluation.

2

Product/service costing – just as financial accounting requires many choices in determining income, management accounting requires many choices to determine the costs of services and products.

Job costing in service organisations using actual costing Why do service firms need costs of individual jobs? Not for costing stock, because there is none. Rather, service firms use job-cost information for cost management, profitability analysis and pricing. Accurate cost information is especially important in public accounting firms where competition is fierce.

Normal costing Normal costing arose because managers did not want to wait for cost information until actual indirect-cost rates are calculated at year-end. The only difference between actual costing and normal costing is that normal costing uses a budgeted OH rate – all other elements of costing are at actual rates and quantities.

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Job costing in manufacturing Emphasise that Chapter 3 explains how manufacturing costs are attached to products. The cost to manufacture a product is necessary for external reporting (e.g. stock and CGS) and internal decisions (e.g. pricing). Concepts introduced here provide a foundation for subsequent topics including relevant costs and pricing, cost allocation, progress costing, flexible budgets and variance, analysis and operations and backflush costing.

Budgeted indirect costs and end-of-period adjustments Underallocated MOH (UAO) and overallocated MOH (OAO) arise for two reasons: (1) the numerator reason, actual MOH costs ≠ budgeted MOH costs and/or (2) the denominator reason, actual quantity of the allocation base consumed ≠ budgeted quantity. In the Wallace Co. example, budgeted MOH is €1,280,000, whereas actual MOH is €1,200,000, so the numerator reason leads to €80,000 OAO (budgeted costs ≥ actual costs). However, actual MHs (the allocation base) were only 12,500 rather than the budgeted 16,000 MH. The denominator reason leads to (16,000 MH – 12,500 MH × €80/MH budgeted MOH rate) = €280,000 UAO. The net effect is €280,000 UAO – €80,000 OAO = €200,000 UAO. The adjusted allocation rate approach to under- or overallocated MOH ‘corrects’ account balances to what they would have been, had accountants had a crystal ball and forecasted MOH cost and quantity of the allocation base perfectly. The feasibility of implementing the adjusted rate approach increases as information progressing costs decline. Proration based on the total amount of indirect costs allocated (method 1) corrects WIP, FG and CGS control closing balances to what they would have been under actual costing, yielding the same closing balances as the adjusted allocation rate approach. The difference is that the adjusted allocation rate method also corrects the individual jobs, whereas proration method 1 corrects only the control account closing balances. It is conceptually preferable to prorate on the basis of the amount of MOH allocated embedded in each account’s EB (method 1). This yields the EB that would have been obtained had the correct (i.e. actual) MOH rate been used. However, many companies that prorate UAO/OAO do so via the EB method (method 2) because the EB of WIP, FG and CGS are readily available. In contrast, the amount of MOH – allocated embedded in EB – may be more difficult to obtain.

Solutions to review questions 3.1

Cost pool – a grouping of individual cost items. Cost tracing – the assigning of direct costs to the chosen cost object. Cost allocation – the assigning of indirect costs to the chosen cost object. Cost allocation base – a factor that is the common denominator for systematically linking an indirect cost or a group of indirect costs to a cost object.

3.2

No. For most service-sector companies, labour is the single largest cost category. For example, labour costs comprise over 70% of the total costs of many law firms.

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3.3

In a job-costing system, costs are assigned to a distinct unit, batch or lot of a product or service. In a progress-costing system, the cost of a product or service is obtained by using broad averages to assign costs to masses of similar units.

3.4

An advertising campaign for Pepsi is likely to be very specific to that individual client. Job costing enables all the specific aspects of each job to be identified. In contrast, the progressing of cheque account withdrawals is similar for many customers. Here, progress costing can be used to compute the cost of each cheque account withdrawal.

3.5

Actual costing and normal costing differ in their use of actual or budgeted direct- or indirect-cost rates.

3.6

The two major goals of a job-costing system are (i) to assist in the cost management of departments and (ii) to determine the cost of individual jobs.

3.7

A cost allocation base is a factor that is the common denominator for systematically linking an indirect cost or a group of indirect costs to a cost object. The role of a manufacturing overhead allocation base is to systematically link manufacturing overhead costs to cost objects such as products, projects or customers.

3.8

Under- or overallocation of indirect (overhead) costs can arise because of (a) the numerator reason – the actual overhead costs differ from the budgeted overhead costs and (b) the denominator reason – the actual quantity used of the allocation base differs from that of the budgeted quantity.

3.9

Alternative ways to make end-of-period adjustments for under- or overallocated overhead are:

3.10

a

Proration based on the total amount of indirect costs allocated (before proration) in the closing balances of work in progress, finished goods and cost of goods sold.

b

Proration based on total closing balances (before proration) in work in progress, finished goods and cost of goods sold.

c

Year-end write-off to cost of goods sold.

The adjusted allocation rate approach results in the most accurate record of individual job costs. It also gives the same closing balances of work in progress, finished goods and cost of goods sold that would have been reported had an actual indirect-cost rate been used. Proration approaches do not make any adjustment to individual job-cost records. Companies wanting an accurate record of job costs for pricing purposes, product profitability purposes and evaluating the performance of managers of those jobs will prefer the adjusted allocation rate approach.

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Solutions to exercises 3.12

Computing direct-cost rates, consulting firm. (15–20 min) 1 and 2

3

(a) Average salary + average fringe benefits (€)

(b) Billable time for clients

(c) Total time

(d) = (a) ÷ (b) Rate per billable hour (€)

(e) = (a) ÷ (c) Rate per total hour (€)

Director

200,000

1,600

2,000

125.00

100

Partner

150,000

1,600

2,000

93.75

75

Associate

80,000

1,600

2,000

50.00

40

Assistant

50,000

1,600

2,000

31.25

25

The difference between requirements 1 and 2 is the denominator. Using only billable time as the denominator results in the hours associated with vacation, sick leave and professional development being built into the direct-cost rate for professional labour. Including vacation, sick leave and professional development in the denominator results in part of the total labour compensation not being assigned to jobs as part of the professional labour cost. In most cases, where this approach is used, the costs associated with vacation, sick leave and professional development are included in the indirect costs assigned to jobs.

3.13

3.14

Accounting for manufacturing overhead. (15 min) 1

Budgeted manufacturing overhead rate €7,000,000 ÷ 200,000 = €35 per machine-hour

2

Work in progress control Manufacturing overhead allocated (195,000 machine-hours ÷ €35 = €6,825,000)

3

€6,825,000 – €6,800,000 = €25,000 overallocated, an insignificant amount Manufacturing overhead allocated €6,825,000 Manufacturing department overhead control €6,800,000 Cost of goods sold €25,000

€6,825,000 €6,825,000

Proration of overhead. (20 min) 1

Budgeted manufacturing overhead rate is €4,800,000 ÷ 80,000 = €60 per machinehour.

2

Manufacturing overhead underallocated = manufacturing overhead incurred – manufacturing overhead allocated = €4,900,000 – €4,500,000* = €400,000 * €60 × 75,000 actual machine-hours = €4,500,000.

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(a) Account

End-of-year balance (before proration) (€)

Proration of €400,000 underallocated manufacturing overhead (€)

Balance (after proration) (€)

750,000

0

750,000

Finished goods

1,250,000

0

1,250,000

Cost of goods sold

8,000,000

400,000

8,400,000

10,000,000

400,000

10,400,000

Work in progress

Total

(b) Account

End-of-year balance (before proration) (€)

Proration of €400,000 underallocated manufacturing overhead (€)

Balance (after proration) (€)

750,000 (7.5%)

0.075 × €400,000 = €30,000

780,000

Finished goods

1,250,000 (12.5%)

0.125 × €400,000 = 50,000

1,300,000

Cost sold

8,000,000 (80.0%)

0.800 × €400,000 = 320,000

8,320,000

10,000,000 (100.0%)

€400,000

10,400,000

Work in progress of

goods

Total

(c) Account

End-of-year balance (before proration) (€)

Work in progress

750,000

Allocated overhead component of end-ofyear balance (before proration) (€)

Proration of €400,000 underallocated manufacturing overhead

Balance (after proration) (€)

240,000 (5.33%)

0.0533 × €400,000 = €21,320

771,320

Finished goods

1,250,000

660,000 (14.67%)

0.1467 × €400,000 = 58,680

1,308,680

Cost of goods sold

8,000,000

3,600,000 (80.00%)

0.8000 × €400,000 = 320,000

8,320,000

10,000,000

450,000,000 (100.00%)

€400,000

10,400,000

Total

3

3.15

Alternative (c) is theoretically preferred to (a) and (b). Alternative (c) yields the same closing balances in work in progress, finished goods and cost of goods sold that would have been reported had actual indirect-cost rates been used. The chapter also discusses an adjusted allocation rate approach that results in the same closing balances as does alternative (c). This approach operates via a restatement of all the individual jobs worked on during the year rather than a restatement of closing balances.

Job costing with single direct-cost category, single indirect-cost pool and law firm. (15–20 min) 1

Pricing decisions at Tricheur are heavily influenced by reported cost numbers. Suppose Tricheur is bidding against Andrault & Maque for a client with a job similar to that of Morges-Guyère. If the costing system overstates the costs of these jobs, Tricheur may bid too high and fail to be hired by the client. If the costing system understates the costs of these jobs, Tricheur may bid low, be hired by the client and then lose money in handling the case. 32 © Pearson Education Limited 2012

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2

Panel A of Solution Exhibit 3.15 at the end of this question presents an overview of the single direct/single indirect (SD/SI) costing approach.

3 Morges-Guyère (€) Direct professional labour, €70 × 104; 96

Verrerie de Lausanne (€)

Total (€)

7,280

6,720

14,000

Indirect costs allocated, €105 × 104; 96

10,920

10,080

21,000

Total costs to be billed

18,200

16,800

35,000

Solution Exhibit 3.15 Alternative job-costing approaches for Tricheur.

3.16

Job costing; fill in the blanks. (20–30 min) 1. Key to filling in the unknowns on the Pablo Café job is to follow Exhibit 3.4. Actual costing

Normal costing

Direct job costs

€3,850

(€55 × 70)

€3,850

(€55 × 70)

Indirect job costs

€2,660

(€38 × 70)

€2,800

(€40 × 70)

Total job costs

€6,510

€6,650

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The road map to calculate these amounts is (g = given): €3,850 (€55g × 70g) €3,850 (€55g × 70g) €2,660g (€38 × 70g) €2,800 (€40 × 70g) Budgeted indirect-cost rate (NC) = €2,800 ÷ 70 = €40 per hour €2,800 (€40 × 70) – same as for indirect job costs for normal costing Direct job costs (AC) = €3,850 (€55g × 70g) Direct job costs (NC) = €3,850 (€55 × 70g) – same as for direct job costs for actual costing. Indirect job costs (AC) = €38.00 (€2,660g ÷ 70g) 2

From requirement 1, we have calculated: Actual rate (€)

Budgeted rate (€)

Direct-cost rate

55

60

Indirect-cost rate

38

40

Hence, the unknowns for Eldorado for 2007–2008 are: Actual amounts for 2007–2008

Budgeted amounts for 2007–2008

1,155,002

1,080,000

21,000

18,000

798,000

720,000

Consulting labour compensation (€) Consulting labour-hours (hour) Consulting support costs (€)

The road map to compute these amounts is:

← Consulting ↑ Consulting

€1,080,000↑

21,000 hours←

18,000g hours

€798,000g

€720,0004

labour-hours (A)

labour compensation (A)

→ Consulting ↓ Consulting

€1,155,000↑

=

€798,000g

=

€1,155,000 (€55 × 21,000←)

labour compensation (B) =

support costs (B)

=

€1,080,000 (€60 × 18,000g) €720,000 (€40 × 18,000g)

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An overview of the Eldorado job-costing system is:

3.18

Job costing, journal entries. (30 min) 1

An overview of the product costing system is:

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2 1 2 3 4

5

6 7

Materials control Accounts payable control Work in progress control Materials control Manufacturing overhead control Materials control Work in progress control Manufacturing overhead control Wages payable control Manufacturing overhead control Accumulated – buildings and manufacturing equipment Manufacturing overhead control Miscellaneous accounts Work in progress control Manufacturing overhead allocated

(1.60 × €1,300 = €2,080) Finished goods control Work in progress control 9 Accounts receivable control (or cash) Revenues 10 Cost of goods Sold Finished goods Control 11 Manufacturing overhead allocated Manufacturing overhead control Cost of goods sold

€800 €800 €710 €710 €100 €100 €1,300 €900 €2,200 €400 €400 €550 €550 €2,080 €2,080

8

€4,120 €4,120 €8,000 €8,000 €4,020 €4,020 €2,080 €1,950 €130

3 Materials control Bal. 31/12/09 1 Purchase

100 800

Bal. 31/12/10

2 3

Issues Issues

710 100

Goods completed

4,120

Goods sold

4,020

90 Work in progress control

Bal. 31/12/09 2 Direct materials 4 Direct manuf. labour 7 Manuf. overhead allocated Bal. 31/12/10

60 710 1,300

8

2,080 4,150 30 Finished goods control

Bal. 31/12/09

500

10

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8

Goods completed Bal. 31/12/10

4,120 600 Cost of goods sold

10

Goods sold

4,020

Bal. 31/12/10

11

Adjust for over-allocation

130

3,890 Manufacturing overhead control

3 4 5 6

Supplies Indirect manuf. labour Depreciation Miscellaneous

100 900 400 550 1,950

Bal.

11

To close

1,950

0 Manufacturing overhead allocated

11

3.19

2,080

7

2,080

Bal.

0

Job costing, journal entries and source documents. (20 min) The analysis of source documents and subsidiary ledgers follows: 1

2

3

4

5

6

7

a

Approved invoice

b

Credit. Materials record, ‘received’ column

a

Materials requisition record

b

Debit. Job-cost records Debit. Materials record, ‘issued’ column

a

Materials requisition record

b

Debit. Department overhead cost records, appropriate column Credit. Materials record, ‘issued’ column

a

Summary of time records or daily time analysis. This summary is sometimes called a labour cost distribution summary.

b

Debit. Job-cost records debit. Department overhead cost records, appropriate columns for various classes of indirect labour

a

Special authorisation from the responsible accounting officer

b

Debit. Department overhead cost records, appropriate columns

a

Various approved invoices and special authorisations

b

Debit. Department overhead cost records, appropriate columns

a

Use of an authorised budgeted manufacturing overhead rate

b

Debit. Job-cost record

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8

a

Completed job-cost records

b

Debit. Finished goods records Credit. Job-cost record

9

a

Approved sales invoice

b

Debit. Customers’ accounts (or cash) Credit. Sales ledger, if any

10 a b 11 a b 3.21

Costed sales invoice Credit. Finished goods records Special authorisation from the responsible accounting officer Subsidiary records are generally not used for these entries

Job costing, accounting for manufacturing overhead, budgeted rates. (25–30 min.) 1

An overview of the product-costing system is:

Budgeted manufacturing overhead divided by allocation base: a

Machining overhead:

€1,800,000 = €36 per machine-hour 50,000 b

Assembly overhead: €3,600,000 = 180% of direct labour costs €2,000,000

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Machining overhead, 2,000 hours × €36 = €72,000

2

Assembly overhead, 180% of €15,000 = €27,000 Total manufacturing overhead allocated = €99,000 3 Actual manufacturing overhead

Machining

Assembly

€2,100,000

€3,700,000

€120,000

€(260,000)

Manufacturing overhead allocated, 55,000 × €36 = €1,980,000 Underallocated (Overallocated)

3.22

Overview of general-ledger relationships. (30–40 min)

1 and 3 An effective approach to this problem is to draw T-accounts and insert all the known figures. Then, working with T-account relationships, solve for the unknown figures (here coded by the letter X for opening stock figures and Y for closing stock figures). Materials control X Purchases

15,000 85,000 100,000

Y

(1)

70,000 70,000

30,000 Work in progress control

X (1) DM (2) DL (3) Overhead

10,000 70,000 150,000 90,000

(4)

305,000

310,000

(a) (c)

320,000 5,000 3,000

Y

23,000

305,000

Finished goods control X (4)

20,000 305,000

(5)

325,000 Y

25,000

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300,000 300,000

Bhimani, Horngren, Datar and Rajan, Management and Cost Accounting, 5th Edition, Instructor’s Manual

Cost of goods sold (5)

300,000

(d)

6,000

Manufacturing department overhead control 85,000 1,000 1,000

(a) (b)

(d)

87,000

(3) (c)

90,000 3,000

(a)

6,000

(b)

1,000

Manufacturing overhead allocated (d)

93,000

Manufacturing overhead cost rate = €90,000 ÷ €150,000 = 60% Wages payable control

Various accounts

2

Adjusting and closing entries: a Work in progress control Manufacturing Department overhead control Wages payable control To recognise payroll costs b Manufacturing Department overhead control Various accounts To recognise miscellaneous manufacturing overhead c Work in progress control Manufacturing overhead allocated To allocate manufacturing overhead

€5,000 1,000 €6,000 €1,000 €1,000

€3,000 €3,000

Note: Students tend to forget entry (c) entirely. Stress that a budgeted overhead allocation rate is used consistently throughout the year. This point is a major feature of this problem. d

Manufacturing overhead allocated Manufacturing Department overhead control To close manufacturing overhead accounts and overallocated overhead to cost of goods sold

€93,000

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€87,000

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An overview of the product-costing system is:

3

See the answer to 1

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CHAPTER 4

Process-costing systems Teaching tips and points to stress Illustrating process costing Before discussing process costing, it is helpful to review the mechanics of WA and first-in, firstout (FIFO) cost flow assumptions in a simple financial accounting context: Opening stock

200 units @ €1

Purchases

100 units @ €3

What is the cost/unit of 250 units sold? Weighted average: 200 @ €1 = €200 100 @ €3 = €300 300

€500 → €500/300 = €1.67/unit

FIFO: We first sell the 200 units of opening stock which are costed at €1 each. The next 50 units are from current purchases, costed at €3 each. WA mingles the opening stock with the current cost layers while FIFO keeps the layers distinct. These cost flow assumptions work the same way in process costing.

Case 1 Without WIP, process costing is quite straightforward because the cost/unit simply equals total costs/total units. When there are no partially complete units, no EU calculations are needed. Ask students what kinds of firms would be likely to fit Case 1 (process costing with no WIP stock): firms with highly perishable stock (e.g. many food processors, milk processors, newspaper publishers, etc.), financial service firms that must process transactions daily (e.g. bank deposits or withdrawals), firms that have adopted virtually no WIP stock. What kinds of firms would not meet the criteria for Case 1? Those for whom the nature of the business dictates large WIP stock (e.g. wineries, textiles).

Case 2 The second case adds the complication of closing WIP. Remind students that the overall goal is to calculate manufacturing cost/unit: =

Total manufacturing cost number of units

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Partially completed closing WIP complicates this calculation. The four-step procedure shows how to use EU to adjust for incomplete units. Suggest that students draw timelines of the production processes for process-costing problems to clarify what costs will have to be added to this period to complete the units. The February timeline for defence is: Assembly DM Added

Testing 60%

DM Added

Closing WIP Use this timeline to explain the logic behind the EU calculations. In assembly, production begins with DMs that are assembled. As soon as the units begin production, they are 100% complete as to materials. The closing WIP is 60% of the way through Assembly at the end of February. It already contains all its DM but has only 60% of the conversion costs. Thus, closing WIP is at different stages of completion with respect to the different inputs. The timeline makes it clear that the closing WIP will be completed during March by adding the remaining 40% of the conversion costs to complete the units. The accuracy of the product costs hinges critically on the accuracy of the percentage of completion estimation, especially when the WIP is large (e.g. wineries). Students are often confused about when a separate EU calculation is necessary. Emphasise that whenever a factor of production is added at a different stage in the production process, a separate EU computation is required. In the Euro-Défense illustration, suppose steel is added at the beginning of the Assembly process and electronics are added two-thirds of the way through Assembly, closing WIP that is 60% complete would have steel but not electronics. We need separate EU calculations for steel and electronics of DM. (Many students erroneously believe that the number of EU should be the same for all DM.) For simplicity, the examples assume that all conversion costs (labour, material handling, utilities, etc.) are incurred uniformly throughout the process. That is, a unit that is 70% complete has incurred 70% of the labour, material handling and utility costs. Extension to multiple cost categories (that are incurred in different patterns throughout the production process) would simply involve calculating separate EU and costs for each indirect cost category.

Case 3 The percentage completion is the percentage complete at that point of time. If opening stock was 40% complete, 40% of the work was completed last period. The remaining 60% will be done in the current period to complete the units. Conversely, if closing stock is 40% complete, the closing stock will be done next period. As the problems become more complex, timelines become more helpful. Consider the following timeline for the Euro-Défense illustration’s March data:

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Assembly 40% DM Added S&C

Testing 60% DM Added Closing WIP

Opening WIP

The timeline shows that during March, Euro-Défense finished the opening WIP by adding the remaining 40% of the CC (all DM were added to the opening WIP during February). They started and completed units, adding 100% of both DM and CC. Finally, they started closing WIP by getting these units 40% of the way through the Assembly process. These closing WIP units have all their DM and 40% of their CC. In April, Euro-Défense will finish these units by adding the remaining 60% of the CC.

Comparison of weighted-average and FIFO methods In the Euro-Défense example, the unit cost declines over time. This is consistent with the continuous improvement theme highlighted in Chapter 1. It should be clear to students from their financial accounting courses that when costs are declining, FIFO yields the lowest stock valuation (because the latest, lowest cost units are still in closing stock) and the highest CGS.

Transferred-in costs in process costing Students have trouble with transfers-in. In the Euro-Défense example, units cannot begin Testing until they are completely assembled. These transferred-in (TI) Assembly Department costs act like DM, which are added at the very beginning of the Testing process. A timeline helps students understand the process. Assembly 62.5% DM Added Opening stock

S&C

Testing 80% DM Added Closing stock

During the current period, the testing process at Euro-Défense will: Finish the Opening stock

(0% TI, 37.5% CC, 100% DM)

S&C

(100% of TI, CC and DM)

Start the Closing stock

(100% TI, 80% CC 0% DM)

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Solutions to review questions 4.1

Industries using process costing in their manufacturing area include chemical processing, oil refining, pharmaceutical, plastics, brick and tile manufacturing, semiconductor chips, beverages and breakfast cereals.

4.2

Process-costing systems separate costs into cost categories according to the timing of when costs are introduced into the process. Often, only two cost classifications, direct materials and conversion costs, are necessary. Direct materials are frequently added at one point in time, often the start or the end of the process, and all conversion costs are added at about the same time, but in a pattern different from direct materials costs.

4.3

The accuracy of the estimates of completion depends on the care and skill of the estimator and the nature of the process. Aircraft blades may differ substantially in the finishing that is necessary to obtain a final product. The amount of work may not always be easy to ascertain in advance.

4.4

The weighted-average process-costing method assigns the average equivalent unit cost of all work done to date (regardless of when it was done) to equivalent units completed and transferred out, and to equivalent units in closing stock.

4.5

FIFO calculations are distinctive because they assign the cost of the earliest equivalent units available (starting with equivalent units in opening work-in-progress stock) to units completed and transferred out, and the cost of the most recent equivalent units worked on during the period to closing work-in-progress stock. In contrast, the weighted-average method costs units completed and transferred out and in closing work in progress at the same average cost.

4.6

A major advantage of FIFO is that managers can judge the performance in the current period independently from the performance in the preceding period.

4.7

The journal entries in process costing are basically like those made in job-costing systems. The main difference is that, in process costing, there is often more than one work-in-progress account – one for each process.

4.8

There are two reasons why the accountant should distinguish between transferred-in costs and additional direct materials costs for a particular department: a

All direct materials may not be added at the beginning of the department process.

b

The control methods and responsibilities may be different for transferred-in items and materials added in this department.

4.9

No. Previous department costs (also called transferred-in costs) are costs incurred in a previous department that have been charged to a subsequent department. These costs may be costs incurred in that previous department during this accounting period or a preceding accounting period.

4.10

Materials are only one cost item. Other items (often included in a conversion costs pool) include labour, energy and maintenance. If the costs of these items vary over time, this variability can cause a difference when weighted average or FIFO is used. A second factor is the amount of stock on hand at the beginning or end of an accounting period. The smaller the amount of production held in opening or closing stock relative to the total number of units transferred out, the smaller the effect on operating income or stock amounts from use of weighted average or FIFO.

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Solutions to exercises 4.11

No opening stock. (25 min) 1

Direct materials cost per unit (€720,000 ÷ 10,000) Conversion cost per unit (€760,000 ÷ 10,000) Assembly Department cost per unit

€72 76 €148

2

Solution Exhibit 4.11A calculates the equivalent units of direct materials and conversion costs in the Assembly Department of Europe Electronics SNC in February 2010. Solution Exhibit 4.11B calculates equivalent unit costs Direct materials cost per unit Conversion cost per unit Assembly Department cost per unit

3

€72 80 €152

The difference in the Assembly Department cost per unit calculated in requirements 1 and 2 arises because the costs incurred in January and February are the same but fewer equivalent units of work are done in February relative to January. In January, all 10,000 units introduced are fully completed resulting in 10,000 equivalent units of work done with respect to direct materials and conversion costs. In February, of the 10,000 units introduced, 10,000 equivalent units of work is done with respect to direct materials but only 9,500 equivalent units of work is done with respect to conversion costs. The Assembly Department cost per unit is therefore higher.

Solution Exhibit 4.11A

Steps 1 and 2: Summarise output in physical units and calculate equivalent units, Assembly Department of Europe Electronics SNC for February 2010.

(Step 1) Physical units

(Step 2) Equivalent units Direct Conversion materials costs

Flow of Production Completed and transferred out during current period Add work in progress, closing* 1,000 × 100%; 1,000 × 50% Total accounted for Deduct work in progress, opening Started during current period Work done in current period only *

9,000 1,000 00,000

9,000

9,000

1,000

500

10,000 0 10,000

10,000 0

9,500 0

10,000

9,500

Degree of completion in this department: direct materials, 100%; conversion costs, 50%.

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Solution Exhibit 4.11B

Step 3: Calculate equivalent unit costs, Assembly Department of Europe Electronics SNC for February 2010. Direct

Conversion

materials

costs

Costs added during February (given)

€720,000

€760,000

Divide by equivalent units of work done in February 2010 (from Solution Exhibit 4.11A)

÷ 10,000

÷ 9,500

€72

€80

Cost per equivalent unit of work done in February 2010

4.13

Equivalent units and equivalent unit costs. (25 min) 1 and 2 Solution Exhibit 4.13A shows equivalent units of work done in the current period. Solution Exhibit 4.13B calculates cost per equivalent unit of opening work in progress and of work done in the current period.

Solution Exhibit 4.13A

Steps 1 and 2: Summarise output in physical units and calculate equivalent units, Assembly Division of Aéro-France for May 2010. (Step 2) Equivalent units

(Step 1) Physical units

Flow of production

Direct materials

Conversion costs

Completed and transferred out during current period Add work in progress, closing*

46 12

46.0

46.0

12 × 60%; 12 × 30% Total accounted for § Deduct work in progress, opening

__ 58 8

7.2 53.2

3.6 49.6

8 × 90%; 8 × 40% Started during current period Work done in current period only

__ 50

7.2 ____ 46.0

3.2 ____ 46.4

____________________________________________________________________________ *

Degree of completion in this department: direct materials, 60%; conversion costs, 30%.

§

Degree of completion in this department: direct materials, 90%; conversion costs, 40%.

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Solution Exhibit 4.13B

Step 3: Calculate equivalent unit costs, Assembly Division of Aéro-France for May 2010. Direct materials

Conversion costs

Equivalent unit costs of opening work in progress Work in progress, opening (given) Divide by equivalent units of opening work in progress (from Solution Exhibit 4.13A) Cost per equivalent unit of opening work in progress

€4,968,000

€928,000

÷ 7.2

÷ 3.2

€690,000

€290,000

€32,200,000

€13,920,000

÷ 46

÷ 46.4

€700,000

€300,000

Equivalent unit costs of work done in current period only Costs added in current period (given) Divide by equivalent units of work done in current period (from Solution Exhibit 4.13A) Cost per equivalent unit of work done in current period only

4.17

Transferred-in costs, weighted-average method. (35–40 min) 1

Solution Exhibit 4.17A calculates the equivalent tonnes of solvent completed and transferred out, and in closing work in progress for each cost element. The key steps to the calculations are: a

Fill in row 4 for equivalent units of opening work in progress as given in the exercise assignment. (Although not needed for doing the exercise, note that the physical units column is the same as the transferred-in column since all transferred-in units are always 100% complete.)

b

Fill in row 5 for equivalent units of work done in June 2010 as given in the exercise assignment.

c

Adding the numbers in rows 4 and 5 gives the numbers for row 3, the total tonnes to be accounted for.

d

Fill in row 1 with 90 (tonnes completed and transferred out).

e

Subtracting the numbers in row 1 from the numbers in row 3 gives the equivalent tonnes in closing work in progress for each cost element.

2

Solution Exhibit 4.17B presents calculations of equivalent unit costs under the weighted-average method.

3

Solution Exhibit 4.17C presents a summary of total costs to account for and assigns these costs to tonnes completed and to tonnes in closing work in progress using the weighted-average method.

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Solution Exhibit 4.17A

Steps 1 and 2: Summarise output in physical units and calculate equivalent units, Cooking Department of Telemark-Kjemi for June 2010. (Step 2) Equivalent units

(Step 1) Physical

Transferred-

Direct

Conversion

units

in costs

materials

costs

90

90

90

90

(30 × 100%; 30 × 0%; 30 × 50%) Total accounted for Deduct work in progress, opening†

30 120

30 120

0 90

15 105

(40 × 100%; 40 × 0%; 40 × 75%) Transferred in during current period Work done in current period only

40

40

0

30

80

80

90

75

Flow of production

Completed and transferred out during current period Add work in progress, closing*

*

Degree of completion in this department: transferred-in costs, 100%; direct materials, 0%; conversion costs, 50%, calculated by dividing equivalent units for each cost element by the physical units.

†

Degree of completion in this department: transferred-in costs, 100%; direct materials, 0%; conversion costs, 75%, calculated by dividing equivalent units for each cost element by the physical units.

Solution Exhibit 4.17B

Step 3: Calculate equivalent unit costs under the weighted-average method, Cooking Department of Telemark-Kjemi for June 2010. Transferred-in costs Equivalent unit costs of opening work in progress Work in progress, opening (given) Divide by equivalent units of opening work in progress (from Solution Exhibit 4.17A) Cost per equivalent unit of opening work in progress

Equivalent unit costs of work done in current period only Costs added in current period (given) Divide by equivalent units of work done in current period (from Solution Exhibit 4.17A)

Cost per equivalent unit of work done in current period only

Direct materials

Conversion costs

NKr 40,000

–

NKr 18,000

÷ 40

–

÷ 30

NKr 1,000

–

NKr 600

NKr 87,200

NKr 36,000

NKr 49,725

÷ 80

÷ 90

÷ 75

NKr 1,090

NKr 400

NKr 663

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Solution Exhibit 4.17C

Step 4: Summarise total costs to account for and assign these costs to units completed and units in closing work in progress using the weighted-average method, Cooking Department of Telemark-Kjemi for June 2010 (in NKr). Total Transferred-in

production

costs

Direct materials

Conversion costs

costs

______________________________________________________________________ Cost per Equivalent equivalent units

unit

(1)

(2)

(from Solution Exhibit 4.17B) 40 Work done in current period only (from Solution Exhibit 4.17B) 80 To account for 120

1,000

Cost per

Cost per

Total

Equivalent

equivalent

Total

costs

units

unit

costs

(3)=(1)×(2)

(4)

*

40,000

0

*

87,200 127,200

90 90

(5)

(6)=(4)×(5)

Equivalent equivalent

Total

units

unit

costs

(10)=

(7)

(8)

(9)=(7)×(8)

(3)+(6)+(9)

Panel A: Total costs to account for work in progress, opening

1,090 1,060*

†

–

0

400 400†

400

30

600

18,000

58,000

36,000 36,000

75 105‡

663 645‡

49,725 67,725

172,925 230,925

36,000**

90**

645

58,050

189,450

0* 36,000

15** 105

645

9,675 67,725

41,475 230,925

Panel B: Assignment of costs Completed and transferred out: ** (90 physical tonnes) Work in progress closing (30 physical tonnes) Accounted for

90**

1,060*

95,400**

30** 120

1,060*

31,800** 127,200

**

90** 0** 90

–

*

Weighted-average cost per equivalent unit of transferred-in costs = Total transferred-in costs divided by total equivalent units of transferred-in costs = NKr 127,200 ÷ 120 = NKr 1,060. **

From Solution Exhibit 4.17A.

†

Weighted-average costs per equivalent unit of direct materials = Total direct materials costs divided by total equivalent units of direct materials = NKr 36,000 ÷ 90 = NKr 400. ‡

Weighted-average cost per equivalent unit of conversion costs = Total conversion costs divided by total equivalent units of conversion costs = NKr 67,725 ÷ 105 = NKr 645.

4.18

Transferred-in costs, FIFO method. (35–40 min) 1

The calculations for equivalent tonnes of solvent completed and closing work in progress for each cost element are exactly as in requirement 1 of 4.17 shown in Solution Exhibit 4.17A.

2

Solution Exhibit 4.18A presents calculations of equivalent unit costs under the FIFO method.

3

Solution Exhibit 4.18B presents a summary of total costs to account for and assigns these costs to tonnes completed and to tonnes in closing work in progress using the FIFO method.

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Solution Exhibit 4.18A

Step 3: Calculate equivalent unit costs under the FIFO method, Cooking Department of Telemark-Kjemi for June 2010. Transferred-in costs Equivalent unit costs of opening work in progress Work in progress, opening (given) Divide by equivalent units of opening work in progress (from Solution Exhibit 4.17A) Cost per equivalent unit of opening work in progress Equivalent unit costs of work done in current period only Costs added in current period (given) Divide by equivalent units of work done in current period (from Solution Exhibit 4.17A) Cost per equivalent unit of work done in current period only

Direct materials

Conversion costs

NKr 39,200

–

NKr 18,000

÷ 40

–

÷ 30

NKr 980

–

NKr 600

NKr 85,600

NKr 36,000

NKr 49,725

÷ 90

÷ 75

NKr 400

NKr 663

÷ €80[AQ2] NKr 1,070

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Solution Exhibit 4.18B

Step 4: Summarise total costs to account for and assign these costs to units completed and units in closing work in progress using the FIFO Method, Cooking Department of Telemark-Kjemi for June 2010 (in NKr). Total Transferred-in costs

production Direct materials

Cost per Equivalent equivalent Total Equivalent units unit costs units (1) (2) (3)=(1)×(2) (4)

Conversion costs

Cost per Cost per equivalent Total Equivalent equivalent unit costs units unit (5) (6)=(4)×(5) (7) (8)

costs Total costs (9)=(7)×(8)

(10)= (3)+(6)+(9)

Panel A: Total costs to account for work in progress, opening (from Solution Exhibit 4.18A)

40

980*

Work done in current period only (from Solution Exhibit 4.18A)

80

1,070*

To account for

120

39,200

0

–

85,600

90

124,800

90

39,200

0

0 39,200

40† 40

53,500

50 ||

92,700

§

400 †

0 36,000

30

600

75

663

105‡

36,000

18,000 49,725

57,200 171,325

67,725

228,525

18,000

57,200

6,630 24,630

22,630 79,830

Panel B: Assignment of costs Completed and transferred out: (90 physical tonnes) Work in progress, opening (40 physical tonnes)

40

Work done in current period to complete opening * work in progress 0** Total from opening stock 40 Started and completed || (50 physical tonnes) 50 || Total completed and transferred § out (90 physical tonnes) 90§ Work in progress, closing § (30 physical tonnes) 30§ Accounted for 120

980*

1,070*

1,070

*

32,100 124,800

–

90§ §

0 90

400

400

0

30

16,000‡ 16,000 20,000||

600

10‡ 40

663

50 ||

663

90§

36,000 §

0 36,000

§

15 105

663

33,150

106,650

57,780

186,480

9,945 67,725

42,045 228,525

*

Opening work in progress is 100% complete as to transferred-in costs, so zero equivalent tonnes of transferred-in costs need to be added to complete opening work in progress.

†

Opening work in progress is 0% complete as to direct materials, which equals 0 equivalent tonnes of direct materials. To complete the 40 physical tonnes of opening work in progress, 40 equivalent tonnes of direct materials need to be added.

‡

Opening work in progress is 75% complete as to conversion costs, which equals 30 equivalent tonnes of conversion costs. To complete the 40 physical tonnes of opening work in progress, 10 (40 − 30) equivalent tonnes of conversion costs need to be added.

||

90 total equivalent tonnes completed and transferred out (Solution Exhibit 4.17A) minus 40 equivalent tonnes completed and transferred from opening stock equals 50 equivalent tonnes.

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4.19

Transferred-in costs, standard costing method. (35–40 min) 1

The calculations for equivalent tonnes of solvent completed and closing work in progress for each cost element are exactly as in requirement 1 of Exercise 4.17 shown in Solution Exhibit 4.17A.

2

Equivalent unit costs per tonne for each cost category are given in the exercise: Transferred-in costs NKr 1,050 Direct materials 390 Conversion costs 640

3

Solution Exhibit 4.19 presents a summary of total costs to account for and assigns these costs to tonnes completed and to tonnes in closing work in progress using the standard costing method.

Solution Exhibit 4.19[AQ3]

Step 4: Summarise total costs to account for and assign these costs to units completed and to units in closing work in progress using standard costs, Cooking Department of Telemark-Kjemi for June 2007 (in NKr). Transferred-in costs

Direct materials

Total production costs

Conversion costs

_________________________________________________________ Cost per Equivalent equivalent

Panel A: Total costs to account for work in progress, opening Work done in current period only To account for

Equivalent

Cost per equivalent

Total

costs

units

unit

costs

units

unit

(1)

(2)

40 80 120

1,050* 1,050*

42,000 84,000 126,000

1,050* 1,050*

Panel B: Assignment of costs Completed and transferred out: (90 physical tonnes) 90 Work in progress closing (30 physical tonnes) 30 Accounted for 120

4.20

Total (3)=(1)×(2)

(4)

Cost per Equivalent equivalent

Total

units

unit

costs

(10)=

(7)

(8)

(9)=(7)×(8)

(3)+(6)+(9)

(5)

(6)=(4)×(5)

0 90 90

390 390

0 35,100 35,100

30 75 105

640 640

19,200 48,000 67,200

61,200 167,100 228,300

94,500

90

390

35,100

90

640

57,600

187,200

31,500

0 126,000

390 90

0

15 35,100

640 105

9,600 67,200

41,100 228,300

Weighted-average method. (25 min) 1

Solution Exhibit 4.20A shows equivalent units of work done in the current period of Direct materials

80 equivalent units

Conversion costs

85 equivalent units

2

Solution Exhibit 4.20B calculates cost per equivalent unit of opening work in progress and of work done in the current period for direct materials and conversion costs.

3

Solution Exhibit 4.20C summarises the total Assembly Department costs for October 2010, and assigns these costs to units completed (and transferred out) and to units in closing work in progress using the weighted-average method.

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Solution Exhibit 4.20A

Steps 1 and 2: Summarise output in physical units and calculate equivalent units Assembly Department of Euro-Défense for October 2010.

(Step 1) Physical units

Flow of production Completed and transferred out during current period Add work in progress, closing † 10 × 100% ; 10 × 70%

*

Total accounted for Deduct work in progress, opening † 20 ×100% ; 20 × 60% Started during current period

§

Direct materials

Conversion Costs

90

90

90

10 __

10

7

100

100

97

20 __

20

12

80

__

__

80

85

Work done in current period only *

(Step 2) Equivalent units

Degree of completion in this department: direct materials, 100%; conversion costs, 50%.

†

Direct materials are 100% complete in work-in-progress stock since all direct materials are introduced at the beginning of the assembly process. §

Degree of completion in this department: direct materials, 100%; conversion costs, 60%.

Solution Exhibit 4.20B

Step 3: Calculate equivalent unit costs, Assembly Department of Euro-Défense for October 2010. Direct materials Equivalent unit costs of opening work in progress Work in progress, opening (given) Divide by equivalent units of opening work in progress (from Solution Exhibit 4.20A) Cost per equivalent unit of opening work in progress Equivalent unit costs of work done in current period only Costs added in current period (given) Divide by equivalent units of work done in current period (from Solution Exhibit 4.20A) Cost per equivalent unit of work done in current period only

Conversion costs

€460,000

€120,000

÷ 20 €23,000

÷ 12 €10,000

€2,000,000

€935,000

÷ 80 €25,000

÷ 85 €11,000

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Solution Exhibit 4.20C

Step 4: Summarise total costs to account for and assign these costs to units completed and units in closing work in progress using the weighted-average method, Assembly Department of EuroDéfense for October 2010 (in €). Total production Direct materials

Conversion costs

Cost per

Panel A: Total costs to account for Work in progress, opening (from Solution Exhibit 4.20B) Work done in current period only (from Solution Exhibit 4.20B) To account for Panel B: Assignment of costs Completed and transferred out: (90 physical units) Work in progress, closing (10 physical units) Accounted for

costs

Cost per

Equivalent

equivalent

Total

Equivalent

equivalent

Total

units

unit

costs

units

unit

costs

(1)

(2)

(3)=(1)×(2)

(4)

(5)

(6)=(4)×(5)

(7)=(3)+(6)

20

23,000

2,460,000

12

10,000.00

1,120,000

2,580,000

80 100

25,000 24,600*

2,000,000 2,460,000

85 97

11,000.00 10,876.29†

935,000 1,055,000

2,935,000 3,515,000

24,600

2,214,000

90‡

10,876.29

1,978,866

3,192,866

24,600

246,000 2,460,000

7‡ 97

10,876.29

76,134 1,055,000

322,134 3,515,000

90‡ ‡

10 100

*

Weighted-average cost per equivalent unit of direct materials = Total direct materials costs divided by total equivalent units of direct materials = €2,460,000 ÷ 100 = €24,600.

†

Weighted-average costs per equivalent unit of direct materials = Total conversion costs divided by total equivalent units of conversion costs = €1,055,000 ÷ 97 = €10,876.29.

‡

From Solution Exhibit 4.20A.

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4.21

FIFO method. (20 min) 1

The equivalent units of work done in the Assembly Department in October 2010 for direct materials and conversion costs are the same as in problem 4.20 and are shown in Solution Exhibit 4.20A.

2

The cost per equivalent unit of work done in the Assembly Department in October 2010 for direct materials and conversion costs are calculated in problem 4.20 in Solution Exhibit 4.20B.

3

Solution Exhibit 4.21 summarises the total Assembly Department costs for October 2010, and assigns these costs to units completed (and transferred out) and units in closing work in progress under the FIFO method. The cost per equivalent unit of opening stock and of work done in the current period differ:

Direct materials Conversion costs

Opening stock

Work done in current period

€23,000 €10,000

€25,000 €11,000

The following table summarises the costs assigned to units completed and those still in progress under the weighted-average and FIFO process-costing methods for our example. Weighted Average (Solution Exhibit 4.20C)

Cost of units completed and transferred out Work in progress, closing Total costs accounted for

€3,192,866 322,134 €3,515,000

FIFO (Solution Exhibit 4.21)

€3,188,000 327,000 €3,515,000

Difference

−€4,866 +€4,866

The FIFO closing stock is higher than the weighted-average closing stock by €4,866. This is because FIFO assumes that all the lower-cost prior-period units in work in progress are the first to be completed and transferred out while closing work in progress consists of only the highercost current-period units. However, the weighted-average method smoothes out cost per equivalent unit by assuming that more of the higher-cost units are completed and transferred out while some of the lower-cost units in opening work in progress are placed in closing work in progress. Hence, in this case, the weighted-average method results in a higher cost of units completed and transferred out and a lower closing work-in-progress stock relative to FIFO.

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Solution Exhibit 4.21

Step 4: Summarise total costs to account for and assign these costs to units completed and units in closing work in progress using the FIFO method, Assembly Department of Euro-Défense for October 2010 (in €). Total production Direct materials

Conversion costs

Cost per Equivalent

equivalent

Total

Equivalent

equivalent

Total

units

unit

costs

units

unit

costs

(1)

(2)

(3)=(1)×(2)

(4)

(5)

(6)=(4)×(5)

Panel A: Total costs to account for Work in progress, opening (from Solution Exhibit 4.20B) Work done in current period only (from Solution Exhibit 4.20B) To account for Panel B: Assignment of costs Completed and transferred out: (90 physical units) Work in progress, opening (20 physical units) Work done in current period to complete opening work in progress Total from opening stock Started and completed (70 physical units) Total completed and transferred out (90 physical units) Work in progress, closing§ (10 physical units) Accounted for

costs

Cost per

20

23,000

2,460,000

12

10,000

120,000

,580,000

80 100

25,000

2,000,000 2,460,000

85 97

11,000

935,000 1,055,000

2,935,000 3,515,000

23,000

2,460,000

12

‡

20 0 20

†

(7)=(3)+(6)

*

70‡

1,120,000

3,580,000

11,000 1,

88,000 208,000

88,000 2,668,000

70‡

11,000

770,000

2,520,000

978,000

3,188,000

77,000 1,055,000

3,327,000 3,515,000

25,000

0 2,460,000

25,000

1,750,000

‡

90 10§ 100

10,000 †

‡

25,000

8 20

2,210,000

90

2,250,000§ 2,460,000

7§ 97

11,000

*

Opening work in progress is 100% complete as to direct materials so zero equivalent units of direct materials need to be added to complete opening work in progress.

†

Opening work in progress is 60% complete as to conversion costs, which equals 12 equivalent units of conversion costs. To complete the 20 physical units of opening work in progress, 8 (20 − 12) equivalent units of conversion costs need to be added.

‡

90 total equivalent units completed and transferred out (Solution Exhibit 4.20A) minus 20 equivalent units completed and transferred from opening stock equals 70 equivalent units.

§

From Solution Exhibit 4.20A.

4.22

Weighted-average method. (25 min)

Solution Exhibit 4.22A shows equivalent units of work done in the current period of Direct materials

2,200 equivalent units

Conversion costs

2,005 equivalent units

Solution Exhibit 4.22B calculates cost per equivalent unit of opening work in progress and of work done in the current period for direct materials and conversion costs. Solution Exhibit 4.22C summarises the total Forming Department costs for April 2010, and assigns these costs to units completed (and transferred out) and to units in closing work in progress using the weighted-average method.

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Solution Exhibit 4.22A

Steps 1 and 2: Summarise output in physical units and calculate equivalent units, Forming Department of Sligo Toys for April 2010. (Step 2) Equivalent units

(Step 1) Physical units

Flow of production Completed and transferred out during current period Add work in progress, closing 500 × 100%; 500 × 25%

Direct materials

2,000

*

Conversion costs

2,000

2,000

500

125

2,500

2,125

300

120

2,200

2,005

500

Total accounted for

2,500

Deduct work in progress, opening 300 × 100%; 300 × 40%

§

Started during current period

300 2,200

Work done in current period only *

Degree of completion in this department: direct materials, 100%; conversion costs, 25%.

§

Degree of completion in this department: direct materials, 100%; conversion costs, 40%.

Solution Exhibit 4.22B

Step 3: Calculate equivalent unit costs, Forming Department of Sligo Toys for April 2010. Direct materials

Conversion costs

Equivalent unit costs of opening work in progress Work in progress, opening (given) Divide by equivalent units of opening work in progress (from Solution Exhibit 4.22A) Cost per equivalent unit of opening work in progress

€7,500

€2,125

÷ 300

÷ 120

€25

€17.71

€70,000

€42,500

÷ 2,200

÷ 2,005

€31.82

€21.20

Equivalent unit costs of work done in current period only Costs added in current period (given) Divide by equivalent units of work done in current period (from Solution Exhibit 4.22A) Cost per equivalent unit of work done in current period only

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Solution Exhibit 4.22C[AQ4]

Step 4: Summarise total costs to account for and assign these costs to units completed and units in closing work in progress using the weighted-average method, Forming Department of Sligo Toys for April 2010 (in €). Total production Direct materials

Conversion costs

Cost per Equivalent

Panel B: Assignment of costs Completed and transferred out: (18,000 physical units) Work in progress, closing (5,000 physical units)† Accounted for

equivalent Total Equivalent

equivalent

units

unit

costs

units

unit

(1)

(2)

(3)=(1)×(2)

(4)

(5)

Panel A: Total costs to account for Work in progress, opening (from Solution Exhibit 4.22B) 300 Work done in current period only (from Solution Exhibit 4.22B) 2,200 To account for 2,500

‡‡

costs

Cost per

25.002, 7,500

120

31.82 70,000 31.00* 77,500

Total costs (6)=(4)×(5) (7)=(3)+(6)

17.71

2,125

2,9,625

2,005 2,125†

21.20 21.00†

42,000 44,625

112,500 122,125

2,000‡

21.00

42,000

104,000

125‡ 2,125

21.00

2,625 44,625

18,125 122,125

*

2,000‡

31.00 62,000

‡

500† 2,500

31.00 15,500 77,500

‡

*

Weighted-average cost per equivalent unit of direct materials = Total direct materials costs divided by total equivalent units of direct materials = €77,500 ÷ 2,500 = €31.

†

Weighted-average costs per equivalent unit of direct materials = Total conversion costs divided by total equivalent units of conversion costs = €44,625 ÷ 2,125 = €21.

‡

From Solution Exhibit 4.22A.

4.23

FIFO computations. (20 min)

The equivalent units of work done in the Forming Department in April 2010 for direct materials and conversion costs are the same as in problem 4.22 and are shown in Solution Exhibit 4.22A. The cost per equivalent unit of work done in the Forming Department in April 2010 for direct materials and conversion costs are calculated in problem 4.22 and Solution Exhibit 4.22B. Solution Exhibit 4.23 summarises the total Forming Department costs for April 2010, and assigns these costs to units completed (and transferred out) and units in closing work in progress under the FIFO method.

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The cost per equivalent unit of opening stock and of work done in the current period differ: Opening Stock Direct materials Conversion costs

Work done in current period

€25

€31.8182

17.7083

€21.197

The following table summarises the costs assigned to units completed and those still in progress under the weighted-average and FIFO process-costing methods for our example. Weighted average (Solution Exhibit 4.22C) Cost of units completed and transferred out

FIFO (Solution Exhibit 4.23)

Difference

€104,000

€103,566

+€434

Work in progress, closing

18,125

18,559

−€434

Total costs accounted for

€122,125

€122,125

The FIFO closing stock is higher than the weighted-average closing stock by €434. This is because FIFO assumes that all the lower-cost prior-period units in work in progress are the first to be completed and transferred out while closing work in progress consists of only the highercost current-period units. However, the weighted-average method smoothes out cost per equivalent unit by assuming that more of the higher-cost units are completed and transferred out, while some of the lower-cost units in opening work in progress are placed in closing work in progress. Hence, in this case, the weighted-average method results in a higher cost of units completed and transferred out and a lower closing work-in-progress stock relative to FIFO.

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Solution Exhibit 4.23

Step 4: Summarise total costs to account for and assign these costs to units completed and units in closing work in progress using the FIFO method, Forming Department of Sligo Toys for April 2010 (in €). Total production Direct materials

Conversion costs

Cost per

costs

Cost per

Equivalent equivalent

Total

Equivalent equivalent

Total

units

unit

costs

units

unit

costs

(1)

(2)

(3)=(1)×(2)

(4)

(5)

(6)=(4)×(5)

Panel A: Total costs to account for Work in progress, opening (from Solution Exhibit 4.22B) Work done in current period only (from Solution Exhibit 4.22B) To account for Panel B: Assignment of costs Completed and transferred out: (2,000 physical units) Work in progress, opening (300 physical units) Work done in current period to complete opening work in progress† Total from opening stock Started and completed (1,700 physical units) Total completed and transferred out (2,000 physical units) Work in progress, closing (500 physical units) Accounted for

300

7,500

0120

17.7083

2,125

9,625

2,200 2,500

31.8182 70,000

2,005

21.1970

42,500

112,500

77,500

2,125

44,625

122,125

1,300

25,0000

7,500

120

17.7083

2,125

229,625

31.8182

0 7,500

180† 300

21.1970

3,815 5,940

3,815 213,440

1,700‡

21.1970

36,035

90,126

41,975

103,566

2,650 44,625

18,559 122,125

0* 300 1,700‡

25.0000

(7)=(3)+(6)

‡

‡

31.8182 54,091

‡

§

2,000§

61,591

§

§

500§ 2,500

31.8182 15,909 77,500

§

2,000§

125§ 2,125

21.1970

*

Opening work in progress is 100% complete as to direct materials, so zero equivalent units of direct materials need to be added to complete opening work in progress.

†

Opening work in progress is 40% complete as to conversion costs, which equals 120 equivalent units of conversion costs. To complete the 300 physical units of opening work in progress, 180 (300 − 120) equivalent units of conversion costs need to be added.

‡

2,000 total equivalent units completed and transferred out (Solution Exhibit 4.22A) minus 300 equivalent units completed and transferred from opening stock equals 1,700 equivalent units.

§

From Solution Exhibit 4.22A.

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4.24

Transferred-in costs, weighted-average. (30 min) 1

Solution Exhibit 4.24A calculates the equivalent units of work done in April 2010 in the Finishing Department for transferred-in costs, direct materials and conversion costs. Solution Exhibit 4.24B calculates the cost per equivalent unit of opening work in progress and of work done in April 2010 in the Finishing Department for transferred-in costs, direct materials and conversion costs. Solution Exhibit 4.24C summarises total Finishing Department costs for April 2010, and assigns these costs to units completed and transferred out and to units in closing work in progress using the weighted-average method.

2

Journal entries: a

Work in Progress – Finishing Department

104,000

Work in Progress – Forming Department Cost of goods completed and transferred out during April from the Forming Department to the Finishing Department b

104,000

Finished Goods Work in Progress – Finishing Department Cost of goods completed and transferred out during April from the Finishing Department to Finished Goods stock

168,552 168,552

Solution Exhibit 4.24A

Steps 1 and 2: Summarise output in physical units and calculate equivalent units, Finishing Department of Sligo Toys for April 2010. (Step 2) Equivalent units

(Step 1) Physical units

Flow of production Completed and transferred out during current period Add work in progress, closing* (400 × 100%; 400 × 0%; 400 × 60%) Total accounted for Deduct work in progress, opening|| (500 × 100%; 500 × 0%; 500 × 60%) Transferred in during current period Work done in current period only

2,100 400 2,500 500 2,000

TransferredDirect in costs materials

Conversion Costs

2,100

2,100

2,100

400 2,500

0 2,100

120 2,220

500 ____ 2,000

0 ____ 2,100

300 1,920

*

Degree of completion in this department: transferred-in costs, 100%; direct materials, 0%; conversion costs, 30%.

||

Degree of completion in this department: transferred-in costs, 100%; direct materials, 0%; conversion costs, 60%.

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Solution Exhibit 4.24B

Step 3: Calculate equivalent unit costs under the weighted-average method, Finishing Department of Sligo Toys for April 2010. Transferredin costs Equivalent unit costs of opening work in progress Work in progress, opening (given) Divide by equivalent units of opening work in progress (from Solution Exhibit 4.24A) Cost per equivalent unit of opening work in progress Equivalent unit costs of work done in current period only Costs added in current period (given) Divide by equivalent units of work done in current period (from Solution Exhibit 4.24A) Cost per equivalent unit of work done in Current period only

Direct materials

Conversion costs

€ 17,750

–

€ 7,250

÷ 500 € 35.50

– –

÷ 300 €24.167

€104,000

€23,100

€38,400

÷ 2,000

÷ 2,100

÷ 1,920

€52

€11

€20

Solution Exhibit 4.24C

Step 4: Summarise total costs to account for and assign these costs to units completed and units in closing work in progress using the weighted-average method, Finishing Department of Sligo Toys for April 2010 (in €).

Transferred-in costs

Direct materials

Conversion costs

Cost per Cost per Equivalent equivalent Total Equivalent equivalent Total Equivalent units unit costs units unit costs units (1) (2) (3)=(1)×(2) (4) (5)(6)=(4)×(5) (7)

Total production costs

Cost per equivalent Total unit costs (10)= (8) (9)=(7)×(8) (3)+(6)+(9)

Panel A: Total costs to account for: Work in progress, opening (from Solution Exhibit 4.24B) 500i Work done in current period only (from Solution Exhibit 4.24B) 2,000i To account for 2,500i Panel B: Assignment of costs Completed and transferred out: (2,100 physical units) 400§ Work in progress closing (400 physical units) Accounted for

2,100§ 2,500

§

35.50*

17,750

52.00* 104,000 48.70* 121,750

0 2,100 2,100 †

48.70* 102,270

**

48.70*

**

19,480 121,750

2,100§ 0§

2,100

–

0

11 11†

23,100 23,100

11

–

300

24.167

7,250

25,000

1,920 2,220‡

20.000 20.563‡

38,400 45,650

165,500 190,500

23,100 *§2,100§

20.563

43,182

168,552

0

120§

20.563

23,100

2,220

2,468

21,948

45,650

190,500

*

Weighted-average cost per equivalent unit of transferred-in costs = Total transferred-in costs divided by total equivalent units of transferred-in costs = €121,750 ÷ 2,500 = €48.70. †

Weighted-average costs per equivalent unit of direct materials = Total direct materials costs divided by total equivalent units of direct materials = €23,100 ÷ 2,100 = €11. ‡

Weighted-average cost per equivalent unit of conversion costs = Total conversion costs divided by total equivalent units of conversion costs = €45,650 ÷ 2,220 = €20.563. §

From Solution Exhibit 4.24A.

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4.25

Transferred-in costs, FIFO costing. (30 min) 1

The equivalent units of work done in April 2010 in the Finishing Department for transferred-in costs, direct materials and conversion costs are exactly as in Solution Exhibit 4.24A. Solution Exhibit 4.25A calculates the cost per equivalent unit of opening work in progress and of work done in April 2010 in the Finishing Department for transferred-in costs, direct materials and conversion costs. Solution Exhibit 4.25B summarises total Finishing Department costs for April 2010, and assigns these costs to units completed and transferred out and to units in closing work in progress using the FIFO method. Journal entries: a

Work in Progress – Finishing Department

103,566

Work in Progress – Forming Department

103,566

Cost of goods completed and transferred out during April from the Forming Department to the Finishing Department. b

Finished Goods

166,723

Work in Progress – Finishing Department

166,723

Cost of goods completed and transferred out during April from the Forming Department to the Finishing Department Solution Exhibit 4.25A Step 3: Calculate equivalent unit costs under the FIFO method, Finishing Department of Sligo Toys for April 2010. Transferredin costs Equivalent unit costs of opening work in progress Work in progress, opening (given) Divide by equivalent units of opening work in progress (from Solution Exhibit 4.24A) Cost per equivalent unit of opening work in progress Equivalent unit costs of work done in current period only Costs added in current period (given) Divide by equivalent units of work done in current period (from Solution Exhibit 4.24A) Cost per equivalent unit of work done in current period only

Direct materials

Conversion costs

€17,520

–

€7,250

÷ 500

–

÷ 300

€35.04

–

€24.167

€103,566

€23,100

€38,400

÷ 2,000

÷ 2,100

÷ 1,920

€51.783

€11

€20

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2

The cost per equivalent unit of opening stock and of work done in the current period differ: Opening stock

Transferred-in costs (FIFO) Transferred-in costs (weighted average) Direct materials Conversion costs

Work done in current period

€35.50 35.04 – 24.167

€52 51.783 11 20

The following table summarises the costs assigned to units completed and those still in progress under the weighted-average and FIFO process-costing methods for our example. Weighted average (Solution Exhibit 4.24C) Cost of units completed and transferred out Work in progress, closing Total costs accounted for

€168,552 21,948 €190,500

FIFO (Solution Exhibit 4.24B) €166,723 23,113 €189,836

Difference +€1,829 −€1,165

The FIFO closing stock is higher than the weighted-average closing stock by €1,165. This is because FIFO assumes that all the lower-cost prior-period units in work in progress (resulting from the lower transferred-in costs in opening stock) are the first to be completed and transferred out while closing work in progress consists of only the higher-cost current-period units. However, the weighted-average method smoothes out cost per equivalent unit by assuming that more of the higher-cost units are completed and transferred out, while some of the lower-cost units in opening work in progress are placed in closing work in progress. Hence, in this case, the weighted-average method results in a higher cost of units completed and transferred out and a lower closing work-in-progress stock relative to FIFO. Note that the difference in cost of units completed and transferred out (+€1,829) does not fully offset the difference in closing work-in-progress stock (−€1,165). This is because the FIFO and weightedaverage methods result in different values for transferred-in costs with respect to both opening stock and costs transferred in during the period.

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CHAPTER 5

Cost allocation Teaching tips and points to stress The terminology of cost allocation Emphasise that there is rarely one ‘best’ way to allocate costs: allocation requires judgement and reasonable people may differ in their judgements. In the absence of an ideal allocation, the object is to obtain a reasonable allocation and insight into the extent to which different judgements would affect the allocation (i.e. sensitivity analysis is appropriate). Cost tracing describes assignment of direct costs to the cost object. Cost allocation describes assigning indirect costs to the cost object. As a company produces a wider variety of products, more costs will be indirect (common to several products). However, advances in information technology have made it feasible to trace more costs directly to products.

Purposes of cost allocation The following sequential outline of the cost-allocation process helps students see the big picture. 1

Determine the purpose of the allocation, since this determines what costs will be allocated.

2

Decide how to allocate the costs from step 1. To do so: a

Decide how many indirect-cost pools to develop, and then

b

Identify an allocation base (preferably a cost driver) for each cost pool.

NB: Allocation bases chosen using a cause-and-effect criterion are most likely to be cost drivers of the costs in the indirect-cost pool.

Cost allocation and costing systems Managers find it difficult to decide how much to spend on cost-allocation systems because it is difficult to quantify the costs and benefits. Benefits of more accurate cost-allocation systems generally increase as (1) the variety of outputs increases (if different outputs make different demands on resources); (2) indirect costs increase (greater potential for material misallocation) and (3) competition increases in the output market (profit margins narrow, so there is less room for error). Costs of more accurate systems decline as information processing costs decline (e.g. bar-coding and metering technologies). For the many companies facing product proliferation, rising indirect costs, increasing competition and decreasing information costs, cost–benefit analysis is shifting in favour of more accurate allocation systems.

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Emphasise that a cost can be direct with respect to one cost object, but indirect with respect to a different cost object. Consider a plant that produces several varieties of spaghetti sauce. Depreciation on the plant is direct with respect to the plant cost object but is indirect with respect to (i.e. cannot be traced directly to) the different sauce products. Depreciation on a machine used solely to make a particular type of spaghetti sauce is direct with respect to that of product line, but indirect with respect to individual jars of sauce.

Indirect-cost pools and cost allocation The distinction is often not clear-cut between (1) direct costs and (2) indirect costs that are allocated on a cause-and-effect basis using a cost driver. For example, in a company that meters the number of photocopies made by each department, are copying costs direct or indirect with respect to using departments? Ask students to classify individual cost components that would be classified as direct to a particular copying job versus those that would be indirect to that job.

Allocating costs of support departments The following diagram keyed to the example in the text illustrates that the three methods of allocating support department costs differ only in the way they account for the reciprocal services. Maintenance

Information Systems

Machining

Assembly

Direct method – NO reciprocal services recognised. Step-down method – One-way reciprocal services recognised: Maintenance ⇒ Information Systems. Reciprocal method – Two-way reciprocal services recognised: Maintenance ⇔ Information Systems. Differences among the three methods’ allocations increase (1) as the magnitude of the reciprocal services increases and (2) as the differences across operating departments’ usage of each support service increase.

Changes in cost-allocation bases Students usually fail to recognise that even in a heavily automated plant, DLH may be a reasonable allocation base. If production is labour-paced, DLH may still capture cause-andeffect relations (i.e. the more labour-hours, the longer the machinery operates). Moreover, DLH is an inexpensive allocation base since it is readily available from the payroll system. Inappropriately using DL base in a machine-paced environment also distorts product costs, because a small change in DL will have a large effect on the product cost. This leads to unstable product costs. Note the dual-motivation effects arising from inappropriate use of a single allocation base such as DL. Management is motivated to reduce DL instead of the larger volume of indirect costs

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where they would be likely to get a ‘larger return for their money’. (It ought to be easier to reduce indirect costs since they are usually greater than DL costs and less attention has been directed to reducing them.) Further, any benefit from reducing indirect costs is ‘spread more thinly’ – it is not visible and so would not be likely to be rewarded. Some companies allocate all indirect manufacturing costs in line with manufacturing lead time. This gives employees a clear signal to reduce manufacturing lead time and these companies believe this benefit outweighs the disadvantages of less accurate product costs from the use of a single allocation base. Eventually, employees are likely to reduce consumption of the single allocation base to a very low level (e.g. reduce manufacturing lead time to a very short time). At that point, the manufacturing lead time problem will be solved and some other problem will become the primary concern. Should management then change the cost system to motivate employees to attack the new problem? Under what circumstances should the cost accounting system be used primarily as a proactive motivational tool? Companies have traditionally used DLH and DL€ as allocation bases. This is reasonable when (1) production is labour-paced, (2) DLH and DL€ are easily available, (3) indirect costs are a small piece of the full-product cost ‘pie’ and (4) companies have limited product-line diversity. Today, there is increased experimentation with new allocation bases because (1) more production is machine-paced; (2) advances in information technology make it feasible to collect non-financial data such as MH, kg of the material, etc.; (3) indirect costs are a more significant percentage of full-product costs and (4) companies have increased the diversity of their products.

Solutions to review questions 5.1

A cost item may change from being classified as an indirect cost to a direct cost (or vice versa) due to a change in the underlying operations – for example, the adoption of dedicated production lines. A change in information-gathering technology can also cause a cost item to change from being an indirect cost to a direct cost – for example, the use of bar codes and optical scanners.

5.2

The salary of a plant security guard would be a direct cost when the cost object is the security department or the plant. It would be an indirect cost when the cost object is a product.

5.3

Exhibit 5.1 in the text outlines four purposes for allocating costs:

5.4

1

To provide information for economic decisions

2

To motivate managers and employees

3

To justify costs or calculate reimbursement

4

To measure income and assets for meeting external regulatory and legal reporting obligations.

Cost–benefit considerations can affect costing choices in several ways: a

Classifying some immaterial costs as indirect when they could, at high cost, be traced to products, services or customers as direct costs.

b

Using a small number of indirect-cost pools when, at high cost, an increased number of indirect-cost pools would provide more homogeneous cost pools.

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c 5.5

5.6

Using allocation bases that are readily available (or can be collected at low cost) when, at high cost, more appropriate cost-allocation bases could be developed.

The three methods differ in how they recognise reciprocal services among support departments: a

The direct allocation method ignores any services rendered by one support department to another; it allocates each support department’s total costs directly to the operating departments.

b

The step-down allocation method allows for partial recognition of support rendered by support departments to other support departments.

c

The reciprocal allocation method allocates costs by explicitly recognising the mutual services rendered among support departments.

The incremental common cost-allocation method first allocates the common costs to the primary user; the incremental party is allocated that component of the common cost arising because there are two users and not just the primary user. The stand-alone common cost-allocation method allocates the common cost on the basis of each user’s percentage of the total of the individual stand-alone costs.

5.7

Disagree. The different costs for different purposes notion means that the same cost figure need not be appropriate for each and every purpose. However, just because a cost is allocated for one purpose does not preclude it from being relevant for other purposes.

5.8

The distinction between labour-paced and machine-paced operations is important when examining the possible cost-allocation bases to use in a costing system. In labour-paced operations, it is likely that labour-hours will capture cause-and-effect relationships. In machine-paced operations, however, there is a greater likelihood that machine-related variables (such as machine-hours) will capture cause-and-effect relationships. These are general guidelines whose validity needs to be examined in specific cases.

5.9

The consequences of using direct manufacturing labour-hours as an allocation base in a machine-paced manufacturing environment are: a

Product managers make excessive use of external vendors to obtain parts with a high direct labour content.

b

Excessive attention is paid by manufacturing managers to control the direct manufacturing labour-hours relative to the attention paid to control the more costly categories of materials and machining.

c

Managers attempt to classify shop-floor personnel as indirect manufacturing labour rather than as direct manufacturing labour.

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Solutions to exercises Alternative allocation bases for a professional services firm. (15 min)

5.10 1

Client (1)

Direct professional time Rate per Number hour of hours Total (2) (3) (4)

Support services Rate (5)

= (2) × (3)

Total (6) = (4) × (5)

Amount billed to client (7) = (4) + (6)

FORTUNE PLASSANS Raquin Rozerot Bernard

€500 120 80

15 3 22

€7,500 360 1,760

30% of (4) 30% of (4) 30% of (4)

€2,250 108 528

€9,750 468 2,288 €12,506

€500 120 80

2 8 30

€1,000 960 2,400

30% of (4) 30% of (4) 30% of (4)

€300 288 720

€1,300 1,248 3,120 €5,668

AU BONHEUR DES DAMES Raquin Rozerot Bernard

2

Client (1)

Direct professional time Rate per Number hour of hours Total (2) (3) (4)

Support services Rate (5)

= (2) × (3)

Total (6) = (3) × (5)

Amount billed to client (7) = (4)+(6)

FORTUNE PLASSANS Raquin Rozerot Bernard

€500 120 80

15 3 22

€7,500 360 1,760

€50 per hour. €50 per hour. €50 per hour.

€750 150 1,100

€8,250 510 2,860 €11,620

€500 120 80

2 8 30

€1,000 960 2,400

€50 per hour. €50 per hour. €50 per hour.

€100 400 1,500

€1,100 1,360 3,900 €6,360

AU BONHEUR DES DAMES Raquin Rozerot Bernard

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Requirement 1 Fortune Plassans Au Bonheur des Dames

Requirement 2

€12,506 5,668 €18,174

€11,620 6,360 €17,980

Both clients use 40 hours of professional labour time. However, Fortune Plassans uses a higher proportion of Raquin’s time (15 hours), which attracts the highest support-services charge. 3

5.12

Assume that the Germinal Group uses a cause-and-effect criterion when choosing the allocation base for support services. You could use several pieces of evidence to determine whether professional labour costs or hours is the driver of support-service costs: a

Interviews with personnel. For example, staff in the major cost categories in support services could be interviewed to determine whether Raquin requires more support per hour than, say, Bernard. The professional labour costs allocation base implies that an hour of Raquin’s time requires 6.25 (€500 ÷ €80) times more support service Euros than does an hour of Bernard’s time.

b

Analysis of tasks undertaken for selected clients. For example, if computerrelated costs are a sizeable part of support costs, you could determine if there was a systematic relationship between the percentage involvement of professionals with high billing rates on cases and the computer resources consumed for those cases.

Cost allocation with a non-financial variable, retailing. (15–20 min)

1 and 2 Breakfast cereal Revenue

Dairy product

Paper towels

Toothpaste

€82

€64

€36

€100

Cost of goods sold

56

52

26

74

Gross margin

26

12

10

26

Goods-handling cost

12

6

12

6

Product contribution

€14

€6

€(2)

€20

Rankings on gross margin percentage and a product contribution to revenue percentage are: Gross margin percentage

Product contribution to revenue %

1.

Breakfast cereal

31.7%

1.

Toothpaste

20%

2.

Paper towels

27.8%

2.

Breakfast cereal

17.1%

3.

Toothpaste

26.0%

3.

Dairy product

9.4%

4.

Dairy product

18.7%

4.

Paper towels

−5.5%

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3

Assigning the goods-handling costs to each product: a

Changes the rankings in terms of profitability.

b

Makes high-volume (cubic feet) products relatively less profitable than lowvolume products.

This information is useful in product-emphasis decisions. 5.13

Cost allocation in centres, alternative allocation criteria. (15–20 min) 1

2

Direct costs

=

€2.40

Indirect costs

=

€11.52 − €2.40 = €9.12

Overhead rate

=

€ 9.12 = 380% € 2.40

The answers here are less than clear-cut in some cases. Overhead cost item

Allocation criteria

Processing of paperwork for purchase

Cause and effect

Supplies room management fee

Benefits received

Operating room and patient room handling charge Cause and effect Administrative hospital costs

Benefits received

University teaching-related recoupment

Ability to bear

Malpractice insurance costs

Ability to bear or benefits received

Costing of treating uninsured patients

Ability to bear

Profit component

None. This is not a cost.

3

5.15

Assuming that McGarrigle’s insurance company is responsible for paying the €4,800 bill, McGarrigle probably can only express outrage at the amount of the bill. The point of this question is to note that even if McGarrigle objects strongly to one or more overhead items, it is his insurance company that is likely to have the greater incentive to challenge the bill. Individual patients have very little power in the medical arena. In contrast, insurance companies have considerable power and may decide that certain costs are not reimbursable – for example, the costs of treating uninsured patients.

Single-rate versus dual-rate allocation methods, support department. (20 min)

Bases available (kilowatt-hours): Roskilde Practical capacity Expected monthly usage

1

a

Køge

Nysted

Ålborg

Total

10,000

20,000

12,000

8,000

50,000

8,000

9,000

7,000

6,000

30,000

Single-rate method based on practical capacity: Total costs in pool = DKr 6,000 + DKr 9,000 = DKr 15,000 Practical capacity = 50,000 kilowatt-hours Allocation rate = DKr 15,000 ÷ 50,000 = DKr 0.30 per hour of capacity

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Roskilde

Køge

Nysted

Ålborg

Total

10,000

20,000

12,000

8,000

50,000

3,000

6,000

3,600

2,400

15,000

Practical capacity in hours Costs allocated at DKr 0.30 per hour

b

Single-rate method based on expected monthly usage: Total costs in pool

=

DKr 6,000 + DKr 9,000 = DKr 15,000

Expected usage

= 30,000 kilowatt-hours

Allocation rate

=

DKr 15,000 ÷ 30,000 = DKr 0.50 per hour of expected usage Roskilde

Køge

Nysted

Årlborg

Total

Expected monthly usage in hours

8,000

9,000

7,000

6,000

30,000

Costs allocated at DKr 0.50 per hour

4,000

4,500

3,500

3,000

15,000

2

Variable cost pool: Total costs in pool =

DKr 6,000

Expected usage

=

30,000 kilowatt-hours

Allocation rate

=

DKr 0.20 per hour of expected usage

Fixed cost pool: Total costs in pool =

DKr 9,000

Practical capacity

=

50,000 kilowatt-hours

Allocation rate

=

DKr 0.18 per hour of capacity

Roskilde

Køge

Nysted

Ålborg

Total

Variable cost pool (DKr)

1,600

1,800

1,400

1,200

6,000

Fixed cost pool

1,800

3,600

2,160

1,440

9,000

Total (DKr)

3,400

5,400

3,560

2,640

15,000

The dual-rate method permits a more refined allocation of the power department costs; it permits the use of different allocation bases for different cost pools. The fixed costs result from decisions that are most likely to be associated with the practical capacity level. The variable costs result from decisions that are most likely to be associated with monthly usage. 5.16

Allocation of common costs. (20–30 min) 1

The available criteria to guide cost-allocations include: a

Cause and effect. It is not possible to trace individual causes (basic news or premium movies or premium sports) to individual effects (viewing by Rolf or Ilse or Ulrich). The €70 total package is a bundled product.

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b

2

Benefits received. There are various ways of operationalising the benefits received: i

Monthly service charge for their prime interest – Basic news for Rolf (€32), premium movies for Ilse (€25) and premium sports for Ulrich (€30). This measure captures the services available to be used by each person.

ii

Actual usage by each person – This would involve having a record of viewing by each person and then allocating the €70 on a percentage viewing time basis. This measure captures the services actually used by each person.

c

Ability to pay. This criterion requires three people to agree upon their relative ability to pay. One measure here would be their respective salaries with Frankfurt Fire Brigade.

d

Fairness or equity. This criterion is relatively nebulous. A straightforward approach would be to split the €70 equally among the three parties.

Three methods of allocating the €70 are: Rolf

Ilse

Stand alone

€25.76

€20.09

€24.15

Incremental

13.00

25.00

32.00

Equal

23.33

23.33

23.33

a

Stand-alone cost-allocation method. Rolf:

€32

×

€70

€32 + €25 + €30 Ilse:

€25

×

€70

€32 + €25 + €30 Ulrich:

€30

×

€70

€32 + €25 + €30

b

Ulrich

=

36.8% × €70

=

€25.76

=

28.7% × €70

=

€20.09

=

34.5% × €70

=

€24.15

Incremental cost-allocation method. Assume Ulrich (the owner) is the primary person, Ilse the first incremental party and Rolf the second incremental party. Party Ulrich Ilse Rolf Total

Cost allocated €32 25 13 €70

Cost remaining to be allocated to other parties €38 (€70 − €32) 13 (€70 − €32 − €25) 0

This method is sure to generate disputes over the ranking of the three parties. Notice that Rolf pays only €13 despite his prime interest in the most expensive basic news package. c

Equal sharing of the €70 amount. Rolf, Ilse and Ulrich each pay €23.33.

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5.17

Allocation of travel costs. (20 mins.) 1

Allocation of the £1,800 airfare. Alternative approaches include: a

The stand-alone cost-allocation method. This method would allocate the air fare on the basis of each user’s percentage of the total of the individual stand-alone costs: Nice employer

£1, 400 × £1,800 = £1,008 (£1, 400 + £1,100)

Copenhagen employer

£1,100 × £1,800 = £792 (£1, 400 + £1,100) £1,800

Advocates of this method often emphasise an equity or fairness rationale. b

The incremental cost-allocation method. This requires the choice of a primary party and an incremental party. If the Nice employer is the primary party, the allocation would be: Nice employer Copenhagen employer

£1,400 400 £1,800

One rationale is that MacDougall was planning to make the Nice trip and the Copenhagen stop was added subsequently. Some students have suggested allocating as much as possible to the Nice employer since MacDougall was not joining them. If the Copenhagen employer is the primary party, the allocation would be: Copenhagen employer Nice employer

£1,100 700 £1,800

One rationale is that the Copenhagen employer is the successful recruiter and presumably receives more benefits from the recruiting expenditures. 2

A simple approach is to split the £60 equally between the two employers. The taxi costs at the Edinburgh end are not a function of distance travelled on the plane. An alternative approach is to add the £60 to the £1,800 and repeat requirement 1: a

Stand-alone cost-allocation method: £1, 460 Nice employer × £1,860 = £1,036 (£1, 460 + £1,160) Copenhagen employer

b

£1,160 × £1,860 = £824 (£1, 460 + £1,160)

Incremental cost-allocation method. With the Nice employer as the primary party: Nice employer Copenhagen employer

£1,460 400 £1,860

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With the Copenhagen employer as the primary party: Copenhagen employer Nice employer

5.18

£1,160 700 £1,860

Support department cost allocation; direct and step-down methods. (30 min) 1 a Direct method Costs

IS

A/HR €600,000

GOVT

CORP

€320,000

€280,000

800,000

1,600,000

€1,120,000

€1,880,000

€2,400,000

Alloc. of A/HR (40/75, 35/75)

(600,000)

Alloc. of IS (30/90, 60/90)

(2,400,000) €

0

€

0

b Step-down (A/HR first) Costs

€600,000

2,400,000

(600,000)

150,000

240,000

210,000

(2,550,000)

850,000

1,700,000

€1,090,000

€1,910,000

€1,440,000

Alloc. of A/HR (0.25, 0.40, 0.35) Alloc. of IS (30/90, 60/90) €

0

€

0

c Step-Down (IS first) Costs

€600,000

2,400,000

240,000

(2,400,000)

720,000

(840,000)

448,000

392,000

0

€1,168,000

Alloc. of IS (0.10, 0.30, 0.60) Alloc. of A/HR (40/75, 35/75)

€

0

€

€1,832,000

2 GOVT

CORP

€1,120,000

€1,880,000

Step-down (A/HR first)

1,090,000

1,910,000

Step-down (IS first)

1,168,000

1,832,000

Direct method

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The direct method ignores any services to other support departments. The step-down method partially recognises support to other service departments. The information systems support group (with total budget of €2,400,000) provides 10% of its services to the A/HR group. The A/HR support group (with total budget of €600,000) provides 25% of its services to the information systems support group. 3

Three criteria that could determine the sequence in the step-down method are: a

b

c

Allocate service departments on a ranking of the % of their total services provided to other service departments. 1

Administrative/HR 25%

2

Information Systems 10%

Allocate service departments on a ranking of the total monetary amount in the service departments. 1

Information Systems €2,400,000

2

Administrative/HR €600,000

Allocate service departments on a ranking of the euro amounts of service provided to other service departments 1

Information Systems (0.10 × €2,400,000) = €240,000

2

Administrative/HR (0.25 × €600,000) = €150,000

5.19

Manufacturing cost allocation, use of a conversion cost pool category, automation. (20–30 min) 1

Total manufacturing overhead cost pool

= €270,000

Total direct manufacturing labour-hours

= 1,500 hours

Manufacturing overhead rate (€270,000 ÷ 1,500) = €180 per hour Costs per instrument:

Direct materials Direct manufacturing labour Manufacturing overhead allocated: 101: 1,000 × €180 per hour 201: 500 × €180 per hour 1 Total 2

Units produced

3

Cost per unit: 1 ÷ 2

Instrument 101 €100,000 20,000

Instrument 201 €300,000 10,000

180,000 – €300,000

– 90,000 €400,000

5,000

20,000

€60

€20

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Note: Direct manufacturing labour costs at Euro-Medi comprise only 4.3% of total production costs: 101 + 201 €400,000 30,000 270,000 €700,000

Direct materials Direct manufacturing labour Manufacturing overhead allocated

2

% 57.1% 4.3% 38.6% 100.0%

Total conversion cost pool (€20,000 + €10,000 + €270,000)

=

€300,000

=

€400,000

Total direct materials cost (€100,000 + €300,000) Conversion cost rate =

€300,000

= 0.75 or 75% of direct materials cost

€400,000 Costs per instrument: Instrument 101 Direct materials Conversion cost 101: 0.75 × €100,000 201: 0.75 × €300,000 (1) Total (2)

Units produced

(3)

Cost per unit: (1) ÷ (2)

3

Instrument 201

€100,000 75,000 – €175,000

€300,000 – 225,000 €525,000

5,000

20,000

€35

€26.25

There are at least two classes of benefits: a

Reduction in the costs of collecting information in separate cost pools. This cost reduction can be sizeable if a standard cost system is used because standards for direct manufacturing labour no longer need to be set.

b

Reduction in suboptimal decisions arising from the use of an inappropriate costallocation base in a machine-paced manufacturing environment. Examples of poor decisions include: i

Product managers using external vendors to obtain parts that require a labour-intensive process when produced internally, even though it is more cost effective to produce the part internally.

ii

Excessive attention by product managers to control direct manufacturing labour-hours relative to the attention paid to control the more costly categories of direct materials and machining.

iii Managers’ attempts to classify manufacturing engineers as indirect labour rather than direct labour resulting in part of their costs being allocated to other products.

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5.20

Segment reporting and cost hierarchies. (20 min) 1

Division A

Net revenues Variable manufacturinga €400,000 Variable marketing costs 200,000 Total variable costs Contribution margin Fixed division costs controllable by Division managerb Contribution controllable by division manager Fixed costs controllable outside division Contribution by division a Total

variable costs Variable marketing and admin. costs Variable manufacturing cost

b

600,000 900,000 300,000 600,000 100,000 €500,000

€600,000 200,000 €400,000

Total traceable costs to Division A Total variable costs Total fixed costs traceable to Division A Fixed costs controllable outside division Fixed costs controllable by division manager

2 a

€1,500,000

€1,000,000 600,000 400,000 100,000 €300,000

Division B

Contribution margin Segment margin Fixed costs traceable to B

€1,200,000 700,000 €500,000

b Net revenues Contribution margin Variable costs

€3,000,000 1,200,000 €1,800,000

3 Koala Company Segment margins Division A Division B Corporate costs unallocated to divisions Operating income

€500,000 700,000

€1,200,000 400,000 €800,000

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5.21

Departmental cost allocation, university computer-service centre. (20–30 min) 1

Each school would be allocated half the €100,000: H&S: (100/200) × €100,000 = €50,000 Engineering: (100/200) × €100,000 = €50,000 The allocation of the €10,000 costs of inefficiency seems unjustified because the ‘consuming departments’ have to bear another department’s cost of inefficiency. The system provides no incentive to the service department manager to control operating costs. An improvement would be to use budgeted unit prices (at least) and where feasible, budgeted total prices for various kinds of work based on flexible budgets and standards. In this way, the consuming department managers will know in advance that inefficiencies will be borne by the supplier, not the consumer.

2

Total costs incurred: €80,000 + 150(€100) = €95,000 H&S: (50/150) × €95,000 = €31,667 Engineering: (100/150) × €95,000 = €63,333 Note that the unit cost per hour has risen from €100,000 ÷ 200 = €500 in requirement 1 to €95,000 ÷ 150 = €633 in requirement 2. Engineering’s total cost rose from €50,000 to €63,333, an increase of 26.7% solely because H&S’s usage declined.

3

Planned long-run usage: 180 + 120 = 300 hours

Fixed costs: (180/300) × €80,000 (120/300) × €80,000 Variable costs: 50 × €100 100 × €100

H&S €48,000

Engineering €32,000

5,000 €53,000

10,000 €42,000

The advantages were described above:

4

a

Use of a budgeted unit rate for variable costs helps planning by consumers and insulates them from intervening price changes and some inefficiencies.

b

Use of the lump-sum approach for fixed costs prevents the total charges from being affected by the short-run usage of the service department by other consuming departments.

Consumers would tend to understate their predictions of long-run usage. Conceivably, if all played the same game, the lump-sum allocations may be unchanged – although that result is unlikely. Top management copes with these tendencies by monitoring these predictions, following up and using feedback to keep future predictions more reliable. In addition, in some organisations, there are definite rewards in the form of salary increases for managers who demonstrate skills in making accurate predictions and some organisations charge a high price for usage that exceeds a budgeted commitment.

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CHAPTER 6

Cost allocation: joint-cost situations Teaching tips and points to stress Meaning of joint products and by-products terms The discussion in Chapter 6 of joint costs and by-products is a special case of allocating common costs to products. The joint costs are caused by the decision to produce the ‘market basket’ of products. Joint-costing problems are particularly troublesome because it is not feasible to apply the cause-and-effect criterion. If a product yields only one product with a relatively high sales value, that product is termed a main product. The term joint product is reserved for cases where the production process yields multiple high sales value products.

Approaches to allocating joint costs Joint-cost-allocation methods are less than ideal between the joint costs and individual products. Consequently, management must be very careful when evaluating performance or making other economic decisions based on numbers resulting from joint-cost allocations. Under the sales value at split-off method, the gross-margin percentage is identical for all products if there are no separable costs (and no opening stock). The sales value at split-off method allocates joint costs on the basis of sales revenue. In the absence of non-joint costs, this makes all products appear equally profitable. Emphasise that the sales value at split-off weighting is based on total sales revenue (of total production), not on sales price per litre (say) of each product (nor on just the sales revenue for the number of units actually sold). The primary advantage of the sales value at split-off method is that it is reasonably objective. No assumptions are necessary about actions beyond the split-off point (e.g. which products will be produced, what separable costs will be incurred). The major disadvantage of the sales value at split-off method is that there may be no market at split-off for some products. The physical measure method is easy to use but has two disadvantages. First, the quantity of the joint products may be measured in different units. For example, natural gas is measured in cubic metres but oil is measured in barrels. This problem can sometimes be overcome by converting both measures to a common denominator (BTUs in this case). Second, the method does not meet any of the cost-allocation criteria: cause-and-effect, benefits received, fairness or ability to bear. For example, in meat packaging, the physical measure method would allocate a much larger share of the total joint costs to soup bones and minced meat than to fillet steak. This result violates all four cost-allocation criteria.

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Irrelevance of joint costs for decision making Later chapters will stress that a cost must differ among alternatives to be relevant to a decision. In a sell or process further decision, the joint costs will be incurred whether or not the product is processed further. Since the joint cost does not differ between the two alternatives – sell or process further – joint costs cannot be relevant to this decision.

Solutions to review questions 6.1

A joint cost is a cost of a single process that yields multiple products simultaneously.

6.2

Separable costs are costs incurred beyond the split-off point that are assignable to one or more individual products.

6.3

Exhibit 6.2 presents nine examples from four different general industries. These include: Separable products at the split-off point

Industry Agriculture: • Lamb • Turkey

•

Mining: • Petroleum

•

Lamb cuts, offal, hides, bones, fat Breasts, wings, drumsticks, poultry meal

•

Crude oil, gas, raw LPG

6.4

A product is any output that has a positive sales value (or an output that enables an organisation to avoid incurring costs). In some joint-cost settings, outputs can occur that do not have a positive sales value. The offshore processing of hydrocarbons yields water, which is recycled back into the ocean, as well as yields oil and gas. The processing of mineral ore to yield gold and silver also yields dirt as an output, which is recycled back into the ground.

6.5

The chapter lists the following six reasons for allocating joint costs: 1

Stock cost and cost-of-goods-sold calculations for external financial statements and reports for income tax authorities.

2

Stock cost and cost-of-goods-sold calculations for internal financial reporting.

3

Cost reimbursement under contracts when only a portion of a business’s products or services is sold or delivered to a single customer.

4

Customer profitability analysis where individual customers purchase varying combinations of joint products or by-products as well as other products of the company.

5

Insurance settlement calculations.

6

Rate regulation when one or more of the jointly produced products or services are subject to price regulation.

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6.6

Limitations of the physical measure method of joint-cost allocation include: a

The physical weights used for allocating joint costs may have no relationship to the revenue-producing power of the individual products.

b

The joint products may not have a common physical denominator – for example, one may be a liquid while another a solid with no readily available conversion factor.

6.7

No joint-cost-allocation method is supported by the cause-and-effect criterion. The cause-and-effect relationship exists only at the joint-process level. Joint costs, by definition, cannot be the subject of cause-and-effect analysis at the individual product level.

6.8

No. Any method used to allocate joint costs to individual products that is applicable to the problem of joint product-cost allocation should not be used for management decisions regarding whether a product should be sold or processed further. When a product is an inherent result of a joint process, the decision to process further should not be influenced by either the size of the total joint costs or the portion of the joint costs assigned to particular products. Joint costs are irrelevant for these decisions. The only relevant items for these decisions are the incremental revenue and the incremental costs beyond the split-off point.

6.9

No. The only relevant items are incremental revenues and incremental costs when making decisions about selling products at the split-off point or processing them further. Separable costs are not always identical to incremental costs. Separable costs are costs incurred beyond the split-off point that are assignable to individual products. Some separable costs may not be incremental costs in a specific setting (e.g. allocated manufacturing overhead that includes depreciation).

6.10

Use of a market-based method [either sales value at split-off or estimated net realisable value (NRV) for all products would eliminate the need for a joint-product/by-product distinction. It would also mean consistently recognising the costs of all products at the point of production.

Solutions to exercises 6.11

Matching terms with definitions. (10 min)

a3

b4

c5

d1

e6

f2

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6.12

Estimated net realisable value method. (10 min)

A diagram of the situation is in Solution Exhibit 6.12 (all numbers are in thousands). Cooking oil

Soap oil

Total

Expected final sales value of production, CO, 1,000 × NKr 50; SO, 500 × NKr 25

NKr 50,000

NKr 12,500

NKr 62,500

30,000

7,500

37,500

NKr 20,000

NKr 5,000

NKr 25,000

NKr 20,000 ÷ NKr 25,000 = 0.8

NKr 5,000 ÷ NKr 25,000 = 0.2

Deduct expected separable costs to complete and sell Estimated net realisable value at split-off point Weighting Joint costs allocated, CO, 0.8 × NKr 24,000; SO, 0.2 × NKr 24,000

NKr 19,200

NKr 4,800

Solution Exhibit 6.12[AQ5]

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NKr 24,000

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6.15

Joint costs and by-products. (35–45 min)

A diagram of the situation is in Solution Exhibit 6.15. 1

Calculating by-product deduction to joint costs:

Quantity

Marketing price of X, 100,000 × €3 Deduct: Gross margin, 10% of sales Marketing costs, 25% of sales Department 3 separable costs Estimated net realisable value of X

€300,000 30,000 75,000 50,000 €145,000

Joint costs Deduct by-product contribution Net joint costs to be allocated

€800,000 145,000 €655,000

Unit sales price

Final sales value

Deduct separable processing cost

Est. net realisable value at split-off Weighting

Allocation of €655,000 joint costs

L

50,000

€10

€500,000

€100,000

€400,000

40%

€262,000

W

300,000

€2

€600,000

–

€600,000

60%

€393,000

€1,100,000

€100,000

€1,000,000

Totals

€655,000

Joint costs allocation

Add separable processing costs

Total costs

Units

Unit cost

L

€262,000

€100,000

€362,000

50,000

€7.24

W

393,000

393,000

300,000

1.31

€755,000

350,000

Totals

€655,000

– €100,000

Unit cost for X: €1.45 + €0.50 = €1.95, or €3.00 − €0.30 − €0.75 = €1.95.

2

If all three products are treated as joint products: Deduct separable processing cost

Est. net realisable value at split-off

Allocation of €800,000 Weighting joint costs

€500,000

€100,000

€400,000

40/125

€256,000

2

600,000

–

600,000

60/125

384,000

3

300,000

50,000

250,000

25/125

160,000

€1,400,000

€150,000

Quantity

Unit sales price

Final sales value

L

50,000

€10

W

300,000

X

100,000

Totals

€1,250,000

€800,000

Joint costs allocation

Add separable processing costs

Total costs

Units

Unit cost

L

€256,000

€100,000

€356,000

50,000

€7.12

W X Totals

384,000 160,000 €800,000

– 50,000 150,000

384,000 210,000 €950,000

300,000 100,000 450,000

1.28 2.10

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Call the attention of students to the differing unit ‘costs’ between the two assumptions regarding the relative importance of Product X. The point is that, costs of individual products depend heavily on which assumptions are made and which accounting methods and techniques are used. Solution Exhibit 6.15

6.16

Estimated net realisable value method, by-products. (30 min) 1 a For the month of November 2011, Flori-Dante’s output (in kg) was: •

sliced apple

89,100

•

apple sauce

81,000

•

apple juice

67,500

•

animal feed

27,000

These amounts were calculated as follows:

Product

Input kg

Proportion

Slices Sauce Juice Feed

270,000 270,000 270,000 270,000

0.33 0.30 0.27 0.10 1.00

*

Net kg:

=

72,900 − (0.08 × net kg)

1.08 net kg

=

72,900

Net kg

=

67,500

Total

Kilograms

Net

kg

lost

kg

– – 5,400 – 5,400

89,100* 81,000* 67,500* 27,000* 264,600*

89,100 81,000 72,900 27,000 270,000

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b

The estimated net realisable value for each of the three main products is calculated below:

Product Slices

Net kg 89,100

Sauce Juice

Price

Revenue

Separable Costs

Estimated net realisable value

€0.80

€71,280

€11,280

€60,000

81,000

0.55

44,550

8,550

36,000

67,500

0.40

27,000

3,000

24,000

€142,830

€22,830

€120,000

c and d

The estimated net realisable value of the by-product is deducted from the production costs prior to allocation to the joint products, as presented below: Allocation of Cutting Department costs to joint products and by-products Net realisable value (NRV) of by-product

= = = =

By-product revenue − Separable costs €0.10 (270,000 × 10%) − €700 €2,700 − €700 €2,000

Costs to be allocated

= =

Joint costs − NRV of by-product €60,000 − €2,000

=

€58,000

Revenue

Separable Costs

€71,280

€11,280

€29,000

€31,000

Sauce

44,550

8,550

17,400

18,600

Juice

27,000

3,000

11,600

12,400

€142,830

€22,830

€58,000

€62,000

Product Slices

2

Joint Costs

Gross Margin

The gross-margin euro information by main product is determined by the arbitrary allocation of joint production costs. As a result, these cost figures and the resulting gross-margin information are of little significance for planning and control purposes. The allocation is made only for purposes of stock costing and income determination.

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6.17

Joint-product/by-product distinctions, ethics. (20–30 min) 1

The 2011 method gives Flori-Dante managers relatively little discretion vis-à-vis the pre-2011 method. The 2011 method recognises all four products in the accounting system at the time of production. The pre-2011 method recognises only two products (apple slices and apple sauce) at the time of production. Consider the data in the question. The €60,000 of joint costs would be allocated as follows (using the €60,000 and €36,000 estimated NRV amounts): Apple slices

=

Apple sauce

=

€60, 000 €96, 000

× €60,000 = €37,500

€ 36,000 × €60,000 = €22,500 €96,000

The gross margin on each product is: Apple slices

=

Apple sauce

=

(€71, 280 – €37, 500 – €11, 280) €71, 280

= 31.57%

(€44,550 – €22,500 – €8,550) = 30.30% €44,550

The gross margins on the two ‘by-products’ are: Apple juice

=

Animal feed

=

€27,000 – €3,000 = 88.89% €27,000 €2, 700 – €700 €2, 700

= 74.07 %

With the pre-2011 method, managers have flexibility as to when to sell the apple juice and the animal feed. Both are frozen and can be kept in cold storage until needed. If there is a need for a large ‘dose’ of gross margin at year-end to meet the target ratio, high gross margins from apple juice or animal feed can be drawn on to help achieve the target. 2

The accountant could examine the sales patterns of apple juice and animal feed at year-end. Do managers, who have ratios from existing sales below the target, sell apple juice and animal feed stocks to achieve the target ratio? Do managers, who have ratios above the target, put apple juice and animal feed production into stock so as to provide a ‘cushion’ for subsequent years? One piece of evidence here would be physical stock-holding patterns on a monthly basis. If the pattern of stock holding for the two by-products was different from that for the two joint products, there would be grounds for further investigation as to whether managers are abusing the bonus system.

3 a Using the estimated net realisable value method with all products treated as a joint product would reduce ‘gaming’ behaviour by managers with respect to bonus payments. The estimated net realisable value of all four products (€60,000 + €36,000 + €24,000 + €2,000 = €122,000) would be used to allocate the €60,000 joint cost:

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Slices:

€60,000 × €60,000 = 0.492 × €60,000 = €29,520 €122,000

Sauce:

€36,000 × €60,000 = 0.295 × €60,000 = €17,700 €122,000

Juice: Feed: b

6.20

€24,000 × €60,000 = 0.197 × €60,000 = €11,820 €122,000 €2,000 × €60,000 = 0.016 × €60,000 = €960 €122,000

A second method that could be used in conjunction with a is to have a stock holding charge. If managers build up stock, they would be penalised. This would reduce incentives to use stock to manipulate reported income to meet target ratios.

Alternative joint-cost-allocation methods, further process decision. (40 min)

A diagram of the situation is in Solution Exhibit 6.20. 1

Methanol

Physical measure of production (litres)

Turpentine

2,500

7,500

2,500 = 0.25 10,000

Weighting

Total 10,000

7,500 = 0.75 10,000

Joint costs allocated, M, 0.25 × €120,000; T, 0.75 × €120,000

€ 30,000

€ 90,000

2

Methanol

Turpentine

Expected final sales value of production, M, 2,500 × €21.00; T, 7,500 × €14.00 Deduct expected separable costs to complete and sell, M, 2,500 × €3.00; T, 7,500 × €2.00 Estimated net realisable value at split-off point Weighting

€120,000 Total

€52,500

€105,000

€157,500

7,500

15,000

22,500

€45,000

€90,000

€135,000

€45, 000 €135, 000

=

1

€90, 000

3

€135, 000

=

2

3

3

3

Joint costs allocated, M, 1/3 × €120,000; T, 2/3 × €120,000

€40,000

€80,000

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€120,000

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3

a

Physical measure (litres) method: Methanol €52,500

Sales Cost of goods sold: Joint costs Separable costs Total costs Gross margin

b

Turpentine €105,000

30,000 7,500 37,500 €15,000

90,000 15,000 105,000 € 0

Total €157,500 120,000 22,500 142,500 €15,000

Estimated net realisable value method: Methanol

Sales

Turpentine

Total

€52,500

€105,000

€157,500

40,000

80,000

120,000

7,500

15,000

22,500

Total costs

47,500

95,000

142,500

Gross margin

€5,000

€10,000

€15,000

Wood alcohol

Turpentine

Cost of goods sold: Joint costs Separable costs

4 Wood Alcohol Turpentine Total Expected final sales value of production, WA, 2,500 × €60.00; T, 7,500 × €14.00 Deduct expected separable costs to complete and sell, WA, 2,500 × €12.00 + 0.20 × €150,000; T, 7,500 × €2.00 Estimated net realisable value at split-off point

€150,000

15,000

75,000

€90,000

€90,000

€180,000

€ 180, 000

Joint costs allocated, WA, 0.5 × €120,000; T, 0.5 × €120,000

€255,000

60,000

€ 90, 000

Weighting

€105,000

Total

= 0.5

€60,000

€90, 000 €180, 000

€60,000

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= 0.5

1.0

€120,000

Bhimani, Horngren, Datar and Rajan, Management and Cost Accounting, 5th Edition, Instructor’s Manual

An incremental approach demonstrates that the company should use the new process: Incremental revenue, (€60.00 − €21.00) × 2,500 Incremental costs: Added processing, €9.00 × 2,500 Taxes, (0.20 × €60.00) × 2,500 Incremental operating income from further processing

€97,500 €22,500 30,000

Proof: Total sales of both products Joint costs Separable costs

52,500 €45,000 €255,000 120,000

75,000 Cost of goods sold New gross margin Old gross margin Difference in gross margin

Solution Exhibit 6.20[AQ6]

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195,000 60,000 15,000 €45,000

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6.21

Alternative methods of joint-cost allocation, product-mix decisions. (40 min)

A diagram of the situation is in Solution Exhibit 6.21. 1

Calculation of joint-cost allocation proportions:

a A

Sales value at split-off €50,000

Proportions 50/200 = 0.25

Allocation of €100,000 joint costs €25,000

B

30,000

30/200 = 0.15

15,000

C

50,000

50/200 = 0.25

25,000

D

70,000

70/200 = 0.35

35,000

€200,000

1.00

€100,000

b Physical measure(litres)

Allocation of €100,000 joint Costs

Proportions

A

300,000

300/500 = 0.60

€60,000

B

100,000

100/500 = 0.20

20,000

C

50,000

50/500 = 0.10

10,000

D

50,000

50/500 = 0.10

10,000

500,000

1.00

€100,000

c Estimated net realisable value

Allocation of €100,000 joint costs

Final sales value

Separable costs

A

€300,000

€200,000

€100,000

100/200 = 0.50

€50,000

B

100,000

80,000

20,000

20/200 = 0.10

10,000

C

50,000

–

50,000

50/200 = 0.25

25,000

D

120,000

90,000

30,000

30/200 = 0.15

15,000

€200,000

1.00

€100,000

Proportions

Calculation of gross-margin percentages: a

Sales value at split-off method: Super A

Super B

Super C

Super D

€300,000

€100,000

€50,000

€120,000

€570,000

25,000

15,000

25,000

35,000

100,000

Separable costs

200,000

80,000

0

90,000

370,000

Total costs

225,000

95,000

25,000

125,000

470,000

Gross margin

€75,000

€5,000

€25,000

€(5,000)

€100,000

25%

5%

50%

(4.17%)

17.54%

Sales Joint costs

Gross-margin percentage

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b

Physical measure method: Super A

Super B

Super D

Total

€300,000

€100,000

€50,000

€120,000

€570,000

60,000

20,000

10,000

10,000

100,000

Separable costs

200,000

80,000

0

90,000

370,000

Total costs

260,000

100,000

10,000

100,000

470,000

Gross margin

€40,000

€

0

€40,000

€20,000

€100,000

Gross-margin percentage

13.33%

0%

80%

16.67%

17.54%

Sales Joint costs

c

Super C

Estimated net realisable value method: Super A

Sales

Super B

Super C

Super D

Total

€300,000

€100,000

€50,000

€120,000

€570,000

50,000

10,000

25,000

15,000

100,000

Separable costs

200,000

80,000

0

90,000

370,000

Total costs

250,000

90,000

25,000

105,000

470,000

Gross margin

€50,000

€10,000

€25,000

€15,000

€100,000

Gross-margin percentage

16.67%

10%

50%

12.5%

17.54%

Joint costs

Summary of gross-margin percentages: Joint cost Super D

Super A

Super B

Sales value at split-off

25.00%

5%

50%

(4.17%)

Physical measure

13.33%

0%

80%

16.67%

16.67%

10%

50%

12.50%

allocation method

Estimated value

2

net

realisable

Super C

Further processing of A into Super A:

Incremental revenue, €300,000 − €50,000 Incremental costs Incremental operating income from further processing

€250,000 200,000 €50,000

Further Processing of B into Super B: Incremental revenue, €100,000 − €30,000 Incremental costs Incremental operating income from further processing

€70,000 80,000 (€10,000)

Further Processing of D into Super D: Incremental revenue, €120,000 − €70,000 Incremental costs Incremental operating income from further processing

€50,000 90,000 €(40,000)

Operating income can be increased by €50,000 if both B and D are sold at their split-off point.

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Solution Exhibit 6.21

6.22

Joint and by-products, estimated net realisable value method. (30 min)

A diagram of the situation is in Solution Exhibit 6.22. 1

Allocate joint costs between Alpha and Gamma

Alpha: Sales value, 46,200 kg of Alpha × €5 (19,800 kg of Beta × €1.20) Deduct marketing costs (Beta) Estimated net realisable value (Beta) Total final sales value Deduct additional costs: Processing (Department Two) Processing (Department Four) Estimated net realisable value at split-off point

€231,000 €23,760 8,100 15,660 246,660 38,000 23,660

61,660 €185,000

Gamma: Sales value, 40,000 kg × €12 Deduct processing (Department Three) Estimated net realisable value at split-off point

Alpha Gamma

Estimated net realisable value €185,000 315,000 €500,000

Weighting 37% 63 100%

€480,000 165,000 €315,000 Allocation of €120,000 joint costs €44,400 75,600 €120,000

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2

Income statement through gross margin for alpha: Sales (38,400 kg × €5) Production costs: Allocated joint costs Department 2 Department 4 Total costs of production Deduct estimated net realisable value of Beta Net cost of production Deduct closing stock Cost of goods sold Gross margin

€192,000 €102,000 38,000 23,660 163,660 15,900 147,760 29,552 118,208 €73,792

Estimated net realisable value of Beta equals the revenue from Beta (€24,000) minus its related marketing costs (€8,100). Closing stock equals the net cost of production (€147,760) times 20%. Solution Exhibit 6.22

*Calculation of kilograms of Gamma: Let X = Good output 44 000 – 0.1X = X X = 40 000

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6.23

Joint-cost allocation, process further or sell by-products. (75 min)

1[AQ7]

Expected final sales value of productiona Deduct expected separable costs to complete and sell Estimated net realisable value at split-off point Weightingb Joint costs allocatedc

Altox

Lorex

Hycol

Total

€595,000 –

€2,500,000

€660,000 –

€3,755,000

1 €595,000 0.253 €455,400

1,400,000 €1,100,000 0.467 €840,600

1 €660,000 0.280 €504,000

1,400,000 €2,355,000 1.000 €1,800,000

(€3.50 × 170,000); (€5.00 × 500,000); (€2 × 330,000) (€595,000 ÷ 2,355,000); (€1,100,000 ÷ €2,355,000); (€660,000 ÷ €2,355,000) c (€1,800,000 × 0.253); (€1,800,000 × 0.467); (€1,800,000 × 0.280) a b

2

Further Processing Altox Incremental revenue (€5.50 × 150,000) − (€3.50 × 170,000) €825,000 − €595,000 Incremental processing cost Incremental operating income

€230,000 250,000 €(20,000)

Further Processing Lorex Incremental revenue (€5.00 × 500,000) − (€2.25 × 500,000) €2,500,000 − €1,125,000 Incremental processing cost

€1,375,000 1,400,000

Incremental operating income

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€(25,000)

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Further Processing Hycol Incremental revenue [€1.80 × (330,000 × 1.25)] − (€2 × 330,000) €742,500 − €660,000 Incremental processing cost Incremental operating income

€82,500 75,000 €7,500

Current Policy Sell Altox at split-off Process Lorex further Sell Hycol at split-off Joint costs Operating income

€595,000 1,100,000 660,000 2,355,000 1,800,000 €555,000

Preferred options Sell Altox at split-off Sell Lorex at split-off Process Hycol further Joint costs Operating income

€595,000 1,125,000 667,500 2,387,500 1,800,000 €587,500

Nor-Pharma is €32,500 better off by changing two of its current policies – it should sell Lorex at split-off (€25,000 improvement) and process Hycol further (€7,500 improvement). 3

a

Nor-Pharma would be better off by €12,000 by selling Dorzine to Nor-Chem.

Further processing Dorzine Incremental revenue (€0.75 × 50,000) + €17,500a €37,500 + €17,500 Incremental processing cost Incremental operating income a

b

€55,000 43,000 €12,000

Disposal costs avoided by processing further €0.35 × 50,000 = €17,500

The decision to treat Dorzine should not affect decisions as to whether to process further or sell at the split-off point. Accounting decisions about jointproduct/by-product distinctions do not affect total revenues or total costs.

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CHAPTER 7

Income effects of alternative stock-costing methods Teaching tips and points to stress Variable costing and absorption costing Students frequently confuse the distinction between gross margin (GM) and contribution margin (CM). There are two differences: fixed manufacturing costs and variable non-manufacturing costs. Absorption Costing (AC) expenses total fixed manufacturing costs related to units sold (as part of CGS) before obtaining GM. In contrast, variable costing (VC) expenses total fixed manufacturing costs only after obtaining CM. In addition, in AC, all non-manufacturing expenses are subtracted after GM, but in VC, variable non-manufacturing expenses are subtracted before CM. The difference between VC and AC operating profits is a matter of timing. Under VC, fixed manufacturing costs are expensed in the period incurred. Under AC, fixed manufacturing costs are inventoried and are not expensed until the related units are sold. VC I/S use the CM approach that highlights the distinction between VC and FC that is central to variable costing. The CM approach emphasises the lump sum FC that is expensed in the period incurred. In contrast, AC I/S use the gross margin approach that distinguishes between manufacturing and non-manufacturing costs. VC is not acceptable for tax or external financial reporting in most countries. If VC is used, it must be run in addition to some type of absorption costing system. Surveys show that 30–50% of companies use VC for some internal reports. Thus, for many companies, the benefits of VC must outweigh the cost of running a VC system and making yearly adjustments to conform to external reporting requirements. Ask students, ‘When are the benefits of VC likely to outweigh its costs?’ [Ans.: When VC tells us something new – i.e. when it gives an answer different from AC.], ‘What factors increase the magnitude of the difference between AC and VC profit?’ [Ans.: High fixed manufacturing costs (otherwise it does not matter much how you account for them) and large fluctuations in stock levels (if stock levels are stable, there is less difference between fixed manufacturing costs embedded in opening versus closing stocks).]

Comparison of standard variable costing and standard absorption costing The PVV is the difference between lump sum budgeted fixed manufacturing costs that are allocated to WIP. Since fixed manufacturing costs are not allocated to WIP under VC (fixed manufacturing costs are expensed as incurred), there can be no PVV under VC. Stress the intuition behind formula 1. VC expenses all fixed manufacturing costs in the period incurred. AC allocates fixed manufacturing costs to units produced in this period and does not 98 © Pearson Education Limited 2012

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expense them until the related units are sold. Fixed manufacturing costs are current period costs that AC defers to the future (making AC profit higher relative to VC profit). Conversely, fixed manufacturing costs are costs deferred from prior periods that AC expenses in the current period, when the related units are sold (making AC lower relative to VC). AC operating profit exceeds VC operating profit if there is a net deferral of fixed manufacturing costs and vice versa. The difference between AC and VC is more important for traditional manufacturers with lots of stock. Under IT, the distinction becomes less important since fixed manufacturing costs in the stocks can be immaterial if stocks are very low.

Performance measures and absorption costing This section emphasises management’s incentives to manipulate AC OS. To increase AC OS, managers increase production and defer fixed manufacturing costs in the increased ES. This incentive opposes recent attempts to reduce (e.g. JIT). Conversely, managers might also decrease AC profit by drawing down, if they have met this year’s target profit. Ask students, ‘Under what conditions is lengthening the time period used to evaluate performance likely to be most effective?’ [Ans.: When managers expect to be in the same position for the next 3–5 years.] The recent increase in managers’ mobility (whether voluntary or not) can limit the effectiveness of this proposal. Again stress the importance of multiple evaluation criteria, such as occurs in the balanced scorecard (see Chapter 22). The object is to get fixed manufacturing costs into the individual product costs. The only way to do this is to ‘unitise’ the fixed manufacturing costs through a fixed manufacturing cost rate. To do so, we need to choose a denominator volume. This choice is the subject of Part II. Stress that this choice arises in AC but not VC or throughput costing. Neither VC nor throughput costing unitises fixed manufacturing costs since they are not attached to individual products, but are expensed as a lump sum in the period incurred.

Solutions to review questions 7.1

No. Differences between variable costing and absorption costing are due to accounting for fixed manufacturing costs. Fixed marketing and distribution costs are not accounted for differently under variable costing and absorption costing.

7.2

Yes, variable manufacturing costing is a more descriptive term than variable costing. The focus is on manufacturing costs only. Variable marketing and other variable nonmanufacturing costs are treated as period costs when variable costing is used.

7.3

The main issue between variable costing and absorption costing is the proper timing of the release of fixed manufacturing costs as costs of the period: a

at the time of incurrence, or

b

at the time the finished units to which the fixed overhead relates are sold.

Variable costing uses (a) and absorption costing uses (b).

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7.4

No. A company that does make a variable-cost/fixed-cost distinction is not forced to use any specific costing method. The example in the text of Chapter 7 makes a variablecost/fixed-cost distinction. As illustrated, it can use variable costing, absorption costing or throughput costing. A company that does not make a variable-cost/fixed-cost distinction cannot use variable costing or throughput costing. However, it is not forced to adopt absorption costing. For internal reporting, it could, for example, classify all costs as costs of the period in which they are incurred.

7.5

Variable costing does not view fixed costs as unimportant or irrelevant, but it maintains that the distinction between behaviours of different costs is crucial for certain decisions. The planning and management of fixed costs is critical, irrespective of what stockcosting method is used.

7.6

Under absorption costing, heavy reductions of stock during the accounting period might combine with low production and a large production volume variance. This combination could result in lower operating profit even if the unit sales level rises.

7.7

Examples of dysfunctional decisions managers may make to increase reported operating profit are:

7.8

a

Plant managers may switch production to those orders that absorb the highest amount of manufacturing overhead, irrespective of the demand by customers.

b

Plant managers may accept a particular order to increase production even though another plant in the same company is better suited to handle that order.

c

Plant managers may defer maintenance beyond the current period to free more time for production.

Approaches used to reduce the negative aspects associated with using absorption costing include: a

Changing the accounting system. •

Adopting either variable or throughput costing, both of which reduce the incentives of managers to build up stock.

•

Adopting a stock-holding charge for managers who tie up funds in stock.

b

Extending the time period used to evaluate performance. By evaluating performance over a longer time period (say, three to five years), the incentive to take short-run actions that reduce long-term profit is lessened.

c

Including non-financial as well as financial variables in the measures used to evaluate performance.

7.9

The theoretical capacity and practical capacity denominator-level concepts emphasise what a plant can supply. The normal utilisation and master-budget utilisation concepts emphasise what customers demand for products produced by a plant.

7.10

Normal utilisation is the denominator-level concept based on the level of capacity utilisation that satisfies average customer demand over a period (say, two or three years), which includes seasonal, cyclical or other trend factors. Where managers do not have a high level of confidence in forecasting two to three years in the future, they may prefer master-budget utilisation (which is based on only one year ahead) as the denominator level.

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7.11

Comparison of actual costing methods. (20–30 min)

The numbers are simplified to ease calculations. This problem avoids standard costing and its complications. 1

a

Variable-costing profit statements Year 1 Sales Production

Profit (€3 per unit)

Year 2

1,000 units

Sales

1,400 units Production €3,000

1,200 units 1,000 units €3,600

Variable costs: Opening stock

€0

€200

Variable cost of goods manufactured

700

500

Cost of goods available for sale Closing stocka

700

700

200

100

Variable manufacturing cost of goods sold

500

600

1,000

1,200

Variable marketing and admin. costs Variable costs:

1,500

1,800

Contribution margin

1,500

1,800

Fixed costs Fixed manufacturing costs

700

700

Fixed marketing and admin. costs

400

400

Fixed costs

1,100

1,100

Operating profit

€400

€700

a Unit stockable costs: Year 1: €700 ÷ 1,400 = €0.50 per unit Year 2: €500 ÷ 1,000 = €0.50 per unit

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b

Absorption-costing profit statements Year 1 Sales 1,000 units Production 1,400 units €3,000

Profit (€3 per unit) Cost of goods sold: Opening stock Variable manufacturing costs Fixed manufacturing costsa Cost of goods available for sale Closing stockb

Year 2 Sales 1,200 units Production 1,000 units €3,600

€0 700 700 1,400 400

Cost of goods sold Gross margin Marketing and administrative costs: Variable marketing and admin. costs Fixed marketing and admin. costs Marketing and admin. costs Operating profit

€400 500 700 1,600 240 1,000

1,360

2,000

2,240

1,000 400

1,200 400 1,400 €600

1,600 €640

a Fixed manufacturing costs: Year 1: €700 ÷ 1,400 = €0.50 per unit Year 2: €700 ÷ 1,000 = €0.70 per unit b Unit stockable costs: Year 1: €1,400 ÷ 1,400 = €1.00 per unit Year 2: €1,200 ÷ 1,000 = €1.20 per unit

2 Year 1 Variable costing: Operating profit Closing stock Absorption costing: Operating profit Closing stock Fixed manuf. overhead • in opening stock • in closing stock

Absorption Variable costing costing operating operating income income

=

Fixed manuf.costs – in closing stock

Year 1: €600 − €400

= =

€200 − €0 €200

Year 2: €640 − €700

= =

€140 − €200 −€60

Year 2

€400 200

€700 100

€600 400

€640 240

0 200

200 140

Fixed manuf.costs in opening stock

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3

7.17

a

Absorption costing is more likely than variable costing to lead to stock buildups. Under absorption costing, operating profit in a given accounting period is increased because some fixed manufacturing costs are accounted for as an asset (stock) instead of as a cost of the current period.

b

Although variable costing will counteract undesirable stock build-ups, other measures can be used without abandoning absorption costing. Examples include budget targets and non-financial measures of performance such as maintaining specific stock levels, stock turnovers, delivery schedules and equipment maintenance schedules.

Variable and absorption costing, explaining operating profit differences. (30 min) 1

Key inputs for profit statement calculations are:

Opening stock Production Goods available for sale Units sold Closing stock

April

May

0 500 500 350 150

150 400 550 520 30

The unit fixed and total manufacturing costs per unit under absorption costing are: April €2,000,000 500 €4,000 €10,000 €14,000

(a) Fixed manufacturing costs (b) Units produced (c) = (a) ÷ (b) Unit fixed manufacturing costs (d) Unit variable manufacturing costs (e) = (c) + (d) Unit total manufacturing costs

a

May €2,000,000 400 €5,000 €10,000 €15,000

Variable costing April 2011

Profitsa Variable costs Opening stock b Variable cost of goods manufactured Cost of goods available for sale c Closing stock Variable manufacturing cost of goods sold Variable marketing costs Total variable costs Contribution margin Fixed costs Fixed manufacturing costs Fixed marketing costs Total fixed costs Operating profit a

May 2011

€8,400,000 € 0 5,000,000 5,000,000 1,500,000 3,500,000 1,050,000

€12,480,000 €1,500,000 4,000,000 5,500,000 300,000 5,200,000 1,560,000 6,760,000 5,720,000

4,500,000 3,850,000 2,000,000 600,000

2,000,000 600,000 2,600,000 €1,250,000

€24,000 × 350; €24,000 × 520

b

€10,000 × 500; €10,000 × 400

c

€10,000 × 150; €10,000 × 30

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2,600,000 €3,120,000

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b

Variable costing April 2011

a

€8,400,000

Profit Cost of goods sold Opening stock b Variable manufacturing costs c Fixed manufacturing costs Cost of goods available for sale d Closing costs Cost of goods sold Gross margin Marketing costs e Variable marketing costs Fixed marketing costs Total marketing costs Operating profit

€ 0 5,000,000 2,000,000 7,000,000 2,100,000

€2,100,000 4,000,000 2,000,000 8,100,000 450,000

1,050,000 600,000

7,650,000 4,830,000 1,560,000 600,000

1,650,000 €1,850,000

€24,000 × 350; €24,000 × 520

b

€10,000 × 500; €10,000 × 400

c

€4,000 × 500; €5,000 × 400

d

€14,000 × 150; €15,000 × 30

e

€3,000 × 350; €3,000 × 520

(

€12,480,000

4,900,000 3,500,000

a

2

May 2011

)(

2,160,000 €2,670,000

)

Absorption costing Variable costing – = operating income operating income

Fixed manufacturing cost in closing stock

–

Fixed manufacturing cost in opening costs

April: €1,850,000 − €1,250,000 €600,000

= =

(€4,000 × 150) − (€0) €600,000

€2,670,000 − €3,120,000 − €450,000 −€450,000

= = =

(€5,000 × 30) − (€4,000 × 150) €150,000 − €600,000 −€450,000

May:

The difference between absorption and variable costing is due solely to moving fixed manufacturing costs into stocks as stocks increase (as in April) and out of stocks as they decrease (as in May).

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7.18

Variable and absorption costing, explaining operating profit differences. (40 min) 1 Key inputs for profit statement calculations are: January

February

March

0

300

300

Production

1,000

800

1,250

Goods available for sale

1,000

1,100

1,550

Units sold

700

800

1,500

Closing stock

300

300

50

Opening stock

The unit fixed and total manufacturing costs per unit under absorption costing are: January

February

March

(a) Fixed manufacturing costs

DKr 400,000

DKr 400,000

DKr 400,000

(b) Units produced

DKr

1,000

DKr

800

DKr

1,250

(c) = (a) ÷ (b) Unit fixed manufacturing costs

DKr

400

DKr

500

DKr

320

(d) Unit variable manufacturing costs

DKr

900

DKr

900

DKr

900

(e) = (c) + (d) Unit total manufacturing costs

DKr

1,300

DKr

1,400

DKr

1,220

7a Variable costing (in DKr) January 2011 a

Profit

February 2011

1,750,000

March 2011

2,000,000

3,750,000

Variable costs b

0

270,000

270,000

Variable cost of goods c manufactured

900,000

720,000

1,125,000

Cost of goods available for sale

900,000

990,000

1,395,000

270,000

270,000

45,000

Variable manufacturing cost of goods sold

630,000

720,000

1,350,000

Variable marketing e costs

420,000

480,000

900,000

Opening stock

Closing stock

d

Total variable costs

1,050,000

1,200,000

2,250,000

Contribution margin

700,000

800,000

1,500,000

Fixed costs Fixed manufacturing costs

400,000

Fixed marketing costs

140,000

400,000

400,000

140,000

140,000

Total fixed costs

540,000

540,000

540,000

Operating profit

160,000

260,000

960,000

a

DKr 2,500 × 700; DKr 2,500 × 800; DKr 2,500 × 1,500

b

DKr 900 × 0; DKr 900 × 300; DKr 900 × 300

c

DKr 900 × 1,000; DKr 900 × 800; DKr 900 × 1,250

d

DKr 900 × 300; DKr 900 × 300; DKr 900 × 50

e

DKr 600 × 700; DKr 600 × 800; DKr 600 × 1,500

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7-1b

Absorption costing (in DKr) January 2011

Profita

February 2011

1,750,000

March 2011

2,000,000

3,750,000

Cost of goods sold Opening stockb

0

390,000

420,000

900,000

720,000

1,125,000

400,000

400,000

400,000

Cost of goods available for sale 1,300,000

1,510,000

1,945,000

420,000

61,000

Variable manufacturing costs d

Fixed manufacturing costs e

c

390,000

Closing stock

Cost of goods sold

910,000

1,090,000

1,884,000

Gross margin

840,000

910,000

1,866,000

Marketing costs Variable marketing costsf

420,000

480,000

900,000

Fixed marketing costs

140,000

140,000

140,000

Total marketing costs

560,000

620,000

1,040,000

Operating profit

280,000

290,000

826,000

a

DKr 2,500 × 700; DKr 2,500 × 800; DKr 2,500 × 1,500

b

DKr 900 × 0; DKr 1300 × 300; DKr 1,400 × 300

c

DKr 900 × 1,000; DKr 900 × 800; DKr 900 × 1,250

d

DKr 400 × 1,000; DKr 500 × 800; DKr 320 × 1,250

e

DKr 1,300 × 300; DKr 1,400 × 300; DKr 1,220 × 50

f

DKr 600 × 700; DKr 600 × 800; DKr 600 × 1,500

2

(

)(

)

Absorption costing Variable costing – = operating income operating income

 Fixed manufacturing  −  Fixed manufacturing   cost in closing stock   cost in opening stock      January:

DKr 280,000 − DKr 160,000 = DKr 120,000 =

DKr 120,000 − DKr 0 DKr 120,000

February:

DKr 290,000 − DKr 260,000 = DKr 30,000 =

DKr 150,000 − DKr 120,000 DKr 30,000

March:

DKr 826,000 − DKr 960,000 = − DKr 134,000 =

DKr 16,000 − DKr 150,000 − DKr 134,000

The difference between absorption and variable costing is due solely to moving fixed manufacturing costs into stocks as stocks increase (as in January) and out of stocks as they decrease (as in March).

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7.20

Alternative denominator-level concepts. (25–30 min)

1 Budgeted fixed manufacturing overhead per period

Budgeted denominator level

€42,000,000

5,256,000

€7.99

Practical capacity

42,000,000

3,500,000

12.00

Normal utilisation

42,000,000

2,800,000

15.00

(a) Jan–June 2011

21,000,000

1,120,000

18.75

(b) July–Dec 2011

21,000,000

1,680,000

12.50

Denominatorlevel concept Theoretical capacity

Budgeted fixed manufacturing overhead cost rate

Master-budget utilisation

The differences arise for several reasons: a

The theoretical and practical capacity concepts emphasise supply factors while normal utilisation and master-budget utilisation emphasise demand factors.

b

The two separate six-month rates for the master-budget utilisation concept differ because of seasonal differences in budgeted production.

2 •

Theoretical capacity – based on the production of output at maximum efficiency for 100% of the time.

•

Practical capacity – reduces theoretical capacity for unavoidable operating interruptions such as scheduled maintenance time, shutdowns for holidays and other days and so on. For each of the three determinants of capacity at Montpazier, practical capacity is less than theoretical capacity:

Theoretical capacity Practical capacity

3

Barrels per hour

Working hours per day

Working days per year

Capacity

600 500

24 20

365 350

= 5,256,000 = 3,500,000

The smaller the denominator, the higher the amount of overhead costs capitalised for stock units. Thus, if the plant manager wishes to be able to ‘adjust’ plant operating profit by building up stock, master-budget utilisation or possibly normal utilisation would be preferred.

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7.21

Operating profit effects of alternative denominator-level concepts. (30 min) 1

Solution Exhibit 7.17 reports the operating profit for each denominator-level concept. Calculations include: Budgeted fixed manufacturing overhead cost rate

Total manufacturing costs

€46.30

€7.99

€54.29

Practical capacity

46.30

12.00

58.30

Normal capacity

46.30

15.00

61.30

Denominatorlevel concept

Variable manufacturing cost*

Theoretical capacity

* €120,380,000 ÷ 2,600,000 = €46.30 per barrel

The output-level overhead variance for each denominator-level concept is: a

Theoretical capacity: €40,632,000 − (€7.99 × 2,600,000) €40,632,000 − €20,774,000 = €19,858,000 U

b

Practical capacity: €40,632,000 − (€12.00 × 2,600,000) €40,632,000 − €31,200,000 = €9,432,000 U

c

Normal utilisation: €40,632,000 − (€15.00 × 2,600,000) €40,632,000 − €39,000,000 = €1,632,000 U

Illustration of operating profit differences: Practical − Theoretical:

€13,848,000 − €13,046,000 = €802,000

Normal − Practical:

€14,448,000 − €13,848,000 = €600,000

Normal − Theoretical:

€14,448,000 − €13,046,000 = €1,402,000

The difference in operating profit across the three denominator-level concepts is due solely to differences in fixed manufacturing overhead included in the closing stock of 200,000 barrels:

Practical capacity:

} €802,000 difference 200,000 × €12.00 = €2,400,000 } €600,000 difference

Normal capacity:

200,000 × €15.00 = €3,000,000

Theoretical capacity:

200,000 × €7.99 = €1,598,000

2

Given the data in this question, the theoretical capacity concept reports the lowest operating profit and thus (other things being equal), the lowest tax bill for 2005. Bières Ronsard benefits by having deductions as early as possible. The theoretical capacity denominator-level concept maximises the deductions for manufacturing costs.

3

The tax office may restrict the flexibility of a company in several ways. a

Restrict the denominator-level concept choice.

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b

Restrict the cost line items that can be expensed rather than inventoried.

c

Restrict the ability of a company to use shorter write-off periods or more accelerated write-off periods for stock-related costs.

Solution Exhibit 7.21 Theoretical capacity Profit (€68 × 2,400,000)

Normal utilisation

€163,200,000

€163,200,000

€163,200,000

0

0

0

120,380,000

120,380,000

120,380,000

0,774,000 141,154,000

31,200,000 151,580,000

39,000,000 159,380,000

10,858,000

11,660,000

12,260,000

130,296,000 a 19,858,000

139,920,000 a 9,432,000

147,120,000 a 1,632,000

150,154,000 13,046,000 0 €13,046,000

149,352,000 13,848,000 0 €13,848,000

148,752,000 14,448,000 0 €14,448,000

Cost of goods sold: Opening stock Variable manufacturing costs, €46.30 × 2,600,000

Practical capacity

Fixed manufacturing overhead costs, €7.99, €12, €15 × 2,600,000 Cost of goods available for sale Closing stock, €54.29, €58.30, €61.30 × 200,000 Total cost of goods sold (at budgeted costs) Adjustment for variances Cost of goods sold Gross margin Other costs Operating profit a. See the answer to requirement 1 for calculation.

7.22

Ginnungagap in 2007. (40 min)

This problem always generates active classroom discussion. 1

The treatment of fixed manufacturing overhead in absorption costing is affected primarily by what denominator level is selected as a base for allocating fixed manufacturing costs to units produced. In this case, is 10,000 tonnes per year, 20,000 tonnes or some other denominator level the most appropriate base? We usually place the following possibilities on the board or overhead projector and then ask the students to indicate by vote how many used one denominator level rather than another. Incidentally, discussion tends to move more clearly if variablecosting profit statements are discussed first, because there is little disagreement as to calculations under variable costing. a

Variable-costing profit statements:

Profit (and contribution margin) Fixed costs: Manufacturing costs Marketing and administrative cost Operating profit

€280,000 40,000

2006 €300,000

2007 €300,000

Together €600,000

320,000 €(20,000)

320,000 €(20,000 )

640,000 €(40,000)

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b

Absorption profit statements:

The ambiguity about the 10,000- or 20,000-unit denominator level is intentional. IF YOU WISH, THE AMBIGUITY MAY BE AVOIDED BY GIVING THE STUDENTS A SPECIFIC DENOMINATOR LEVEL IN ADVANCE. Alternative 1. Use 20,000 units as a denominator; fixed manufacturing overhead per unit is €280,000 ÷ 20,000 = €14.

Profit Manufacturing costs @ €14 Deduct closing stock Cost of goods sold Underallocated manuf. overhead − output level variance Marketing and administrative costs Total costs Operating profit

2006 €300,000 280,000 140,000 140,000

2007 €300,000 — — 140,000*

Together €600,000 280,000 — 280,000

—

280,000

280,000

40,000 180,000 €120,000

40,000 460,000 €(160,000)

80,000 640,000 €(40,000)

* Stock carried forward from 2010 and sold in 2011.

Alternative 2. Use 10,000 units as a denominator; fixed manufacturing overhead per unit is €280,000 ÷ 10,000 = €28. 2006 €300,000 560,000 280,000 280,000

2007 €300,000 — — 280,000

Together €600,000 560,000 — 560,000

Underallocated manuf. overhead − output level variance

—

280,000

—

Overallocated manuf. overhead − output level variance Marketing and administrative costs Total costs Operating profit

(280,000)

—

—

40,000 40,000 €260,000

40,000 600,000 €(300,000)

80,000 640,000 €(40,000)

Profit Manufacturing costs @ €28 Deduct closing stock Cost of goods sold*

*Stock carried forward from 2010 and sold in 2011.

Note that operating profit under variable costing follows sales and is not affected by stock changes. Note also that students will understand the variable-costing presentation much more easily than the alternatives presented under absorption costing.

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2

Breakeven point =

Fixed costs = Contribution margin per tonne

€320, 000 €30

= 10,667 tonnes per year or 21,333 tonnes for two years. If the company could sell 667 more tonnes per year at €30 each, it could get the extra €20,000 contribution margin needed to break even. Most students will say that the breakeven point is 10,667 tonnes per year under both absorption costing and variable costing. The logical question to ask a student who answers 10,667 tonnes for variable costing is: ‘What operating profit do you show for 2011 under absorption costing?’ If a student answers €120,000 (alternative 1 above) or €260,000 (alternative 2 above), ask: ‘But you say your breakeven point is 10,667 tonnes. How can you show an operating profit on only 10,000 tonnes sold during 2010?’ The answer to the above dilemma lies in the fact that operating profit is affected by both sales and production under absorption costing. Optional: Given that sales would be 10,000 tonnes in 2010, solve for the production level that will provide a breakeven level of zero operating profit. Using the formula in Chapter 7, sales of 10,000 units and a fixed manufacturing overhead rate of €14 (based on €280,000 ÷ 20,000 units, denominator level = €14): Let P = Production level

Breakeven sales in units = 10,000 tonnes =

(

)

Total fixed + costs

Fixed manuf. Breakeven overhead × sales in – Units rate units produced Unit contribution margin

€320, 000 + €14(10,000 - P ) €30

= €320,000 + €140,000 − €14P = €160,000 = 11,429 units (rounded)

€300,000 €14P P Proof:

Gross margin, 10,000 × (€30 − €14) Output level variance (20,000 − 11,429) × €14 Marketing and administrative costs Operating profit

€160,000 €120,000 40,000 € 0

160,000

Given that production would be 20,000 tonnes in 2010, solve for the breakeven unit sales level. Using the formula in the chapter and a fixed manufacturing overhead rate of €14 (based on a denominator level of 20,000 units): Let N

N=

(

= Breakeven sales in units

)

Total fixed + costs

Fixed manuf. overhead × N – Units rate produced

Unit contribution margin

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€320, 000 + €14(N – 20, 000)

N

=

€30N

= €320,000 + €14N − €280,000

€16N

= €40,000

N

= 2,500 units

€30

Proof: Gross margin, 2,500 × (€30 − €14) Output level MOH variance Marketing and administrative costs Operating profit

€40,000 € 0 40,000

40,000 € 0

We find it helpful to put the following comparisons on the board: Variable costing breakeven

= f(sales) = 10,000 tonnes

Absorption costing breakeven

= f(sales and production) = f(10,000 and 11,429) = f(2,500 and 20,000)

3

Absorption costing stock cost: Either €140,000 or €280,000 at the end of 2010 and zero at the end of 2011. Variable costing: Zero at all times. This is a major criticism of variable costing and focuses on the issue of the definition of an asset.

4

Operating profit is affected by both production and sales under absorption costing. Hence, most managers would prefer absorption costing because their performance in any given reporting period, at least in the short run, is influenced by how much production is scheduled towards the end of a period.

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PART II

ACCOUNTING INFORMATION FOR DECISION MAKING

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CHAPTER 8

Cost–volume–profit relationships Teaching tips and points to stress Terminology and abbreviations Management accounting research has shown that volume, while not the only cost driver, is usually a major cost driver.

The breakeven point The equation method has two advantages. First, if students can remember the income statement format, they can reconstruct the equation. Memorisation is unnecessary. Second, the equation form is more general and so is easier to apply with multiple products (see product mix discussion later in this chapter), with multiple cost and revenue drivers, and with changes in the cost structure (e.g. following annotation). In the Do-All example, what would be the breakeven point (BEP) if Mary had paid the wholesaler €20 per unit for the first 10 units and then €100 per unit for additional units? All order data remain unchanged. There are two relevant ranges, and each should be examined for a BEP. 0–10 units €200Q − €120Q − €2,000 = €0 Q = 25 units → not a valid BEP, since 25 is outside the relevant range (0–10) in which this cost structure is valid.

Over 10 units €200Q − [(€120 ×10) − €100 (Q − 10)] − €2,000 = € 0 Q = 22 units → valid BEP, since 22 is within the relevant range (over ten units).

In contrast to the linear model depicted in Exhibit 8.1, economists usually specify curvilinear TR and TC functions. Within the relevant range (RR), a linear approximation is acceptable, but projections outside the RR will be misleading. At higher volumes, this linear approximation overstates TR (since prices must be cut to increase volume) and understates TC (since ever higher output increases costs such as overtime premiums). Overstating revenues and understating costs yields a bad combination in which the linear model overestimates profit at high volume levels beyond the RR. In economics, the slope of the TR function equals marginal revenue (MR). Since the TR function in Exhibit 8.1 is linear, its slope – MR – is a price per unit. The slope of the TC function is marginal cost (also a constant in Exhibit 8.1), which equals variable cost (VC) per 114 © Pearson Education Limited 2012

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unit. Note that selling price and VC per unit are constant across a wide range of volumes only if there is perfect competition in input and output markets. Under imperfect competition, selling price must be reduced to increase unit sales. Linear CAP analysis is most appropriate under perfect competition. Even if TR and TC are not linear functions across a broad range of quantities (i.e. if CVP assumptions 1 and 2 are violated), a linear approximation may still be acceptable within a relevant range of, say, 15–40 units. In this case, an alternative (to Exhibit 8.1) presentation is as follows. This format clearly conveys the limitations of the data and suggests that interferences outside the 15–40 unit range are potentially dangerous explorations.

The PV graph Curriculum linkage. This example illustrates how individual managers can use CVP analysis to make cost structure choices that fit their own risk–return preferences. Trading off higher FC to reduce VC increases managers’ downside risk if demand is low, but increases the potential (upside) return if demand is high (because the lower VC per unit increases CM per unit). This is the operating leverage concept; students may have encountered it in a finance course.

As explained previously, relative to the curvilinear economist’s model, the linear CVP model tends to overestimate profits. Consequently, the PV relation is especially sensitive to violations of the linearity assumption, so it is important to confine the analysis to a relevant range within which linearity is a reasonable approximation. The following linkage helps students integrate several topics in Chapter 8. The text discusses two approaches to dealing with uncertainty in CVP analysis (i.e. violation of CVP assumption 3) – sensitivity analysis and decision models that explicitly incorporate uncertainty via probability distributions (i.e. expected value analysis presented in the Appendix to Chapter 8). The sensitivity analysis presented here estimates outcomes under various combinations of USP, UVC, FC and TOI. This approach can be viewed as estimating payoffs (TOI) under a variety of actions (UVC and FC) and states (revenue EUR). The Appendix explains how to employ payoffs under various actions/states of nature in combination with the probabilities of these states occurring in decision models that help managers choose the action that maximises expected monetary value.

Effects of revenue mix on profit This section raises an important question: How short is the short run? A grey area requiring judgement; the short run is often defined as the length of time FC will remain fixed, or hard to change, in the normal course of business. To help students internalise the mix concept, suggest that they visualise the software being sold only in bundles of 3 units: 2 Do-Alls plus 1 Superword. Explain that ‘bundling’ is a good way to think of a problem, even though it need not be literally true. Some students find it easier to analyse CVP problems with multiple products in terms of ‘bundles’ – in the Do-All illustration, 1 bundle would include 2 Do-Alls and 1 Superword.

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USP = 2 × €200 + €130 = €530 UVC = 2 × €120 + €90 = €330 FC = €2,000 €530Q − €330Q − €2,000 = 0 Q = 10 bundles

→ (2 Do-Alls/bundle) × 10 bundles = 20 Do-Alls (1 Bundle/bundle) × 10 bundles = 10 Superwords This example illustrates how the CM helps firms decide which products to push. In the absence of production constraints, shifting the marketing efforts to high CM products – if successful – can increase profits dramatically. This is one reason why the dealers push loaded (high CM) rather than stripped-down cars. If, however, the firm faces production constraints, such as limited MH or DLH, then management should push products that have the highest CM per unit of the constraint.

Not-for-profit institutions and CVP This application of CVP in a not-for-profit setting is particularly interesting for two reasons. First, the effect of budget cuts on government agencies is topical, given the current political climate that emphasises reducing spending on social programmes. Second, the not-for-profit sector constitutes an increasing proportion of the economy. There are two distinctions between CM and GM. Variable non-manufacturing expenses are subtracted to get CM (but not GM), and fixed manufacturing costs are subtracted to get GM (but not CM); e.g.: Selling price/case Variable manufacturing cost/case Variable mktg. and admin. cost/case Fixed manufacturing cost/case Fixed mktg. and admin. cost/case

€15.00 2.00 4.00 4.50 1.50

CM = €15 − 2 − 4 = €9 GM = €15 − 2 − 4.5 = €8.50

Solutions to review questions 8.1

The general case is costs and revenues – cost and revenue drivers – profit analysis. The general case has many revenue and many cost drivers. CVP is a special case, where there is a single revenue driver (output units) and a single cost driver (output units).

8.2

Operating profit is total revenues from operations for the accounting period minus total costs from operations (excluding income taxes): Operating profit = Total revenues − Total costs

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Net profit is operating profit plus non-operating revenues (such as interest revenue) minus non-operating costs (such as interest cost) minus income taxes. Chapter 8 assumes non-operating revenues and non-operating costs are zero. Thus, Chapter 8 calculates net profit as: Net profit = Operating profit − Income taxes 8.3

The assumptions underlying the CVP analysis outlined in Chapter 8 are: 1

Total costs can be divided into a fixed component and a component that is variable with respect to the level of output.

2

The behaviour of total revenues and total costs is linear (straight line) in relation to output units within the relevant range.

3

The unit selling price, unit variable costs and fixed costs are known.

4

The analysis either covers a single product or assumes that a given revenue mix of products will remain constant as the level of total units sold changes.

5

All revenues and costs can be added and compared without taking into account the time value of money.

8.4

CVP certainly is simple, with its assumption of a single revenue driver, a single cost driver, and linear revenue and cost relationships. Whether these assumptions make it simplistic depends on the decision context. In some cases, these assumptions may be sufficiently accurate for CVP to provide useful insights. The examples in Chapter 8 illustrate how CVP can provide such insights. In more complex cases, the general case can be used in a computer planning model.

8.5

Contribution margin is calculated as revenues minus all costs that vary with respect to the output level. Gross margin is calculated as revenues minus cost of goods sold. Contribution margin percentage is the total contribution margin divided by revenues. Variable-cost percentage is the total variable costs (with respect to units of output) divided by revenues. Margin of safety is the excess of budgeted revenues over breakeven revenues.

8.6

8.7

Examples include: •

Manufacturing – substituting a robotic machine for hourly paid workers.

•

Marketing – changing a sales force compensation plan from a percentage of sales revenue to a fixed salary.

•

Customer service – hiring a subcontractor to do customer repair visits on an annual retainer basis rather than a per visit basis.

Examples include: •

Manufacturing – subcontracting a component to a supplier on a per unit basis to avoid purchasing a machine with a high fixed depreciation cost.

•

Marketing – changing a sales compensation plan from a fixed salary to a percentage of sales revenue basis.

•

Customer service – hiring a subcontractor to do customer service on a per visit basis rather than an annual retainer basis.

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8.8

CVP analysis is always conducted for a given specified time horizon. One extreme is a very short time horizon. For example, some holiday cruises offer deep price discounts for people who offer to take any cruise on a day’s notice. One day prior to a cruise most costs are fixed. The other extreme is several years. Here, a much higher percentage of total costs typically is variable. CVP itself is not made any less relevant when the time horizon lengthens. What happens is that many items classified as fixed costs in the short run may become variable costs with a longer time horizon.

8.9

A company with multiple products can compute a breakeven point by assuming there is a constant mix of products at different levels of total revenue.

8.10

An increase in the income tax rate does not affect the breakeven point. Operating income at the breakeven point is zero and thus no income taxes will be paid at this point.

Solutions to exercises 8.12

CVP, changing revenues and costs. (15–20 min) 1

USP = 8% × €1,000 = €80 UVC = €35 (€17 + €18) UCM = €45 FC = €22,000 a month a

Q=

b

Q=

FC €22,000 = UCM 45 = 489 tickets (rounded up) FC + TOI €22,000 + €10,000 = UCM €45 €32,000 = €45 = 712 tickets (rounded up)

2

USP UVC UCM FC a

Q =

= = = =

€80 €29 (€17 + €12) €51 €22,000 a month

FC €22,000 = €51 UCM = 432 tickets (rounded up)

b

Q =

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8.13

CVP, changing revenues and costs. (20 min) 1

Soleil charges €1,000 per round-trip ticket. Hence, each ticket will yield only a €48 commission. USP UVC UCM FC a

Q =

= = = =

€48 €29 (€17 + €12) €19 €22,000

FC €22,000 = €19 UCM = 1,158 tickets (rounded up)

b

Q =

FC + TOI €22,000 + €10,000 = UCM €19 =

€32,000 €19

= 1,685 tickets (rounded up) The reduced commission sizably increases the breakeven point and the number of tickets required to yield a target operating income of €10,000: 8% old commission

Upper limit on commission of €48

Breakeven point

432

1,158

Attain OI

628

1,685

2

The €5 delivery fee can be treated as either an extra source of revenue (as done below) or a cost offset. Either approach increases UCM by €10: USP UVC UCM FC a

Q =

= = = =

€53 (€48 + €5) €29 (€17 + €12) €24 €22,000

FC €22,000 = €24 UCM = 917 tickets (rounded up)

b

Q =

FC + TOI €22,000 + €10,000 = UCM €24 =

€32,000 €19

= 1,334 tickets (rounded up) The €5 delivery fee results in a higher contribution margin which reduces both the breakeven point and the tickets sold to attain operating income of €10,000. 119 © Pearson Education Limited 2012

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8.14

CVP exercises. (20 min) 1

USP UVC UCM FC Output a

= = = = =

€0.50 €0.30 €0.20 €900,000 a year 5,000,000 units

Operating profit = (UCM × Output) − FC = €100,000

b

Breakeven Q =

FC €900,000 = USM 0.20

= 4,500,000 pens Breakeven revenue = 4,500,000 × €0.5 = €2,250,000 2

USP UVC UCM FC Output

= = = = =

€0.50 €0.34 €0.16 €900,000 a year 5,000,000 units

Operating profit = (UCM × Output) − FC = (€100,000) 3

USP UVC UCM FC Output

= = = = =

€0.50 €0.30 €0.20 €990,000 a year 5,500,000 units

Operating profit = (UCM × Output) − FC = €110,000 4

USP UVC UCM FC Output

= = = = =

€0.40 €0.27 €0.13 €720,000 a year 7,000,000 units

Operating profit = (UCM × Output) − FC = €190,000

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5

USP UVC UCM FC Output

= = = = =

€0.50 €0.30 €0.20 €990,000 a year 5,000,000 units

Breakeven Q =

FC €990,000 = USM 0.20

= 4,950,000 pens 6

USP UVC UCM FC Output

= = = = =

€0.55 €0.30 €0.25 €920,000 a year 5,000,000 units

Breakeven Q =

FC €920,000 = USM 0.25

= 3,680,000 pens 8.15

CVP, changing cost inputs. (5–10 min) 1

Revenues −

Variable Fixed Target − = costs costs operating income

Let Q = number of units to yield target operating income. For target operating income of €0:

2

= €15Q − €6Q − €450 €9Q = Q =

€0 €450 50 units

€15Q − €5Q − €450 = €10Q = Q =

€0 €450 45 units

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8.16

CVP, international cost structure differences. (10 min)

1 Annual fixed costs (€)

Variable Variable Unit Breakeven manuf. mark/dist. contrib. point in costs per costs per margin (€) units sweater (€) sweater (€) 6,500,000 32 8.00 11.00 13 500,000 4,500,000 32 5.50 11.50 15 300,000 12,000,000 32 13.00 9.00 10 1,200,000 (a) Breakeven point in units sold (b) Breakeven point in revenues (€) 500,000 16,000,000 300,000 9,600,000 1,200,000 38,400,000

Cyprus Turkey Ireland Cyprus Turkey Ireland

Selling price (€)

2 Revenues (€) 25,600,000 25,600,000 25,600,000

Cyprus Turkey Ireland

Variable costs (€)

Fixed costs (€)

Operating income (€)

6,500,000 4,500,000 12,000,000

3,900,000 7,500,000 −4,000,000

15,200,000 13,600,000 17,600,000

Turkey has the lowest breakeven point – it has both the lowest fixed costs (€4,500,000) and the lowest variable cost per unit (€17.00). Hence, for a given selling price, Turkey will always have a higher operating income (or a lower operating loss) than Cyprus or Ireland. The Ireland breakeven point is 1,200,000 units. Hence, with sales of 800,000 units, it has an operating loss of €4,000,000. 8.17

CVP, income taxes. (10–15 min) 1

2

3

4

Operating profit

= Net profit ÷ (1 − tax rate) =

€84,000 ÷ (1 − 0.40)

=

€140,000

Contribution margin

=

Fixed costs + Operating profit

Contribution margin

=

€300,000 + €140,000

Contribution margin

=

€440,000

Revenues: 0.80 Revenues =

Contribution margin

0.20 Revenues =

€440,000

Revenues

€2,200,000

=

Breakeven point

= Fixed costs ÷ Contribution margin percentage

Breakeven point

= €300,000 ÷ 0.20 =

€1,500,000

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8.18

CVP, movie production. (10 min) 1

Fixed costs = €5,000,000 (production cost) Unit variable cost = €0.20 per €1 revenue (marketing fee) Unit contribution margin = €0.80 per €1 revenue a

Break even point in revenues =

Fixed costs Unit contribution margin per € 1 revenue €5, 000, 000

=

€0.80

= €6,250,000 b 2

8.19

Espasso receives 62.5% of box-office receipts. Box-office receipts of €10,000,000 translate to €6,250,000 in revenues to Espasso.

Revenues, 0.625 × €300,000,000

€187,500,000

Variable costs, 0.20 × €187,500,000 Contribution margin Fixed costs Operating income

37,500,000 150,000,000 5,000,000 €145,000,000

CVP, cost structure differences, movie production. (20 min) 1 a

Contract A Fixed costs for Contract A: Production costs €21,000,000 Fixed salary 15,000,000 Total fixed costs €36,000,000

Unit variable cost = €0.25 per €1 revenue marketing fee Unit contribution margin = €0.75 per €1 revenue Box-office receipts of €76,800,000 translate to €48,000,000 in revenues to Espasso. 2[AQ8] b Contract B Fixed costs for Contract B: Production costs €21,000,000 Fixed salary 3,000,000 Total fixed costs €24,000,000

Unit variable cost = €0.25 per €1 revenue fee to Artes e Media €0.15 per €1 revenue residual to director/actors €0.40 per €1 revenue Unit contribution margin = €0.60 per €1 revenue €24,000,000

= €40,000,000 €0.60 Box-office receipts of €64,000,000 translate to €40,000,000 in revenues to Espasso. Breakeven points in revenues =

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Difference in breakeven points

Contract A has a higher fixed cost and a lower variable cost per sales euro. In contrast, Contract B has a lower fixed cost and a higher variable cost per sales euro. In Contract B, there is risk sharing between Espasso and Vieira, Moura and Rebello that lowers the breakeven point, but results in Espasso receiving less operating income if Tornado 2 is a mega-success. 2

Revenues, 0.625 × €300,000,000 Variable costs, 0.40 × €187,500,000 Contribution margin Fixed costs Operating income

€187,500,000 75,000,000 112,500,000 24,000,000 € 88,500,000

Tornado 2 has a higher breakeven point than Tornado due to having a higher level of fixed costs and a lower unit contribution margin. 8.20

Not-for-profit institution. (15–25 min) 1

Let Q = Number of patients Revenues − Variable costs − Fixed costs

= 0

SFr 400,000 − SFr 400Q − SFr 150,000 = 0 SFr 400Q = SFr 400,000 − SFr 150,000 Q = SFr 250,000 ÷ 400 Q = 625 patients 2

Revenues − Variable costs − Fixed costs

= 0

SFr 360,000 − SFr 400Q − SFr 150,000 = 0 SFr 400Q = SFr 360,000 − SFr 150,000 Q = SFr 210,000 ÷ 400 Q = 525 patients

The reduction in service is more than the 10% reduction in the budget. Without restructuring operations, the quantity of service units must be reduced by 16% (from 625 to 525 patients) to stay within the budget. 3

Let Y = Drug prescriptions per patient SFr 360,000 − 625Y − SFr 150,000 = 0 625Y = SFr 210,000 Y = SFr 336 Percentage drop: (SFr 400 − SFr 336) ÷ 400 = 16%

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Regarding requirements 2 and 3, note that the decrease in service can be measured by a formula: % Reduction in service =

% Budget change % Variable cost

The variable-cost percentage is (SFr 400 × SFr 625) ÷ SFr 400,000 = 62.5% % Reduction in service = 8.21

10% = 16% 6.25%

Appendix: CVP analysis under uncertainty. (15 min) 1. Both products have the same unit contribution margin:

Unit contribution margin

Breakeven point

2

=

Selling price per unit − Variable costs per unit

=

€10 − €8 = €2

=

Fixed cost Unit contribution margin

=

€400,000 €2

=

200,000 units for each product

The expected demand for the two umbrellas is: Event

Emerald green

Shocking pink

(1) Demand

(2) Probability

(1) % (2) Units

(3) Probability

(1) % (3) Units

50,000

0.0

–

0.1

5,000

100,000

0.1

10,000

0.1

10,000

200,000

0.2

40,000

0.1

20,000

300,000

0.4

120,000

0.2

60,000

400,000

0.2

80,000

0.4

160,000

500,000

0.1

50,000

0.1

50,000

1.0 Expected demand

1.0 300,000

305,000

Expected operating income of emerald green umbrellas: €2(300,000 − €400,000) = €200,000 Expected operating income of shocking pink umbrellas: €2(305,000 − €400,000) = €210,000 The shocking pink umbrellas should be chosen because they have the higher expected operating income.

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3

The expected operating income from the two products would be identical. If the choice criterion is to maximise expected operating income, the company will be indifferent between emerald green and shocking pink umbrellas. However, assume that the management considers risk factors. Emerald green umbrellas, for example, have a 10% chance of selling only 100,000 units, which would result in a net operating loss of €200,000. Also, there is a 30% chance that sales of emerald green will exceed 300,000 units. If this event happens, the operating income of emerald green umbrellas will be higher than the operating income of shocking pink umbrellas. The expected values are important, but the dispersion of the probability distribution is also important. Normally, the wider the dispersion, the greater the risk. Knowledge of the entire probability distribution helps management assess the risk before reaching a decision.

8.23

Appendix: uncertainty, CVP. (15–20 min) 1

Larsson pays Häglund SKr[AQ9] 2 million plus SKr 4 (25% of SKr 16) for every home purchasing the pay-per-view. The expected value of the variable component is: Demand (1)

Payment (2) = (1) × SKr 4

Probability (3)

Expected payment (4)

100,000

SKr 400,000

0.05

SKr 20,000

200,000

800,000

0.10

80,000

300,000

1,200,000

0.30

360,000

400,000

1,600,000

0.35

560,000

500,000

2,000,000

0.15

300,000

1,000,000

4,000,000

0.05

200,000 SKr 1,520,000

The expected value of Larsson’s payment to Häglund is SKr 3,520,000 (SKr 2,000,000 fixed fee + SKr 1,520,000). 2

USP = SKr 16 UVC = SKr 6 (SKr 4 payment to Häglund + SKr 2 variable cost) UCM = SKr 10 FC = SKr 2,000,000 + SKr 1,000,000 = SKr 3,000,000 Q

=

FC UCM

= Skr 3,000,000 SKr 10 = 300,000 If 300,000 homes purchase the pay-per-view, Larsson will break even.

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8.24

CVP, shoe stores. (20–30 min) 1 a

In number of pairs: Fixed costs £360,000 = = 40,000 pairs Contribution margin per pair £9.00

b

In revenues: Fixed costs £360,000 = = £1, 200,000 Contribution margin % per pound sterling 100% − 70%

2

Revenues, £30 × £35,000

£1,050,000

Variable costs, £21 × £35,000

735,000

Contribution margin

315,000

Fixed costs

360,000

Operating income (loss)

£ (45,000)

An alternative approach is that 35,000 units is 5,000 units below the breakeven point and the unit contribution margin is £9.00: £9.00 × 5,000 = £45,000 below the breakeven point. 3

Fixed costs: £360,000 + £81,000 = £441,000 Contribution margin per pair = £10.50

4

£441,000 = 42,000 pairs £9.00

a

Breakeven point in units =

b

Breakeven point in revenues = £30 × 42,000 = £1,260,000

Fixed costs = £360,000 Contribution margin per pair = £8.70 £360,000 = 41,380 pairs £8.70

a

Breakeven point in units =

b

Breakeven point in revenues = £30 × 41,380 = £1,241,400

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5

Breakeven point = 40,000 pairs Store manager receives commission on 10,000 pairs Cost of commission = £0.30 × 10,000 = £3,000 Revenues, £30 × £50,000

£1,500,000

Variable costs Cost of shoes

£975,000

Salespeople commission

75,000

Manager commission

3,000

1,053,000

Contribution margin

447,000

Fixed costs

360,000

Operating income

£87,000

An alternative approach is 10,000 units × £8.70 = £87,000 8.25

CVP, shoe stores. (20–25 min) 1

Because the unit sales level at the point of indifference would be the same for each plan, the revenue would be equal. Therefore, the unit sales level sought would be that which produces the same total costs for each plan. Let Q = unit sales level a

£19.50Q + £360,000 + £81,000 = £21.00Q + £360,000 £81,000 = £1.50Q Q = 54,000 units

2 Commission plan Sales in units

Salary plan

50,000

60,000

50,000

60,000

£1,500,000

£1,800,000

£1,500,000

£1,800,000

1,050,000

1,260,000

975,000

1,170,000

Contribution margin

450,000

540,000

525,000

630,000

Fixed costs

360,000

360,000

441,000

441,000

90,000

180,000

84,000

189,000

Revenues @ £30.00 Variable costs @ £21.00 and £19.50

Operating income (£)

The decision regarding the plans will depend heavily on the unit sales level that is generated by the fixed salary plan. For example, as the answer to requirement (1) shows, at identical unit sales levels in excess of 54,000 units, the fixed salary plan will always provide a more profitable final result than the commission plan.

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Let TQ = Target number of units

3

a

£30.00TQ − £19.50TQ − £441,000 = £168,000 £10.50TQ = £609,000 TQ = £609,000 ÷ £10.50 TQ = 58,000 units

b

£30.00TQ − £21.00TQ − £360,000 = £168,000 £9.00TQ = £528,000 TQ = £528,000 ÷ £9.00 TQ = 58,667 units (rounded)

The decision regarding the salary plan depends heavily on predictions of demand. For instance, the salary plan offers the same operating income at 58,000 units as the commission plan offers at 58,667 units. 8.26

Sensitivity and inflation. (10–20 min) 1 Revenues

£30 × 48,000

£1,440,000

£18 × 2,000

36,000

£1,476,000

Variable costs Goods sold

£19.50 × 50,000

975,000

Commission

5% × £1,476,000

73,800

1,048,800

Contribution margin

427,200

Fixed costs

360,000

Operating income

£67,200

An alternative approach is: Contribution margin on 48,000 pairs × £9.00 Deduct negative contribution margin on unsold pairs, 2,000 × [£18.00 − (£19.50 + £.90* commission)]

*

2

£432,000 4,800

Contribution margin

427,200

Fixed costs

360,000

Operating income

£67,200

5% of £18.00 = £0.90

Optimal operating income, given perfect knowledge, would be the £432,000 contribution calculated above, minus £360,000 fixed costs, or £72,000.

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3

The point of indifference is where the operating incomes are equal. Let X = unit cost per pair that would produce the identical operating income of £67,200. Then, 48,000[£30.00 − (X[AQ10] + £1.50)] − £360,000 = £ 67,200 48,000(£28.50 − X) − £360,000 = £ 67,200 £1,368,000 − 48,000X − £360,000 = £ 67,200 48,000X = £940,800 X = £19.60

Therefore, any rise in purchase cost in excess of £19.60 per pair increases the operating income benefit of signing the long-term contract. As a short-term solution you could take the £4,800 difference between the ‘ideal’ operating income (of £72,000) at the current cost per pair and the operating income under the contract (of £67,200) and divide it by 48,000 units to get 10p per pair difference.

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CHAPTER 9

Determining how costs behave Teaching tips and points to stress General issues in estimating cost functions Linearity means that within the relevant range (RR), all costs are either totally fixed or truly variable. Although economists suggest that total costs are likely to behave in a non-linear fashion, a linear approximation may be reasonable within the RR. Whether the linear approximation is acceptable depends on the cost of more sophisticated analysis as against the likelihood of improved decisions from more accurate cost estimates. Classification of labour as a VC or FC often depends on how employees are paid. In many fastfood chains, if sales are insufficient to justify the number of employees at the store, some employees are sent home and paid only for the hours they worked. Here, labour is a VC. Conversely, for a manufacturer with a stable, guaranteed-wage work force, labour is not a VC.

Cost estimation approaches The industrial engineering, conference and account analysis methods require less historical data than do most quantitative analyses. Therefore, cost estimation for a new product will usually begin with one or more of these three methods. Quantitative analysis may be adopted later, after the company gains experience (and the necessary data).

Steps in estimating a cost function Remind students that the high–low method simply calculates the formula for a line, based on two data points. The concept is the same as in secondary school algebra. An important criticism of the high–low method is that it bases the cost function on only two data points – two that may be extreme cases! If students have learned regression, remind them of the following: 1

The data should first be plotted to determine whether a linear relation exists. If not, a nonlinear model should be estimated.

2

If the data span more than one RR, piece-wise regression (estimating a different function for each relevant range) is appropriate.

3

Regression minimises the sum of the squared deviations, so the reasons for and effect of extreme observations must be investigated.

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Evaluating and choosing cost drivers Cost functions have a good fit either simply by chance or because there is an underlying economic relation between the cost and the driver. The cost function is more likely to predict accurately in the future if that function is based on an economic relation. It is important for cost functions to be economically plausible, in addition to fitting the data well. Some students give excessive (sole) emphasis to the goodness-of-fit criterion. For example, when using simple regression (where one independent variable is used to explain the change in the dependent variable), students often choose the variable that has the highest r2. Stress the need to consider all three evaluation criteria. As in most real-world applications, the cost function is not valid at shutdown in the Møre-Teppe example. The intercept term does not capture fixed costs at zero machine-hours, because at shutdown, some costs can be avoided; e.g. companies can generally cut FC by dismissing salaried workers, selling PPE, etc. In sum, zero volume or shutdown is typically outside the relevant range, so the intercept term should not be interpreted as fixed costs at shutdown. It is simply the constant component of the equation that provides the best (linear) fit. Students are often confused by the difference between the behaviour of total costs and that of unit costs. Exhibit 9.8 illustrates a cost function that increases at a decreasing rate. Stress that a declining cost per unit does not mean that total costs decline. (For total costs to decline, unit costs would have to become negative!) With a declining cost per unit, total sales will still increase, but at a decreasing rate as in Exhibit 9.8. To illustrate, ask students to think about purchasing personalised business cards. Cards might cost €50 for the first 100, €40 for the next 100 and thereafter. Even though the cost per 100 declines, students will still pay more for additional cards.

Non-linearity and cost functions Step-fixed costs may be hard to affect. Consequently, a major means of cost management is to utilise each level as fully as possible, within the constraints of prediction and sales capacity. For example, in Exhibit 9.10, the manager’s goal would be to have about 7,500, 15,000 or 22,500 hours of furnace time in order to fully utilise 1, 2 or 3 furnaces.

Learning curves and non-linear cost functions Emphasis on the continuous improvement management theme (introduced in Chapter 1) has prompted companies to develop experience curves that target continual cost reductions. These experience curves yield information useful in preparing budgets, developing continuous improvement standards and performance evaluation.

Appendix: regression analysis It is important to examine the data carefully for extreme observations because extremes can have a material effect on the estimated regression line. This is because regression analysis estimates the regression lines to minimise the sum of the squared deviations of each data point from the line. This squaring reflects a quadratic loss function, whereby extreme data points have a relatively large influence in the regression estimates. Many statistical regression packages have procedures to identify such ‘influential observations’. 132 © Pearson Education Limited 2012

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Most statistical regression packages can help assess the extent to which the goodness of fit, significance of independent variables and specification of estimation assumptions criteria are met. In addition, the packages often provide procedures designed to mitigate the effects of these violations of the regression assumptions. However, in the end, it is most important that cost analysts use their judgement to assess whether the independent variable is plausibly a cost driver for the dependent variable costs. Costs are often ‘sticky’ downwards. Once employees become accustomed to a certain level of resources, it can be difficult to reduce those resources, even if the amount of work to be done has declined. For example, many managers now do their own word processing. However, secretarial costs will not decline unless management consciously reduces the number of secretaries. Thus, the level of control management exerts can affect the linearity of the cost function. Constant variance of residuals and independence of residuals are relatively technical concepts. The text does not pursue these concepts in detail, as the basic concern is with the use of cost data in regression and not with regression analysis itself. Users of regression analysis may want to consult with technical experts on regression, when obtaining a reliable cost function is critical to their decisions.

Solutions to review questions 9.1

9.2

9.3

Three alternative linear cost functions are: 1

Variable-cost function – a cost function in which total costs change in proportion to the cost driver in the relevant range.

2

Fixed-cost function – a cost function in which total costs do not change with changes to the cost driver in the relevant range.

3

Mixed-cost function – a cost function that has both variable and fixed elements. Total costs change, but not in proportion to changes in the cost driver in the relevant range.

The two assumptions are: 1

Variations in the total cost of a cost object are explained by variations in a single cost driver.

2

A linear cost function adequately approximates cost behaviour within the relevant range of the cost driver. A linear cost function is a cost function, where within the relevant range, the graph of total costs versus a single cost driver forms a straight line.

A linear cost function is a cost function, where within the relevant range, the graph of total costs versus a single cost driver forms a straight line. An example of a linear cost function is a cost function for use of a telephone line, where the terms of use are a fixed charge of €10,000 per year plus a €2 per minute charge for phone use. A non-linear cost function is a cost function, where within the relevant range, the graph of total costs versus a single cost driver does not form a straight line. Examples include economies of scale in advertising, where an agency can double the number of advertisements for less than twice the cost, step-function costs and learning-curve-based costs.

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9.4

No. High correlation merely indicates that the two variables move together in the data examined. It is essential also to consider economic plausibility before making inferences about cause and effect. Without any economic plausibility for a relationship, it is less likely that a high level of correlation observed in one set of data will be similarly found in other sets of data.

9.5

Four approaches to estimating a cost function are:

9.6

9.7

9.8

1

Industrial engineering approach

2

Conference method

3

Account analysis method

4

Quantitative analysis of current or past cost relationships.

The conference method develops cost estimates on the basis of analysis and opinions gathered from various departments of an organisation (purchasing, process engineering, manufacturing, employee relations, etc.). Three criteria for evaluating cost functions and choosing cost drivers are: 1

The speed with which cost estimates can be developed.

2

The pooling of knowledge from experts across functional areas.

3

The improved credibility of the cost function to all personnel.

A learning curve is a function that shows how labour-hours per unit decline as units of output are increased. Two models used to capture different forms of learning are: 1

Cumulative average-time learning model. The cumulative average time per unit declines by a constant percentage, each time the cumulative quantity of the units produced is doubled.

2

Incremental unit-time learning model. The incremental unit time (the time needed to produce the last unit) declines by a constant percentage, each time the cumulative quantity of units produced is doubled.

Four key assumptions examined in specification analysis are: 1

Linearity between the dependent variable and the independent variable.

2

Constant variance of residuals for all values of the independent variable.

3

Residuals are independent of each other.

4

Residuals are normally distributed.

9.9

No. A cost driver is any factor whose change causes a change in the total cost of a related cost object. A cause-and-effect relationship underlies selection of a cost driver. Some users of regression analysis include numerous independent variables in a regression model in an attempt to maximise goodness of fit, irrespective of the economic plausibility of the independent variables included. Some of the independent variables included may not be cost drivers.

9.10

No. Multicollinearity exists when two or more independent variables are highly correlated with each other.

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Solutions to exercises 9.12

Identifying variable-, fixed- and mixed-cost functions. (15 min) 1

See Solution Exhibit 9.12.

2

Contract 1: y = €50 Contract 2: y = €30 + €0.20 × D Contract 3: y = €1 × D where D is the number of kilometres travelled in the day.

3 Contract 1 2 3

Cost function Fixed Mixed Variable

Solution Exhibit 9.12

Plots of car rental contracts offered by Bellingwolde.

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9.13

9.14

Matching graphs with descriptions of cost behaviour. (20 min) 1

(1)

2

(7) A step-function cost rather than a fixed cost.

3

(11)

4

(2)

5

(9)

6

(12)

7

(3)

8

(9)

Account analysis method. (20 min) 1

2

Variable costs: Car wash labour Soap, cloth and supplies Water Power to move conveyor belt Total variable costs

€240,000 32,000 28,000 72,000 €372,000

Fixed costs: Depreciation Supervision Cashier Total fixed costs

€64,000 30,000 16,000 €110,000

Variable costs per car =

€372, 000 80, 000

= €4.65 per car

Total costs estimated for 90,000 cars = €110,000 + (€4.65 × 90,000) = €528,500.

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3

Average cost in 2010 = Average cost in 2011 =

€372, 000 + €110, 000 80, 000

€528, 500 90, 000

=

€482, 000 80, 000

= €6.025

= €5.87

Some students may assume that power costs of running the continuously moving conveyor belt is a fixed cost. In this case the variable costs in 2010 will be €300,000 and the fixed costs be €182,000. The variable costs per car in 2010 = €300,000 ÷ 80,000 cars = €3.75 per car. Total costs for 90,000 cars in 2011 = €182,000 + (€3.75 × 90,000) = €519,500. The average cost of washing a car in 2011 = €519,500 ÷ 90,000 = €5.77. 9.15

Linear cost approximation. (25 min) 1

Slope coefficient (b) = =

Constant (a)

Difference in cost Difference in labour hours €529, 000 – €400,000 7,000 – 4, 000

= €43.00

= €529,000 − €43.00 (7,000) = €228,000

Cost function

= €228,000 + €43.00 (professional labour-hours)

The linear cost function is plotted in Solution Exhibit 9.15. No, the constant component of the cost function does not represent the fixed overhead cost of Marre-Quise. The relevant range of professional labour-hours is from 3,000 to 8,000. The constant component provides the best available starting point for a straight line that approximates how a cost behaves within the 3,000– 8,000 relevant range. 2

A comparison at various levels of professional labour-hours is as follows. The linear cost function is based on the formula of €228,000 per month plus €43.00 per professional labour-hour. Total overhead cost behaviour:

Actual total overhead costs Linear approximation Actual minus linear approximation

Month 1

Month 2

Month 3

Month 4

Month 5

Month 6

€340,000

€400,000

€435,000

€477,000

€529,000

€587,000

357,000

400,000

443,000

486,000

529,000

572,000

0

€ (8,000)

€ (9,000)

0

€ 5,000

00007,000

00008,000

€(17,000)

Professional labour-hours

3,000

€

0004,000

5,000 00006,000

€

The data are shown in Solution Exhibit 9.15. The linear cost function overstates costs by €8,000 at the 5,000-hour level and understates costs by €15,000 at the 8,000-hour level.

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3

Based on

Based on linear

Actual Contribution before deducting incremental overhead Incremental overhead Contribution after incremental overhead

Cost function

€38,000

€38,000

35,000

43,000

€ 3,000

€(5,000)

Solution Exhibit 9.15

Linear-cost function plot of professional labour-hours on total overhead costs for Marre-Quise consultants.

9.16

Regression analysis, service company. (25 min) 1a Solution Exhibit 9.16 plots the relationship between labour-hours and overhead costs and shows the regression line.

y = €48,271 + €3.93X b

Economic plausibility. Labour-hours appears to be an economically plausible driver of overhead costs for a catering company. Overhead costs such as scheduling, hiring and training of workers and managing the workforce are largely incurred to support labour. Goodness of fit. The vertical differences between actual and predicted costs are extremely small, indicating a very good fit. The good fit indicates a strong relationship between the labour-hour cost driver and overhead costs. Slope of the regression line. The regression line has a reasonably steep slope from left to right. The positive slope indicates that, on average, overhead costs increase as labour-hours increase.

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2

The regression analysis indicates that, within the relevant range of 2,500–7,500 labour-hours, the variable cost per person for a cocktail party equals: Food and beverages

€15.00

Labour (0.5 hours × €10 per hour) Variable overhead (0.5 hours × €3.93 per labour-hour) Total variable cost per person

3

5.00 1.97 €21.97

To earn a positive contribution margin, the minimum bid for a 200-person cocktail party would be any amount greater than €4,394. This amount is calculated by multiplying the variable cost per person (€21.97) by the total number of people (200). At a price above the variable costs of €4,394, Hans Mehrlich will be earning a contribution margin towards coverage of his fixed costs. Of course, Hans Mehrlich will consider other factors in developing his bid, including (a) an analysis of the competition – vigorous competition will limit Mehrlich’s ability to obtain a higher price; (b) a determination of whether or not his bid will set a precedent for lower prices – overall, the prices Hans Mehrlich charges should generate enough contribution to cover fixed costs and earn a reasonable profit and (c) a judgement of how representative past historical data (used in the regression analysis) is about future costs.

Solution Exhibit 9.16

Regression line of labour-hours on overhead costs for Hans Mehrlich’s catering company.

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9.17

Learning curve, cumulative average-time learning curve. (20 min)

The direct manufacturing labour-hours (DMLH) required to produce the first 2, 4 and 8 units given the assumption of a cumulative average-time learning curve of 90% is as follows: Cumulative average-time per unit (2)

Cumulative number of units (1) 1 2 4 8

Cumulative total time (3) = (1) × (2) 3,000 5,400 9,720 17,496

3,000 2,700 (3,000 × 0.90) 2,430 (2,700 × 0.90) 2,187 (2,700 × 0.90)

Alternatively, to calculate the values in column (2) we could use the formula y = pXq where p = 3,000, X = 2, 4 or 8 and q = –0.1520, which gives when X = 2, y = 3,000 × 2–0.1520 = 2,700 when X = 4, y = 3,000 × 4–0.1520 = 2,430 when X = 8, y = 3,000 × 8–0.1520 = 2,187 Variable costs of producing 2 units 4 units 8 units Direct materials SFr 80,000 × 2; 4; 8 Direct manufacturing labour SFr 25 × 5,400; 9,720; 17,496 Variable manufacturing overhead SFr 15 × 5,400; 9,720; 17,496 Total variable costs

9.18

SFr 160,000

SFr 320,000

SFr 640,000

135,000

243,000

437,400

81,000 SFr 376,000

145,800 SFr 708,800

262,440 SFr 1,339,840

Learning curve, incremental unit-time learning curve. (20 min) 1

The direct manufacturing labour-hours (DMLH) required to produce the first 2, 3 and 4 units given the assumption of an incremental unit-time learning curve of 90% is as follows: Cumulative number of units (1) 1 2 3 4

Individual unit time for Xth unit (2) 3,000 2,700 (3,000 × 0.90) 2,539 2,430 (2,700 × 0.90)

Cumulative total time (3) 3,000 5,700 8,239 10,669

Values in column 2 are calculated using the formula y = pXq where p = 3,000, X = 2, 3 or 4 and q = –0.1520, which gives when X = 2, y = 3,000 × 2–0.1520 = 2,700 140 © Pearson Education Limited 2012

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when X = 3, y = 3,000 × 3–0.1520 = 2,539 when X = 4, y = 3,000 × 4–0.1520 = 2,430 Variable costs of producing Direct materials SFr 80,000 × 2; 3; 4 Direct manufacturing labour SFr 25 × 5,700; 8,239; 10,669 Variable manufacturing overhead SFr 15 × 5,700; 8,239; 10,669 Total variable costs

2 units

3 units

4 units

SFr 160,000

SFr 240,000

SFr 320,000

142,500

205,975

266,725

85,500 SFr 388,000

123,585 SFr 569,560

160,035 SFr 746,760

2 Variable costs of producing 2 units Incremental unit-time learning curve (from requirement 1) Cumulative average-time learning curve (from Exercise 9.18) Difference

4 units

388,000

746,760

376,000 SFr 12,000

708,800 SFr 37,960

Total variable costs for manufacturing 2 and 4 units are lower under the cumulative averagetime learning curve than under the incremental unit-time learning curve. Direct manufacturing labour-hours required to make additional units decline more slowly in the incremental unit-time learning curve than in the cumulative average-time learning curve, assuming the same 90% factor is used for both curves. The reason is that in the incremental unit-time learning curve, as the number of units doubles, only the last unit produced has a cost of 90% of the initial cost. In the cumulative average-time model, doubling the number of units causes the average cost of all the additional units produced (not just the last unit) to be 90% of the initial cost. 9.19

Evaluating alternative simple regression models, not for profit. (30–40 min) 1a Solution Exhibit 9.19A plots the relationship between number of academic programmes and overhead costs. b Solution Exhibit 9.19B plots the relationship between number of enrolled students and overhead costs. 2

Solution Exhibit 9.19C compares the two simple regression models estimated by Raphaël. Both regression models appear to perform well when estimating overhead costs. Cost function 1 using number of academic programmes as the independent variable appears to perform slightly better than cost function 2 which uses number of enrolled students as the independent variable. Cost function 1 has a high r2 and goodness of fit, a high t-value indicating a significant relationship between the number of academic programmes and overhead costs and meets all the specification assumptions for ordinary least squares regression. Cost function 2 has a lower r2 than cost function 1 and exhibits positive autocorrelation among the residuals as indicated by a low Durbin–Watson statistic.

3

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at closing down some of its academic programmes and reducing its intake of students. Reducing enrolled students may cut down on overhead costs, but it also cuts down on revenues (tuition payments), hurts the reputation of the school and reduces its alumni base, which is a future source of funds. For these reasons, ESM may prefer to downsize its academic programmes, particularly those programmes that attract few students. Of course, ESM should continue to reduce costs by improving the efficiency of the delivery of its programmes. Solution Exhibit 9.19A

Plot of number of academic programmes versus overhead costs (in thousands).

Solution Exhibit 9.19B

Plot of number of enrolled students versus overhead costs (in thousands).

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Solution Exhibit 9.19C

Comparison of alternative cost functions for overhead costs estimated with simple regression for Ecole Supérieure des Mines.

Criterion 1

Economic plausibility

2

Goodness of fit

Cost function 1: number of academic programmes as independent variable

Cost function 2: number of enrolled students as independent variable

A positive relationship between overhead costs and number of academic programmes is economically plausible at Ecole Supérieure des Mines. r2 = 0.72

A positive relationship between overhead costs and number of enrolled students is economically plausible at Ecole Supérieure des Mines. r2 = 0.55

Excellent goodness of fit.

Good goodness of fit, but not as good as for number of academic programmes.

3

t-value of 5.08 is significant. Significance of independent variable(s)

4

Specification analysis of estimation assumptions

Plot of the data indicates that assumptions of linearity, constant variance, independence of residuals and normality of residuals hold, but inferences drawn from only 12 observations are not reliable; Durbin–Watson statistic = 1.81 indicates that independence of residuals holds.

t-value of 3.53 is significant. Plot of the data indicates that assumptions of linearity, constant variance and normality of residuals hold, but inferences drawn from only 12 observations are not reliable; the Durbin–Watson statistic = 0.77 indicates that independence of residuals does not hold.

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CHAPTER 10

Relevant information for decision making Teaching tips and points to stress Information and the decision process The relevance concept is the underlying theme of Chapter 10. Students find this chapter difficult because of the variety of different types of decisions that are based on relevant costs and revenues and they have trouble applying the relevance concept to new situations. Try to assign a variety of homework problems with this chapter and emphasise the importance of independently solving problems. Emphasise to students that there are two primary keys to analysing relevant cost/revenue decisions. The first key is to distinguish between relevant and irrelevant costs and revenues. The second key is to use a CM approach. Distinguishing between VC and FC spurs, analysts to consider whether each variable and fixed cost is affected by the alternatives under consideration. The CM approach is most useful for short-run decisions, because in the long run, fewer costs are ‘fixed’. (In the very long run, nothing is fixed.) Relevant costs meet two criteria: (1) future costs that (2) differ between alternatives. Actually, only the second criterion is necessary. Past costs are already incurred, so they cannot differ between future alternative choices. However, emphasising the first criterion helps students remember that past costs are always irrelevant (except to the extent that they facilitate predictions).

An illustration of relevance: choosing output levels This section emphasises that the traditional CM approach is appropriate if (1) costs are either totally fixed or purely variable and (2) the number of output units is the only cost driver. Current management accounting thought has restricted the number of situations to which these assumptions apply. A later section relaxes these assumptions and illustrates an approach that can be used in conjunction with ABC and the hierarchy of costs described in Chapter 11. What is a one-time special order? Ask students, ‘What if the customer asks for a special order, but then a year later requests a similar deal? What if customer A asks for a special order in January, customer B asks for one in March and customer C asks for one in June?’ The one-time special order concept is more ambiguous than students realise. If the company has chronic excess capacity, it may be better off downsizing than accepting a series of special orders that do not cover full costs. The CM approach is appropriate in the short run. In the longer term, other more profitable opportunities may arise, so the company should not tie up its resources in marginally profitable products. Also, all costs must be covered in the long run. The company cannot survive by producing products that consistently sell for less than full cost.

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Warn students to be very careful with the total cost per unit that includes fixed costs (FCs) per unit. Managers often misuse total cost per unit data for decisions where FCs are not relevant. Managers may also mistakenly multiply the same ‘total cost per unit’ by different numbers of units. They may not realise that the total cost per unit changes, as the output level changes because FCs are spread over different numbers of outputs. Telling students that total cost per unit figures are valid only at the assumed output levels may help get the point across. Special orders usually do not incur regular marketing costs because they usually do not go through normal channels. There may be special fixed (marketing) costs of obtaining the order if there is excess manufacturing OH. However, the special order could increase fixed manufacturing OH if it increases output to a higher relevant range or if it requires special machinery, etc. Fixed manufacturing OH and marketing and distribution costs may or may not be relevant in special-order decisions, depending on the specific situation.

Outsourcing and make-or-buy decisions In the example in Chapter 10, even though the number of units remains the same, the total purchasing, receiving and set-up costs increase because the number of batches is doubled. This illustrates why reduction in set-up time is key as firms move to small-batch production and JIT delivery systems.

Opportunity costs, outsourcing and capacity constraints One general approach to outsourcing decisions is the following: Maximum we would pay

=

Incremental cost (outlay cost)

+

Opportunity cost of insourcing

This formula tells us how much we can pay the outside supplier and still make a profit as if we produced the number of units ourselves. We are willing to pay at least the incremental cost of insourcing (i.e. our outlay cost). If facilities would otherwise be idle, the opportunity cost of insourcing is zero because there is nothing better to do with the plant. In the example, opportunity cost is not zero because the plant can be used to produce another product. The incremental outlay cost is €150,000 and opportunity costs are €25,000 (see Panel B of Exhibit 10.7). The maximum that should be paid to the outside supplier is €175,000/10,000 = €17.50 per unit. At least two factors help explain why some companies have had high stock levels. First, since the cost of capital tied up in stock is not reported by the accounting system, management may never see this information. Second, purchasing managers are frequently rewarded for favourable price variances, so they may be tempted to purchase large quantities to obtain a quantity discount.

Irrelevance of past costs and equipment-replacement decisions The concept of sunk costs also applies to students’ personal lives. People who recognise the irrelevance of sunk costs tend to be more productive. For example, research has shown that students who start again on weak course assignments and academic staff who abandon research 145 © Pearson Education Limited 2012

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that is not progressing perform better than their peers who follow traditional advice to ‘stick with it.’ Many managers like the old adage, ‘Use it up, wear it out, make it do or do without.’ They think that past costs are relevant. This problem often occurs in the context of rapid technology changes. Managers argue that they need to recoup their investment in the old technology before investing in a new technology. However, customers may not continue to buy products based on old technology. Managers should compare the expected net inflows from the new technology with the expected net inflows from the old technology.

Appendix: linear programming The LP discussion in this appendix extends the notion, ‘maximise CM per unit of scarce resource’, advanced in the chapter in more complex settings with multiple constraints. The objective is to maximise the contribution margin (rather than the profit) per unit of the constraints. Fixed costs are irrelevant, since they are assumed to remain the same regardless of the product mix. Such analysis is most appropriate in the short run where many costs are indeed fixed with respect to the number of units of output. The graphic approach illustrated in Exhibit 10.14 is feasible with two products, three products would require a three-dimensional graph, etc. Stress that we use the graphic approach to help students develop an intuitive understanding of the basic concepts. In practice, the graphic solution is almost never used, since most LP problems involve numerous products and constraints. Companies use calculator software packages programmed to solve large LP problems. The discussion of the intuition underlying LP helps students understand why LP works. The basic point is that LP systematically analyses the exchange of a given CM per unit of scarce resource for some other contribution margin of scarce resource in order to find the optimal product mix (highest contribution margin or lowest cost). This section shows that large changes in contribution margin per unit of product may not affect the optimal product mix if there are no other nearby corner points.

Solutions to review questions 10.1

10.2

The five steps in the decision process outlined in Exhibit 10.1 of the text are: 1

Gathering information

2

Making predictions

3

Choosing an alternative

4

Implementing the decision

5

Evaluating performance.

Relevant costs are those expected future costs that differ among alternative courses of action. Historical costs are irrelevant because they are past costs and therefore cannot differ among alternative future courses of action.

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10.3

No. Relevant costs are defined as those expected future costs that differ among alternative courses of action. Thus, future costs that do not differ among the alternatives are irrelevant for deciding which alternative to choose.

10.4

Quantitative factors are outcomes that are measured in numerical terms. Some quantitative factors are financial – that is, they can be easily expressed in financial terms. Direct material is an example of a quantitative financial factor. Qualitative factors are factors that are not measured in numerical terms. An example is employee morale.

10.5

No. Some variable costs may not differ among the alternatives under consideration and hence will be irrelevant. Some fixed costs may differ among the alternatives and hence will be relevant.

10.6

No. Some of the total unit costs to manufacture a product may be fixed costs and hence, will not differ between the make and buy alternatives. These fixed costs are irrelevant to the make-or-buy decision. The key comparison is between purchase costs and the costs that will be saved if the company purchases the component parts from outside.

10.7

Opportunity cost is the contribution to income that is forgone (rejected) by not using a limited resource in its next-best alternative use.

10.8

Cost written off as depreciation is irrelevant when it pertains to a past cost. But the purchase cost of new equipment to be acquired in the future that will then be written off as depreciation is often relevant.

10.9

No. Managers tend to favour the alternative that makes their performance look best, so they focus on the measures used in the performance–evaluation model. If the performance–evaluation model does not emphasise maximising operating income or minimising costs, managers are not likely to choose the alternative that maximises operating income or minimises costs.

10.10

The text outlines two methods of determining the optimal solution to an LP problem: 1

Trial-and-error solution approach

2

Graphical solution approach.

Most LP applications in practice use standard software packages that rely on the simplex method to calculate the optimal solution.

Solutions to exercises 10.11

Relevant costs, contribution margin and product emphasis. (20–25 min) 1 Cola Selling price per case Deduct variable costs per case Contribution margin per case

Lemonade

Punch

Natural orange juice

€108.00

€115.20

€158.40

€230.40

81.00

91.20

120.60

181.20

€27.00

€24.00

€37.80

€49.20

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2

The argument fails to recognise that shelf space is the constraining factor. There are only 12 metres of front shelf space to be devoted to drinks. Consuelo should aim to get the highest daily contribution margin per metre of front shelf space:

Cola Contribution margin per case Sales (number of cases) per metre of shelf space per day Daily contribution per metre of front shelf space

3

Lemonade

Natural orange juice

Punch

€27.00

€24.00

€37.80

€49.20

25

24

4

5

€675.00

€576.00

€151.20

€246.00

The allocation that maximises the daily contribution from soft drink sales is:

Metres of shelf space

Daily contribution per metre of front shelf space

Total contribution margin per day

Cola

6

€675.00

€4,050.00

Lemonade Natural orange juice Punch

4 1 1

576.00 151.20 246.00

2,304.00 151.20 246.00

€6,751.20 The maximum of 6 metres of front shelf space will be devoted to Cola because it has the highest contribution margin per unit of the constraining factor. Four metres of front shelf space will be devoted to Lemonade, which has the second highest contribution margin per unit of the constraining factor. No more shelf space can be devoted to Lemonade, since each of the remaining two products, Natural orange juice and Punch (that have the second lowest and lowest contribution margins per unit of the constraining factor), must be given at least one metre of front shelf space. 10.12

Customer profitability, choosing customers. (20–25 min) 1

Jours-Daim should not drop the Fourbe-Riz business as the following analysis shows: Loss in revenues from dropping Fourbe-Riz

€(80,000)

Savings in costs: Variable costs Fixed costs 20% × €100,000 Total savings in costs Effect on operating income

48,000 20,000 68,000 €(12,000)

Jours-Daim would be worse off by €12,000 if it drops the Fourbe-Riz business.

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2

If Jours-Daim accepts the additional business from Fourbe-Riz, it would take an additional 500 hours of machine time. If Jours-Daim accepts all of Fourbe-Riz’s and Harpes-à-Gonds’ business for February, it would require 2,500 hours of machine time (1,500 hours for Harpes-à-Gonds and 1,000 hours for Fourbe-Riz). Jours-Daim has only 2,000 hours of machine capacity. It must, therefore, choose how much of the Harpes-à-Gonds or Fourbe-Riz business to accept. If Jours-Daim accepts any additional business from Fourbe-Riz, it must forgo some of Harpes-àGonds’s business. To maximise operating income, Jours-Daim should maximise contribution margin per unit of the constrained resource. (Fixed costs will remain unchanged at €100,000 whatever business Jours-Daim chooses to accept in February, and are therefore irrelevant.) The contribution margin per unit of the constrained resource for each customer in January is: Harpes-à-Gonds Revenues

€120,000

€80,000

42,000

48,000

€78,000

€32,000

Variable costs Contribution margin

€78,000 = €52 1,500

Contribution margin per machine-hour

Fourbe-Riz

€32,000 = €64 500

Since the €80,000 of additional Fourbe-Riz business in February is identical to jobs done in January, it will also have a contribution margin of €64 per machine-hour, which is greater than the contribution margin of €52 per machine-hour from Harpes-à-Gonds. To maximise operating income, Jours-Daim should first allocate all the capacity needed to take the Fourbe-Riz business (1,000 machine-hours) and then allocate the remaining 1,000 (2,000 − 1,000) machine-hours to Harpes-àGonds. Jours-Daim’s operating income in February would then be €16,000 as shown below, greater than the €10,000 operating income in January. Harpes-à-Gonds Contribution margin per machine-hour Machine-hours to be worked Contribution margin

Fourbe-Riz

€52

€64

1,000

1,000

€52,000

€64,000

Total

€116,000

Fixed costs

100,000

Operating income

€16,000

Alternatively, we could present Jours-Daim’s operating income by taking twothirds (1,000 ÷ 1,500 machine-hours) of Harpes-à-Gonds’s January revenues and variable costs and doubling (1,000 ÷ 500 machine-hours) Fourbe-Riz’s January revenues and variable costs.

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Harpes-à-Gonds Fourbe-Riz

Total

€80,00

€160,000

€240,000

Variable costs

28,0

96,000

124,000

Contribution margin

52,0

64,000

116,000

Revenues

Fixed costs

100,000

Operating income

€16,000

The problem indicated that Jours-Daim could choose to accept as much of the Harpes-à-Gonds and Fourbe-Riz business for February as it wants. However, some students may raise the question that Jours-Daim should think more strategically before deciding what to do. For example, how would Harpes-à-Gonds react to Jours-Daim’s inability to satisfy its needs? Will Fourbe-Riz continue to give JoursDaim €160,000 of business each month or is the additional €80,000 of business in February a special order? For example, if Fourbe-Riz’s additional work in February is only a special order and Jours-Daim wants to maintain a long-term relationship with Harpes-à-Gonds, it may in fact prefer to turn down the additional Fourbe-Riz business. It may feel that the additional €6,000 in operating income in February is not worth jeopardising its long-term relationship with Harpes-à-Gonds. Other students may raise the possibility of Jours-Daim accepting all the Harpes-à-Gonds and Fourbe-Riz business for February if it can subcontract some of it to another reliable, high-quality printer. 10.13

Relevance of equipment costs. (30–40 min) 1a Statements of cash receipts and disbursements Buy new machine

Keep Four Year 1

Years

years

2–4

together

Years Year 1

Four years together

2–4

Receipts from operations: €600,000

€150,000

€150,000

€600,000

(110,000)

(440,000)

iiiii(110,000)

iiiii(110,000)

(440,000)

(15,000)

iiiii i(60,000)

iiiii (9,000)

iiiiiiii (9,000)

(36,000)

iiiii(20,000)

iiiii (20,000)

(20,000)

iiiii (24,000)

(24,000)

8,000

8,000

€150,000

€150,000

Other operating costs

(110,000)

Operation of machine

(15,000)

Sales Deduct disbursements:

(20,000)*

Purchase of ‘old’ machine Purchase of ‘new’ equipment Cash inflow from sale of old equipment Net cash inflow

€5,000

€25,000

€80,000

€(5,000)

€31,000

€88,000

*Some students ignore this item because it is the same for each alternative. However, note that a statement for the entire year has been requested. Obviously, the €20,000 would affect Year 1 only under both the ‘keep’ and ‘buy’ alternatives.

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The difference is €8,000 for four years taken together. In particular, note that the €20,000 book value can be omitted from the comparison. Merely cross out the entire line; although the column totals are affected, the net difference is still €8,000. Note the motivational factors here. A manager may be reluctant to replace simply because the large loss on disposal severely harms profitability in Year 1. Nevertheless, the cumulative cash flow effects are beneficial to the company as a whole (assuming a world of no income taxes and no interest). 1b Again, the difference is €8,000:

Income statements Buy new machine

Keep Four

Sales

Years

years

1–4

together

Four years together

Years Year 1

2–4

€150,000

€600,000

€150,000

€150,000

€600,000

110,000

440,000

110,000

110,000

440,000

5,000

20,000

6,000

6,000

24,000

15,000

60,000

9,000

9,000

36,000

130,000

20,000

125,000

125,000

500,000

Costs (excluding disposal): Other operating costs Depreciation Operating costs of machine Total costs (excluding disposal) Loss on disposal: Book value (‘cost’)

–

–

20,000

–

20,000*

Proceeds (‘revenue’)

–

–

(8,000)

–

(8,000)

Loss on disposal

–

–

12,000

–

12,000

Total costs

130,000

520,000

137,000

125,000

512,000

Operating income

€20,000

€80,000

€13,000

€25,000

€88,000

* As in requirement (1a), the €20,000 book value may be omitted from the comparison without changing the €8,000 difference. This adjustment would mean excluding the depreciation item of €5,000 per year (a cumulative effect of €20,000) under the ‘keep’ alternative and excluding the book value item of €20,000 in the loss on disposal calculation under the ‘buy’ alternative.

1c The €20,000 purchase cost of the ‘old’ equipment, the sales and the other costs are irrelevant because their amounts are common to both alternatives. 2

The net difference would be unaffected. Any number may be substituted for the original €20,000 figure without changing the final answer. Of course, the net cash outflows under both alternatives would be high. The Car Wash manager really blundered. However, keeping the ‘old’ equipment will increase the cost of the blunder to the cumulative tune of €8,000 over the next 4 years.

3

Book value is irrelevant in decisions about the replacement of equipment, because it is a past (historical) cost. All past costs are down the drain. Nothing can change what has already been spent or what has already happened. The €20,000 has been spent. How it is subsequently accounted for is irrelevant. The analysis in requirement (1) clearly shows that we may completely ignore the €20,000 and still have a correct analysis. The only relevant items are those expected future items that will differ among alternatives.

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Despite the economic analysis shown here, many managers would keep the old machine rather than replace it. Why? Because, in many organisations, the income statements of requirement (2) would be a principal means of evaluating performance. Note that the first-year operating income would be higher under the ‘keep’ alternative. The conventional accrual accounting model might motivate managers towards maximising their first-year reported operating income at the expense of long-run cumulative betterment for the organisation as a whole. This criticism is often made of the accrual accounting model. That is, the action favoured by the ‘correct’ or ‘best’ economic decision model may not be taken, either because the performance–evaluation model is inconsistent with the decision model or because the focus is only on the short-run part of the performance–evaluation model. 10.15

Optimal production plan, computer manufacturer. (30 min) 1

Let X = Units of printers, and Y = Units of desktop computers.

Objective: Maximise total contribution margin of €200X + €100Y Constraints: For production line 1: For production line 2: Sales of X and Y: Negative production impossible:

6 X + 4Y 10X X −

Y

X Y

2

<

24

<

20

<

0

>

0

>

0

Solution Exhibit 10.15 presents a graphical summary of the relationships. The salesmix constraint here is somewhat unusual. The X − Y < 0 line is the one going upward at 45° angle from the origin. Using the trial-and-error method: Trial

Corner (X; Y)

Total contribution margin

1

(0; 0)

€200 (0)

+

€100 (0)

=

€0

2

(2; 2)

200 (2)

+

100 (2)

=

600

3

(2; 3)

200 (2)

+

100 (3)

=

700

4

(0; 6)

200 (0)

+

100 (6)

=

600

The optimal solution that maximises operating income is two printers and three computers.

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Solution Exhibit 10.15

Graphic solution to find optimal mix, Fiordi-Ligio Srl.

10.16

Optimal sales mix for a retailer, sensitivity analysis. (30–40 min) 1

Let G

=

floor space of grocery products carried.

D

=

floor space of dairy products carried.

The LP formula of the decision is: Maximise:

€10G

+

€3D

Subject to:

€10G

+

€3D

€10G €3D

<

4,000

>

1,000

>

1800

2

Vier-und-Zwanzig may wish to maintain its reputation as a full-service food store carrying both grocery and dairy products. Customers may not be attracted if Vierund-Zwanzig carries only the product line with the highest unit contribution margins. (Marketing and economics courses examine this issue under the label of interdependencies in the demand for products.)

3

Solution Exhibit 10.16 presents the graphic solution. The optimal solution is 3,200 square metres of grocery products and 800 square metres of dairy products.

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The trial-and-error solution approach is: Trial

Corner (G; D)

TCM = €10G + €3D

1

(1,000; 800)

€10 (1,000) + €3 (800) = €12,400*

2

(1,000; 3,000)

€10 (1,000) + 3 (3,000) = 19,000*

3

(3,200; 800)

€10 (3,200) + 3 (800) = € 34,400*

.

* Optimal solution is G = 3,200 and D = 800. 4

The optimal mix determined in requirement (3) will not change if the contribution margins per square metre change to grocery products, €8 and dairy products, €5. To avoid cluttering the graphic solution in Solution Exhibit 10.16, we demonstrate this using the trial-and-error solution approach. Trial

Corner (G; D)

1

(1,000; 800)

2

(1,000; 3,000)

3

(3,200; 800)

TCM = €8G + €5D €8 (1,000) + €5 (800) = €12,000* €8 (1,000) + €5 (3,000) = €23,000* €8 (3,200) + €5 (800) = €29,600*

* Optimal solution is still G = 3,200 and D = 800. The student can also verify, by drawing lines parallel to the line through G = 500 and D = 800 (the equal contribution line for €4,000) that the furthest point, where the equal contribution line intersects the feasible region, is the point G = 3,200 and D = 800. Solution Exhibit 10.16

Graphic solution to find optimal mix, Vier-und-Zwanzig.

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CHAPTER 11

Activity-based costing Teaching tips and points to stress Refining a costing system More refined cost systems are cost effective when (1) different jobs (customers, services, etc.) consume resources differently, (2) competition in the output market is keen (accurate cost information helps companies decide what jobs to emphasise and how to price them) and (3) processing costs are lower. Ask students, ‘What jobs tend to be over- or undercosted?’ If the cost system uses a single allocation base, then products that consume relatively more of that base will tend to be overcosted, since all indirect costs are loaded on that base. Products that consume proportionally less of the base will tend to be undercosted. How can a manager tell if a cost system needs refinement? This is difficult, but several clues should spur management to examine the accuracy of their cost system: (1) managers do not believe the cost data the system provides and may even keep their own private set of off-thebook records; (2) the company loses bids it thought it priced ‘high’; (3) the cost system has not changed much despite major changes in operations.

Activity-based costing (ABC) systems Consider asking students to write a short essay on the costs and benefits of ABC. What changes in the business environment made ABC more attractive today than in the past? ABC is most likely to yield benefits for a company with (1) many products that consume different amounts of resources (if there is only one product or if all products consume resources similarly, then broad-based averages from traditional systems are sufficient), (2) operations that are varied and complex (otherwise, just a few indirect-cost pools would suffice), (3) a highly competitive environment where knowledge of costs and cost control is critical and (4) access to accounting and information systems expertise to implement and maintain the system. ABC is increasing in popularity because changes in business are decreasing implementation costs while increasing the relative benefits (i.e. companies are producing a wider variety of products using more complex operations in a more competitive environment). Accountants may need to re-evaluate the cost system if it yields numbers that are counterintuitive to operating and marketing managers or if costs/prices appear to be out of line with those of the competition. Companies that have successfully implemented ABC usually limit the number of activity/cost pool/allocation bases to 5–10 per department, at least in the initial implementation. More activities can be added later, if additional complexity is warranted. The danger with identifying

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too many activities is that the company may get bogged down in a morass of detail and the implementation may fail. ABC can help managers control costs in two ways. First, employees can try to reduce consumption of the allocation base. Second, ABC can provide incentives to reduce the indirect cost allocation rate for each activity (because the cost of each activity is now visible). A manager can be rewarded for reducing the indirect-cost rate for an activity because the accounting system visibly links the manager to this cost reduction. (In a single MOH cost pool system, managers have little incentive to reduce MOH. The effects of any reduction are not linked to a particular manager, if all the MOH is aggregated in one pool.)

Cost hierarchies If any student has worked in a manufacturing plant (or if you have shown videos of a manufacturing process), ask the student to illustrate unit-output-level, batch-level, productsustaining and facility-sustaining costs (and related cost drivers) in that context. Traditional cost accounting systems treated all costs as if they were unit-output-level costs. It can be difficult to identify drivers of higher-level costs, particularly facility-sustaining costs (e.g. what drives MD’s salary?). It can be expensive to obtain data on values of higher-level cost drivers, as this information is not generally collected by the cost accounting system (e.g. batchlevel drivers might include number of set-ups, number of purchase orders and number of engineering change orders). Decreasing information processing costs makes it less expensive to obtain data on non-traditional cost drivers and increased competition increases the benefits of accurate cost information. Hence, companies are adopting more complex systems that recognise the hierarchy of costs and cost drivers. Reducing consumption of a cost driver will not automatically reduce OH. For example, reducing the number of suppliers is unlikely to reduce material procurement costs substantially, unless management recognises that fewer suppliers means less work for purchasing agents and actively reduces the size of the purchasing department (through attrition, reassignment or layoffs). The method that management uses to reduce the size of the purchasing department will affect the extent to which employees cooperate with future cost reductions. If they are ‘rewarded’ by layoffs, employees will hesitate to cooperate in the future.

Comparing alternative costing systems A major reason for low-volume products are often undercosted is that low-volume products’ batch-level and product-sustaining costs should be spread over the relatively few units of lowvolume products rather than spread like peanut butter over all products.

Solutions to review questions 11.1

Cost smoothing describes a costing approach that uses broad averages uniformly to assign the cost of resources to cost objects when the individual products, services or customers, in fact, use those resources in a non-uniform way.

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One way of determining if cost smoothing is occurring is to examine separately how individual products (services, customers, etc.) use the resources of the organisation and to compare the results with the way the accounting system represents that usage. 11.2

Overcosting may result in competitors entering a market and taking a market share for products, when a company erroneously believes those products to be profitable. Undercosting may result in competitors selling products on which they are in fact losing money, when they erroneously believe them to be profitable.

11.3

Costing system refinement means making changes to an existing costing system that results in a better measure of the way that jobs, products, customers and so on differentially use the resources of the organisation. Three guidelines for refinement are: a

Classify as many of the total costs as direct costs as is economically feasible.

b

Select the number of indirect-cost pools on the basis of homogeneity.

c

Use cost drivers as the chosen allocation bases.

11.4

An activity-based approach focuses on activities as the fundamental cost objects. It uses the cost of these activities as the basis for assigning costs to other cost objects such as products, services or customers.

11.5

Increasing the number of indirect-cost pools does NOT guarantee increased accuracy of product, service or customer costs. If the existing cost pool is already homogeneous, increasing the number of cost pools will not increase accuracy. If the existing cost pool is not homogeneous, accuracy will only increase if the increased cost pools themselves increase in homogeneity vis-à-vis the single cost pool.

11.6

The accountant faces a difficult challenge. The benefits of a better accounting system show up in improved decisions by managers. It is important that the accountant has the support of these managers when seeking increased investments in accounting systems. Statements by these managers showing how their decisions will be improved by a better accounting system are the accountant’s best base when seeking increased funding.

11.7

The most frequently used allocation bases for manufacturing overhead costs are: (i) direct labour-hours, (ii) direct labour-euros, (iii) units of production, (iv) machine-hours and (v) direct materials euros. This ranking is based on an average usage in the five countries reported in the Surveys of Company Practice box in Chapter 11.

11.8

Four levels of a manufacturing cost hierarchy are:

11.9

1

Output unit-level costs

2

Batch-level costs

3

Product-sustaining costs

4

Facility-sustaining costs.

The purpose for computing a product cost will determine whether unit costs should be based on total manufacturing costs in all or only some levels of the cost hierarchy. Inventory valuation for financial reporting requires total or only some manufacturing costs (all levels of the hierarchy) to be expressed on a per output-unit basis. In contrast, for cost management purposes, the cost hierarchy need not be unitised as the cost driver is not uniformly allocated to units of output at each level in the hierarchy.

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11.10

An ABC approach focuses on activities as the fundamental cost objects. The costs of these activities are built up to compute the costs of products, services, customers and so on. The traditional approach seeks to have one or a few indirect-cost pools, irrespective of the heterogeneity in the facility. An ABC approach attempts to use cost drivers as the allocation base, whereas the traditional approach is less clear on this issue.

Solutions to exercises 11.13

Activity-based costing, product cost cross-subsidisation. (30–40 min)

The idea for Exercise 11.13 came from ‘ABC Minicase: Let them Eat Cake’, in Cost Management Update (Issue No. 31). Budgeted MOH rate in 2011

1

=

€210,800 200,000 units = €1.054 per 1 Kg unit of cake Raisin cake

Unit direct manufacturing cost Direct materials Direct manufacturing labour Unit indirect manufacturing cost Manufacturing overhead (€1.054 × 1, 1) Unit total manufacturing cost

€0.600 0.140

€1.054

2

€0.740

1.054 €1.794

Raisin cake

Unit direct manufacturing cost Direct materials Direct manufacturing labour Unit indirect manufacturing cost Mixing (€0.04 × 5, 8) Cooking (€0.14 × 2, 3) Cooling (€0.2 × 3, 5) Creaming/icing (€0.25 × 0, 3) Packaging (€0.08 × 3, 7) Unit total manufacturing cost

€0.600 0.140 €0.200 0.280 0.060 0.000 0.240

€0.740

0.780 €1.520

Layered carrot cake

€0.900 0.200

€1.054

€1.100

1.054 €2.154

Layered carrot cake

€0.900 0.200 €0.320 0.420 0.100 0.750 0.560

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2.150 €3.250

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3

The unit product costs in requirements 1 and 2 differ only in the assignment of indirect costs to individual products. The assumed usage of indirect-cost areas under each costing system is: Existing system Layered Raisin cake carrot cake

ABC system Layered Raisin cake carrot cake

Mixing Cooking

50% 50

50% 50

38.5% 40.0

61.5% 60.0

Cooling

50

50

37.5

62.5

Creaming/icing

50

50

0.0

100.0

Packaging

50

50

30.0

70.0

The ABC system recognises the substantial difference in usage of individual activity areas between raisin cake and layered carrot cake. The existing costing system erroneously assumes equal usage of activity areas by 1 kg of raisin cake and 1 kg of layered carrot cake. 4

Uses of activity-based cost numbers include: a

Pricing decisions. Starkuchen can use the ABC data to decide preliminary prices for negotiating with its customers. Raisin cake is currently overcosted while layered carrot cake is undercosted. Actual production of layered carrot cake is 100% more than budgeted. One explanation could be the underpricing of layered carrot cake.

b

Product emphasis. Starkuchen has more accurate product margins with ABC. Starkuchen can use this information for deciding which products to push (especially if there are production constraints).

c

Product design. ABC provides a road map on how a change in product design can reduce costs. The percentage breakdown of total indirect costs for each product is: Raisin cake Mixing Cooking Cooling Creaming/icing Packaging

25.6% (€0.20/€0.78) 35.9 7.7 0.0 30.8 100.0%

Layered carrot cake 14.9% (€0.32/€2.15) 19.5 4.7 34.9 26.0 100.0%

Starkuchen can reduce the cost of either cake by reducing its usage of each activity area. For example, Starkuchen can reduce raisin cake’s cost by sizably reducing its cooking time or packaging time. Similarly, a sizeable reduction in creaming/icing will have a marked reduction on layered carrot cake costs. d

Process improvements. Improvements in how activity areas are configured will cause a reduction in the costs of products that use those activity areas.

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e

11.14

Cost planning and flexible budgeting. ABC provides a more refined model to forecast costs of Starkuchen and to explain why actual costs differ from budgeted costs.

Activity-based costing, under- or overallocated indirect costs. (40 min.)

1 Activity area

Mixing Cooking Cooling Creaming/icing Packaging

Manufacturing overhead incurred

Manufacturing overhead allocated

Under- or over allocated overhead

€62,400

€49,600a

12,800 U.A.

83,840 12,416 36,000 61,600

b

67,200 15,200c 60,000d 73,600e

16,640 U.A. 2,784 O.A. 24,000 O.A. 12,000 O.A.

€256,256

€265,600

€9,344 O.A.

a

(€0.040 × 5 × 120,000) + (€0.040 × 8 × 80,000) (€0.140 × 2 × 120,000) + (€0.140 × 3 × 80,000) c (€0.020 × 3 × 120,000) + (€0.020 × 5 × 80,000) d (€0.250 × 0 × 120,000) + (€0.250 × 3 × 80,000) e (€0.080 × 3 × 120,000) + (€0.080 × 7 × 80,000) b

The five activity areas differ sizably in the extent of under- or over-absorption of overhead. The ratio of actual overhead to allocated overhead for each activity area is: Mixing Cooking

1.25806 1.24762

Cooling

0.81684

Creaming/Icing

0.60000

Packaging

0.83696

The ratio of actual overhead to allocated overhead in aggregate is 0.96482 (€256,256 ÷ €265,600). 2

The advantages of using a single total manufacturing overhead cost pool adjustment include: a

Simplicity – one adjustment vis-à-vis five adjustments.

b

The effect may be immaterial. If the focus is only on income statement effects and Starkuchen holds minimal inventory (WIP or FG), the effect of using five adjustments may be minimal.

The argument against is a reduction in the accuracy of actual product cost numbers where there are major differences across activity areas in the magnitude and sign of the under- or over-allocation of overhead. The advantage of making five cost pool adjustments is the greater accuracy of the cost numbers (in both the activity areas and the resultant product costs). The disadvantage is the extra ‘paperwork’ of making the adjustments.

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3

The 2011 actual unit indirect manufacturing costs for raisin cake and layered carrot cake using the under- or overallocated amounts from requirement 1 are: Ratio of actual/ allocated (1)

Mixing Cooking Cooling Creaming/Icing Packaging

1.25806 1.24762 0.81684 1.60000 0.83696

Raisin cake Budgeted Actual MOH MOH (2) (3) = (1) × (2) €0.200 0.280 0.060 0.000 0.240

€0.25161 0.34933 0.04901 0.00000 0.20087 €0.85082

Layered carrot cake Budgeted Actual MOH MOH (4) (5) = (1) × (4) €0.320 0.420 0.100 0.750 0.560

€0.40258 0.52400 0.08168 0.45000 0.46870 €1.92696

The actual unit product costs in 2011 are:

Direct manufacturing cost Indirect manufacturing cost (from above)

4

Raisin cake

Layered carrot cake

€0.740 0.851 €1.591

€1.100 1.927 €3.027

More accurate product costs lead to more informed pricing decisions. The calculated product costs with a normal activity-based costing system are:

Normal costing Actual costing (five-activity area adjustment from requirement 3) Actual costing (with a single overhead adjustment)*

Raisin cake €1.520

Layered carrot cake €3.250

€1.591

€3.027

€1.493

€3.174

*Had Starkuchen used a single total manufacturing overhead cost pool adjustment for the total overallocated overhead of €9,344, the total allocated overhead costs of each product would be restated to be 0.9648 × allocated amount (€256,256 ÷ €265,600 = 0.9648). The resulting product cost numbers would have been:

Raisin cake Direct costs

Layered carrot cake

€0.740

€1.100

0.753

2.074

€1.493

€3.174

Indirect costs (€0.780 × 0.9648) Indirect costs (€2.150 × 0.9648)

Raisin cake has a higher actual cost with the more accurate five-activity area adjustment, as it makes proportionally more use of the activity areas with underallocated overhead (mixing and cooking). Layered carrot cake has a lower cost under the more accurate five-activity area adjustment, as it makes proportionally more use of the activity area with the largest overallocated cost (creaming/icing).

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11.16

Activity-based job-costing system. (40 min) 1

Solution Exhibit 11.16 presents costing overviews of the previous job-costing system and the refined activity-based job-costing system.

2

Direct manufacturing costs: Direct materials Indirect manufacturing costs: Materials handling, DKr 8 × 50 Machining, DKr 68 × 12 Assembly, DKr 75 × 15 Inspection, DKr 104 × 4 Total manufacturing costs

DKr 3,000 DKr 400 816 1,125 416

2,757 DKr 5,757

Total manufacturing costs = DKr 5,757 × 50 = DKr 287,850.

3

A direct cost is a cost that is related to the particular cost object and that can be traced to it in an economically feasible way. Henriksen may differ from its competitor in several ways. a

Henriksen uses a more automated production approach with the result that manufacturing labour provides support to the machines.

b

Henriksen uses a less sophisticated information tracking system for manufacturing labour than its competitors.

Manufacturing labour costs are included in the individual indirect manufacturing (overhead) cost pools. 4

The refined activity-based costing system can provide information to: a

Product designers – the indirect-cost rates in each of the four indirect-cost areas can guide decisions about how much (say) machine-hours to use versus assembly-line-hours when designing packaging machines.

b

Manufacturing personnel – decisions about productivity and cost management can focus on ways to reduce the indirect-cost rates (such as decisions on how to make more efficient use of machines).

c

Marketing personnel – the ABC approach can help guide pricing decisions and negotiations with potential customers on ways to manufacture a lower-cost packaging machine.

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Solution Exhibit 11.16

Job Costing Systems for Henriksen

11.17

Activity-based job costing. (15 min) 1

An overview of the product-costing system is:

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Executive chair Direct manufacturing costs: Direct materials Direct manufacturing labour, €20 × 7,500; 500 Direct manufacturing costs Indirect manufacturing costs: Materials handling, €0.25 × 100,000; 3,500 Cutting, €2.50 × 100,000; 3,500 Assembly, €25.00 × 7,500; 500 Indirect manufacturing costs Total manufacturing costs

Chairman chair

€600,000

€25,000

150,000 750,000

10,000 35,000

25,000

875

250,000

8,750

187,500 462,500 €1,212,500

12,500 22,125 €57,125

Unit costs Executive chair: €1,212,500 ÷ 5,000 = €242.50 Chairman chair: €57,125 ÷ 100 = €571.25

2 Executive chair Upstream costs Manufacturing costs Downstream costs Total costs

11.19

Chairman chair

€60.00 242.50 110.00 €412.50

€146.00 571.25 236.00 €953.25

Question from the Association of Chartered Certified Accountants, Pilot Paper 2.4, Financial Management and Control. (45 min) a

General Activity-based costing (ABC) focuses the mindset of the organisation from processes to activities and in this way, provides a framework to enable management to manage costs by altering activities undertaken. Traditional methods of product costing were often volume related (e.g. hours of labour used), but this did not develop with the growth in activities that had no relation to volume or in multiproduct businesses. There are general conditions under which ABC is most likely to operate and are: •

where there is a requirement to apportion costs (e.g. in a multiproduct business);

•

where there are significant overheads to apportion and

•

where the availability of sophisticated information retrieval systems allows management to track product costs as they pass through a production system.

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Multiproduct businesses

The main issue is that there has to be at least two products in the business, otherwise there are no costs to apportion between products. For a single product company, all costs of the business are identifiable with the product and product probability is directly related to the profitability of the business as a whole. Other advantages of ABC in multiproduct business relate to the accurate valuation of stock and facilitating the effective management of stock levels with multiple products. Allied to this is that there is reduced cross-subsidisation of products: with costs accurately identified with products, it becomes easier for management to discern which products are profitable against those that are not. The significance of overheads and the ABC method of charging costs

Since ABC is a cost apportionment system, it is principally beneficial when there is a high proportion of overhead costs – if a business incurs only direct costs, there is no issue for ABC to resolve. ABC is based on the premise that it is activities that lead to costs being incurred and that costs should, therefore, be apportioned on the basis of those activities. Cost drivers are then chosen that reflect the events that create costs when the activities are undertaken. These costs are then collected into cost pools where there are common cost drivers. Finally, products are allocated costs on the basis of the activities they use. Information systems

A basic requirement for any cost allocation system is information availability. This is particularly so for ABC systems that rely heavily on activity information. In addition, ABC requires the monitoring of activities that have not involved monitoring previously. This raises issues of information capture and it is in new technology that answers to this are most likely to be found. b

ABC can enable the exclusion of non-controllable costs, focusing only on those costs that are traceable to manager decisions, thereby providing a more fair outcome than absorption costing. ABC is often claimed to rest on a more accurate information base than absorption costing and hence, the impact of management decisions is potentially more easily seen under ABC than it is under traditional volume-related absorption methods. Also, ABC absorbs costs into products in a wider variety of ways than traditional absorption methods that rely mostly on labour and/or machine-hours. In extending the range of absorption bases, ABC is able to more closely track costs to the causes of the costs, which then links to management decisions.

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CHAPTER 12

Pricing, target costing and customer-profitability analysis Teaching tips and points to stress Costing and pricing for the short run Often there is no clear-cut distinction between short-run (SR) and long-run (LR) pricing decisions. The LR is just a series of SRs. Some critics believe that many managers often err by classifying too many decisions at SR. For example, in the SR, accepting a special order for any price above incremental outlay cost will increase profits. Some companies, however, accept a series of special orders that in effect become an LR decision. The text of Chapter 12 uses the phrase ‘one-time-only special order’ to highlight the limited context in which a focus on only SR incremental costs is appropriate. Students often erroneously assume that VCs are relevant while FCs are irrelevant. However, the text’s ETC example shows that some VCs are irrelevant (marketing, distribution, etc.), whereas the special order engenders some incremental batch-level costs that are relevant (material procurement, process changeover, etc.). Moreover, some, but not all manufacturing costs are relevant because the special order does not affect regular fixed manufacturing costs. Lowering prices for special orders may adversely affect regular business, unless the market is segmented such that (1) regular customers (or their customers) cannot buy from the specialorder customer, (2) the regular customers will not learn about the special order and demand a lower price and (3) the special-order items are marketed as distinct from the regular items to avoid cheapening the image of the latter. In the example, GT appears to be in a different market segment from ETC’s regular customers, so it seems reasonable to expect regular demand to be unaffected by the special order. When calculating relevant costs for a special order, follow the ETC’s example in Chapter 12 and determine how the order will affect indirect costs such as materials procurement and process changeover. Because such costs are not usually traced directly to products, managers may overlook them. These indirect costs can be sizeable and may be the difference between a profit and a loss on a special order.

Costing and pricing for the long run Although direct manufacturing labour may be relatively fixed in the SR, if a company employs a stable, salaried workforce, direct manufacturing labour is usually considered variable in the LR. Over time, management adjusts the size of the workforce (through hiring/attrition/layoffs) to meet demand. For pricing decisions, it is important to assign to products the costs from all the value-chain areas. In the real world, building up these product costs is more complex than students realise. Astel has only one manufacturing department and it has three direct-cost and three indirect-cost 166 © Pearson Education Limited 2012

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categories. Most manufacturing firms have more categories. If the other five elements of the value chain each have three direct and indirect costs, then Astel has (3 + 3 = 6 costs/value-chain element) × (6 value-chain elements) = 36 cost categories to allocate to products. Traditional cost-accounting systems do not classify costs as VA or NVA. To obtain this information, management usually orders a special study. Management accountants can work closely with production and marketing to classify costs as VA or NVA. Students usually erroneously believe that employees candidly reveal information. However, employees are unlikely to forthrightly reveal information regarding VA/NVA activities. Employees sometimes tend to overestimate the proportion of their time spent on VA tasks, out of concern for job security. A large proportion of costs (often the majority of costs) are locked in by the design stage – see Exhibit 12.4. Target costing and value engineering help control costs before they are locked in – within the constraints of satisfying customer needs. Traditional cost accounting has not recognised the opportunity for this sort of ex ante cost control and has instead focused on ex post comparisons of costs actually incurred with planned or budgeted costs (e.g. variance analysis). Both kinds of cost control are important. However, in many cases there is greater potential for cost reduction in the design stage because (1) a large proportion of the costs are locked in at the design stage and (2) design has (historically) received less ‘cost cutting’ attention than manufacturing (to use an agricultural analogy, ‘you get the biggest potatoes in the first pass through the field’). As mentioned earlier, management accountants have a long history of providing data for controlling manufacturing costs in the design stage. This is one area where we expect future developments in cost accounting. This is a good opportunity to emphasise that the world is changing so fast that much of what students learn on their course will be outdated within 10 years. It is imperative that they keep abreast of new techniques and developments if they are to remain competent professionals. To achieve target costs, many companies use kaizen, a process of continuous improvement. For example, Hewlett–Packard cut costs of its DeskJet printers by 50% over a 6-year period. In some companies, every worker makes suggestions for improvement. Much of the cost reduction occurs gradually via these many small improvements. Also, since DM are often significant cost manufacturers, often works closely with their suppliers to achieve target DM costs. For example, Toyota has sent its own engineers to help suppliers produce more efficiently – with the proviso that much of the cost saving is passed back to Toyota. To improve product quality, many manufacturers redesign their products to be more tolerant of minor variations in the production process. This is often more cost effective than striving for perfect-quality manufacturing within very tight tolerances. ABC makes explicit how product costs can be reduced by lowering the per unit usage of resources in each activity area. ABC therefore assists in cost management, in addition to providing more accurate product-cost data for pricing and product emphasis decisions.

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Cost-plus pricing The following outline helps students see the big picture: 1

2

Market-based pricing a

Customer-driven external focus

b

Used by companies facing stiff competition

c

Target pricing, for example.

Cost-based pricing a

Internal focus

b

Used by companies facing less competition or those whose products have no observable market value

c

Cost-plus pricing, for example.

Market-based pricing is becoming more popular, as more companies adopt a customer-driven focus. Target pricing starts with a desired selling price and subtracts target profit to yield allowable target cost that is usually less than currently achievable cost. Cost-plus pricing usually starts with achievable cost and adds desired profit to yield a higher selling price. When achievable cost exceeds allowable cost, cost-based pricing will yield a higher selling price than the target price. Of course, each pricing approach is just a starting point. Before setting a final selling price, managers re-evaluate both the effect of proposed prices on demand and their ability to cut costs. Many students want to know whether it is appropriate to set prices based on VC as opposed to full costs. There is no easy answer to this question. In the SR, for a single one-time-only (OTO) special order, contribution margin will increase as long as the selling price exceeds incremental costs. However, ‘single OTO special orders’ have a way of recurring and a series of OTO special orders is really an LR decision. If a company continually fills its plant with output that it cannot sell above full cost, the company should consider downsizing (if it cannot cut costs, raise prices or find an alternative more profitable use for its facilities).

Life-cycle product budgeting and costing This section introduces life-cycle costing, a concept that is especially important given the frequency of changes in production and the increased magnitude of pre- and post-production costs. This approach is most helpful in industries where revenues and their related costs occur in different periods and are not well matched by financial accounting procedures. For example, financial accounting expenses, R&D, marketing, distribution and customer service, costs in the period incurred, not when the related revenue is earned. Firms with a high percentage of total costs in these areas (e.g. real estate developers, publishers and motion picture studios) would be most likely to benefit from life-cycle costing.

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Life-cycle costing can be implemented fairly and easily by coding revenue and expense journal entries by product as well as by functional account (e.g. R&D and advertising). Data can then easily be compiled for each product. At the beginning of the life cycle, it is difficult to determine how successful a product will be. Hence, the earlier in a product’s life-cycle costs are locked in (i.e. before there is much information on the probability that the product will succeed), the riskier the product.

Solutions to review questions 12.1

12.2

12.3

The three major influences on pricing decisions are: 1

Customers

2

Competitors

3

Costs.

Two examples of pricing decisions with a short-run focus are: 1

Pricing for a one-time-only special order with no long-term implications

2

Adjusting product mix and volume in a competitive market.

Activity-based costing (ABC) helps managers in pricing decisions in two ways: 1

It gives managers more accurate product-cost information for making pricing decisions.

2

It helps managers to manage costs during value engineering by identifying the cost impact of eliminating, reducing or changing various activities.

12.4

A target cost per unit is the estimated long-run cost per unit of a product (or service) that, when sold at the target price, enables the company to achieve the targeted operating income per unit.

12.5

A value-added (VA) cost is a cost that customers perceive as adding value or utility to a product or service. Examples are costs of materials, direct labour, tools and machinery. Examples of non-value-added (NVA) costs are costs of reworking, scrap, expediting and breakdown maintenance.

12.6

No. It is important to distinguish between when costs are locked in and when costs are incurred, because it is difficult to alter or reduce costs that have already been locked in.

12.7

Cost-plus pricing methods vary depending on the bases used to calculate prices. Examples are (a) variable manufacturing costs; (b) manufacturing function costs; (c) variable product costs and (d) full product costs.

12.8

Two examples where the difference in the incremental or outlay costs of two products or services is much smaller than the differences in their prices are as follows: 1

The difference in prices charged for a telephone call, hotel room or for hiring a car during busy versus slack periods is often much greater than the difference in costs to provide these services.

2

The difference in incremental or outlay costs for an aircraft seat sold to a passenger travelling on business or a passenger travelling for pleasure is roughly the same. However, airline companies routinely charge business travellers – those who are

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likely to start and complete their travel during the same week excluding the weekend – a much higher price than pleasure travellers who generally stay at their destinations over at least one weekend. 12.9

Customer-profitability analysis highlights to managers how individual customers differentially contribute to total profitability. It helps managers to see whether customers who contribute sizably to total profitability are receiving a comparable level of attention from the organisation.

12.10

No. A customer-profitability profile highlights differences in the current period’s profitability across customers. Dropping customers should be the last resort. An unprofitable customer in one period may be highly profitable in subsequent future periods. Moreover, costs assigned to individual customers need not be purely variable with respect to short-run elimination of sales to those customers. Thus, when customers are dropped, costs assigned to those customers may not disappear in the short run.

Solutions to exercises 12.11

Relevant-cost approach to short-run pricing decisions. (20–30 min) 1

Analysis of special order: Sales, 3,000 units × €80 Variable costs: Direct materials, 3,000 units × €35 Direct manufacturing labour, 3,000 units × €10 Variable manufacturing overhead, 3,000 units × €5 Other variable costs, 3,000 units × €5 Sales commission Total variable costs Contribution margin

€240,000 €105,000 30,000 15,000 15,000 6,000 171,000 €69,000

Note that the variable costs, except for commissions, are affected by production volume, not sales euros. If the special order is accepted, operating income would be €1,000,000 + €69,000 = €1,069,000. 2

Whether García-Salve is making a correct decision depends on many factors. He is incorrect if the capacity would otherwise be idle and if his objective is to increase operating income in the short run. If the offer is rejected, Alexon, in effect, is willing to invest €69,000 in immediate gains forgone (an opportunity cost) to preserve the long-run selling-price structure. García-Salve is correct if he thinks future competition or future price concessions to customers will hurt Alexon’s operating income by more than €69,000. There is also the possibility that Xuclà Mecàniques Fluvià could become a longterm customer. In this case, is a price that covers only short-run variable costs adequate? Would Zamora be willing to accept a €6,000 sales commission (as distinguished from her regular €36,000 = 15% × €240,000) for every Xuclà Mecàniques Fluvià order of this size if Xuclà Mecàniques Fluvià becomes a longterm customer?

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12.12

Target prices, target costs, activity-based costing. (25–30 min) 1

Pagnol-Carrelages’s operating income in 2011 is as follows: Total for 250,000 tiles (1)

Per unit (2) = (1) ÷ 250,000

€1,000,000

€4.00

750,000

3.00

25,000

0.10

120,000

0.48

Shipping (€40 × 1,500)

60,000

0.24

Fixed cost

40,000

0.16

Total costs

955,000

3.82

Operating income

€45,000

€0.02

Revenues (€4 × 250,000) Purchase cost of tiles (€3 × 250,000) Ordering costs (€50 × 500) Receiving and storage (€30 × 4,000)

2

Price to retailers in 2012 is 95% of 2007’s price = 0.95 × €4 = €3.80; cost per tile in 2012 is 96% of 2011’s cost = 0.96 × €3 = €2.88. Pagnol-Carrelages’s operating income in 2012 is as follows: Total for (1)

Per unit (2) = (1) ÷ 250,000

€950,000

€3.80

720,000

2.88

25,000

0.10

120,000

0.48

60,000

0.24

Total costs

925,000

3.70

Operating income

€25,000

€0.10

250,000 tiles Revenues (€3.80 × 250,000) Purchase cost of tiles (€2.88 × 250,000) Ordering costs (€50 × 500) Receiving and storage (€30 × 4,000) Shipping (€40 × 1,500)

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3

Pagnol-Carrelages’s operating income in 2012, if it makes changes in ordering and material handling, will be as follows: Total for 250,000 tiles (1)

Per unit (2) = (1) ÷ 250,000

€950,000

€3.80

720,000

2.88

5,000

0.02

Receiving and storage (€28 × 3,125)

87,500

0.35

Shipping (€40 × 1,500)

60,000

0.24

Total costs

872,500

3.49

Operating income

€77,500

€0.31

Revenues (€3.80 × 250,000) Purchase cost of tiles (€2.88 × 250,000) Ordering costs (€25 × 200)

Through better cost management, Pagnol-Carrelages will be able to achieve its target operating income of €0.30 per tile, despite the fact that its revenue per tile has decreased by €0.20 (€4.00 − €3.80) whereas its cost per tile has decreased by only €0.12 (€3.00 − €2.88). 12.15

Product costs, activity-based costing systems. (20–25 min)

This problem assumes knowledge of activity-based costing systems as described in Chapter 11. The problem illustrates how both product designers and manufacturing personnel can play key roles in a company manufacturing competitively priced products. Solution Exhibit 12.15 presents an overview of the product-costing system at Combrai Informatique. The following table presents the manufacturing cost per unit for different cost categories for P-41 and P-63. Cost categories Direct manufacturing product costs Direct materials Indirect manufacturing product costs Materials handling

P-41

P-63

€407.50

€292.10

(85 × €1.20; 46 × €1.20) Assembly management

102.00

55.20

(3.2 × €40; 1.9 × €40) Machine insertion of parts

128.00

76.00

(49 × €0.70; 31 × €0.70) Manual insertion of parts

34.30

21.70

(36 × €2.10; 15 × €2.10) Quality testing

75.60

31.50

(1.4 × €25; 1.1 × €25) Total indirect manufacturing product costs Total manufacturing product costs

35.00

27.50

€374.90 €782.40

€211.90 €504.00

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Solution Exhibit 12.15

Overview of product costing at Combrai Informatique.

INDIRECT COST POOLS

} }

COST ALLOCATION BASES

}

COST OBJECT: PRODUCT

DIRECT PRODUCT COSTS

12.18

}

Materials Handling

Assembly Management

Machine Insertion of Parts

Manual Insertion of Parts

Quality Testing

Number of Parts

Hours of Assembly Time

Number of MachineInserted Parts

Number of ManuallyInserted Parts

Hours of QualityTesting Time

INDIRECT COSTS DIRECT COSTS

Direct Materials

Target cost, activity-based costing systems. (50–60 min) 1

A target cost per unit is the estimated long-run cost per unit of a product (or service) that, when sold at the target price, enables the company to achieve the target operating income per unit. A target cost per unit is the estimated unit long-run cost of a product that will enable a company to enter or to remain in the market and compete profitably against its competitors.

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2

The following table presents the manufacturing cost per unit for different cost categories for P-41 REV and P-63 REV: Cost categories Direct manufacturing product costs: Direct materials Indirect manufacturing product costs: Materials handling (71 × €1.20; 39 × €1.20) Assembly management Cost categories (2.1 × €40; 1.6 × €40) Machine insertion of parts (59 × €0.70; 29 × €0.70) Manual insertion of parts (12 × €2.10; 10 × €2.10) Quality testing (1.2 × €25; 0.9 × €25) Total indirect manufacturing costs Total manufacturing costs Target cost

P-41 REV

P-63 REV

€381.20

€263.10

85.20

46.80

P-41 REV 84.00

P-63 REV 64.00

41.30

20.30

25.20

21.00

30.00 265.70 €646.90 €680.00

22.50 174.60 €437.70 €390.00

P-41 REV is €33.10 below its target cost. However, P-63 REV is €47.70 above its target cost. It appears that Combrai Informatique will have major problems competing with the foreign printer costing €390. 3

P-41 = €782.40 P-41 REV = 646.90 Difference = €135.50

P-63 P-63 REV Difference

= = =

€504.00 437.70 € 66.30

The sources of the cost reductions in the redesigned products are: P-41 a Reduction in direct materials costs €26.30 b

Changes in design: Reduced materials handling costs due to fewer parts (85 − 71); (46 − 39) × €1.20 Reduced assembly time (3.2 − 2.1); (1.9 − 1.6) × €40 Reduced insertion of parts* (49 − 59) × €0.70 + (36 − 12) × €2.10 (31 − 29) × €0.70 + (15 − 10) × €2.10 Reduced quality testing (1.4 − 1.2); (1.1 − 0.9) × €25

P-63 €29.00

16.80

8.40

44.00

12.00

43.40 11.90 5.00 €135.50

5.00 €66.30

*Note that the reduced costs for insertion of parts come from two sources: (a) a reduction in total number of parts to be inserted and (b) an increase in the percentage of parts inserted by the lower-cost machine method.

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4

The €12 reduction in cost per hour of assembly time (from €40 to €28) reduces product costs as follows: P-41 REV:

€12 × 2.1 hours = €25.20. The new total manufacturing product cost is €621.70. (€646.90 − €25.20)

P-63 REV:

€12 × 1.6 hours = €19.20. The new total manufacturing product cost is €418.50. (€437.70 − €19.20)

The reduction in the assembly management activity rate further reduces the cost of P-41 REV below the target cost. It also makes it more likely that P-63 REV will achieve its target cost. 12.19

Life-cycle product costing, activity-based costing. (35–40 min) 1

The budgeted life-cycle operating income for the new watch MX3 is €1,852,500 as shown below. Year 1

Year 2

Year 3

Life cycle

(1)

(2)

(3)

(4) = (1) + (2) + (3)

Revenues €45 × 50,000; €40 × 200,000; €35 × 150,000 R&D and Design costs

€2,250,000

€8,000,000

900,000

100,000

0

1,000,000

800,000

3,000,000

2,250,000

6,050,000

87,500

240,000

180,000

507,500

600,000

600,000

600,000

1,800,000

180,000

640,000

420,000

1,240,000

400,000

300,000

300,000

1,000,000

50,000

200,000

150,000

400,000

30,000

150,000

125,000

305,000

240,000

240,000

240,000

720,000

100,000

300,000

225,000

625,000

3,387,500

5,770,000

4,490,000

13,647,500

€(1,137,500)

€2,230,000

€760,000

€1,852,500

€5,250,000

€15,500,000

Manufacturing costs: Variable €16 × 50,000; €15 × 200,000; €15 × 150,000 Batch €700 × 125a; €600 × 400b; €600 × 300c Fixed Marketing costs: Variable €3.60 × 50,000; €3.20 × 200,000; €2.80 × 150,000 Fixed Distribution costs: Variable €1 × 50,000; €1 × 200,000; €1 × 150,000 Batch €120 × 250d; €120 × 1,250e; €100 × 1,250f Fixed Customer service costs: Variable €2 × 50,000; €1.50 × 200,000; €1.50 × 150,000 Total costs Operating income a50,000 ÷ 400 = 125 d50,000 ÷ 200 = 250

b200,000 ÷ 500 = 400 e200,000 ÷ 160 = 1,250

c150,000 ÷ 500 = 300 f 150,000 ÷ 120 = 1,250

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2

Budgeted product life-cycle costs for R&D and design Total budgeted product life-cycle costs

€1,000,000 €13,647,500

1, 000, 000 Percentage of budgeted product life-cycle costs incurred at the end of the R&D and design stages = 13, 647, 500 = 7.33% 3

An analysis reveals that 80% of the total product life-cycle costs of the new watch will be locked in at the end of the R&D and design stages, when only 7.33% of the costs are incurred (requirement 2). The implication is that it will be difficult to alter or reduce the costs of MX3 once Saturniens finalises the design of MX3. To reduce and manage total costs, Saturniens must act to modify the design before costs get locked in.

4

The budgeted life-cycle operating income for MX3, if Saturniens reduces its price by €3, is €1,251,000 as shown below. This is less than the operating income of €1,852,500 calculated in requirement 1. Therefore, Saturniens should not reduce MX3’s price by €3. Year 1 (1)

Year 2 (2)

Year 3 (3)

Life cycle (4) = (1) + (2) + (3)

€2,310,000

€8,140,000

€5,280,000

€15,730,000

900,000

100,000

0

1,000,000

€15 × 165,000 Batch €700 × 125a; €600 × 400b; €600 × 300c

880,000

3,300,000

2,475,000

6,655,000

87,500

240,000

180,000

507,500

Fixed

600,000

600,000

600,000

1,800,000

198,000

704,000

462,000

1,364,000

400,000

300,000

300,000

1,000,000

55,000

220,000

165,000

440,000

30,000

150,000

125,000

305,000

240,000

240,000

240,000

720,000

110,000

330,000

247,500

687,500

3,500,500

6,184,000

4,794,500

14,479,000

€(1,190,500)

€1,956,000

€485,500

€1,251,000

Revenues €42 × 55,000; €37 × 220,000; €32 × 165,000 R&D and design costs Manufacturing costs: Variable €16 × 55,000; €15 × 220,000;

Marketing costs: Variable €3.60 × 55,000; €3.20 × 220,000; €2.80 × 165,000 Fixed Distribution costs: Variable €1 × 55,000; €1 × 220,000; €1 × 165,000 Batch €120 × 250d; €120 × 1,250e; €100 × 1,250f Fixed Customer service costs: Variable €2 × 55,000; €1.50 × 220,000; €1.50 × 165,000 Total costs Operating income a 55,000 ÷ 440 = 125

b 220,000 ÷ 550 = 400

c 165,000 ÷ 550 = 300

d 550,000 ÷ 220 = 250

e 220,000 ÷ 176 = 1,250

f 165,000 ÷ 132 = 1,250

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12.20

Customer profitability, service company. (20–30 min) 1

(in thousands)

Hytop BV KNMI HSP BPC ES HE KIM ED RC NRCH

Customer revenues

Customer costs

€260 180 163 322 235 80 174 76 137 373

€182 184 178 225 308 74 100 108 110 231

Customer operating income €78 (4) (15) 97 (73) 6 74 (32) 27 142

This information can be presented as follows (in thousands):

Operating Customer income NRCH BPC Hytop BV KIM RC HE KNMI HSP ED ES

€142 97 78 74 27 6 (4) (15) (32) (73)

% of cumulative Cumulative to total operating operating income income €142 239 317 391 418 424 420 405 373 300

47% 80 106 130 139 141 140 135 124 100

Revenue €373 322 260 174 137 80 180 163 76 235

Cumulative revenue

% of cumulative to total revenue

€373 695 955 1,129 1,266 1,346 1,526 1,689 1,765 2,000

19% 35 48 56 63 67 76 84 88 100

Two of the ten customers provide 80% of the total operating income while providing only 35% of the total revenue. 2

The options that Overloon should consider include: a

Increase the attention paid to NRCH and BPC. These are ‘key customers’ and every effort has to be made to ensure they retain Overloon. Overloon may well want to suggest a minor price reduction to signal how important it is in their view to provide a cost-effective service to these customers.

b

Seek ways of reducing the costs or increasing the revenues of the problem accounts – ES and ED. For example, are the copying machines at ES outdated and in need of repair? If yes, an increased charge may be appropriate. Can Overloon provide better on-site guidelines to users about ways to reduce breakdowns? 177 © Pearson Education Limited 2012

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c

3

As a last resort, Overloon may want to consider dropping particular accounts. For example, if ES will not agree to a fee increase but has machines continually breaking down, Overloon may well decide that it is time not to bid on any more work for this customer.

Major problems in accurately estimating are:

[AQ11]the

operating costs of each customer

a

Basic underlying records may not be accurate. For example, some technicians include travel time, break time, etc., in their time records to create an appearance of high-work effort.

b

Not all costs are easily assignable to individual customers. For example, how is the cost of a trip to pick up parts for three customers assigned among individual customers?

c

Many of Overloon’s costs are not related to specific customers. For example, advertising by Overloon is aimed at a general market rather than being targeted to a specific potential customer.

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CHAPTER 13

Capital investment decisions Teaching tips and points to stress Discounted cash-flow (DCF) methods Students who rely solely on pre-programmed calculators to calculate present and future value are unlikely to internalise the concepts. It is helpful for students to walk through the presentvalue tables (Appendix B to the text). To show the impact of interest, use a high interest rate and a long time span. Urge students to begin DCF analysis by drawing a time line of the cash inflows and outflows. Emphasise that this time line includes only actual cash Euros coming in and going out of the organisation. For example, the cost of a new machine is a cash outflow at time zero when it is purchased. This contrasts with the accrual accounting system that records an asset at time zero that gradually becomes depreciated expense over its useful life.

Income tax factors Keep students focused on the big picture. Income tax laws are very detailed and the tax rates, useful lives, depreciation patterns and tax credits often change. However, the DCF approach for measuring the impact of income tax laws on cash flows does not change with changes in specific income tax rates, useful lives allowed, etc. (although, of course, the specific numbers in the analysis will be affected). Income tax laws are a major means of implementing national fiscal policies. Changes are often aimed at encouraging or discouraging investments. During the 1980s, the UK carried accelerated depreciation to the extreme. For qualified assets, it permitted 100% write-off of the original cost during the year of acquisition in some instances.

Capital budgeting and inflation Students often confuse nominal and real cash flows and discount rates. Emphasise that in the nominal approach, students must put everything in terms of the future-year Euros (using the cumulative inflation rate factor) and then discount back to the present value using the nominal (real plus inflation) discount rate. That is, future cash flows are first compounded up by the cumulative inflation factor and then discounted back by the (real plus inflation) discount rate. While this may appear to be ‘doing’ and then ‘undoing’ the effect of inflation, it is necessary because the effects on the interest rates are non-linear.

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Project risk and required rate of return Petroleum companies use higher required rates for exploration than for refining. Both of these activities are likely to have higher required rates of return than would petroleum companies’ marketing projects. Companies with foreign operations find it even more difficult (and important) to adjust for risk in overseas projects. There is additional uncertainty inherent in operating outside Europe. The local political climate and consequent risk of takeover by foreign governments are relevant considerations in many international capital-budgeting decisions.

Capital rationing and the net present-value (NPV) decision rule The Supergraph/Mastergraph example in Chapter 13 illustrates the difficulty of choosing between mutually exclusive projects that require investments of very different magnitudes, under capital rationing. The choice of a project will affect funds available for other projects, and this effect must be carefully considered. As in the example, the larger project may be preferred even if its excess present-value index is lower. This occurs when the return on the large project’s funds is sufficiently higher than the return on alternative uses of the extra funds that would be available if the smaller projects were chosen instead.

Payback method The Supergraph/Mastergraph example in Chapter 13 shows that the payback method does not necessarily maximise profits, because it is silent about project profitability. However, companies often use payback in conjunction with DCF analyses and select those positive NPV projects that also have an acceptable payback period. Management is most likely to emphasise payback period when the future is very uncertain (and they do not want to tie up cash for long) and when interest rates are high (making it expensive to tie up cash for long periods of time). The major deficiencies of the payback calculation are that (1) it does not necessarily lead to profit maximisation and (2) it discourages selection of long-term projects (e.g. major R&D or automation projects may have a long payback period, but nevertheless may be critical to a company’s long-term survival). Too much focus on payback can contribute to short-term ‘myopia.’

Accounting rate of return (ARR) method Students are often confused about when to include depreciation expense in evaluating a capitalbudgeting project. NPV, IRR, payback and BET methods are all based on cash flows. Depreciation expense is not a cash flow. In contrast, the ARR is accounting income divided by investment. Depreciation expense is relevant in calculating the accounting income.

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Solutions to review questions 13.1

In essence, the discounted cash-flow method calculates the cash inflows and outflows of a project, as if they occurred at a single point in time so that they can be aggregated (added, subtracted, etc.) in an appropriate way and then can be compared to cash flows from other projects.

13.2

No. Only quantitative outcomes are formally analysed in capital-budgeting decisions. Many effects of capital-budgeting decisions, however, are difficult to quantify in financial terms. These non-financial or qualitative factors, for example, the number of accidents in a manufacturing plant or employee morale, are important to consider in making capital-budgeting decisions.

13.3

The payback method measures the time it will take to recoup, in the form of net cash inflows, the total amount invested in a project. The payback method is simple and easy to understand. It is a handy method when precision in estimates of profitability is not crucial and when predicted cash flows in later years are highly uncertain. The main weakness of the payback method is its neglect of profitability and the time value of money.

13.4

There are many different ways to calculate the accounting rate of return (ARR). One way frequently used is: ARR =

Increase in expected average annual operating income Net initial investment

The strengths of the ARR method are that it is simple, easy to understand and considers profitability. Its weakness is that it ignores the time value of money. 13.5

The ARR method differs from the payback method in that it considers profitability. Both methods ignore the time value of money.

13.6

A point of agreement is that an exclusive attachment to the mechanics of any single method examining only quantitative data is likely to result in overlooking important aspects of a decision. Two points of disagreement are (a) DCF can incorporate those strategic considerations that can be expressed in financial terms and (b) ‘practical considerations of strategy’ not expressed in financial terms can be incorporated into decisions after DCF analysis.

13.7

A post-investment audit compares the predictions of investment costs and outcomes made at the time a project was selected to the actual results. It is important because it provides management feedback about performance. For example, if actual outcomes are much lower than predicted outcomes, management will investigate whether this occurred because the original estimates were overly optimistic or because of problems in implementing the project.

13.8

No. Income taxes also affect the cash-operating flows from an investment and the cash flows from current and terminal disposal of machines in the capital-budgeting decision. When a company has positive cash-operating flows and gains on disposal of machines, income taxes reduce the cash flows available to the company from these sources.

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13.9

The real rate of return is the rate of return required to cover only investment risk. This rate is made up of two elements: (a) a risk-free element and (b) a business-risk element. The nominal rate of return is the rate of return required to cover investment risk and the anticipated decline, due to inflation, in general purchasing power of the cash that the investment generates. This rate is made up of two elements: (a) the real rate of return and (b) an inflation element. The nominal rate of return and the real rate of return are related as follows: Nominal rate = [(1 + Real rate) (1 + Inflation rate)] − 1

13.10

13.11

Chapter 13 outlines five approaches used to recognise risk in capital budgeting: 1

Varying the required payback time

2

Adjusting the required rate of return

3

Adjusting the estimated future cash flows

4

Sensitivity (‘what-if’) analysis

5

Estimating the probability distribution of future cash inflows and outflows for each project.

No. Discounted cash-flow analysis applies to both for-profit and not-for-profit organisations. Not-for-profit organisations must also decide which long-term assets will accomplish various tasks at the least cost. Not-for-profit organisations also incur an opportunity cost of funds.

Solutions to exercises 13.12

Comparison of approaches to capital budgeting. (22–25 min) 1

Payback period = €220,000 ÷ €50,000 = 4.4 years

2

The table for the present value of annuities (Appendix B, Table 4) shows 10 periods at 16% = 4.833 Net present value = €50,000 (4.833) − €220,000 = €241,650 − €220,000 = €21,650

3

Internal rate of return (IRR): €220,000 = Present value of annuity of €50,000 at X% for 10 years or what factor (F) in the table of present values of an annuity (Appendix B, Table 4) will satisfy the following equation. €220,000 = €50,000F F=

€220,000 €50,000

= 4.400

On the 10-year line in the table for the present value of annuities (Appendix B, Table 4), find the column closest to 4.400; 4.400 is between a rate of return of 18% and 20%.

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Interpolation is necessary: Present-value factors 4.494 4.494 – 4.400 4.192 – 0.302 0.094

18% IRR rate 20% Difference

Internal rate of return

0.094 = 18% + 0.302 (2%)





= 18% + (0.311) (2%) = 18.62% 4

Accounting rate of return based on net initial investment: Net initial investment

= €220,000

Estimated useful life

= 10 years

Annual straight-line depreciation

= €220,000 ÷ 10 = €22,000

ARR = =

Increase in expected average annual operating income Net initial investment 50, 000 − 22, 000 220, 000

=

28, 000 220, 000

= 12.73%

Note how the accrual accounting rate of return, whichever way calculated, can produce results that differ markedly from the internal rate of return. 13.13

Special order, relevant costs, capital budgeting. (30 min) 1

Relevant cash inflow from accepting the special order Relevant cash flows Per car (1)

Incremental revenues (cash inflows)

Total (2) = (1) × 100,000

€50

€5,000,000

Neon paint

6

600,000

Boxes

3

300,000

Direct manufacturing labour

8

800,000

Total incremental costs

17

1,700,000

Net incremental benefit

€33

€3,300,000

Incremental costs (cash outflows)

Notes a

The costs of plastic cars are irrelevant because these cars have already been purchased and so entail no incremental cash flow.

b

VAT depreciation is irrelevant because it is a past cost.

c

Allocated plant manager's salary is irrelevant because it will not change whether or not the special order is accepted.

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d

Variable marketing costs are not deducted because they will not be incurred on the special order.

e

Fixed marketing costs are irrelevant because they will not change whether or not the special order is accepted.

If it must offer the same €50 price to its other customers, Euro-Jouets will lose cash flow of €9 × 130,000 = €1,170,000 per year for 4 years from its existing customers. Note that whatever incremental costs Euro-Jouets incurs on sales to its existing customers is irrelevant. These costs would continue to be incurred whether Euro-Jouets prices the cars at €50 or €59. You can verify that Euro-Jouets generates positive contribution margin at a price of €50 and so should continue to sell to its existing customers. From Appendix B, Table 4, the present value of a stream of €1,170,000 payments for 4 years discounted at 16% is €1,170,000 × 2.798 = €3,273,660. The net relevant benefit of accepting the special order is €3,300,000 − €3,273,660 = €26,340. Therefore, Euro-Jouets should accept the special order. 2

Let the Euro discount from the current €59 price offered to existing customers be €X. Then

€X (130,000) (2.798) = 3,300,000 3, 300, 000 X = = €9.0724 (130, 000)(2.798)

At a price of €49.9276 (€59 − €9.0724) per car to its existing customers, Euro-Jouets would just be indifferent between accepting and rejecting Mille-Fontaines’ special order. 13.15

Net present value, internal rate of return, sensitivity analysis. (20–30 min) 1a The table for the present value of annuities (Appendix B, Table 4) shows

16 periods at 14% = 3.889 Net present value

= €40,000 (3.889) − €120,000 = €155,560 − €120,000 = €35,560

b Internal rate of return: €120,000

=

€120,000

=

F

=

Present value of annuity of €40,000 at X% for 6 years or what factor (F) in the table of present values of an annuity (Appendix B, Table 4) will satisfy the following equation. €40,000F €120, 000 €40, 000

= 3.0

On the 6-year line in the table for the present value of annuities (Appendix B, Table 4), find the column closest to 3.0; 3.0 is between a rate of return of 24% and 26%.

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Interpolation is necessary: Present-value factors 3.020 3.020 – 3.000 2.885 – 0.135 0.020

24% IRR rate 26% Difference

Internal rate of return

0.020 = 24% + 0.135 (2%)





= 24% + (0.148) (2%) = 24.30% 2

Let the minimum annual cash savings be €X. Then we want

€X (3.889)

=

€120,000

€120, 000

= €30,856 3.889 Carmelo, SA, would want annual cash savings of at least €30,856 for the net present value of the investment to equal zero. This amount of cash savings would justify the investment in financial terms. X

3

13.16

=

When the manager is uncertain about future cash flows, the manager would want to do sensitivity analysis, a form of which is described in requirement 2. Calculating the minimum cash flows necessary to make the project desirable gives the manager a feel for whether the investment is worthwhile or not. If the manager were quite certain about the future cash-operating cost savings, the approaches in requirement 1 would be preferred.

DCF, accounting rate of return, working capital, evaluation of performance. (20–30 min) 1a Summary of cash inflows and outflows (in thousands) is:

8

Present value of annuity of savings in cash-operating costs (€25,000 per year for 8 years at 14%): €25,000 × 4.639 Present value of €30,000 terminal disposal price of machine at end of year 8: €30,000 × 0.351 Present value of €8,000 recovery of working capital at end of year 8: €8,000 × 0.351 Gross present value Deduct net initial investment Special-purpose machine, initial investment €110,000 Additional working capital investment 8,000 Net present value

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1

€115,975 10,530 2,808 129,313

118,000 €11,313

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1b Use a trial and error approach. First, try a 16% discount rate: €25,000 × 4.344

€108,600

(€30,000 + €8,000) × 0.305

11,590

Gross present value

120,190

Deduct net initial investment

(118,000)

Net present value

€2,190

Second, try an 18% discount rate: €25,000 × 4.078

€101,950

(€30,000 + €8,000) × 0.266

10,108

Gross present value

112,058

Deduct net initial investment

(118,000)

Net present value

€(5,942)

By interpolation: Internal rate of return



  (2%)  2,190 + 5, 942 

= 16% + 

2,190

= 16% + (.269) (2%) = 16.54% 2

The accounting rate of return based on net initial investment: Net initial investment

= €110,000 + €8,000 = €118,000

Annual depreciation (€110,000 − €30,000) ÷ 8 years Accounting rate of return 3

= €10,000 =

€25, 000 − €10, 000 €118, 000

= 12.71%

If your decision is based on the DCF model, the purchase would be made because the net present value is positive and the 16.54% internal rate of return exceeds the 14% required rate of return. However, you may believe that your performance may actually be measured using accrual accounting. This approach would show a 12.71% return on the initial investment, which is below the required rate. Your reluctance to make a ‘buy’ decision would be quite natural unless you are assured of reasonable consistency between the decision model and the performance evaluation method.

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13.17

Sporting contract, net present value, payback. (30 min) 1a Summary of cash inflows and outflows (in millions) is as follows: Cash outflows Year 1 (start) Year 1 (end) Year 2 (end) Year 3 (end) Year 4 (end)

NKr 3.000 5.500 6.200 7.300 7.900 PV discount factor

Year

Cash outflows

Cash inflows

Net cash inflows

NKr 0 5.600 8.300 9.100 9.700

NKr (3.000) 0.100 2.100 1.800 1.800

PV of cash outflows

Cash inflows

PV of cash inflows

0: Year 1 (start)

1.000

NKr 3.000

NKr 3.0000

NKr 0

NKr 0

1: Year 1 (end)

0.893

5.500

4.9115

5.600

5.0008

2: Year 2 (end)

0.797

6.200

4.9414

8.300

6.6151

3: Year 3 (end)

0.712

7.300

5.1976

9.100

6.4792

4: Year 4 (end)

0.636

7.900

5.0244

9.700

6.1692

NKr23.0749

NKr24.2643

The net present value of the Monteiro contract is NKr1.1894 (NKr24.2643 − NKr23.0749) million. An alternative approach to determine the NPV of the Monteiro contract is as follows: Present

Total present

value

value

of NKr 1 discounted at 12%

(in millions)

Year 1 (start) Year 1 (end) Year 2 (end) Year 3 (end) Year 4 (end)

End of year 1.

Initial signing bonus

2.

Recurring operating cash flows

Net present value

Sketch of relevant cash flows

NKr(3.0000)

←−− 1.000←−− NKr(3.0)

0.0893

←−− 0.893←−−−−−−−−−NKr0.1

1.6737

←−− 0.797←−−−−−−−−−−−−−−−−NKr2.1

1.2816

←−− 0.712←−−−−−−−−−−−−−−−−−−−−−−NKr1.8

1.1448

←−− 0.636←−−−−−−−−−−−−−−−−−−−−−−−−−−−NKr1.8

NKr 1.1894

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1b Payback period: Cash investment yet to be recovered at end of year

Net cash inflows

Cumulative net cash inflows

0: Year 1 (start)

–

–

1: Year 1 (end)

NKr0.100

NKr0.100

2.900

2: Year 2 (end)

2.100

2.200

0.800

3: Year 3 (end)

1.800

4.000

–

4: Year 4 (end)

1.800

5.800

–

Year

NKr3.000

 NKr 0.800  Payback period = 2 years +   = 2.44 years  NKr1.800  2

13.18

Other factors Aspelund might consider include: a

Uncertainty over the predicted cash inflows for 2012 to 2015. A key factor here is the possible risk of injury to Monteiro or a diminishing of his soccer ability.

b

Increase in number of championships Aalesund Fotballklubb wins.

c

Increase in community pride that accompanies a championship team.

d

Aspelund's own personal prestige of being president of a championship club.

e

The effect the signing would have on Aalesund Fotballklubb’s ability to sign other players.

Comparison of projects with unequal lives. (20–30 min) 1

Internal rate of return Project 1 Let F = Present-value factor of €1 at X% received at the end of year 1 (Appendix B, Table 2) €10,000

=

F

=

IRR

=

PV of €12,000 at X% to be received at the end of year 1 €10, 000 €12, 000

= 0.833

20%

Project 2 Let F = Present-value factor of €1 at X% received at the end of year 4 (Appendix B, Table 2). €10,000

= F

=

PV of €17,500 at X% to be received at the end of year 4

€10, 000 €17, 500

= 0.571

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The internal rate of return can be calculated by interpolation: Present-value factors for €1 received after 4 years 14% IRR rate 16% Difference

0.592 – 0.552 0.040

0.592 0.571 – 0.021

0.021 IRR rate: 14% + 0.040 (2%) = 15.05%





Project 1 is preferable to Project 2 using the IRR criterion. 2

Net present value Project 1 Gross present value

= PV of €12,000 at 10% to be received at the end of year 1 = €12,000 (0.909) = €10,908

Net present value

= €10,908 − €10,000 = €908

Project 2 Gross present value

= PV of €17,500 at 10% to be received at the end of year 4 = €17,500 (0.683) = €11,952.50

Net present value

= €11,952.50 − €10,000 = €1,952.50

Project 2 is preferable to Project 1 using the net present-value criterion. 3

This problem contrasts the implied reinvestment rates of return under the internal rate of return and net present-value methods. Where the economic lives of mutually exclusive projects are unequal, this clash of reinvestment rates may give different conclusions under the two methods. This result occurs because the internal rate of return method assumes that the reinvestment rate is at least equal to the calculated rate of return on the project. The net present-value method assumes that the funds obtainable from competing projects can be reinvested at the rate of the company's required rate of return. Comparisons are as follows:

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Ranking by internal rate of return

Assumption: Project 1 funds can be reinvested at 20% over the life of the shorter-lived project. 13.19

Ranking by net present value

Assumption: Project 1 funds can be reinvested at 10%, the required rate of return.

Ranking projects. (40 min) 1

Project B Let F = Present-value factor for an annuity of €1 for 10 years in Appendix B, Table 4. €100,000 = €20,000F F = 5.000 for 10-year life

The internal rate of return can be calculated by interpolation: Present-value factors for annuity of €1 for 10 years 14%

5.216

5.216

IRR

–

5.000

16%

4.833

–

Difference

0.383

0.216

 0.216  IRR = 14% +   (2%) = 15.1%  0.383 

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Project C €200,000 = €70,000F Let F = Present-value factor for an annuity of €1 for 5 years in Appendix B, Table 4. F = 2.857 for 5-year life

The internal rate of return can be calculated by interpolation: Present-value factors for annuity of €1 for 5 years 22%

2.864

2.864

IRR

–

2.857

24%

2.745

–

Difference

0.119

0.007

 0.007  IRR = 22% +   (2%) = 22.1%  0.119 

Project D We need to find the discount rate at which Initial investment, €200,000 = PV of a 4-year annuity of €200,000 per year deferred 5 years since the €200,000 of cash inflows are received in years 6–9. Trial and error: At 18%

At 20%

At 22%

2.690

2.589

2.494

Multiply by €200,000, the total value of the annuity

€538,000

€517,800

€498,80 0

Multiply by the present value of €1 5 years hence

0.437

0.402

0.370

€235,106

€208,156

€184,55 6

€1 per year for 4 years

PV of annuity in arrears

IRR = 20% + = 20% +

€208,156 – €200,000 (2%) €208,156 – €184,556 €8,156 (2%) = 20.7% €23,600

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Ranking of projects

2

Rank

Project

IRR (%)

Initial investment (€)

1

C

%22.1

200,000

2

D

%20.7%

€200,000

3

B

%15.1%

€100,000

4

A

%14.0%

€100,000

5

E

%12.6%

€200,000

6

F

%12.0%

€ 50,000

Budget limit: €500,000

€550,000

€650,000

C

C

C

D

D

D

B

B

B

F

A F

3

Ranking by net present value, discounting at 16% Rank

Project

Net present value

1

D

€66,370)

2

C

29,180)

3

B

(3,340)

4

F

(3,384)

5

A

(13,170)

6

E

(35,965)

Project D is more desirable than Project C because it has a higher NPV. Because 16% is the implicit reinvestment rate, these rankings are different from the rankings made on the basis of internal rates of return in requirement 1. Calculations Project D PV of €200,000 per year for 4 years at 16% = €200,000 (2.798) It is in arrears 5 years, so PV = €559,600 (0.476) Net initial investment

€559,600 266,370 (200,000)

Net present value

€66,370

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Project C PV of €70,000 per year for 5 years at 16% = €70,000 (3.274)

€229,180

Net initial investment

(200,000)

Net present value

€ 29,180

Project B PV of €20,000 per year for 10 years at 16% = €20,000 (4.833)

€ 96,660

Net initial investment

(100,000)

Net present value

€ (3,340)

Project F PV at 16%

€23,000 × 0.862

€ 19,826

20,000 × 0.743

14,860

10,000 × 0.641

6,410

10,000 × 0.552

5,520

Total PV

46,616

Net initial investment

(50,000)

Net present value

€ (3,384)

Project A PV of annuity of €20,000 for 15 years

=

€20,000 × 0.862

Deduct deferral of 2 years

=

20,000 × 1.605

PV of annuity in arrears

€ 111,500 (32,100) 79,400

PV of €10,000 due in 2 years

=

10,000 × 0.743

Total PV

7,430 86,830

Net initial investment

(100,000)

Net present value

€ (13,170)

Project E PV of annuity of €50,000 for 10 years

=

€50,000 × 4.833

Deduct deferral of 3 years

=

50,000 × 2.246

PV of annuity in arrears

€ 241,650 (112,300) 129,350

PV of €30,000 due in 3 years

=

30,000 × 0.641

19,230

PV of €15,000 due in 2 years

=

15,000 × 0.743

11,145

PV of €5,000 due in 1 year

=

5,000 × 0.862

4,310

Total PV

164,035

Net initial investment

(200,000)

Net present value

€ (35,965)

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4

13.20

Other influential factors include: a

The risk linked with a given proposal may prompt management to judge it more or less attractive than other proposals that promise a comparable internal rate of return.

b

Future investment opportunities may affect the current relative attractiveness of alternative proposals. For example, if management expects that, 5 years hence, the best available alternatives will bring less than 20%, Project D (which promises an internal rate of return of 20.7% for 9 years) may be preferable to Project C (which promises 22.1% for 5 years). However, if future opportunities are expected to bring equal or higher internal rates of return, a shorter-lived project may be more attractive, even though a longer-lived project may yield a higher rate of return. Thus, if a choice must be made now between E and F, Project F (12.0% for 4 years) may be chosen instead of Project E (12.6%, but it locks in capital for 10 years and necessitates a much larger investment).

Equipment replacement, relevant costs, sensitivity analysis. (30–40 min) 1

The first step is to analyse all relevant operating cash flows and align them with the appropriate alternative. This analysis is as follows: Moulding machine (1) Sales (irrelevant)

–

Automatic machine (2)

Increment (3)

–

–

Costs: £10,000

£9,000

£1,000

Direct manufacturing labour*

20,000

10,000

10,000

Variable overhead*

15,000

7,500

7,500

–

–

–

–

–

–

£45,000

£26,500

£18,500

Direct materials

Fixed overhead (irrelevant) Marketing and administrative costs (irrelevant) Total relevant operating cash outflows

*Because the automatic machine produces twice as many units per hour, the direct manufacturing labour cost with the automatic machine would be £10,000; variable overhead, being 75% of direct manufacturing labour cost, would be £7,500.

Solution Exhibit 13.20 indicates that the automatic machine has a £9,423 net presentvalue advantage over the moulding machine. Note: The book value of the old machine is irrelevant and thus is completely ignored. In the light of subsequent events, nobody will deny that the original £50,000 investment could have been avoided, with a little luck or foresight. But nothing can be done to alter the past. The question is whether the company will nevertheless be better off buying the new machine. Management would have been much happier if the £50,000 had never been spent in the first place, but the original mistake should not be compounded by keeping the old machine.

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Solution Exhibit 13.20

Net present-value analysis of purchasing new automatic machine. Presentvalue Total

discount

present

factor

value

at 18%

End of year A.

0

1

2

3 4

Automatic machine Net initial investment Current disposal price

B.

Sketch of relevant cash flows

£(44,000)

←−1.000

of old equipment Recurring operating

5,000←−−1.000

cash costs Present value of net cash outflows

(71,285)←−−2.690

←−£(44,000) ←−− £5,000 ←−−−−−−−− £(26,500)

£(26,500) £(26,500) £(26,500)

£(110,285)

Moulding machine Terminal disposal price of old equipment 4 years hence

£1,342 ←−−0.516←−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−− £2,600

Recurring operating cash costs

(121,050) ←−− 2.690 ←−−−−−−−− £(45,000) £(45,000) £(45,000) £(45,000)

Present value of net cash outflows

£(119,708)

Difference in favour of replacement (A − B)

£9,423

An alternative analysis of cash inflows and outflows (in thousands) is: Presentvalue Total

discount

present

factor

value

at 18%

End of year

Sketch of relevant cash flows

0

1

Initial machine investment

£(44,000)

2

Current disposal price of old machine Net initial investment

£5,000 £(39,000) ←− 1.000←−−− £(39,000)

3 4

1

2

3

4

Recurring operating cash savings

49,765

←− 2.690←−−−−−−−−−−−−− £18,500

Difference in terminal disposal prices of machines

(1,342)

←− 0.516 ←−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−− (2,600)

Net present value

£18,500 £18,500 £18,500

£9,423

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Note the cash outflow of £2,600 from the difference in terminal disposal prices of machines. The relevant cash flow equals the difference in terminal disposal prices of the two machines. If the toy manufacturer continues to use the old machine, it will receive £2,600 on disposal of its machine at the end of year 4. If it switches to the new machine, it will receive £0 on disposal at the end of year 4. Hence, by investing in the new machine instead of continuing with the old one, the toy manufacturer forgoes £2,600 in terminal disposal price. Hence, £2,600 appears as a cash outflow in year 4 in the sketch of relevant cash flows. 2

The uniform payback formula can be used because the operating savings are uniform: Payback period = P=

Net initial investment Uniform increase in annual cash inflow

£44,000 – £5,000 = 2.1 years £18,500

The £5,000 current disposal price of the moulding machine is deducted from the £44,000 cost of the automatic machine to determine the net initial investment in the automatic machine. 3

This is an example of sensitivity analysis: Note that the net initial investment and the difference in terminal disposal prices of machines are unaffected and hence, are included in the equation at the present values that we calculated earlier. The present value of an annuity of £1 received at the end of each year for 4 years is 2.690. 2.690X = £40,342

X = £14,997 If the annual savings fall by £3,503, from the estimated £18,500 to £14,997, the point of indifference will be reached. (Rounding errors may affect the calculation slightly.) Because the annual operating savings are equal, an alternative way to get the same answer is to divide the net present value of £9,423 by 2.690 (see Table 4 of Appendix B), obtaining £3,503; £3,503 is the amount of the annual difference in savings that will eliminate the £9,423 of net present value.

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13.21

Capital budgeting, computer-integrated manufacturing (CIM), sensitivity. (25 min.)

The net present-value analysis of the CIM proposal is as follows. We consider the differences in cash flows if the machine is replaced. All values in millions.

1

Presentvalue

1

Initial investment in CIM today

2a

Current disposal price of old production line

2b

Current recovery of working capital (€6 − €2)

3

Recurring operating cash savings

Relevant

discount

Total

cash

factors at

present

flows

14%

value

€(45)

€4* each year for 10 years 4a

€(45.000)

5

1.000

5.000

4

1.000

4.000

4

5.216

20.864

14

0.270

3.780

(4)

0.270

(1.080)

Higher terminal disposal price of machines (€14 − €0) in year 10

4b

1.000

Reduced recovery of working capital (€2 − €6) in year 10

€(12.436)

Net present value of CIM investment * Recurring operating cash flows are as follows: Cost of maintaining software programs and CIM equipment

€(1.5)

Reduction in lease payments due to reduced floor-space requirements

1.0

Fewer product defects and reduced reworking

4.5

Annual recurring operating cash flows

€4.0

On the basis of this formal financial analysis, Dinamica should not invest in CIM – it has a negative net present value of €(12.436) million. 2

Requirement 1 only looked at cost savings to justify the investment in CIM. Manuel estimates additional cash revenues net of cash operating costs of €3 million a year as a result of higher quality and faster production resulting from CIM. From Appendix B, Table 4, the net present value of the €3 million annuity stream for 10 years discounted at 14% is €3 × 5.216 = €15.648. Taking these revenue benefits into account, the net present value of the CIM investment is €3.212 (€15.648 − €12.436) million. On the basis of this financial analysis, Dinamica should invest in CIM.

3

Let the annual cash flow from additional revenues be €X. Then we want the present value of this cash flow stream to overcome the negative NPV of €(12.436) calculated in requirement 1. Hence, X (5.216) = 12.436 X = €2.384 million

An annuity stream of €2.384 million for 10 years discounted at 14% gives an NPV of €2.384 × 5.216 = 12.436 (rounded).

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4 Relevant

Present-value

Total

cash

discount

present

flows

factors at 14%

€(45)

1.000

value €(45.000)

1

Initial investment in CIM today

2a

Current disposal price of old production line

5

1.000

5.000

2b

Current recovery of working capital (€6 − €2)

4

1.000

4.000

3a

Recurring operating cash savings €4 each year for 5 years

4

3.433

13.732

3b

Recurring cash flows from additional revenues of €3 each year for 5 years

3

3.433

10.299

4a

Higher terminal disposal price of machines (€20 − €4) in year 5

16

0.519

8.304

4b

Reduced recovery of working capital (€2 − €6) in year 5

(4)

0.519

Net present value of CIM investment

(2.076) €(5.741)

The use of too short a time horizon such as 5 years biases against the adoption of CIM projects. Before finally deciding against CIM in this case, Manuel should consider other factors, including: a

Sensitivity to different estimates of recurring cash savings or revenue gains.

b

Accuracy of the costs of implementing and maintaining CIM.

c

Benefits of greater flexibility that results from CIM and the opportunity to train workers for the manufacturing environment of the future.

d

Potential obsolescence of the CIM equipment. Dinamica should consider how difficult the CIM equipment would be to modify if there is a major change in CIM technology.

e

Alternative approaches to achieve the major benefits of CIM such as changes in process or implementation of just-in-time systems.

f

Strategic factors. CIM may be the best approach to remain competitive against other low-cost producers in the future.

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PART III

PLANNING AND BUDGETARY CONTROL SYSTEMS

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CHAPTER 14

Motivation, budgets and responsibility accounting Teaching tips and points to stress Major features of budgets There are costs (as well as benefits) of budgeting. First, managers often spend much time working on budgets. Studies of large companies suggest that about 5% of staff FTE positions are devoted to budgeting. Second, increasing uncertainty in the rapidly changing business environment makes it difficult to budget. Third, if the budget is rigidly implemented, employees may take actions that will help meet the budget, but will hurt the company in the long run (e.g. deferring maintenance). Planning is setting goals and developing strategies to achieve these goals. Budgets show how resources will be deployed to implement their strategic plans. Budgets are planning ‘tools’, but there is more to planning than budgeting. To evaluate current performance, management needs a standard or benchmark for comparison. The example given in Chapter 14 of the mobile phone company, Mobile Communications, suggests two problems with using historical data as benchmarks for performance evaluation. First, historical data may encompass inefficiencies. Second, management usually expects the future to differ from the past. The advantage of historical data is that they are generally available at low cost. In contrast, budgeted benchmarks may be expensive to develop, but they can reflect anticipated changes and improved efficiency. If students are familiar with JIT (just in time) (discussed in Chapter 21), point out that JIT requires sophisticated coordination mechanisms. If production is to flow smoothly without stock buffers, each department’s inputs and outputs must precisely coordinate with the ‘supplier’ and ‘customer’ departments.

Types of budget The length of the budget period also depends on the nature of the business. A firm in a stable industry (e.g. a utility) will have a longer budget horizon than will a small start-up company in a rapidly changing high-tech field. If the production process is labour paced, DL can be a reasonable base for allocating MOH, even if labour is only a small proportion of total costs. In a labour-paced production process, workers control the speed with which the product moves through the plant. If MOH depends on the length of time the product is in the plant, and if this time is determined by DL, then DL (which is readily available from the accounting records) is associated with MOH costs incurred, so it can provide a reasonable basis for allocation.

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Closing stock is not just a ‘leftover’; it is planned or budgeted. The amount budgeted depends on the firm’s philosophy (JIT or traditional), the variation in demand for the product, perishability, etc. Students often fail to appreciate potential behavioural effects of budgeting. If employees perceive budgets as too difficult to achieve, they may simply view the budget as unrealistic and ‘give up’ trying to achieve it. This is particularly likely if employees feel the budget has been imposed by higher levels. On the other hand, if employees themselves determine the budget, they often set budgets that are too easily achieved by building in slack. (These behavioural issues arise in cost budgets as well as revenue budgets.) Management must make tough choices in determining the degree of employee participation in the budgetary process and the extent to which employees should view the budget as achievable. The nature of the product makes it difficult for some companies to synchronise production levels with expected sales. When inputs are available only seasonally, production occurs when inputs are available. For example, a manufacturer of jams produces the year’s supply of strawberry jam during the strawberry season, the year’s supply of cherry jam during the cherry season, etc. Variable OH costs fluctuate in proportion to the quantity of the cost allocation base (DLH in the Wessex Engineering example, given in Chapter 14), whereas fixed OH remains constant across a wide range of output. Walk the students through the consumption of the cost/unit of FG. This shows how the DM, DL and MOH budgets fit together. Students often have trouble with this integration.

Kaizen budgeting One way to set kaizen budgets for continuous improvement is to use learning curves, discussed in Chapter 9. The magnitude of budgeted improvement would decline over time, recognising that it is more difficult to achieve improvements in later periods, after the ‘easy’ improvements have been made. Another way is to link expected improvement to the life cycle of a product. In the early stages, higher importance is expected. Much of the cost reduction associated with kaizen arises from many small incremental improvements, rather than ‘quantum leaps’. The success of kaizen budgeting depends on the quantity and quality of employees’ suggestions. Some Japanese companies require each of their employees to contribute suggestions every day. Kaizen budgeting is often used in conjunction with target costing, where the company estimates the price customers will pay for the product and then subtracts the desired profit margin to determine target allowable cost (see Chapter 12).

Activity-based budgeting Activity-based budgeting (ABB) is a natural complement to activity-based costing (ABC). Steps 1 (budgeted cost of activity) and 2 (budgeted demand for activity) are used to develop the indirect cost allocation rate for each activity, used in both ABB (where the rate is multiplied by expected usage) and ABC (where the rate is multiplied by actual or standard usage).

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ABB is helpful for ex ante and ex post cost control. ABB reveals the costs of different activities so that managers can attempt to reduce consumption of the cost drivers before costs are committed or locked in. After the incurrence of actual costs, ABB can pinpoint activities where (1) the actual cost rate of the activity was higher than budgeted or (2) the usage of the cost driver was higher than budgeted.

Budgeting and responsibility accounting In the example in Chapter 14 of the text, the new responsibility accounting system helps top management achieve their profit maximisation goals by ensuring that sales managers accept a rush order only if that order’s profit exceeds the incremental cost of rushing the order. Variances should be used to raise questions and direct attention to employees who should have answers – variances should not be used to ‘fix the blame’. For example, a marketing manager may decide to run an extra advertising campaign. If the extra sales’[AQ12] profits more than offset the advertisement’s costs, the manager should be commended, not penalised.

The cash budget Students are often confused by several aspects of the cash budget. 1

The ending balance (EB) of cash in one quarter is the beginning balance (BB) of cash in the next quarter.

2

In the ‘Year as a Whole’ column, receipts and disbursements are totalled for the four quarters. However, the BB is the BB at quarter 1 and the EB is the EB at quarter 4. (Students often try to add the balances across the four quarters.)

3

Depreciation and depletion are not cash disbursements.

Solutions to review questions 14.1

A master budget is a single income statement that combines information from many individual budgeted income statements. The term ‘master’ refers to its being a comprehensive organisation-wide set of budgets.

14.2

The budgeting cycle includes the following elements: a

Planning the performance of the organisation as a whole as well as its subunits. The entire management team agrees as to what is expected.

b

Providing a frame of reference, a set of specific expectations against which the actual results can be compared.

c

Investigating variations from the plans. If necessary, corrective action follows investigation.

d

Planning again, considering feedback and changed conditions.

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14.3

Strategy, plans and budgets are interrelated and affect one another. Strategy is a broad term that usually means selection of overall objectives. Strategy analysis underlies both long-run and short-run planning. In turn, these plans lead to the formulation of budgets. Budgets provide feedback to managers about the likely effects of their strategic plans. Managers use this feedback to revise their strategic plans.

14.4

Budgeted performance is better than past performance for judging managers. Why? This is mainly because the inefficiencies included in past results can be detected and eliminated in budgeting. Also, new opportunities in the future, which did not exist in the past, may be ignored if past performance is used.

14.5

Budgets may be a vehicle for communication, but sometimes the vehicle breaks down. For example, the budget staff often find they are unable to obtain line management participation in developing budgets. In some cases, line people tend to relinquish line budget responsibilities to the budget staff. Line personnel simply do not wish to be bothered with the budget. This indicates a lack of good communication.

14.6

Kaizen budgeting is a budgeting approach that explicitly incorporates continuous improvement during the budget period into the resultant budget numbers.

14.7

Benefits that companies report from using activity-based budgeting include: 1

Ability to set more realistic budgets

2

Better identification of resource needs

3

Linking of costs to outputs

4

Clearer linking of costs with staff responsibilities

5

Identification of budgetary slack.

14.8

Responsibility accounting is a system that measures the plans (by budgets) and actions (by actual results) of each responsibility centre.

14.9

The choice of a responsibility centre type guides the variables to be included in the budgeting exercise. For example, if a revenue centre is chosen, the focus will be on variables that assist in forecasting revenue. Factors related to, say, costs of the investment base will only be considered if they assist in forecasting revenue.

14.10

Exhibit 14.7 in Chapter 14 summarises key points. Examples are: Criticism

Proposal for change

1

Excessive reliance on extrapolating past trends

Link budgeting explicitly to strategy

2

Across-the-board percentage cuts

Use ABB to guide cost reduction approach

3

Functional areas treated as independent silos

Adopt cross-functional approach

4

Myopic emphasis on calendar horizons

Tailor budget cycle to purpose

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Solutions to exercises 14.11

Cost of goods sold budget, fill in the missing numbers. (20 min) June 2011

a

2,215 − (481 + 772) = 962.

b

87 + 2,215 = 2,302.

c

2,302 − 2,189 = 113.

d

1,878 − (847 + 389) = 642.

e

1,949 − 1,878 = 71.

f

1,949 − 94 + 1,855.

November 2011

€87G

Opening finished goods stock Direct materials used Direct manufacturing labour Manufacturing overhead Cost of goods manufactured Cost of goods available for sale Deduct closing finished goods stock Cost of goods sold

€71e

€962a €481G €772G

€847G €389G € 642d 2,215G 2,302b 113c €2,189G

1,878G 1,949G 94G €1,855f

G = given.

14.13

Sales and production budget. (5 min) Budgeted sales (units) Add target closing finished goods stock Total requirements Deduct opening finished goods stock Units to be produced N S

14.14

= =

900,000 960,000

+ −

60,000 70,000

S 70,000 N 60,000 900,000 = =

960,000 890,000

Direct materials purchases budget. (5 min) Direct materials to be used in production (bottles) Add target closing direct materials stock (bottles) Total requirements (bottles) Deduct opening direct materials stock (bottles) Direct materials to be purchased (bottles)

14.15

1,500,000 50,000 1,550,000 20,000 1,530,000

Budgeting material purchases. (10 min) Finished goods (units) Budgeted sales Add target closing finished goods stock Total requirements Deduct opening finished goods stock Units to be produced

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42,000 24,000 66,000 22,000 44,000

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Direct materials (in litres) Direct materials needed for production (44,000 × 3) Add target closing direct materials stock Total requirements Deduct opening direct materials stock Direct materials to be purchased

14.16

132,000 110,000 242,000 90,000 152,000

Budgetary slack and ethics. (15 min)

The use of budgetary slack, particularly if it has a detrimental effect on the company, may be unethical. In assessing the situation, the specific Standards of Ethical Conduct for Management Accountants, summarised in Exhibit 1.7, that the management accountant should consider are listed below. a. Competence

Clear reports using relevant and reliable information should be prepared. Reports prepared on the basis of incorrect revenue or cost projections would violate the management accountant’s responsibility for competence. Performance of Czereszewski and Sazanowicz would appear to look better than they actually are because their performances are being compared to understated and unreliable budgets. b. Integrity

Any activity that subverts the legitimate goals of the company should be avoided. Incorrect reporting of revenue and cost budgets could be viewed as violating the responsibility for integrity. Ethical guidelines require the management accountant to communicate favourable as well as unfavourable information. Zielinski will probably regard Czereszewski’s and Sazanowicz’s behaviour as unethical because it is attempting to project their results in a favourable light. c. Objectivity

The management accountant’s ethical guidelines require that information should be fairly and objectively communicated and that all relevant information should be disclosed. From a management accountant’s standpoint, Czereszewski and Sazanowicz are clearly violating both these precepts. For the various reasons cited above, Zielinski should take the position that the behaviour described by Czereszewski and Sazanowicz is unethical. 14.17

Revenue, production and purchases budget. (15–20 min) 1 2

800,000 motorcycles × 400,000 yen = 320,000,000,000 yen Budgeted sales (units) Add target closing finished goods stock Total requirements Deduct opening finished goods stock Units to be produced

800,000 100,000 900,000 120,000 780,000

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3

Direct materials to be used in production 780,000 × 2 Add target closing direct materials stock Total requirements Deduct opening direct materials stock Direct materials to be purchased Cost per wheel in yen Direct materials purchased cost in yen

1,560,000

30,000 1,590,000 20,000 1,570,000 16,000 25,120,000,000

Note the relatively small stock of wheels. In Japan, suppliers tend to be located very close to the major manufacturer. Stocks are controlled by just-in-time and similar systems. Indeed, some direct materials stocks are almost non-existent. 14.18

Budgeted profit and loss account. (30 min) Castelo Branco Company Budgeted Profit and Loss Account for 2011 (in thousands) Net sales Equipment (€6,000 × 1.06 × 1.10) Maintenance contracts (€1,800 × 1.06) Total net sales Cost of goods sold (€4,600 × 1.03 × 1.06) Gross margin Operating costs: Marketing costs (€600 + €250) Distribution costs (€150 × 1.06) Customer maintenance costs (€1,000 + €130) Administrative costs Total operating costs Operating income

14.19

€6,996 1,908 €8,904 5,022 3,882 850 159 1,130 900 3,039 €843

Responsibility of purchasing agent. (15 min)

The time lost in the plant should be charged to the purchasing department. Certainly, the plant manager could not be asked to underwrite a loss due to failure of delivery over which he had no supervision. Although the purchasing agent may feel that he has done everything he possibly could, he must realise that, in the whole organisation, he is the one who is in the best position to evaluate the situation. He receives an assignment. He may accept it or reject it. But if he accepts, he must perform. If he fails, the damage is evaluated. Everybody makes mistakes. The important point is to avoid making too many mistakes and also to understand fully that the extensive control reflected in ‘responsibility accounting’ is the necessary balance to the great freedom of action that individual executives are given. Discussions of this problem have again and again revealed a tendency among students (and among accountants and managers) to ‘fix the blame’ – as if the variances arising from a responsibility accounting system should pinpoint misbehaviour and provide answers. The point is that no accounting system or variances can provide answers. However, variances can lead to questions. In this case, in deciding where the penalty should be assigned, the student might enquire who should be asked – not who should be blamed. 206 © Pearson Education Limited 2012

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Classroom discussions have also raised the following diverse points: a

Is the rail company liable?

b

Costs of idle time are usually routinely charged to the production department. Should the information system be fine-tuned to reallocate such costs to the purchasing department?

c

How will the purchasing managers behave in the future regarding willingness to take risks?

The text emphasises the following: Beware of overemphasis on controllability. For example, a time-honoured theme of management is that responsibility should not be given without accompanying authority. Such a guide is a useful first step, but responsibility accounting is more far-reaching. The basic focus should be on information or knowledge, not on control. The key question is: Who is the best informed? Put another way, ‘Who is the person who can tell us the most about the specific item, regardless of ability to exert personal control?’ 14.23

Kaizen approach to activity-based budgeting. (20–30 min) 1

March 2011 rates January Ordering Delivery Shelf-stacking Customer support

February

DKr 90 82 21 0.18

March

DKr 89.820 81.836 20.958 0.17964

DKr 89.64 81.67 20.92 0.179

These March 2011 rates can be used to calculate the total budgeted cost for each activity area: Soft drinks

Fresh produce

Packaged food

Total

Ordering DKr 89.64 × 14; 24; 14

DKr 1,255

DKr 2,151

DKr 1,255 DKr 4,661

980

5,063

1,552

7,595

335

3,598

1,966

5,899

823 DKr 3,393

6,122 DKr 16,934

Delivery DKr 81.67 × 12; 62; 19 Shelf-stacking DKr 20.92 × 16; 172; 94 Customer support DKr 0.179 × 4,600; 34,200; 10,750

1,924 8,869 DKr 6,697 DKr 27,024

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2

A kaizen budgeting approach signals management’s commitment to systematic cost reduction. Ordering

Delivery

Shelfstacking

Question 14.21 DKr 4,680 Question 14.22 (Kaizen) 4,661

DKr 7,626 7,595

DKr 5,922 5,899

Customer support DKr 8,919 8,869

The kaizen budget numbers will show unfavourable variances for managers whose activities do not meet the required monthly cost reductions. This is likely to put more pressure on managers to creatively seek out cost reductions by working ‘better’ within Nyborg Supermarkets or by having ‘better’ interactions with suppliers or customers. One limitation of kaizen budgeting, as illustrated in this question, is that it assumes small incremental improvements each month. It is possible that some cost improvements arise from large discontinuous changes in operating processes, supplier networks or customer interactions. Companies need to highlight the importance of seeking these large discontinuous improvements as well as the small incremental improvements. 14.24

Comprehensive review of budgeting. (50–60 min) 1

Schedule 1: Revenue budget (in £)

For the year ended 31 December 2011 Units (Lots) Lemonade Diet lemonade Total

2

1,080 540

Selling price £9,000 8,500

Total sales £9,720,000 4,590,000 £14,310,000

Schedule 2: Production budget (in units)

For the year ended 31 December 2011 Products Budgeted sales (Schedule 1) Add target closing finished goods stock Total requirements Deduct opening finished goods stock Units to be produced

Lemonade 1,080 20 1,100 100 1,000

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Diet lemonade 540 10 550 50 500

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3

Schedule 3A: Direct materials usage budget (in units and £)

For the year ended 31 December 2011 Syrup– lemon. Units of direct materials to be used for production of lemonade (1,000 lots × 1) Units of direct materials to be used for production of diet lemonade (500 lots × 1) Total direct materials to be used (in units) Units of direct materials to be used from opening stock (under FIFO)

Syrup– diet lemon.

Containers Packaging

1,000

–

1,000

1,000

– 1,000

500 500

500 1,500

500 1,500

80

70

200

400 £900

Total

Multiply by cost per unit of opening

£1,100

£1,000

£950

Cost of direct materials to be used from opening stock (a)

stock

£88,000

£70,000

£190,000

Units of direct materials to be used from purchases (1,000 − 80; 500 − 70; 1,500 − 200; 1,500 − 400)

920

430

1,300

1,100

£1,200

£1,100

£1,000

£800

Multiply by cost per unit of purchased materials

Cost of direct materials to be used from £1,104,000 purchases (b)

£473,000 £1,300,000

£360,000 £708,000

£880,000 £3,757,000

Total costs of direct materials to be used

(a + b)

£1,192,000

4

£543,000 £1,490,000 £1,240,000 £4,465,000

Schedule 3B: Direct materials purchases budget (in units and £)

For the year ended 31 December 2011 Syrup– lemon. Direct materials to be used in production (in units) from Schedule 3A Add target closing direct materials stock in units Total requirements in units

Syrup– Diet lemon. Containers

Packaging

1,000

500

1,500

1,500

30 1,030

20 520

100 1,600

200 1,700

70 45

200 1,400

400 1,300

£1,100 £495,000

£1,000 £1,400,000

Deduct opening direct materials stock in units 80 Units of direct materials to be purchased 950 Multiply by cost/unit of purchased materials £1,200 Direct materials purchase costs £1,140,000

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Total

£800 £1,040,000 £4,075,000

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5

Schedule 4: Direct manufacturing labour budget

For the year ended 31 December 2011 Output Direct units manufacturing produced labour hours (Schedule 2) per unit Lemonade Diet Lemonade Total

6

1,000 500

Total hours

20 20

20,000 10,000 30,000

Hourly rate £25 25

Total £500,000 250,000 £750,000

Schedule 5: Manufacturing overhead costs budget

For the year ended 31 December 2011 Variable manufacturing overhead costs: Lemonade [£600 × 2 hours per lot × 1,000 lots (Schedule 2)] Diet lemonade [£600 × 2 hours per lot × 500 lots (Schedule 2)] Variable manufacturing overhead costs Fixed manufacturing overhead costs Total manufacturing overhead costs

£1,200,000 600,000 1,800,000 1,200,000 £3,000,000

Fixed manufacturing overhead per bottling hour = £1,200,000 ÷ 3,000 = £400. Note that the total number of bottling hours is 3,000 hours: 2,000 hours for lemonade (2 hours per lot × 1,000 lots) plus 1,000 hours for diet lemonade (2 hours per lot × 500 lots). 7

Schedule 6A: Closing finished goods stock budget

For the year ended 31 December 2011

Direct materials: Syrup for lemonade Syrup for diet lemonade Containers Packaging

Units (Lots)

Cost per unit (Lot)

30 20 100 200

£1,200 1,100 1,000 800

Units Finished goods: Lemonade Diet lemonade Total closing stock

20 10

Total £36,000 22,000 100,000 160,000 £318,000

Cost per unit £5,500* 5,400*

£110,000 54,000

*From Schedule 6B below.

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Schedule 6B: Calculation of unit costs of manufacturing finished goods

For the year ended 31 December 2011 Cost per Lemonade unit (Lot) Inputs in or hour units (Lots) of input or hours Amount Syrup Containers Packaging Direct manufacturing labour £25 Variable manufacturing overhead *600 Fixed manufacturing overhead* 400 Total

20 2 2

Diet Lemonade Inputs in units (Lots) or Hours Hour

£1,200 1,000 800 500 1,200 800 £5,500

20 2 2

£1,100 1,000 800 500 1,200 800 £5,400

*Variable manufacturing overhead varies with bottling hours (2 hours per lot for both Lemonade and Diet Lemonade). Fixed manufacturing overhead is allocated on the basis of bottling hours at the rate of £400 per bottling hour calculated in Schedule 5.

8

Schedule 7: Cost of goods sold budget

For the year ended 31 December 2011 From schedule Opening finished goods stock, 1 January 2011 Direct materials used Direct manufacturing labour Manufacturing overhead Cost of goods manufactured Cost of goods available for sale Deduct closing finished goods stock, 31 December 2011 Cost of goods sold

Given* 3A 4 5

Total £790,000 £4,465,000 750,000 3,000,000 8,215,000 9,005,000

6

164,000 £8,841,000

*Given in description of basic data and requirements (Lemonade, £5,300 × 100; Diet Lemonade, £5,200 × 50).

9

Schedule 8: Marketing costs budget

For the year ended 31 December 2011

Marketing costs 12% × Sales £14,310,000 = £1,717,200 10 Schedule 9: Distribution costs budget

For the year ended 31 December 2011

Distribution costs 8% × Sales £14,310,000 = £1,144,800

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11 Schedule 10: Administration costs budget

For the year ended 31 December 2011

10% × Cost of goods manufactured £8,215,000 = £821,500 12 Budgeted profit and loss account

For the year ended 31 December 2011 Sales Cost of goods sold

Schedule 1 Schedule 7

£14,310,000 8,841,000

Gross margin

5,469,000

Operating costs: Marketing costs

Schedule 8

£1,717,200

Distribution costs

Schedule 9

1,144,800

Administration costs

Schedule 10

821,500

Total operating costs Operating income

3,683,500 £ 1,785,500

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CHAPTER 15

Flexible budgets, variances and management control: I Teaching tips and points to stress Static-budget variances Companies prepare flexible budgets (FBs) for two reasons. The first is ex ante planning. An FB is a highly summarised model of revenues and costs, so it facilitates planning-oriented sensitivity analyses that predict costs (e.g. Exhibit 15.2). FBs are also prepared ex post to facilitate control. Here, the FB is prepared at the end of the period to estimate what costs and revenues should have been at the output (or revenue/cost driver) level. The FB developed for control purposes provides a benchmark against which to compare actual results, as in Exhibit 15.3. In this case, the FB cannot be prepared until the end of the period because the actual output levels (or revenue/cost driver levels) are not known until the end of the period. In sum, the FB can be used as either a planning tool or a control tool.

Flexible-budget variances and sales-volume variances To calculate an FB for ex post control purposes, students should work ‘backwards’. First, determine the number of actual outputs (or actual units of the revenue/cost driver). Then, work out what costs and revenues should have been for that exact number of outputs. The FBV is the difference between what we have actually spent (received) and what we should have spent (received) for the actual number of outputs. If the FB is based on actual outputs (units of revenue/cost driver), which are not known until the end of the period, how can it be a budget? [Answer: The FB shows the costs that should have been incurred (i.e. the budgeted costs) to achieve the actual output level. The FB is the budget we would have made at the beginning of the period if we had perfectly predicted the actual number of outputs.] Can fixed costs have a sales-volume variance (SVV)? If the expected (static budget) and actual (FB) number of outputs are in the same relevant range, then budgeted fixed costs are the same at both levels, and there will be no SVV for fixed costs. The SVV arises only because expected quantities of revenue and cost drivers used to develop the static budget do not equal the actual quantities of revenue and cost drivers used to develop the FB.

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Price variances and efficiency variances Students get confused about the relations among these variances. Emphasise that levels of variance analysis can be likened to ‘peeling an onion’. With each deeper level of analysis, the manager peels away another layer and acquires a further insight into the problem. Also, emphasise the overall structure of the analysis. Level 2 analysis decomposes the SBV into (1) FBV and (2) SVV. Level 3 decomposes the FBV into (1) input price and (2) input-efficiency variances. The FB (and FBV and SVV) can be calculated without information on budgeted and actual input prices and quantities. This is important since many companies do not keep detailed records of input prices and quantity, especially in non-manufacturing areas. Such companies can still gain much insight from a Level 2 FB analysis, but students must understand that Level 3 analysis – decomposition of the FBV into price and efficiency variance – does not require such information on inputs. Price and efficiency variances are subcomponents of the FB variance. Managers generally have more control over efficiency variances than price variances because the quantity of inputs is primarily affected by factors inside the firm, whereas price changes arise primarily because of factors outside the firm. Students do not have to memorise the formulae if they grasp the intuition. The price variance is obviously the difference in prices multiplied by some quantity. The purchasing agent is responsible for the price variance. Common sense suggests that purchasing agents should be responsible for buying all the inputs (AQ purchased), not just the inputs that should have been used. Hence, the price variance is Difference in price × AQ purchased. In evaluating purchasing agents, most companies also emphasise other factors beyond price variances; e.g. quality and timely delivery are very important, especially in companies that have adopted JIT. Stress the intuition behind the efficiency variance so that students do not memorise the formula. The plant supervisor is responsible for the efficiency variance. The efficiency variance (often termed a quantity variance) is the difference between the actual quantity of inputs used (not purchased, the plant supervisor generally has no control over purchases) and the quantity that should have been used to obtain the actual number of outputs. This quantity is then costed at some input price. Since the supervisor is not responsible for the AP of inputs, the variance is costed at the budgeted price: (Difference in quantity) × BP = (AQ − BQIA) × BP Students are nearly always confused by BQIA (total budgeted quantity of inputs allowed for actual number of outputs). They must first distinguish between inputs (e.g. metres of materials, DLH, MH) and outputs (e.g. finished jackets). BQIA is the total budgeted quantity of inputs allowed for good actual outputs achieved. It is calculated by working backwards from the actual number of good outputs to see how many inputs should be used. The FB for inputs is based on BQIA. Another explanation for U efficiency variances is poor-quality material inputs. If purchasing agents are evaluated primarily on price variations, they have incentives to purchase low-cost, perhaps poor-quality materials, particularly if they are not held responsible for subsequent U materials and labour efficiency variances.

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In the Sofiya example, labour is a variable cost, so it is appropriate to calculate labour efficiency variances. However, if labour is viewed as more of a fixed cost, workers are paid regardless of the amount of production. If the firm has excess capacity, then workers’ efficiency is not a vital issue as long as they are efficient enough to produce sufficient units to satisfy demand. Even if workers were more efficient and finish the work quickly, they would still get paid the same amount (since labour is a fixed cost). However, managers who are evaluated on labour efficiency variances may be tempted to ‘improve’ this variance by increasing production. If there is excess capacity, this extra production increases stock, counter to recent stock reduction initiatives (e.g. JIT).

Value-chain explanations of variances[AQ13] Japanese companies have begun helping their suppliers reduce costs, so they can pass along those savings. For example, Toyota requires its suppliers to reduce the prices they charge Toyota for component parts. In turn, Toyota may send their own engineers and other production experts to help the supplier reduce costs by streamlining their production process. Companies develop benchmarks and calculate variances on items that are important in their lines of business. Because materials constitute a large proportion of Parker–Hannifin’s manufacturing costs, they prepare detailed information on supplier-related costs. In contrast, McDonald’s calculates average order time, window time and queuing time for their drive-in restaurants. In addition to these non-accounting standards and variances, however, they also calculate hourly sales and labour variances, and they calculate raw material and finished goods waste per shift. Investigating variances entails activities ranging from phone calls to engineering analyses of the production process, and can be expensive. Investigation is warranted only when the expected benefits (e.g. reduced costs, better decisions due to more accurate data) exceed the investigation’s expected costs. If a production line is malfunctioning, the supervisor cannot wait for an accounting report with variances denominated in euros. The supervisor controls the process by physical observation and timely physical measurements. For example, a Nissan plant compiles data such as percentage defects, production schedule attainment and broadcasts them in a ticker-tape fashion on screens throughout the plant.

An illustration of journal entries using standard costs In standard costing, we want to get work-in-progress (WIP) costs at standard so each lot or batch of product has the same standard cost. When purchasing materials, we must pay the AP for the AG purchased, but we debit materials at the BP for the AQ purchased. At the purchase date, we know the BP. The difference between debit and credit [(BP − AQ)(AQpurchased)] is the materials’ purchase value (PV). By the time the materials are used, we know the BQIA for actual outputs. Hence, we debit WIP for BP × BQIA. Materials Control is credited for BQ × AQ used (we put materials into the account at AQ, so we must take them out at AQ). The difference between the debit and credit [BP × (BQIA − AQused)] is the materials’ EV. From WIP to EG to CGS, all costs remain at standard.

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Solutions to review questions 15.1

A benchmark is a point of reference from which comparisons may be made. Types of benchmarks include: •

Financial variables reported in a company’s own accounting system

•

Financial variables not reported in a company’s own accounting system

•

Non-financial variables.

15.2

The use that managers can make of variance information should guide the variances to be calculated and analysed. For example, variances that provide substantial insight into why actual results differ from budgeted amounts can often lead to actions promoting continuous improvement in an organisation.

15.3

A Level 2 flexible-budget analysis enables a manager to distinguish how much difference between an actual result and a budgeted amount is due to (a) differences between actual and budgeted output levels and (b) differences between actual and budgeted selling prices, variable costs and fixed costs.

15.4

Effectiveness is the degree to which a predetermined objective or target is met. Efficiency is the relative amount of inputs used to achieve a given level of output. Assume that the objective is to deliver a package to a customer by 10 a.m. the next day. Effective performance would be making the delivery before 10 a.m. Efficient performance would be making the delivery using the least amount of resources (time, fuel, etc.).

15.5

Four reasons for using standard costs are: 1

Cost management

2

Price making and pricing policy

3

Budgetary planning and control

4

Financial statement preparation.

15.6

Direct materials price variances are often calculated at the time of purchase, whereas direct materials efficiency variances are often calculated at the time of usage. Purchasing managers are typically responsible for price variances, whereas production managers are typically responsible for usage variances.

15.7

Cost of acquiring and using materials over and above purchase costs include:

15.8

•

Purchase order activities

•

Inspection activities

•

Material movement activities

•

Supplier payment activities

•

Materials carrying costs.

Budgeted costs can be successively reduced over consecutive time periods to incorporate continuous improvement. Chapter 15 uses the phrase ‘continuous improvement standard costs’ to describe this approach[AQ14].

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An individual business function, such as production, is interdependent with other business functions. Factors outside production can explain why variances arise in the production area. For example:

15.9

•

Poor design of products and processes can lead to a sizeable number of defects.

•

Marketing personnel making promises for delivery times that require a large number of rush orders that create production scheduling difficulties.

The plant supervisor has good grounds for complaint if the plant accountant puts excessive emphasis on using variances to pin the blame on. The key value of variances is to help understand why actual results differ from budgeted amounts and then use that knowledge to promote learning and continuous improvement.

15.10

Solutions to exercises 15.11

Flexible budget. (20–30 min) 1 Flexiblebudget variances (2) = (1) − (3)

Actual results (1) Units sold

2,800

Revenues

€313,600

a

€229,600

d

Variable costs

Salesvolume variances (4) = (3) − (5)

Flexible budget (3)

0

8,800 b

€48,000 U

€400,000

c

€22,400 U

€207,200

e

€14,800 F

€222,000

f

7,200 U

108,000

84,000

16,800 U

100,800

Fixed costs

50,000

4,000 F

54,000

€34,000

€12,800 F

€528,000

Operating profit

10,000

€308,000

€5,600 F

Contribution margin

G

G

0 €7,200 U

€12,800 U

€7,200 U

Flexible-budget variance

Sales-volume variance €20,000 U

Static-budget variance a

Static budget (5)

€112 × 2,800 = €313,600.

b

€110 × 2,800 = €308,000.

c

€ 110 × 3,000 = €330,000.

d

Given. Unit variable cost = €229,600 ÷ 2,800 = €82 per tyre.

e

€74 × 2,800 = €207,200.

f

€74 × 3,000 = €222,000. Given.

G

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G

54,000 €54,000

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2

The key information items are:

Units Unit selling price Unit variable cost Fixed costs

Actual

Budgeted

2,800 €112 €82 €50,000

3,000 €40 €74 €54,000

The total static-budget variance in operating income is €20,000 U. There is both an unfavourable total flexible-budget variance (€12,800) and an unfavourable salesvolume variance (€7,200). The unfavourable sales-volume variance arises solely because the actual units manufactured and sold were 200 less than the budgeted 3,000 units. The unfavourable static budget of €12,800 in operating income is primarily due to the €8 increase in unit variable costs. This increase in unit variable costs is only partially offset by the €2 increase in selling price and the €4,000 decrease in fixed costs. 15.13

Professional labour variances, efficiency comparisons. (25–30 min) 1 Actual costs incurred (Actual input × Actual price)

PA staff

Flexible budget (Budgeted input allowed for actual output achieved × Budgeted price)

Actual input × Budgeted price

(4,608 × 0.42 × £48) £92,897.28

(4,608 × 0.42 × £45) £87,091.20

£5,806.08 U Price variance

(4,608 × 0.40 × £45) £82,944.00 £4,147.20 U Efficiency variance

£9,953.28 U Flexible-budget variance

OS staff

(3,600 × 0.46 × £42) £69,552

(3,600 × 0.46 × £40) £66,240

£3,312 U Price variance

(3,600 × 0.50 × £40) £72,000 £5,760 F Efficiency variance

£2,448 F Flexible-budget variance

2

The PA staff have an unfavourable efficiency variance of £4,147.20, whereas the OS staff have a favourable efficiency variance of £5,760. Note that variances are calculated relative to budgeted amounts. The PA staff average 0.42 hours per return, whereas the OS staff average 0.46 hours per return. Thus, the PA staff work at a relatively faster rate than the OS staff. However, the PA staff are working at a slower rate than budgeted, whereas the OS staff are working at a faster rate than budgeted. 218 © Pearson Education Limited 2012

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3

15.14

Factors Khan should consider in addition to efficiency when hiring staff are: a

Competence of their staff to professionally do the tax work.

b

Ethical standards of potential staff.

c

Hourly rates to be paid. The OS staff have a lower rate per hour. The average cost per tax return completed of the two groups of staff members are: PA staff £20.16 OS staff £19.32.

Comprehensive variance analysis. (30–40 min) 1

Direct materials

Actual costs incurred (Actual input × Actual price)

Actual input × Budgeted price

(12,640 × €20.50) €259,120

Purchase

Flexible budget (Budgeted input allowed for actual output achieved × Budgeted price)

(12,640 × €20) €252,800

€5,806.08 U Price variance (750 × 15.8 × €20) €237,000

Usage

(750 × 16 × €20) €240,000

€3,000 F Efficiency variance Direct Manufacturing Labour

2

(750 × 3.1 × €31.00) (750 × 3.1 × €30.00) (750 × 3.0 × €30.00) €72,075 €69,750 €67,500 €2,325 U €2,250 U Price variance Efficiency variance

Direct materials price variance

(€6,320 U, due to actual price of €20.50 exceeding budgeted price of €20.00.) •

Standard wrongly (unrealistically) set.

•

Poor price negotiation.

•

Purchase of higher-quality wood.

•

Materials price unexpectedly increased due to external shocks (e.g. a natural disaster in major forest areas).

•

Purchased in smaller lot sizes than budgeted and did not get quantity discounts.

•

Change in supplier when lower-priced supplier went out of business.

Direct materials efficiency variance (€3,000 F, due to actual usage of 15.8 square metres per desk, compared to budgeted 16.0 square metres). •

Standard wrongly (unrealistically) set.

•

Increased skills of workers.

•

Use of more automated machinery (e.g. laser cutting).

•

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•

Economies of scale in production.

Direct manufacturing labour price variance (€2,325 U, due to actual rate of €31.00 compared to budgeted €30.00). •

Standard wrongly (unrealistically) set.

•

Use of higher-skill mix than budgeted.

•

Poor negotiations with labour.

•

Overtime may have been necessary to produce the extra 50 desks more than budgeted.

•

Unexpected labour shortage due to external factors.

Direct manufacturing labour efficiency variance (€2,250 U, due to actual time being 3.1 hours compared to budgeted 3.0 hours per desk).

15.15

•

Standard wrongly (unrealistically) set.

•

Labour may be less efficient at higher output levels due to tiredness.

•

Scheduler assigned less skilled workers to desk production.

•

Machine breakdowns required more use of labour.

•

Lower-quality wood purchased requiring more labour input to finish desks.

Flexible budget. (15 min)

The existing performance report is a Level 1 analysis, based on a static budget. It makes no adjustment for changes in output levels. The budgeted output level is 10,000 units – direct materials of €400,000 in the static budget ÷ budgeted direct materials cost per attaché case of €40. The following is a Level 2 analysis that presents a flexible-budget variance and a salesvolume variance of each direct-cost category:

Output units

Actual results

Flexiblebudget variance s

Flexible budget

Salesvolume variances

Static budget

(1)

(2) = (1) − (3)

(3)

(4) = (3) − (5)

(5)

8,800

Direct materials Direct manufacturing labour Direct marketing labour Total direct costs

€364,000 78,000 110,000 €552,000

0

8,800

€12,000 U 7,600 U 4,400 U €24,000 U

€352,000 70,400 105,600 €528,000

€24,000 U Flexible-budget variance

1,200 U

10,000

€48,000 F €400,000 9,600 F 80,000 14,400 F 120,000 €72,000 F €600,000

€72,000 F Sales-volume variance

€48,000 F Static-budget variance

The Level 1 analysis shows total direct costs have a €48,000 favourable variance. However, the Level 2 analysis reveals that this favourable variance is due to the reduction in output of 1,200 units from the budgeted 10,000 units. Once this reduction in output is taken into account (via a flexible budget), the flexible-budget variance 220 © Pearson Education Limited 2012

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shows each direct-cost category to have an unfavourable variance indicating less efficient use of each direct-cost item than was budgeted. Each direct-cost category has an actual unit variable cost that exceeds its budgeted unit cost: Units Direct materials Direct manufacturing labour Direct marketing labour

Actual

Budgeted

8,800 €41.35 € 8.86 €12.50

10,000 €40 €8 €12

Analysis of price and efficiency variances for each cost category could assist in further identifying the causes of these more aggregated (Level 2) variances. 15.16

Price and efficiency variances. (20–30 min) 1

The key information items are:

Output units (pies) Input units Cost per input unit

Actual

Budgeted

60,800 16,000 £0.82

60,000 15,000 £0.89

Ched Ltd budgets to obtain four cheddar cheese pies from every kg of cheddar cheese. The flexible-budget variance is £408F. 2

Cheddar cheese costs

Actual results (1)

Flexiblebudget variances (2) = (1) − (3)

£13,120a

£408 F

Flexible budget (3) £13,528b

Salesvolume Static variances budget (4) = (3) − (5) (5) £178 U

£13,350c

a

16,000 × £0.82 = £13,120 60,800 × £0.25 × £0.89 = £13,528 c 60,000 × £0.25 × £0.89 = £13,350 b

3

The favourable flexible-budget variance of £408 has two offsetting components: •

Favourable price variance of £1,120 – Reflects the £0.82 actual purchase cost being lower than the £0.89 budgeted purchase cost per kg.

•

Unfavourable efficiency variance of £712 – Reflects the actual materials yield of 3.80 pies per kg of cheddar cheese (60,800 ÷ 16,000 = 3.80) being less than the budgeted yield of 4.00 (60,000 ÷ 15,000 = 4.00).

One explanation is that Ched purchased lower-quality cheddar cheese at a lower cost per kg.

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15.17

Flexible-budget preparation and analysis. (25–30 min) 1

Variance analysis for Norland-Norge AS for September 2011

Level 1 Analysis

Units sold Revenue Variable costs Contribution margin Fixed costs Operating income

Actual results (1)

Static-budget variances (2) = (1) − (3)

Static budget (3)

12,000 NKr252,000a 84,000d 168,000 150,000 NKr18,000

3,000 U NKr48,000 U 36,000 F 12,000 U 5,000 U NKr17,000 U

15,000 NKr300,000c 120,000f 180,000 145,000 NKr35,000

NKr 17,000 U Total static-budget variance

2

Level 2 Analysis Flexiblebudget variances (2) = (1) − (3)

Actual results (1) Units sold

12,000

Revenue

NKr252,000

0

a

Salesvolume variances (4) = (3) − (5)

12,000 b

NKr12,000 F NKr 240,000

84,000d

Variable costs

Flexible budget (3)

3,000

15,000

NKr60,000 U NKr300,000c

96,000e

12,000 F

Static budget (5)

24,000 U

120,000f

Contribution margin

168,000

24,000 F

144,000

36,000 U

180,000

Fixed costs

150,000

5,000 F

145,000

0U

145,000

NKr18,000

NKr19,000 F

NKr36,000 U

NKr35,000

Operating income

NKr(1,000)

NKr19,000 F

NKr36,000 U

Total flexible-budget variance

Total sales-volume variance

NKr 17,000 U Total static-budget variance a b c

12,000 × NKr21 12,000 × NKr20 15,000 × NKr20

= = =

NKr252,000 NKr240,000 NKr300,000

d e f

12,000 × NKr7 12,000 × NKr8 15,000 × NKr8

= = =

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NKr84,000 NKr96,000 NKr120,000

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3

15.18

Level 2 analysis provides a breakdown of the static-budget variance into a flexiblebudget variance and a sales-volume variance. The primary reason for the staticbudget variance being unfavourable (NKr 17,000 U) is the reduction in unit volume from the budgeted 15,000 to an actual 12,000. One explanation for this reduction is the increase in selling price from a budgeted NKr 20 to an actual NKr 21. Operating management was able to reduce variable costs by NKr 12,000 relative to the flexible budget. This reduction could be a sign of efficient management. Alternatively, it could be due to using lower-quality materials (which in turn adversely affected the unit volume).

Price and efficiency variances, journal entries. (30 min) 1 Actual costs incurred (Actual input × Actual price)

Actual input × Budgeted price

Purchases (100,000 × €3.10*) (100,000 × €3.00) €310,000 €300,000

Direct materials

Usage (98,073 × €3.00) €294,219

€10,000 U Price variance Direct manufacturing labour

Flexible budget (Budgeted input Allowed for actual Output achieved × Budgeted price)

(4,900 × €21**) €102,900

€81 F Efficiency variance (9,810 × 0.5 × €20) or (4,905 × €20) €98,100

(4,900 × €20) €98,000 €4,900 U Price variance

(9,810 × 10 × €3.00) €294,300

€100 F Efficiency variance

** €310,000 ÷ 100,000 = €3.10 ** €102,900 ÷ 4,900 = €21

2 Materials Control Direct materials price variance Accounts payable or Cash control

€300,000 10,000

Work in progress control Materials control Direct materials efficiency variance

€294,300

Work in progress control Direct labour price variance Wages payable control Direct labour efficiency variance

€310,000 €294,219 81 €98,100 4,900 €102,900 100

Note: Some students’ comments will be full of conjecture about higher prices for materials, better-quality materials, higher-grade labour, better efficiency in use of materials and so on. A possibility is that approximately the same labour force is taking slightly less time with better materials and causing less waste and spoilage.

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A key point in this problem is that all of these efficiency variances are likely to be insignificant. They are so small as to be nearly meaningless. Fluctuations about standards are bound to occur in a random fashion. Practically, from a control viewpoint, a standard is a band or a range of acceptable performance rather than a single-figure measure. The purchasing point is where responsibility for price variances is found most often. The production point is where responsibility for efficiency variances is found most often. Drogheda Chemical Ltd may calculate variances at different points in time to tie in with these different responsibility areas.

3

15.19

Continuous improvement. (20 min)

Standard quantity input amounts per output unit are:

1

Direct materials 10.0000 9.9700 9.9400

January February (January × 0.997) March (February × 0.997)

Direct manufacturing labour 0.5000 0.4985 0.4970

The answer is identical to that for requirement 1 of Exercise 15.18 except for the flexible-budget amount.

2

Actual costs incurred (Actual input × Actual price)

Direct materials

Actual input × Budgeted price

(100,000 × €3.10*) €310,000

Purchases

Usage

(100,000 × €3.00) €300,000

(98,073 × €3.00) €294,219

€10,000 U Price variance Direct manufacturing labour

Flexible budget (Budgeted input allowed for actual output achieved × Budgeted price)

(4,900 × €21**) €102,900

(9,810 × 9.940 × €3.00) €292,534

€1,685 F Efficiency variance (4,900 × €20) €98,000

€4,900 U Price variance

(9,810 × 0.497 × €20) €97,511 €489 F Efficiency variance

** €310,000 ÷ 100,000 = €3.10 ** €102,900 ÷ 4,900 = €21

Using continuous improvement standards sets a tougher benchmark. The efficiency variances for January (from Exercise 15.18) and March (from Exercise 15.19) are: Direct materials Direct manufacturing labour

January

March

€81 F €100 F

€1,685 U €489 U

Note: The question assumes that the continuous improvement applies only to quantity inputs. An alternative approach is to have continuous improvement applied to budgeted input cost per output unit (€30 for direct materials in January and €10 for direct manufacturing labour in January). This approach is more difficult to incorporate in a Level 2 variance analysis as Level 2 requires separate amounts for quantity inputs and the cost per input. 224 © Pearson Education Limited 2012

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15.21

Flexible-budget variances for finance function activities. (30 min) 1

Receivables are an output-level unit-driven activity. The flexible budget number of receivables for the actual output level is 948,000. Payables and travel and expenses are bath-type activities. The flexible-budget-based number of payable invoices and travel and expense reports are: Payable invoices: = 948,000 × (200,000 ÷ 1,000,000) = 948,000 × 0.20 = 189,600 Travel and expense reports: = 948,000 × (2,000 ÷ 1,000,000) = 948,000 × 0.002 = 1,896 Flexiblebudget variance

Actual results Payables

Receivables

(212,150 x £2.80) £594,020

(189,600 x £2.90) £549,840

Static budget (200,000 x £2.90) £580,000

£44,180 U

£30,160 F

Flexible-budget variance

Sales-volume variance

(948,000 × £0.75) £711,000

Travel and expenses

Salesvolume variance

Flexible budget

(948,000 × £0.639) £605,772

(1,000,000 x £0.639) £639,000

£105,228 U

£33,228 F

Flexible-budget variance

Sales-volume variance

(1,890 × £7.40) £13,986

(1,896 × £7.60) £14,410

(2,000 × £7.60) £15,200

£424 F

£790 F

Flexible-budget variance

Sales-volume variance

Comparison of the unit costs per finance activity are: Actual cost Payables Receivables Travel

£2.800 0.750 7.400

Budgeted cost

(Actual cost − Budgeted cost) Budgeted cost

£2.900 0.639 7.600

−3.4% 17.4% −2.6%

Receivables are an output-level unit-driven activity. The unfavourable flexible-budget variance for receivables reflects the actual cost per remittance (£0.750) exceeding the budgeted amount (£0.639).

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The (a) payables, and (b) travel and expense finance activities are batch activities: Payables

Travel and expenses

Static-budget

Actual

Static-budget

Actual

amounts

amounts

amounts

amounts

948,000 4.468 212,150 £2.80 £594.020

1,000,000 500 2,000 £7.60 £152,000

948,000 501.587 1,890 £7.40 £13,986

Number of deliveries Batch size Number of batches Cost per activity Total activity

1,000,000 5.000 200,000 £2.90 £580,000

The flexible-budget variances can be broken into price and efficiency variances: Price variance: = (Actual price of input − Budgeted price of input) × Actual quantity of input Payables: = (£2.80 − £2.90) × 212,150 = £21,215 F Receivables: = (£0.750 − £0.639) × 948,000 = £105,228 U Travel and expenses: = (£7.40 − £7.60) × 1,890 = £378 F Efficiency variance: =

(

)

Budgeted price Actual quantity of _ Budgeted quantity of input × of input input used allowed for actual output

Payables: = (212,150 − 189,600) × £2.90 = £63,395 U Receivables: = (948,000 − 948,000) × £0.639 = £0 Travel and expenses: = (1,890 − 1,896) × £7.600 = £46 F Changes in output levels show up as sales-volume variances. When actual volume exceeds the budgeted amount, the sales-volume variance is unfavourable for cost items. The sales-volume variance is favourable when actual output is less than the budgeted amount for cost items. The actual output level (948,000 deliveries/remittances) is less than the budgeted output level (1,000,000 deliveries/remittances). Hence, the salesvolume variance for costs is favourable for each of the three finance activities.

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15.22

2

Efficiency measures the relative amount of inputs used to achieve a given level of output. Effectiveness measures the degree to which a predetermined objective or target is met. The variances do not examine the extent to which the finance activities help Flowers.co.uk achieve its objective(s). Suppose this objective is to maximise operating income. Chase would want to examine how, say, changes in the cost of processing travel visit reimbursements affect operating income. For example, what is the effect of delays or errors in processing travel reimbursements?

3

Effectiveness could be examined by having operating managers evaluate the contribution of the individual finance activities to assisting them attain Flowers.co.uk’s objectives. For example, travelling representatives could evaluate how their field activities are helped or hindered by the expense report requirements and procedures of the finance function.

Finance function activities, benchmarking. (20 min) 1

The Hackett benchmark data are attention-directing inputs. The key new insight is how Flowers.co.uk compares with world-class organisations. At face value, there is much room for improvement. The per unit cost differences are dramatic: Flowers.co.uk

Payables Receivables Travel

2

2004 Budgeted £2.900 0.639 7.600

2004 Actual £2.80 0.75 7.40

World-class cost performance £0.71 per invoice 0.10 per remittance £1.58 per expense report

Chase should first examine whether there is an ‘apples to apples’ comparison with these figures. Are costs of the finance department activities measured in the same way in Flowers.co.uk and the company with ‘world-class cost performance’? Is the unit of activity measured the same? Suppose Flowers.co.uk allocates other costs into the finance area (such as the Chairman’s salary), while the £1.58 per expense report figure is for finance department costs only. Will Chase either adjust the £1.58 figure upwards or exclude non-finance department costs in Flowers.co.uk’s cost figures? Chase should also gain information on why the large cost differences occur. For example, is it because the ‘world-class performer’ is more aggressive in using new technology in the finance area? For example, some companies are reducing financing department costs by the use of web-based reporting procedures. A related issue is whether Chase is willing to invest in new technologies in the same way that world-class finance function organisations do. If not, then the £1.58 benchmark could be unattainable, no matter how well the travel expense reporting group performs.

15.23

Price and efficiency variances, problems in standard setting, benchmarking. (30–40 min) 1

Budgeted materials input per shirt = 0.10 roll of cloth Budgeted manufacturing labour-hours per shirt = 0.25 hours Budgeted materials cost = €50 per roll Budgeted manufacturing labour cost per hour = €18 per hour Actual output achieved = 4,488 shirts.

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Actual costs incurred (Actual input × Actual price) Direct materials

Actual input × Budgeted price

Flexible budget (Budgeted input allowed for actual Output achieved × Budgeted price)

(408 × €450) €20,400

(4,488 × 0.10 × €50) €22,440

€20,196 €204 F Price variance

Direct manufacturing labour

€2,040 F Efficiency variance

(1,020 × €18) €18,360

€18,462 €102 U Price variance

2

(4,488 × 0.25 × €18) €20,196

€1,836 F Efficiency variance

Actions employees may have taken include: a

Adding steps in working on a shirt that are not necessary.

b

Taking more time on each step than is necessary.

c

Creating problem situations so that the budgeted amount of average downtime will be overstated.

d

Creating defects in shirts so that the budgeted amount of average rework will be overstated.

Employees may take these actions for several possible reasons: a

They may be paid on a piece-rate basis with incentives for above-budgeted production.

b

They may want to create a relaxed work atmosphere, and less demanding standards can reduce stress.

c

They may have a ‘them versus us’ mentality rather than a partnership perspective. This behaviour is unethical if it is deliberately designed to undermine the credibility of the standards used at Textiles-Georges-Grassens.

3

Poitou-Chemises could use the France-Solutions information in several ways: a

For pricing and product emphasis purposes. Poitou-Chemises should avoid getting into a pricing war with a competitor who has a sizeably lower cost structure.

b

As indicators of areas where Poitou-Chemises is either highly cost competitive or highly cost non-competitive.

c

As performance targets for motivating and evaluating managers.

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4

Main pros of France-Solutions information: a

Highlights to Poitou-Chemises in a direct way how it may or may not be cost competitive.

b

Provides a ‘reality check’ to many internal positions about efficiency or effectiveness.

Main cons are: a

Poitou-Chemises may not be comparable to companies in the database.

b

Data about other company’s costs may not be reliable.

c

Cost of France-Solutions reports.

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CHAPTER 16

Flexible budgets, variances and management control: II Teaching tips and points to stress Planning of variable- and fixed-overhead costs It is not unusual for 20–50% of total product costs to be classified as indirect. Surveys show that 10–22% of the total product cost in four segments of the electronics industry is comprised of indirect manufacturing costs. Inclusion of indirect costs from other value-chain elements would further increase the percentage of costs classified as indirect. Increased automation, complexity of production and distribution processes and product proliferation usually increase the proportion of total costs that are indirect. (However, the lower cost of information processing works against this trend by facilitating more direct-cost tracing.) This section explains that the two means of managing variable costs discussed in Chapter 2 also apply to VOH costs: 1

Eliminate non-value-added (NVA) costs (e.g. reduce consumption of electricity by using more energy-efficient equipment).

2

Reduce consumption of the cost drivers (e.g. redesign products to require fewer MH).

Two ways to manage FOH costs are: 1

Eliminate NVA costs (e.g. adoption of JIT may enable the plant to terminate a warehouse lease).

2

Plan for appropriate capacity levels – too little capacity, we forgo profits on lost sales; too much capacity, we pay for unused resources.

If it is possible to identify cause-and-effect relationships, the allocation base ideally should be a cost driver so that product costs will better reflect resource consumption. The text uses a single VOH cost pool and a single cost allocation base to simplify the analysis. However, multiple VOH cost pools and cost allocation bases could be used, as in an ABC system.

Developing budgeted variable-overhead rates (BVOHRs) Students are often confused about the calculation of the BVOHR, so stress the intuition and the timing. In a single cost pool system, the accountant adds up all the variable costs (e.g. sanitation and maintenance wages, utilities, etc.) that are budgeted for a given period of time, usually one year. These are budgeted costs, so this is done before the year starts. Accountants or production personnel identify the allocation base and estimate the number of units of the allocation base for the same time period. Again, this occurs before the period begins. Finally, the BVOHR is calculated by dividing the budgeted VOH costs by the budgeted quantity of the allocation base. Remind students that since it is a budgeted rate, all elements of the rate must be available before the start of the period. 230 © Pearson Education Limited 2012

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Variable-overhead (OH) cost variance You may wish to point out the distinction between the OH rate/unit of output (i.e. jacket) and the OH rate/unit of the allocation base. Level 3 variance analysis requires OH rates expressed in terms of units of the allocation base.

Developing budgeted fixed-overhead rates To highlight the subsequent contrast with stock costing, emphasise that the FB FOH is FIXED, FIXED, FIXED across the levels of output within the relevant range.

Fixed-overhead cost variances Students become confused by many different euro values and by different quantities of the allocation base. Emphasise that in budgeted OH rates, all elements must be known before the period: budgeted OH € and budgeted units of the allocation base. Students frequently also have trouble with recalling as to which is the numerator and which is the denominator. Remind them that OH rates are often specified as ‘€X per hour’, for example. Per means ‘divided by’. OH rates are calculated as € of OH per (‘divided by’) unit of the allocation. Students find it confusing that for FOH, the SBV, the FBV and the spending variances are all identical. The lump-sum budgeted FOH is the same for actual output units (FB) and for budgeted output units (SB) – as long as both are in the same relevant range. Thus, the SB FOH equals the FB FOH, so there is no FOH SVV (unless actual and expected outputs are not in the same relevant range). Since SB FOH equals FB FOH, the SBV equals the FBV. Further, the FBV for FOH is typically not decomposed into separate price and efficiency variances. Rather, the FOH FBV is conventionally attributed entirely to the FOH spending variance. The FOH FBV arises because the amount spent is different from the budget (not because the manager was more or less efficient in dealing with a given amount of FOH). Thus, for FOH, SBV = FBV = Spending variance. It is only the VC that put the ‘flex’ in the FB. FOH is fixed across output levels within the relevant range, so there is no SVV for FOH. This is because the budgeted amount of FOH is the same for the actual number of outputs (10,000 in the Sofiya example) as for the budgeted number of outputs (12,000 for Sofiya).

Production-volume variance The SB and SVV do not appear in Exhibit 16.3 in Chapter 16: the column to the extreme right (Allocated) is NOT the SB amount. The PVV arises only for fixed costs. For variance costs, the overhead allocation will always equal the FB amount. When we allocate FMOH to WIP for stock costing, we unitise FMOH and treat it as if it were a variable cost. In contrast, FB FMOH is FIXED, FIXED, FIXED across output levels, in the relevant range. FB FOH equals FOH allocated to WIP only if the number of output units actually produced equals the denominator level. This creates a variance that is unique to FMOH – the production-volume variance.

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Students often erroneously believe the FOH PVV is analogous to the VOH efficiency variance. The FOH FBV is analogous to the VOH FBV, which includes both the VOH spending and the efficiency variances. The PVV is a new concept that is unique to FOH. The PVV arises only because the lump-sum FOH in the FB usually differs from the FOH allocated to WIP (BOHR × BQIA). (In contrast, for DM, DL and VOH, the FB = Costs allocated to WIP; there can be no PVV for these costs.)

Financial and non-financial performance measures Day-to-day control of MOH items occurs on the factory floor through physical observation and physical measures of individual line items (e.g. overtime authorisation, downtime, scrap rates). The accounting system transforms these physical measures into financial measures. The financial data inform lower level managers of the materiality of the variances, and upper management can also use these data in evaluating performance across departments.

Actual, normal and standard costing Remind students that under a standard costing system, WIP is kept at standard costing OHAllocated, which equals BP of OH, that is, (BOHR/unit of allocated base) × BQIA (of allocation base) for actual number of outputs. This calculation is analogous to the WIP debits for DM and DL covered in Chapter 15. Also note that the calculation differs from normal costing OHAllocated, which would be BOHR × AQbase.

Solutions to review questions 16.1

Effective planning of variable-overhead costs involves: 1

Planning to undertake only those variable-overhead activities that add value.

2

Planning to use the drivers of costs in those activities in the most efficient way.

16.2

At the start of an accounting period, a larger percentage of fixed-overhead costs are locked in than is the case with variable-overhead costs.

16.3

Steps in developing a budgeted variable-overhead cost rate are:

16.4

1

Identify the costs to include in the variable-overhead cost pool(s).

2

Select the cost allocation base(s).

3

Estimate the budgeted variable-overhead rate(s).

Drivers of variable manufacturing overhead costs include: •

Machine-hours

•

Direct manufacturing labour-hours or costs

•

Number of production set-ups

•

Number of parts per product

•

Number of testing-hours.

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16.5

Financial •

Direct manufacturing labour costs

•

Energy costs.

Non-financial

16.6

•

Machine-hours

•

Testing-hours.

Reasons for a €25,000 favourable variable overhead efficiency variance are: •

Workers more skilful in using machines than budgeted.

•

Production scheduler was able to schedule jobs better than budgeted, resulting in lower than budgeted machine-hours.

•

Machines operated with fewer slowdowns than budgeted.

•

Machine-time standards set with padding built in by machine workers.

16.7

A direct materials efficiency variance indicates whether more or less direct materials were used than budgeted for the actual output achieved. A variable manufacturing overhead efficiency variance indicates whether more or less of the chosen allocation base was used than was budgeted for the actual output achieved.

16.8

The relationship for fixed manufacturing overhead variances is:

Flexible-budget variance

Spending variance

Efficiency variance (Never a variance)

There is never a variance for fixed overhead because managers cannot be more or less efficient in dealing with an amount that is fixed regardless of the output level. The result is that the flexible-budget variance amount is the same as the spending variance for fixed manufacturing overhead. 16.9

A 4-variance analysis relies on a

a breakdown of overhead into its variable and fixed components;

b

a breakdown into three components – spending, efficiency and production volume.

A 3-variance analysis relies only on the breakdown of variances into the three components in (b). A 2-variance analysis breaks down variances into only two components (flexible-budget and production volume). A 1-variance analysis reports only one variance where there is no breakdown of the (a) or (b) categories as noted above. Flexible-budget variance

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Efficiency variance (Never a variance) Spending variance. 16.10

There are two ‘never a variance’ entries in the 4-variance analysis: •

‘Never a variance’ for the production-volume variance for variable manufacturing overhead – the production-volume variance applies only to a fixed manufacturing overhead because a lump sum is to be allocated.

•

‘Never a variance’ for the efficiency variance for fixed manufacturing overhead – because there can be no efficiency variance for fixed overhead, this amount is a lump sum regardless of the output level.

Solutions to exercises 16.12

Fixed manufacturing overhead, variance analysis. (20 min) 1 Budgeted fixed overhead SFr62,400 = [AQ15] rate per unit of 1, 040 × 4 allocation base

=

62,400 4,160

= SFr 15 per hour

Actual costs incurred

Same lump sum regardless of output level

Same lump sum regardless of output level

Allocated (Budgeted input allowed for actual output achieved × Budgeted rate)

SFr 63,916

SFr 62,400

SFr 62,400

(4 × 1,080 × SFr 15) SFr 64,800

SFr 1,516 U Spending variance

Never a variance

SFr 1,516 U Flexible-budget variance

SFr 2,400 F Production-volume variance SFr 2,400 F Production-volume variance

The fixed manufacturing overhead spending variance and the fixed manufacturing overhead variance are the same – SFr 1,516 U. Lavertezzo spent SFr 1,516 above the SFr 62,400 budget amount for June 2011. 2

The production volume variance is SFr 2,400 F. This arises because the actual production of 1,080 suits exceeds the budgeted 1,040 suits. This results in overallocated fixed manufacturing overhead of SFr 2,400 (4 × 40 × SFr 15). 1,040 × 4 = 4,160

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16.13

Comprehensive review of Chapters 15 and 16, static budget. (15 min) 1

Actual results (1)

Revenues Circulation Advertising Costs Direct materials Direct labour costs Variable indirect costs Fixed indirect costs Operating income

2

Static-budget amounts (2)

Variances (3)

SFr154,000 394,600 548,600

SFr140,000 360,000 500,000

SFr14,000 F 34,600 F 48,600 F

224,640 50,112 63,936 97,000 435,688 SFr112,912

180,000 45,000 60,000 90,000 375,000 SFr125,000

44,640 U 5,112 U 3,936 U 7,000 U 60,688 U SFr12,088 U

L’Evénement du Dimanche had an increase in total revenues of SFr 48,600 above that budgeted. This arose from both a favourable circulation variance (SFr14,000 increase or 28,000 extra copies sold at SFr0.50 per copy) and a favourable advertising revenue variance of SFr34,600. The actual costs are SFr 60,688 above budget. The largest source of this increase comes from direct materials. The sources of this increase include: (a) 20,000 extra copies printed and (b) quality problems leading to many pages being unusable. The budgeted print pages for 320,000 copies of 50 pages each was 16,000,000 pages; an extra 1,280,000 pages were used above this budgeted amount.

16.14

Engineered and discretionary overhead costs. (20 min) 1

Assuming full utilisation of each worker, the budgeted labour cost per order is:

€15 per hour €15 = = €6 per hour 2 articles × 0.2 hours per article 0.4

Actual costs incurred €56,000

Same lump sum regardless of output level

Allocated: Budgeted input allowed for actual output achieved × Budgeted rate

20 × 180 × €15 €54,000

8,500 × €6 €51,000

€2,000 U

€3,000 U

Spending variance

Production-volume variance

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2

Using a discretionary overhead cost approach, the variances are:

Same lump sum regardless of output level

Actual costs incurred €56,000

3

Allocated: Budgeted input allowed for actual output achieved × Budgeted rate €54,000

20 × 180 × €15 €54,000 €2,000 U

€0

Spending variance

Production-volume variance

The engineered overhead cost approach assumes that each order can have labour time assigned to it on a cause-and-effect basis. The €3,000 production-volume variance alerts management to the possibility of overstaffing and unused capacity.

The discretionary overhead cost approach assumes Stientje cannot identify a cause-andeffect relation between the number of orders processed and labour costs. The control of labour costs is based on the manager’s judgement and experience about likely workloads. 16.19

Manufacturing overhead, variance analysis. (30–40 min) 1

The summary analysis is:

Variable manufacturing overhead Fixed manufacturing overhead

Spending variance

Efficiency variance

Production-volume variance

€40,700 F

€59,200 U

Never a variance

€23,420 U

Never a variance

€36,000 U

Variable manufacturing overhead

Actual costs incurred

Actual input × Budgeted rate

Flexible budget (Budgeted input allowed for actual output achieved × Budgeted rate)

€610,500

(16,280 × €40) €651,200

(7,400 × 2 × €40) €592,000

€40,700 F

€59,200 U

Spending variance

Efficiency variance €18,500 U

Flexible-budget variance

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Fixed manufacturing overhead

Actual costs incurred

Same lump sum regardless of output level

Same lump sum regardless of output level

€503,420

€480,000

€480,000

€23,420 U Spending variance

Never a variance

Allocated (Budgeted input allowed for actual output achieved × Budgeted rate)

(7,400 × 2 × €30.00) €444,000 €36,000 U

Production-volume variance

Summary information is:

Output units Allocation base (hours) Allocation base per output unit Variable MOH Variable MOH per hour Fixed MOH Fixed MOH per hour a c

Actual 7,400 16,280 2.20 €610,500 €37.50d €503,420 €30.92e b

7,400 × 2.00 = 14,800

7,400 × 2 × €40 = €592,000 e €503,420 ÷ 16,280 hours ~ – €30.92 per hour

2

d f

Flexible budget 7,400 14,800a 2.00 €592,000c €40.00 €480,000 –

Static budget 8,000 16,000b 2.00 – – €480,000 €30.00f

8,000 × 2.00 = 16,000 €610,500 ÷ 16,280 hours = €37.50 per hour €480,000 ÷ 16,000 hours = €30 per hour

Mondragon produces 600 fewer CardioX units than were budgeted. The variable manufacturing overhead cost efficiency variance of €59,200 U arises because more assembly time hours per output unit (16,280 ÷ 7,400 = 2.2 hours) were used than the budgeted 2.0 hours per unit. The variable manufacturing overhead cost spending variance of €40,700 F indicates one or more of the following probably occurred: (i) actual prices of individual items included in variable overhead differ from their budgeted prices, or (ii) actual usage of individual items included in variable overhead differs from their budgeted usage. The fixed manufacturing overhead cost spending variance of €23,420 U means that the fixed overhead was above that of the budgeted. For example, it could be due to an unexpected increase in plant leasing costs. The unfavourable production-volume variance of €36,000 arises because the actual output of 7,400 units is below the 8,000 units used in determining the €30.00 per assembly-hour budgeted rate.

3

Planning and control of variable manufacturing overhead costs has both a long-run and a short-run focus. It involves Mondragon planning to undertake only valueadded overhead activities (a long-run view) and then managing the cost drivers of those activities in the most efficient way (a short-run view). Planning and control of fixed manufacturing overhead costs at Mondragon has primarily a long-run focus. It involves undertaking only value-added fixed-overhead activities for a budgeted level of output. Mondragon makes most of the key decisions that determine the level of fixed-overhead costs at the start of the accounting period.

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16.20

Spending and efficiency overhead variances, service sector. (20–25 min) 1

Budgeted variable overhead rate

=

DKr 2 per hour of home delivery time

Budgeted fixed overhead rate =

DKr 24,000 8,000 × 0.80

24,000 6, 400

=

DKr 3.75 per hour of home delivery time

=

A detailed comparison of actual and flexible budgeted amounts is:

Output units (deliveries) Allocation base (hours) Allocation base per output unit Variable MOH Variable MOH per hour Fixed MOH Fixed MOH per hour

Actual

Flexible budget

Static budget

7,460c 5,595c 0.75c DKr 14,174c DKr 2.53e DKr 27,600c DKr 4.93f

7,460 5,968a 0.80 DKr 11,936d DKr 2.00 DKr 24,000 –

8,000 6,400b 0.80 – DKr 2.00 DKr 24,000 DKr 3.75g

a

7,460 × 0.80 = 5,968 8,000 × 0.80 = 6,400 c 5,595 ÷ 7,460 = 0.75 d 7,460 × 0.80 × DKr 2.00 = DKr 11,936 e DKr 14,174 ÷ 5,595 = DKr 2.53 f DKr 27,600 ÷ 5,595 = DKr 4.93 h DKr 24,000 ÷ 6,400 = DKr 3.75 b

The required variances are:

Variable overhead Fixed overhead

Spending variance

Efficiency variance

DKr 2,984 U DKr 3,600 U

DKr 746 F –

These variances are calculated as follows:

Variable overhead

Actual costs incurred

Actual input × Budgeted rate

Flexible budget (Budgeted input allowed for actual output achieved × Budgeted rate)

DKr 14,174

(5,595 × DKr 2) DKr 11,190

(7,460 × 0.80 × DKr 2) DKr 11,936

↑

DKr 2,984 U ↑ DKr 746 F ↑ Spending variance Efficiency variance

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Fixed

Actual costs incurred

Same lump sum regardless of output level

Flexible budget (Budgeted input allowed for actual output achieved × Budgeted rate)

DKr 27,600

DKr 24,000

DKr 24,000

Allocated (Budgeted input allowed for actual output achieved × Budgeted rate) (7,460 × 0.80 × DKr 3.75)

Overhead

DKr 22,380

↑ DKr 3,600 U ↑ Spending variance

↑ Never a variance

DKr 1,620 U ↑ Production-volume variance

The spending variances for variable and fixed overhead are both unfavourable. This means that Danskmat had increases in either or both the cost of individual items (such as telephone calls and vehicle fuel) in the overhead cost pools, or higher than budgeted usage of these individual items per unit of the allocation base (delivery time). The favourable efficiency variance for variable-overhead costs results from more efficient use of the cost allocation base – each delivery takes 0.75 hours versus a budgeted 0.80 hours. 2

16.21

Danskmat best manages its fixed-overhead costs by long-term planning of capacity rather than day-to-day decisions. This involves planning to undertake only valueadded fixed-overhead activities and then determining the appropriate level for those activities. Most fixed-overhead costs are committed well before they are incurred. In contrast, for variable overhead, a mix of long-run planning and daily monitoring of the use of individual items is required to manage costs efficiently. Danskmat plans to undertake only value-added variable-overhead activities (a long-run focus) and then manage the cost drivers of those activities in the most efficient way (a short-run focus).

Total overhead, 3-variance analysis. (35–50 min) 1

This problem has two major purposes: (a) to give experience with data allocated on a total overhead basis instead of on separate variable and fixed bases and (b) to reinforce distinctions between actual hours of input, budgeted (standard) hours allowed for actual output, and denominator level. An analysis of direct manufacturing labour will provide the data for actual hours of input and standard hours allowed. One approach is to plug the known figures (designated by asterisks) into the analytical framework and solve for the unknowns. The direct manufacturing labour efficiency variance can be calculated by subtracting SKr9,640 from SKr14,440. The complete picture is:

Actual costs incurred

Actual input × Budgeted price

Flexible budget (Budgeted input allowed for actual output achieved × Budgeted price)

(12,050 hours × SKr 16.80)

(12,050 hours × SKr16.00*)

(11,750 hours × SKr16.00*)

SKr192,800

SKr188,000

*

SKr202,440

↑ ↑

SKr9,640 U* Price variance

↑

SKr4,800 U Efficiency variance

SKr14,440 U* Flexible-budget variance

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↑ ↑

Bhimani, Horngren, Datar and Rajan, Management and Cost Accounting, 5th Edition, Instructor’s Manual

Manufacturing Overhead

Variable-overhead rate = SKr 64,000* ÷ 8,000* hours = SKr 8.00 per standard labourhour Budgeted fixed * overhead costs = SKr 197,600 − 10,000 × (SKr 8.00) = SKr 117,600 If total manufacturing overhead is allocated at 120% of direct standard manufacturing labour-hours, the single overhead rate must be 120% of SKr 16.00 or SKr 19.20 per hour. Therefore, the fixed-overhead component of the rate must be SKr 19.20 – SKr 8.00, or SKr 11.20 per direct standard manufacturing labour-hour. Let D = denominator level in input units Budgeted fixed overhead rate per input unit SKr 11.20

= =

Budgeted fixed overhead costs Denominator level in input units

17,600

D D = 10,500 standard direct manufacturing labour-hours

A summary 3-variance analysis for October follows:

Actual costs incurred *

SKr 249,000

↑

Allocated (Budgeted input allowed for actual output achieved × Budgeted rate)

SKr 117,600 + (12,050 × SKr 8.00)

SKr 117,600 + (11,750 × SKr 8.00)

(11,750 × SKr 19.20)

SKr 214,000

SKr 211,600

SKr 225,600

SKr 35,000 U ↑ SKr 2,400 U ↑ SKr 14,000 F* ↑ Spending variance Efficiency variance Production-volume variance

↑ *

Actual input × Budgeted rate

Flexible budget (Budgeted input allowed for actual output achieved × Budgeted rate)

↑ SKr 14,000 F* ↑ Production-volume variance

SKr 37,400 U Flexible-budget variance

Known figure.

An overview of the 3-variance analysis using the block format in the text is: 3-variance analysis Total manufacturing overhead

2

Spending variance

Efficiency variance

Productionvolume variance

SKr 35,000 U

SKr 2,400 U

SKr 14,000 F

The control of variable manufacturing overhead requires the identification of the cost drivers for such items as energy, supplies, equipment and maintenance. Control often entails monitoring non-financial measures that affect each cost item, one by one. Examples are kilowatts used, quantities of lubricants used and equipment parts and hours used. The most convincing way to discover why overhead performance did not agree with a budget is to investigate possible causes, line item by line item. 240 © Pearson Education Limited 2012

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Individual fixed manufacturing overhead items are not usually affected very much by day-to-day control. Instead, they are controlled periodically through planning decisions and budgeting that may sometimes have horizons covering six months or a year (for example, management salaries) and sometimes covering many years (for example, longterm leases and depreciation on plant and equipment). 16.22

Comprehensive review of Chapters 15 and 16, flexible budget. (40 min) 1

A summary of the variances for the four categories of cost is: Static-budget Variances Direct materials SFr 44,640 U Direct labour 5,112 U Variable indirect 3,936 U Fixed indirect 7,000 U

Flexible-budget variances Direct materials SFr 32,640 U Direct labour 2,112 U Variable indirect 64 F Fixed indirect 7,000 U

Sales-volume variances Direct materials SFr 12,000 U Direct labour 3,000 U Variable indirect 4,000 U Fixed indirect –

Price-spending variances Direct materials SFr 17,280 U Direct labour 1,728 F Variable indirect 5,184 F Fixed indirect 7,000 U

Efficiency variances Direct materials SFr 15,360 U Direct labour 3,840 U Variable indirect 5,120 U Fixed indirect –

a

Direct[AQ16]-cost variances The key items for calculating the sales-volume, price and efficiency for direct cost items are:

Actual quantity of inputs (1) Direct materials Direct labour costs

17,280,000* pages 1,728* hours

Actual unit cost of inputs (2)

Actual cost of inputs (3) = (1) × (2) a

SFr 0.0130 b SFr 29.00

Actual quantity of inputs × Budgeted unit cost of inputs (5) = (1) × (4)

Budgeted unit cost of inputs (4) c

SFr 224,640* SFr 0.0120 d SFr 50,112* SFr 30.00

a

SFr 224,640 ÷ 17,280,000 = SFr 0.0130 per page SFr 50,112 ÷ 1,728 = SFr 29.00 per hour c SFr 180,000 ÷ 15,000,000 = SFr 0.0120 per page d SFr 45,000 ÷ 1,500 = SFr 30.00 per hour * Known b

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SFr 207,360 SFr 51,840

Bhimani, Horngren, Datar and Rajan, Management and Cost Accounting, 5th Edition, Instructor’s Manual Budgeted input allowed per output unit (1)

Direct materials Direct labour costs

Actual output achieved (2)

50 e 0.005

320,000 320,000

Budgeted unit cost of inputs (3)

SFr 0.0120 SFr 30.00

Flexible budget (4) = (1) × (2) × (3)

SFr 192,000 48,000

e

Budgeted 10,000 pages produced per labour hour yields budgeted output of 200 newspapers (50 pages each) per hour. Thus, each output unit is budgeted to require 0.005 units of a direct labour hour.

The sales-volume variances for direct materials and direct labour are: Sales-volume variance

=

Flexible-budget − Static-budget    amount  amount

Direct materials

=

(320,000 × 50 × SFr 0.012) − (SFr 180,000)

= =

SFr 192,000 − SFr 180,000 SFr 12,000 U

=

 320,000 × 50  × SFr 30 − (45,000)  10,000   

= =

SFr 48,000 − SFr 45,000 SFr 3,000 U

Direct labour

The price and efficiency variances for direct materials and direct labour are:

Direct materials

Actual costs incurred (Actual input × actual price)

Price variance

Actual input × Budgeted prices

Efficiency variance

SFr 224,640

SFr 17,280 U

SFr 207,360

SFr 15,360 U

SFr 192,000

50,112

1,728 F

SFr 51,840

SFr 3,840 U

48,000

Direct labour costs

b

Flexible budget (Budgeted input allowed for actual output achieved × Budgeted price)

Indirect cost variances A summary of the information is: Actual

Output units (papers) Allocation base (printed paper) Allocation base per output unit Variable MOH Variable MOH per printed page Fixed MOH Fixed MOH per printed page

Flexible budget

Static budget

320,000

300,000

320,000 17,280,000 54 SFr 63,936 SFr 0.0037 SFr 97,000 d SFr 0.0056

a

d

b

e

320,000 × 50 = 16,000,000 SFr 60,000 ÷ 15,000,000 = SFr 0.0040 per printed page c

a

16,000,000 50 c SFr 64,000 SFr 0.0040 SFr 90,000 –

15,000,000 SFr 60,000 b SFr 0.0040 SFr 90,000 e SFr 0.0060

SFr 97,000 ÷ 17,280,000 = SFr 0.0056 per printed page SFr 90,000 ÷ 15,000,000 = SFr 0.0060 per printed page

SFr 320,000 × 50 × SFr 0.0040 = SFr 64,000

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The flexible-budget and sales-volume variances for variable indirect costs are: Flexible budget variance

Actual results

Sales volume variance

Flexible budget

Static budget

(17,280,000 × SFr 00.0037)

(16,000,000 × SFr 0.004)

(15,000,000 × SFr 0.004)

SFr 63,936

SFr 69,120

SFr 60,000

↑

SFr 64F Flexible-budget variance

↑

↑

SFr 4,000 U Sales-volume variance

↑ ↑

SFr 3,936 U Static-budget variance

The spending and efficiency variances for variable indirect costs are:

Actual costs incurred

Actual input × Budgeted rate

Flexible budget: Budgeted input allowed for actual output achieved × Budgeted rate

(17,280,000 × SFr 0.0037) SFr 63,936

(17,280,000 × SFr 0.004) SFr 69,120

(16,000,000 × SFr 0.004) SFr 64,000

↑

↑

↑

SFr 5,184 F Spending variance

↑

SFr 5,120 U Efficiency variance

SFr 64 F Flexible-budget variance

↑

The spending and production-volume variances for fixed indirect costs are:

2

Actual costs incurred

Same lump-sum regardless of output level

Same lump-sum regardless of output level

SFr 97,000

SFr 90,000

SFr 90,000

↑

↑

SFr 7,000 U Spending variance

Allocated: Budgeted input allowed for actual output achieved × Budgeted rate (16,000,000 × SFr 0.0060) SFr 96,000

↑ SFr 6,000 F ↑ Never a variance Production-volume variance

The unfavourable sales-volume variance for direct materials, direct labour and variable indirect costs is due to 20,000 extra copies of the newspaper being produced. The largest individual variance category is for direct materials – comprising a SFr 17,280 U price variance (the actual cost per page of SFr 0.013 exceeds the budgeted SFr 0.012 per page) and a SFr 15,360 U efficiency variance (the 1,280,000 unusable pages × SFr 0.012 budgeted cost).

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The direct-labour price variance (SFr 1,728 F) is due to the actual labour rate being SFr 29.00 per hour compared to the budgeted SFr 30.00 per hour. The unfavourable variable indirect costs efficiency variance of SFr 5,120 U is due to 1,280,000 extra pages being used (the cost allocation base) over the number budgeted. The spending variance for fixed indirect costs is due to actual costs being SFr 7,000 above the budgeted SFr 90,000. An analysis of the line items in this budget would help assist in determining the causes of this variance. 16.23

Flexible budgets, 4-variance analysis. (15–25 min) 1

Budgeted hours allowed Budgeted DLH = per unit of output Budgeted actual output 3,600,000 720,000

=

5 hours

Budgeted DLH allowed for May output

= 66,000 units × 5 = 330,000

Allocated total MOH = 330,000 × Total MOH rate per hour = 330,000 × NKr 1.20 = NKr 396,000 2, 3, 4, 5 See solution to Exercise 16.18.

Variable overhead rate per DLH = NKr 0.25 + NKr 0.34 = NKr 0.59 Fixed overhead rate per DLH = NKr 0.18 + NKr 0.15 + NKr 0.28 = NKr 0.61 Fixed overhead budget for May = (NKr 648,000 + NKr 540,000 + NKr 1,008,000) ÷ 12 = NKr 2,196,000 ÷ 12 = NKr 183,000 Using the format of Exhibit 16.3 in Chapter 16 for variable overhead and then fixed overhead: Actual variable overhead: NKr 75,000 + NKr 111,000 = NKr 186,000 Actual fixed overhead: NKr 51,000 + NKr 54,000 + NKr 84,000 = NKr 189,000 An overview of the 4-variance analysis using the block format in the text is: 4-Variance analysis

Spending variance

Efficiency variance

Productionvolume variance

Variable manufacturing overhead

SKr35,000 U

SKr2,400 U

SKr14,000 F

Fixed manufacturing overhead

SKr35,000 U

SKr2,400 U

SKr14,000 F

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Actual input × Budgeted rate (2)

Flexible budget (Budgeted input allowed for actual output achieved × Budgeted rate) (3)

(315,000 × SKr0.59)

(330,000 × SKr0.59)

SKr185,850

SKr194,700

Actual costs incurred (1) Variable Manufacturing Overhead

SKr186,000

*

SKr150 U

SKr8,850 F

(2) Spending variance (4) Efficiency variance *

Known figure.

Actual costs incurred Fixed manufacturing overhead

SKr189,000

Same lump sum regardless of output level

SKr183,000

SKr6,000 U (3) Spending variance

Same lump sum regardless of output level

Allocated (Budgeted input allowed for actual output achieved × Budgeted rate

SKr183,000

(330,000 × SKr0.61) SKr201,300

Never a variance

SKr18,300 F (4) Efficiency variance

Alternative calculation of the production-volume variance: Budgeted

 Budgeted hours  Denominator fixed = allowed for actual −  ×  hours overhead  output achieved    rate

(

)

3,600,000  × SKr 0.61 =  (330,000) −  12  = (330,000 − 300,000) × SKr0.61 = SKr18,300 F 16.24

Review of Chapters 15 and 16, 3-variance analysis. (30–50 min) 1

Total standard production costs are based on 7,800 units of output. Direct materials, 7,800 × €15.00 (or 7,800 × 3 kg × €5.00 or 23,400 kg × €5.00) Direct manufacturing labour, 7,800 × €75.00 (or 7,800 × 5 hours × €15.00 or 39,000 hours × €15.00) Manufacturing overhead: Variable, 7,800 × €30.00 (or 39,000 hours × €6.00) Fixed, 7,800 × €40.00 (or 39,000 hours × €8.00) Total

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117,000 585,000 234,000 312,000 €1,248,000

Bhimani, Horngren, Datar and Rajan, Management and Cost Accounting, 5th Edition, Instructor’s Manual

The following is for later use: Fixed manufacturing overhead, a lump-sum budget *

2

Fixed manufacturing overhead rate =

€320,000*

Budgeted fixed manufacturing overhead Denominator level

€8.00

=

Budget 40,000 hours

Budget

=

40,000 hours × €8.00 = €320,000

Solution Exhibit 16.22 presents a columnar presentation of the variances. An overview of the 3-variance analysis using the block format of the text is: 3-variance analysis Total manufacturing overhead

Spending variance

Efficiency variance

€39,400 U

€6,600 U

Productionvolume variance

€8,000 U

Solution Exhibit 16.24 Actual costs incurred (Actual input × Actual rate) Direct materials

(25,000 × €5.20)

(Actual input × Budgeted price) Purchases Usage (25,000 × €5.00)

€130,000 €125,000 ↑ ↑ €5,000 U a. Price variance Direct manufacturing labour

(23,100 × €5.00) €115,500 ↑

(23,400 × €5.00)

€117,000 €1,500 F ↑ b. Efficiency variance

(40,100 × (40,100 × €15.00) (39,000 × €15.00) €14.60) €601,500 €585,000 €585,460 ↑ €16,040 F ↑ €16,500 U ↑ c. Price variance d. Efficiency variance

Actual costs incurred

Variable manufacturing overhead

Flexible budget (Budgeted input allowed for actual output achieved × Budgeted price)

(not given)

Flexible budget (Budgeted input allowed for Actual input actual × Budgeted rate output achieved × Budgeted rate)

(40,100 × €6.00) €240,600 ↑

(39,000 × €6.00) €234,000

€6,600 U ↑ Efficiency variance

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Allocated: (Budgeted input allowed for actual output achieved × Budgeted rate)

Bhimani, Horngren, Datar and Rajan, Management and Cost Accounting, 5th Edition, Instructor’s Manual Fixed manufacturing overhead Total manufacturing overhead

(not given)

( given) €600,000 ↑

(39,000 × €8.00) €320,000 €320,000 €312,000 ↑ ↑ €8,000 U* ↑ Never a variance Production-volume variance

(€240,600 + €320,000) €560,600

€39,400 U ↑ e. Spending variance

*

Denominator level in hours Production volume in standard hours allowed Production-volume variance

(€234,000 + €312,000) €546,000 €8,000 U ↑ g. Production-volume variance

(€234,000 + €320,000) €554,000

€6,600 U ↑ f. Efficiency variance

40,000 39,000 1,000 hours × €8.00 = €8,000 U

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CHAPTER 17

Measuring yield, mix and quantity effects Teaching tips and points to stress Input variances When manufacturing fruit-flavoured drinks, sugar, fructose and corn syrup are to some extent substitutable sweeteners. In contrast, in a plant that produces frozen Mexican style ready meals, beef and chicken are not substitutable. Here, a substitution would change the fundamental character of the product. Chapters 15 and 16 focused on subdividing the FBV into price and efficiency variances and the static budget was not used in those calculations. Chapter 16 subdivides the SVV into the SMV and the SQV. For this purpose, the actual column is not used. This chapter subdivides the efficiency variance (a component of the FBV) into mix and yield components. For this purpose, neither the actual nor the static-budget column is used. As an alternative to the columnar method illustrated in Exhibit 17.1, remind students that price and efficiency variances can also be calculated using the formula approach described in Chapter 15. For each type of input, the price variance is: AQpurchased × Difference in price = AQpurchased × (BP – AP) For Aliya’s Jonagold apples, this is 975 tonnes × (€90/tonne – €96/tonne) = €5,850 U. The efficiency variance is: BP × Difference in quantity = BP × (TBQIA – AQused ) where TBQIA is the total budgeted quantity of inputs allowed for the actual outputs. For Aliya, this is €90/tonne × (1,280 tonnes – 975 tonnes) = €27,450 F. Mix variances arise only when inputs are substitutable. If there can be no substitutions, the mix of inputs is constant. The mix variance becomes 0 and the entire efficiency variance is attributable to the yield variance. The mix and yield exhibits in Chapter 17 each have three columns and students often fail to realise that it is NOT the same three columns in each exhibit. Emphasise that the three columns in Exhibit 17.2 are a decomposition of the efficiency variance from Exhibit 17.1. Column 1 in Exhibit 17.2 corresponds to column 2 in Exhibit 17.1 and column 3 in Exhibit 17.2 corresponds to column 3 in Exhibit 17.1. The intuition behind the material (and labour) mix and yield variances is analogous to the intuition behind the sales mix and quantity variances. The yield variance tells us whether we used more or less total material (or labour) inputs than budgeted, given the actual number of

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outputs. It is the difference between the actual and budgeted quantities of inputs at the budgeted mix (i.e. holding the mix constant). The material (labour) mix variance arises because the mix of materials (labour) differs from the budget. It is the difference between the actual and budgeted mix for the actual quantity of inputs (i.e. holding the total quantity of inputs constant). Yield and mix-variance calculations are, here, based on the budgeted price per unit of material (or labour). Keeping prices constant at the budgeted amounts allows us to compare (1) the actual quantity of total inputs with the budgeted quantity and (2) the actual mix with the budgeted mix, without input prices affecting the results. However, companies differ in how they calculate mix and yield variances, so it is important that accountants gain a clear understanding of the definitions used in each individual company. If there is a material-mix variance, the variance must be F for at least one individual material and U for at least one other material. If we use a lower than budgeted percentage of some material inputs, then we must have used a higher than budgeted percentage of at least one other input (e.g. in the example in Exhibit 17.1, we cannot use less than 30% of British Coxes’ and less than 20% of Jonagold’s and less than 50% of Golden Delicious’). The same intuition applies to labour-mix variances. Stress the intuition behind the labour yield and mix variances. The yield variance is the difference between budgeted and actual quantity of total labour-hours, at budgeted mix and budgeted prices. The mix variance is the difference between actual and budgeted mix, at actual total labour-hours and budgeted prices.

Revenue and sales variances Curriculum linkage

This part extends the variance analysis discussed in Chapter 15. The SVV in Chapter 15 is decomposed into the SMV and the SQV. The SQV is then further decomposed into market-size and market-share variances. These variances provide information on why sales differ from expectations, which helps marketing managers plan and control their activities. The earlier part of Chapter 17 explains an analogous decomposition of the FBV (for costs) into yield and mix variances. Teaching tip/correction of students’ misconceptions

Chapter 15 explained how the FBV for DM and DL is decomposed into price and efficiency variances. Ask students whether there can be both price and efficiency variances for revenues. The answer is no. The FBV for revenues arises because: Actual revenues (AP × AQoutputs ) ≠ FBrevenues (BP × AQoutputs ). The FBV for revenues arises only because AP ≠ BP, so it is entirely a (selling) price variance. (The DM and DL efficiency variances arise because the FB cost is BP × BQIA and the BQIA ≠ AQinputs.) Students often confuse the three columns in the decomposition of the SVV with the three columns in Chapter 15’s decomposition of the FBV. The text’s graphic that shows the four levels of variance analysis helps to clarify the big picture.

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FBV Actual FB Actual quantity inputs @ BP PV EV

SVV Actual quantity output units sold @ budgeted mix @ BP SMV SQV Actual market size @ budgeted market share @ budgeted price and mix. Market share variance

SB

Market size variance

Note that the FBV decomposition is based on inputs, whereas the SVV decomposition of the SVV is based on outputs. In addition, the decomposition of the SVV is based entirely on budgeted prices. (Differences between BP and AP create FBV.) Students find sales mix and quantity variances difficult. They tend to get lost in the detailed calculations, so it is important to go slowly. Stress the intuition. For example, the SQV arises because the total quantity of units actually sold differs from the SB. The SMV arises because the mix of individual products actually sold differs from the budgeted mix. To capture the SQV, we hold the sales mix constant; and to capture the SMV, we must hold sales quantity constant. Add perspective by emphasising the big picture. Points to stress

If there is a non-zero SMV, at least one product must have an F variance and at least one product must have a U variance. The SMV cannot be F for all products or U for all products. Actual prices are used in variance analysis only in calculating the FBV. Actual prices are not used in calculating the SVV or any of its components. Thus, we use budgeted (rather than actual) selling price when calculating the SMV. Note that many alternative formulae are found in practice. Advise students that they should always examine the specific formula when interpreting reported sales-mix variances. Curriculum linkage

Most marketing managers want to know why actual sales differ from budgeted sales. If the SQV is primarily due to uncontrollable changes in market size, the company may need to expand, downsize or shift to new product markets. In contrast, market share is more controllable, since traditional marketing activities such as pricing and promotion are more likely to affect market share than total market size. The SMV tells managers whether the mix is shifting in favour of high- or low-revenue (margin) items when variances are based on revenues (margins). And the sales revenue price variance (an FBV discussed in Chapter 15) reveals the effects of a change in selling price. Point to stress

Variances are often interrelated. A favourable sales revenue price variance (caused by a price increase) may reduce market share (U market-share variance) leading to reduced sales volume (U SQV and SVV).

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Correcting students’ misconceptions

Students often confuse the three-column decomposition of the SQV into market-size and share variances with the three-column decomposition of the SVV into sales quantity and mix variances. Points to stress

Actual prices are used in variance analysis only in the actual column used to calculate the FBV (as in Chapter 15). In contrast, both the FB and the SB are based on the BP of inputs and outputs. The FB and SB are also based on the budgeted quantity of inputs per output. Hence, both the FB and the SB are based on the budgeted CM per output. Teaching tip

The following tabulation shows why the total SVV is the difference between the actual and expected outputs, multiplied by the unit CM. Revenue VC CM FC Op. Inc.

FB xxx xx xx x x

SVV SVV SVV NEVER A SVV * SVV

SB xxx xx xx x x

* As long as actual and expected outputs are in the same relevant range.

Solutions to review questions 17.1

Total direct materials-yield variance focuses on the effect of the difference between the actual total quantity of all direct materials used and the budgeted number (given that the budgeted input mix is unchanged) by calculating the difference between the two amounts: (1) the budgeted cost of direct materials based on the actual total quantity of all direct materials input used and (2) the flexible-budget cost of direct materials based on the budgeted total quantity of all direct materials inputs for the actual output achieved. The total direct materials-mix variance focuses on the difference between the actual sales mix and the budgeted mix, given the actual total quantity of all direct materials inputs used are unchanged, by determining the difference between: (1) the budgeted cost for the actual direct materials input mix and (2) the budgeted cost if the budgeted direct materials mix had been unchanged. In calculating both these variances, budgeted (standard) materials prices are held constant.

17.2

Yes. When inputs are substitutable, direct materials efficiency improvement relative to budgeted costs can come from two sources: (1) using less input to achieve a given output and (2) using a cheaper mix to produce a given output. The direct materials yield and mix variances divide the efficiency variance into two variances: the yield variance focusing on total inputs used and the mix variance focusing on how the substitutable inputs are combined. However, when direct materials inputs are not substitutable, calculating only the direct materials efficiency variance may suffice. Managers control each individual input and no discretion is permitted regarding the substitution of 251 © Pearson Education Limited 2012

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materials inputs. All deviations from the input–output relationships are due to efficient or inefficient usage of individual direct materials. 17.3

The text of Chapter 17 gives three sources of the standards used in calculating the direct materials yield and direct materials-mix variances: 1

Internally generated actual costs of the most recent accounting period adjusted for expected improvement.

2

Internally generated standard costs based on best performance standards or currently attainable standards.

3

Externally generated target cost numbers based on an analysis of the cost structures of the leading competitors in an industry.

17.4

Disagree. Changes in the mix of direct materials from the budgeted mix could improve yield, for example, if the mix of direct materials shifts in favour of using more of the higher-quality, costlier materials. This could potentially have the effect of hurting mix but improving yield, if the actual total quantity of direct materials used to produce the actual output is lower than the budgeted total quantity.

17.5

The direct-labour mix variance helps managers to understand how costs (calculated at budgeted prices) change as the actual mix varies from the budgeted mix. The directlabour yield variance indicates the total amount of hours taken and costs incurred (at budgeted prices) relative to budgeted hours to complete a given task. If the mix variance is unfavourable, say, but the yield variance is favourable, the manager can evaluate if the mix-versus-yield tradeoff reduced cost, that is, improved the direct-labour efficiency variance. If it did not, for example, managers will understand that shifting to a higher skills mix would only be worthwhile if the total time taken can be further reduced. Managers would then have to consider ways to achieve this goal – better training for lower-costs workers, improved work procedures, etc.

17.6

Yield and mix variances might be useful in managing inputs such as energy. For example, calculating these variances could further be a company's understanding of how changing the mix of energy inputs – self-generated versus purchased – would affect the operating income. Managers can then take actions that would improve operating income performance.

17.7

Two possible explanations for the manager's statement are: 1

The plant manager has no flexibility in determining the direct material or the direct manufacturing labour content. If a plant is highly automated, it is likely that a computer program would calculate the specific direct materials or manufacturing labour content.

2

The plant manager believes that other (probably non-financial) information is sufficient to manage costs on a day-to-day basis.

17.8

A favourable sales-quantity variance arises because the actual units of product sold exceed the budgeted units of product sold.

17.9

The sales-quantity variance can be decomposed into (a) a market-size variance (the actual total market-size change from that of the budgeted) and (b) a market-share variance (the actual market share change from that of the budgeted). Both variances use the budgeted average selling price per unit, when the focus is on revenues.

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17.10

Some companies, which believe that reliable information on total market size is not available, choose not to calculate market-size and market-share variances.

Solutions to exercises 17.12

Direct nursing labour efficiency, yield and mix variances. (25 min) 1 and 2. Actual total quantity of all inputs used and actual input mix percentages for each input are as follows: Nursing staff Nurses Nursing assistants Orderlies Total

Actual hours

Actual mix percentage

8,750 4,900 3,850 17,500

8,750 ÷ 17,500 = 0.50 4,900 ÷ 17,500 = 0.28 3,850 ÷ 17,500 = 0.22 1.00

Budgeted total quantity of all inputs allowed and budgeted input mix percentages for each input are as follows: Nursing staff Nurses Nursing assistants Orderlies Total

Budgeted hours

Budgeted mix percentage

8,100 5,400 4,500 18,000

8,100 ÷ 18,000 = 0.45 5,400 ÷ 18,000 = 0.30 4,500 ÷ 18,000 = 0.25 1.00

Solution Exhibit 17.12 presents the total direct nursing labour-efficiency variance (SFr 50 F), the total direct nursing labour-yield variance (SFr 9,675 F) and the total direct nursing labour-mix variance (SFr 9,625 U) for Les Cliniques du Parc in July 2011. The total direct nursing labour efficiency variance can also be calculated as: Direct nursing Budgeted Actual Budgeted inputs allowed  labour efficiency variance =   inputs – for actual outputs achieved × price for each input Nurses

=

(8,750 – 8,100) × SFr 25

=

Nursing assistants

=

(4,900 – 5,400) × SFr 17

=

8,500 F

Orderlies = (3,850 – 4,500) × SFr 12 Total direct nursing labour efficiency variance

=

7,800 F SFr 50 F

SFr 16,250 U

The total direct nursing labour-mix variance can also be calculated as the sum of the direct nursing labour-mix variances for each input. Actual Direct nursing Budgeted nursing labour labour nursing labour input mix – input mix mix variance = percentage for each input percentage

  

  

Actual total quantity Budgeted of all price of × × nursing nursing labour inputs used labour inputs

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Nurses

=

(0.50 – 0.45) × 17,500 × SFr 22 = 0.05 × 17,500 × SFr 25 = SFr 21,875 U

Nursing assistants =

(0.25 – 0.30) x 17,500 × SFr 17

= –0.02 x 17,500 × SFr 17 =

5,950 F

Orderlies

(0.22 – 0.25) x 17,500 x SFr 12

= –0.03 x 17,500 x SFr 12 =

6,300 F

=

SFr 9,625 U

Total direct nursing labour mix variance

The total direct nursing labour yield variance can also be calculated as the sum of the direct nursing labour yield variances for each input. Direct nursing labour yield variance = for each input

Budgeted total quantity  Budgeted direct Budgeted Actual total quantity of all direct nursing nursing price of   of all direct nursing – labour inputs allowed  × labour input × direct nursing  labour inputs used  for actual output achieved mix percentage labour input

Nurses

=

(17,500 – 18,000) × 0.45 × SFr 25

=

–500 x 0.45 × SFr 25 = SFr 5,625 F

Nursing assistants

=

(17,500 – 18,000) × 0.30 × SFr 17

=

–500 x 0.30 × SFr 17 =

2,550 F

Orderlies

=

(17,500 – 18,000) × 0.25 × SFr 12

=

–500 x 0.25 × SFr 12 =

1,500 F SFr 9,675 F

Total direct nursing labour yield variance

3

Les Cliniques du Parc shows an unfavourable mix variance because it used a higher percentage of the higher (budgeted) priced nurses in the actual mix relative to the budgeted mix. It shows a favourable yield variance because the total number of actual hours of nursing time was less than the budgeted amount. One possible explanation is that using more experienced and qualified nurses reduced the total time needed for nursing activities – the unfavourable mix variance was more than offset by the favourable yield variance. Alternatively, of course, management might find that the mix and yield variances are unrelated. In either case, management must evaluate if using fewer nursing hours compromised the quality of care. Poor-quality care could hurt the long-term reputation and prospects of the hospital. Management's goal is to control costs without reducing the quality of care.

Solution Exhibit 17.12

Columnar presentation of direct nursing labour yield and mix variances for Les Cliniques du Parc for July 2011

(Actual total quantity of all inputs used x Actual input mix) x Budgeted prices (SFr) (1) 17,500 x 0.50 x 25 = 218,750

(Actual total quantity of all inputs used x Budgeted input mix) x Budgeted prices (SFr) (2) 17,500 x 0.45 x 25 = 196,875

Flexible budget (Budgeted total quantity of all inputs allowed for actual output achieved x Budgeted input mix) x Budgeted prices (SFr) (3) 18,000 x 0.45 x 25 = 202,500

Nursing assistants

17,500 x 0.28 x 17 = 83,300

17,500 x 0.30 x 17 = 89,250

18,000 x 0.30 x 17 = 91,800

Orderlies

17,500 x 0.22 x 12 = 46,200 SFr 348,250

17,500 x 0.25 x 12 = 52,500 SFr 338,625

18,000 x 0.25 x 12 = 54,000 SFr 348,300

Nurses

↑

SFr 9,625 U Total mix variance

↑

↑

SFr 9,675 F ↑ Total yield variance

SFr 50 F

Total efficiency variance

Note that F = favourable effect on operating income; U = unfavourable effect on operating income.

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17.13

Variance analysis of revenues, multiple products. (30–40 min) 1

Sales − volume  Actual sales Budgeted sales  Budget net variance = −  × revenue per ticket  Quantity in units Quantity in units  of revenue Lower tier tickets

=

(6,600 – 8,800) × €20 =

€28,000U

Upper tier tickets

=

(15,400 – 12,000) × €5 =

€17,000F

All tickets

€11,000U

2

Budgeted average net revenue per ticket

=

(8,000 × €20) + (12,000× €5) 20,000

=

€160,000 + €60,000 €220,000 = 20,000 20,000

=

€11 per unit (seat sold)

Sales-mix percentages: Budgeted __________________

Actual ___________________

Lower tier

8,000 = 0.40 20,000

6,600 = 0.30 22,000

Upper tier

12,000 = 0.40 20,000

15, 400 = 0.70 22,000

Solution Exhibit 17.13 presents the sales-volume, sales-quantity and sales-mix variances for lower tier tickets, upper tier tickets and in total for Antwerp Lions in 2011. The sales-quantity variances can also be calculated as: Sales-quantity variance of revenues

=

Actual units of all tickets sold

–

Budgeted units of all tickets sold

Budgeted × sales-mix percentage

× Budgeted net revenue per ticket The sales-mix variance can also be calculated as: Lower tier tickets

=

(22,000 – 20,000) × 0.40 × €20

= €16,000F

Upper tier tickets All tickets

=

(22,000 – 20,000) × 0.60 × €5

= €6,000F €22,000U

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The sales-mix variance can further be calculated as: Sales-quantity variance of revenues

=

Actual units of all tickets sold

–

Budgeted × sales-mix percentage

Actual sales-mix percentage

× Budgeted net revenue per ticket The sales-mix variance can also be calculated as: Lower tier tickets

=

22,000 × (0.30 – 0.40)

=

€44,000U

Upper tier tickets

=

22,000 × (0.70 – 0.60)

=

€11,000F

All tickets 3

€33,000U

The Antwerp Lions increased average attendance by 10% per game. However, there was a sizeable shift from lower tier seats (budgeted net revenue of €20 per seat) to upper tier seats (budgeted net revenue of €5 per seat). The net result: the actual revenue was €11,000 below the budgeted net revenue.

Solution Exhibit 17.13 Columnar presentation of sales-volume, sales-quantity and sales-mix variances for Antwerp lions

Panel A: Lower tier

Flexible budget (Actual units of all tickets sold x Actual sales mix) x Budgeted Unit net revenue (1)

(Actual units of all tickets sold x Budgeted sales mix) x Budgeted unit net revenue (2)

Static budget (Budgeted units of all tickets sold x Budgeted sales mix) x Budgeted unit net revenue (3)

a (22,000 x 0.30 ) x €20 = 6,600 x €20 = €132,000

b (22,000 x 0.40 ) x €20 = 8,800 x €20 = €176,000

b (20,000 x 0.40 ) x €20 = 8,000 x €20 = €160,000

↑

↑ Panel B: Upper tier

↑

€44,000 U Sales-mix variance

(22,000 x 0.70c) x €20 = 15,400 x €5 = €77,000 ↑

€16,000 F ↑ Sales quantity variance ↑

€28,000 U Sales-volume variance

(22,000 x 0.60d) x €20 = 13,200 x €5 = €66,000

€11,000 F Sales-mix variance ↑

↑

(20,000 x 0.60d) x €5 = 12,000 x €20 = €60,000 €132,000

€6,000 F Sales-quantity variance

€17,000 F Sales-volume variance

↑

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↑

Bhimani, Horngren, Datar and Rajan, Management and Cost Accounting, 5th Edition, Instructor’s Manual Panel C: All tickets ↑

€209,000e €33,000 U Sales-mix variance ↑

€242,000f ↑ €22,000 F ↑ Sales-quantity variance

€220,000g

↑

€11,000 U Sales-volume variance

Note that F = favourable effect on operating profit; U = unfavourable effect on operating profit.

Actual sales mix:

Budgeted sales mix:

a

Lower tier = 6,600 ÷22,000 = 30%

b

c

Upper tier = 15,400 ÷ 22,000 = 70% €132,000 + €77,000 = €209,000

d

e

f

17.17

Lower tier = 8,000 ÷ 20,000 = 40%

Upper tier = 12,000 ÷ 20,000 = 60% €176,000 + €66,000 = €242,000 g €160,000 + €60,000 = €220,000

Direct materials price and efficiency variances, direct materials yield and mix variances, perfume manufacturing. (40 min) 1

The direct materials standard to produce 80 litres of perfume are: 40 litres of Tartarus; 30 litres of Erebus; 30 litres of Uranus. Therefore, budgeted inputs allowed for each litre of perfume are: Tartarus: 40 litres ÷ 80 litres = 0.500 litres Erebus: 30 litres ÷ 80 litres = 0.375 litres Uranus: 30 litres ÷ 80 litres = 0.375 litres All fluids: 1.250 litres Budgeted input allowed for 75,000 litres of perfume are: Tartarus

75,000 × 0.500

=

37,500 litres

Erebus

75,000 × 0.375

=

28,125 litres

Uranus All fluids

75,000 × 0.375

=

28,125 litres 93,750 litres

Solution Exhibit 17.15A presents the total direct materials price and efficiency variances for Markku Antero for the week. The total direct materials price variance can also be calculated as: Direct materials Actual Actual Budgeted price variance =   price – price  × inputs for each input Tartarus

=

(€5.50 – €6.00) x 45,000

=

€22,500 F

Erebus

=

(€4.20 – €3.50) x 35,000

=

24,500 U

Uranus

=

(€2.75 – €2.50) x 20,000

=

5,000 U

Total direct materials price variance

€ 7,000 U

The total direct materials efficiency variance can also be calculated as: Direct materials efficiency variance = for each input

Actual inputs – Budgeted inputs allowed  × Budgeted  prices for actual output achieved used

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Tartarus

=

(45,000 – 37,500) × €6.00

=

€45,000.00 U

Erebus

=

(35,000 – 28,125) × €3.50

=

24,062.50 U

Uranus

=

(20,000 – 28,125) × €2.50

=

20,312.50 F

Total direct materials efficiency variance

€48,750.00 U

Solution Exhibit 17.17A

Columnar presentation of direct materials price and efficiency variances for Markku. (Actual costs incurred × Actual inputs) × Actual prices (1) 45,000% €5.50 = €247,500

Actual inputs × Budgeted prices (2) 45,000% €6.00 = €270,000

Flexible budget (Budgeted inputs allowed for actual output achieved × Budgeted prices) (3) 37,500% €6.00 = €225,000.00

Erebus

35,000% €4.20 = €147,000

35,000% €3.50 = €122,500

28,125% €3.50 = € 98,437.50

Uranus All fluids

20,000% €2.75 = € 55,000 €449,500

20,000% €2.50 = 50,000

28,125% €2.50 = € 70,312.50 €393,750.00

arus

↑

€442,500 €7,000 U Total price variance

↑

↑

€48,750 U Total efficiency variance

↑ ↑

€55,750 U Total flexible-budget variance

F = favourable effect on operating income; U = unfavourable effect on operating income.

2

Solution Exhibit 17.15B presents the direct materials yield and mix variances for Tartarus, Erebus and Uranus and in total for Markku Antero for the week. The direct materials yield variances can also be calculated as: Budgeted total

Direct materials = yield variance for each input

total Actual quantity of all  quantity of direct  all direct – materials  allowed  materials inputs  for actual inputs used  output achieved

Budgeted direct materials × input mix percentage

Budgeted price of × direct materials input

Tartarus

=

(100,000 – 93,750) × 0.40 × €6.00 = 6,250 × 0.40 × €6.00

=

€15,000.00 U

Erebus

=

(100,000 – 93,750) × 0.30 × €3.50 = 6,250 × 0.30 × €3.50

=

6,562.50 U

Uranus

=

(100,000 – 93,750) × 0.30 × €2.50 = 6,250 × 0.30 × €2.50

=

4,687.50 U €26,250.00 U

Total direct materials yield variance

The direct materials-mix variances can also be calculated as: Direct materials mix variance = for each input

Budgeted   Actual direct materials direct materials  – input mix  input mix    percentage percentage 

Actual total quantity of all × direct materials inputs used

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Budgeted price of × direct materials input

Bhimani, Horngren, Datar and Rajan, Management and Cost Accounting, 5th Edition, Instructor’s Manual

Tartarus

=

(0.45 – 0.40) × 100,000 × €6.00

= 0.05 × 100,000 × €6.00

= €30,000 U

Erebus

=

(0.35 – 0.30) × 100,000 × €3.50

= 0.05 × 100,000 × €3.50

= 17,500 U

Uranus

=

(0.20 – 0.30) × 100,000 × €2.50

= –0.10 × 100,000 × €2.50

= 25,000 F €22,500 U

Total direct materials mix variance

3

Markku Antero has an unfavourable direct materials price variance of €7,000 and an unfavourable direct materials efficiency variance of €48,750. Both the yield and the mix variances are unfavourable. Markku Antero may have used more quantities of all input fluids because of the lower quality of Tartarus and Erebus. The unfavourable direct materials mix variance occurs with Tartarus and Erebus because Markku Antero used a greater percentage of these fluids in its direct materials mix than budgeted. Uranus shows a favourable direct materials mix variance because the actual direct materials mix percentage of Uranus is less than the budgeted direct materials mix percentage. The total direct materials mix variance is unfavourable because the actual mix of direct materials inputs had a greater proportion of the more costly inputs (Tartarus and Erebus) than the budgeted mix. Direct materials-yield and direct materials-mix variances are especially informative when management can substitute among the individual material inputs. Such substitution is possible in the processing of individual inputs into perfume.

Solution Exhibit 17.17B

Columnar presentation of direct materials-yield and mix-variances for Markku Antero.

(Actual total quantity of all inputs used × Actual input mix) × Budgeted prices (€) (1)

(Actual total quantity of all inputs used × Budgeted input mix) × Budgeted prices (€) (2)

Erebus

100,000 × 0.45a % 6.00 = 100,000 % 0.35c % 3.50 =

122,500

Uranus

100,000 % 0.20e % 2.50 =

50,000

Tartarus

All Fluids

Flexible budget (Budgeted total quantity of all inputs allowed for actual output achieved × Budgeted input mix) × Budgeted prices (€) (3)

270,000

(100,000 % 0.4b) % 6.00 = 240,000 (100,000 % 0.3d) % 3.50 = 105,000

(93,750 % 0.4) % 6.00 = 225,000.00

(100,000 % 0.3f) % 2.50 =

75,000

(93,750 % 0.3) % 2.50 = 70,312.50

€420,000

€393,750.00

€442,500

↑

€22,500 U Total mix variance

↑

↑

(93,750 % 0.3) % 3.50 = 98,437.50

€26,250 U Total yield variance

€48,750 U Total efficiency variance

↑ ↑

F = favourable effect on operating income; U = unfavourable effect on operating income. Actual input mix: aTartarus = 45,000 ÷ 100,000 = 45% cErebus = 35,000 ÷ 100,000 = 35% eUranus = 20,000 ÷ 100,000 = 20%

Budgeted input mix: bTartarus = 40 ÷ 100 = 40% dErebus = 30 ÷ 100 = 30% f Uranus = 30 ÷ 100 = 30%

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17.18

Direct materials price and efficiency variances, direct materials yield and mix variances, food processing. (50 min) 1

The direct materials standard to produce 80 kg of tropical fruit salad are:

50 kg of pineapple; 30 kg of watermelon and 20 kg of mango. Therefore, budgeted input allowed for each kg of tropical fruit salad: Pineapples Watermelons Mango All fruit

50 kg ÷ 80 kg 30 kg ÷ 80 kg 20 kg ÷ 80 kg

= = =

0.625 kg 0.375 kg 0.250 kg 1.250 kg

Budgeted input allowed for 54,000 kg of tropical fruit salad: Pineapples

54,000 × 0.625

=

33,750 kg

Watermelons

54,000 × 0.375

=

20,250 kg

Mango All fruit

54,000 × 0.25

=

13,500 kg 67,500 kg

Solution Exhibit 17.16A presents the total direct materials price and efficiency variances for Tropica, AB for October. The total direct materials price variances can also be calculated as: Direct materials Actual Actual Budgeted price variance =   price – price  × inputs for each input Pineapples

=

(SFr 0.90 – SFr 1.00) × 36,400

=

SFr 3,640 F

Watermelons

=

(SFr 0.60 – SFr 0.50) ×18,200

=

1,820 U

Mango

=

(SFr 0.70 – SFr 0.75) × 15,400

=

770 F

Total direct materials price variance

SFr 2,590 F

The direct materials efficiency variances can also be calculated as: Direct materials Actual inputs – Budgeted inputs allowed  × Budgeted price efficiency variance =  used for actual output achieved for each input Pineapples

=

(36,400 – 33,750) × SFr 1.00

= SFr 2,650 U

Watermelons

=

(18,200 – 20,250) × SFr 0.50

=

1,025 F

Mango = (15,400 – 13,500) × SFr 0.75 Total direct materials efficiency variance

=

1,425 U SFr 3,050 U

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Solution Exhibit 17.18A

Columnar presentation of direct materials price and efficiency variances for Tropica AB Actual costs incurred (Actual inputs % Actual prices) (1)

Flexible budget (Budgeted inputs allowed for actual output achieved % Budgeted prices) (3)

Actual inputs % Budgeted Prices (2)

Pineapple

36,400

× SFr 0.90 = SFr 32,760

36,400

× SFr 1

Watermelons

18,200

× SFr 0.60 = SFr 10,920

18,200

× SFr 0.50 = SFr 9,100

20,250

× SFr 0.50 = 10,125

Mango

15,400

× SFr 0.70 =

15,400

× SFr 0.75 = SF11,550

13,500

× SFr 0.75 = 10,125

All inputs

10,780

↑

33,750

× SFr 1

SFr 57,050

SFr 54,460

↑

= SFr 36,400

SFr 2,590 F Total price variance

↑

= 33,750

SFr 54,000

SFr 3,050 U Total efficiency variance

↑ ↑

SFr 460 U Total flexible-budget variance

F = favourable effect on operating income; U = unfavourable effect on operating income.

2

Solution Exhibit 17.16B presents the total direct materials yield and mix variances for Tropica, AB for October.

The total direct materials yield variance can also be calculated as the sum of the direct materials yield variances for each input.

 Actual total Budgeted total quantity quantity of all of all direct materials =  direct materials – inputs allowed for  ×    inputs used actual output achieved  Pineapple

Budgeted Budgeted direct materials price of × direct materials input mix percentage inputs

= (70,000 – 67,500) × 0.5 × SFr 1.00 = 2,500 × 0.5 × SFr 1.00 = SFr 1,250 U

Watermelon = (70,000 – 67,500) × 0.3 × SFr 0.50 = 2,500 × 0.3 × SFr 0.50 =

375 U

Mango = (70,000 – 67,500) × 0.2 × SFr 0.75 = 2,500 × 0.2 × SFr 0.75 = 375 U Total direct materials yield variance SFr 2,000 U

The total direct materials mix variance can also be calculated as the sum of the direct materials mix variances for each input: Direct Budgeted  Actual total quantity Budgeted  Actual materials direct materials direct materials of all price   × of direct materials mix variance =  input mix – input mix  × direct materials for each input  percentage percentage  inputs used inputs Pineapple U

= (0.52 – 0.50) × 70,000 × SFr 1.00 = 0.02 × 70,000 × SFr 1.00

=SFr

Watermelon = (0.26 – 0.30) × 70,000 × SFr 0.50 = –0.04 × 70,000 ×SFr 0.50 = Mango = (0.22 – 0.20) × 70,000 × SFr 0.75 = 0.02 × 70,000 ×SFr 0.75 Total direct materials mix variance

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1,400 1,400 F

= 1,050 U SFr 1,050 U

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3

Tropica, AB has traded off a favourable material-price variance of SFr 2,590 against an unfavourable material-efficiency variance of SFr 3,050. Tropica, AB should investigate if the favourable price variances on pineapples and mango were obtained by compromising quality. Both the yield and the mix variances are unfavourable. Tropica, AB could have used larger quantities of all fruits to produce the given output because of lower quality of pineapples and mango. The total direct materials mix variance is unfavourable because the actual mix of direct materials inputs had a greater proportion of the more costly inputs (pineapples and mango) than the budgeted mix.

4

Direct materials-yield and direct-materials mix variances are especially informative when management can substitute among the individual material inputs. Such substitution is possible in the processing of individual fruits into tropical fruit salad.

Solution Exhibit 17.18B

Columnar presentation of direct materials yield and mix variances for Tropica, AB

(Actual quantities of all inputs used × Actual input mix) × Budgeted prices (1) Pineapple

(Actual quantities of all inputs used × Budgeted input mix) × Budgeted prices (2)

(70,000 × 0.52a) × SFr 1 = SFr 36,400

(70,000 × 0.5b) × SFr 1 = SFr 35,000

(67,500 × 0.5) × SFr 1 = SFr 33,750

(70,000 × 0.26c) × SFr 0.50 = 9,100

(70,000 × 0.3d) × SFr 0.50 = 10,500

(67,500 × 0.3) × SFr 0.50 = 10,125

(70,000 × 0.22e) × SFr 0.75 = 11,550

(70,000 × 0.2f) × SFr 0.75 = 10,500

(67,500 × 0.2) × SFr 0.75 = 10,125

SFr 57,050 ↑

SFr 56,000 ↑

Watermelon Mango

Flexible budget (Budgeted total quantity of all inputs allowed for actual output achieved × Budgeted input mix) × Budgeted prices (3)

All Inputs

SFr 1,050 U Total mix variance

↑

SFr 2,000 U Total yield variance

SFr 54,000 ↑

SFr 3,050 U Total efficiency variance

↑

F = favourable effect on operating income; U = unfavourable effect on operating income. Actual input mix: aPineapple cWatermelon eMango

17.19

= = =

Budgeted input mix: 36,400 ÷ 70,000 18,200 ÷ 70,000 15,400 ÷ 70,000

= 52% = 26% = 22%

bPineapple dWatermelon fMango

= = =

50 ÷ 100 = 50% 30 ÷ 100 = 30% 20 ÷ 100 = 20%

Direct materials efficiency variance, mix and yield variances; working backward. (30–40 min) 1, 2 and 3 Solution Exhibit 17.17 presents the direct materials efficiency, yield and mix variances for the Alpha and Gamma inputs and in total for Calypso SA. The steps to fill in the numbers in Solution Exhibit 17.17 follow: Step 1:

Alpha required per tonne of fertiliser

=

75% × 1.20

0.90 tonnes

Gamma required per tonne of fertiliser All inputs

=

25% × 1.20

0.30 tonnes 1.20 tonnes

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Step 2:

Fill in the flexible budget column (column 3) for Alpha, Gamma and in total for the 2,000 tonnes of fertiliser produced.

Step 3:

Consider column 2 of Solution Exhibit 17.17. The total of column 2 in panel C is €875,000 (the total flexible-budget direct materials costs of €840,000 + the unfavourable total direct materials yield variance of €35,000 which was given in the problem).

We need to find the actual quantities of all direct material inputs used, which we denote by m. The budgeted input mix is Alpha, 75% and Gamma, 25%. From column 2, we know that: (m × 0.75 × €400) + (m × 0.25 × €200) = €875,000 300 m + 50 m = €875,000 m = €875,000 ÷ 350 = 2,500 tonnes Hence, the total quantity of all direct materials inputs is 2,500 tonnes. This calculation allows us to fill in all the numbers in column 2. Step 4:

Fill in all the numbers in column 1 of Solution Exhibit 17.17, using actual quantities of all direct materials, the actual mix of inputs and budgeted prices of materials.

Solution Exhibit 17.17 displays the following total direct materials mix, total direct materials yield and direct materials efficiency variances: 1

2

3

4

Direct materials yield variances: Alpha Gamma Total direct materials yield variance

€30,000 U 5,000 U €35,000 U

Direct materials mix variances: Alpha Gamma Total direct materials mix variance

€250,000 F 125,000 U €125,000 F

Direct materials efficiency variances: Alpha Gamma

€220,000 F 130,000 U

Total direct materials efficiency variance

€ 90,000 F

Calypso SA has a total favourable efficiency variance of €90,000 F largely because of a favourable mix variance of €125,000. The favourable mix variance arises because Calypso uses a greater proportion of the cheaper Gamma input in its direct materials mix. Using more of Gamma may have caused the unfavourable yield variance, but this unfavourable variance is more than offset by the favourable mix variance.

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Solution Exhibit 17.17

Columnar presentation of direct materials, efficiency, yield and mix variances for Calypso SA.

Alpha Gamma All Inputs

(Actual total quantity of all inputs used × Actual input mix) × Budgeted prices (1)

(Actual total quantity of all inputs used × Budgeted input mix) × Budgeted prices (2)

Flexible budget (Budgeted total quantity of all inputs allowed for actual outputs × Budgeted input mix) × Budgeted prices (3)

(2,500 × 0.50) × €400 = €500,000

(2,500 × 0.75) × €400 = €750,000

(2,000 × 0.90) × €400 = €720,000

(2,500 × 0.50) × €200 = 250,000

(2,500 × 0.25) × €200 = 125,000

(2,000 × 0.30) × €200 = 120,000

€750,000 ↑ ↑

€875,000 €840,000 €125,000 F ↑ €35,000 U ↑ Total mix variance Total yield variance ↑ €90,000 F Total efficiency variance

F = favourable effect on operating income; U = unfavourable effect on operating income.

17.20

Direct service labour price, efficiency, yield and mix variances. (40 min) 1

Solution Exhibit 17.18A presents the total service labour price and efficiency variances for five architectural jobs done by O’Connell & Associates.

The total direct service labour price variance can also be calculated as: Direct service Actual Actual Budgeted labour price variance =   prices – prices  × inputs for each input Principal-hours = (€108 – €105) × 295 Senior-hours = (€70 – €75) × 2,360 Junior-hours = (€30 – €25) × 3,245 Total direct service labour price variance

= = =

€ 885 U 11,800 F 16,225 U € 5,300 U

The total direct service labour efficiency variance can also be calculated as: Direct service labour Budgeted Actual Budgeted inputs allowed  efficiency variance =   inputs – for actual outputs achieved × prices for each input Principal-hours = (295 – 600) × €105 Senior-hours = (2,360 – 1,800) × €75 Junior-hours = (3,245 – 3,600) × €25 Total direct service labour efficiency variance

= = =

€32,025 F 42,000 U 8,875 F € 1,100 U

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Solution Exhibit 17.20A

Columnar presentation of direct service labour price and efficiency variances for O’Connell & Associates. Actual costs incurred (Actual inputs × Actual prices) (1)

Principal-hours 295 × €108 = €31,860 Senior-hours 2,360 × € 70 = 165,200 Junior-hours 3,245 × € 30 = 97,350 €294,410

↑

Flexible budget (Budgeted inputs allowed for actual outputs achieved) × Budgeted Prices (3)

Actual input × Budgeted price (2)

295 × €105 = 2,360 × € 75 = 3,245 × € 25 =

€30,975 0177,000 81,125 €289,100

€5,310 U Total price variance

↑

↑

600 × €105 = €63,000 1,800 × € 75 = 135,000 3,600 × € 25 = 90,000 €288,000 €1,100 U Total efficiency variance

↑ ↑

€6,410 U Total flexible-budget variance

Note that U = unfavourable effect on operating income.

Overall, O’Connell paid more than the budgeted rate for labour which resulted in an unfavourable price variance. O’Connell also used more than the standard quantity of labour resulting in an unfavourable efficiency variance. 2

Solution Exhibit 17.18B presents the total direct service labour mix and yield variances for the five architectural jobs done by O’Connell & Associates. The total direct service labour mix variance can also be calculated as the sum of the direct service labour mix variances for each input. Actual Direct service Budgeted service labour service labour labour mix input mix – input mix variance for = percentage each input percentage

  

  

Principal-hours = (5,900 – 6,000) × 0.10 × €105

Actual total Budgeted quantity of all price of × service labour × service labour inputs used input

= (–100) × 0.10 × €105

= €1,050 F

= (5,900 – 6,000) × 0.30 × € 75

= (–100) × 0.30 × € 75

=

2,250 F

Junior-hours = (5,900 – 6,000) × 0.60 × € 25 Total direct service labour yield variance

= (–100) × 0.60 × € 25

=

1,500 F €4,800 U

Senior-hours

The distribution labour-mix variance is unfavourable because O’Connell used more of the senior-hours service labour than the budgeted mix. The total quantity of all service labour used was less than budgeted resulting in a favourable yield variance.

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Solution Exhibit 17.20B

Columnar presentation of direct service labour yield and mix variances for O’Connell & Associates

(Actual total quantity of all inputs used × Actual input mix) × Budgeted prices (1)

(Actual total quantity of all inputs used × Budgeted input mix) × Budgeted Prices (2)

Flexible budget (Budgeted total quantity of all inputs allowed for actual output achieved × Budgeted input mix) × Budgeted prices (3)

Principal-hours

5,900 × 0.05 × €105 = €30,975

5,900 × 0.10 × €105 = €61,950

Senior-hours

5,900 × 0.40 × € 75 = 177,000

5,900 × 0.30 × € 75 = 132,750

6,000 × 0.30 × € 75 = 135,000

Junior-hours

5,900 × 0.55 × € 25 =

5,900 × 0.60 × € 25 =

88,500

6,000 × 0.60 × € 25 = 90,000

€283,200

€288,000

81,125

€289,100

↑ ↑

€5,900 U Total mix variance

↑

6,000 × 0.10 × €105 = €63,000

€4,800 F Total yield variance

€1,100 U Total efficiency variance

↑ ↑

Note that F = favourable effect on operating income; U = unfavourable effect on operating income.

3

O’Connell & Associates shows an unfavourable price and efficiency variance. The unfavourable price variance is due to the higher than budgeted rates paid to principals and juniors, partly offset by the lower rate paid to seniors. The unfavourable efficiency variance is due to the higher number of hours worked by seniors, only partially offset by the fewer hours worked by principals and juniors. The shift in mix of inputs toward more senior-hours (40% in actual mix versus 30% in budgeted mix) results in an unfavourable mix variance. The mix variance was partially offset by a favourable yield variance because the work was completed in 5,900 actual total hours compared with the 6,000 budgeted total hours, but the net effect was an increase in costs relative to the budget. Note, however, that these variances focus only on costs. Management at O’Connell & Associates would also need to consider the effects of changes in the mix, for example, on quality, and, hence, current and future revenues.

4

Management at O’Connell & Associates should use information from the variance analysis to ask questions that would lead to improvement in future performance. For example, management would want to understand why higher wage rates were paid to principals and juniors. Did it result from a general shortage of available staff in these categories or from factors specific to O’Connell? Similarly, O’Connell would want to understand reasons for the unfavourable efficiency variance. Were more senior-hours, for example, used because the seniors were not well trained or because the work processes were inappropriate? Why were senior-hours used to substitute for principals and juniors? Was it a conscious choice or because of unavailability of principals and juniors? The analysis indicates that a strategy to use more seniors in the type of architectural jobs analysed here would only be worthwhile if the total time taken for these jobs can be further reduced. Managers would need to look at ways in which this can be done – for example, better hiring and training and better work methods. Of course, the analysis here focuses only on cost. Management would need to consider the effects of mix changes, for example, on other strategic factors like service quality and timeliness that can have favourable effects on current and future revenues and profitability.

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PART IV

MANAGEMENT CONTROL SYSTEMS AND PERFORMANCE ISSUES

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CHAPTER 18

Control systems and transfer pricing Teaching tips and points to stress Management control systems Teaching tips

Help students put Chapters 18 and 19 into perspective. Chapter 18 discusses management control systems, decentralisation and transfer pricing. Chapter 19 covers performance evaluation, emphasising problems encountered in decentralised companies, especially those organised into divisional investment centres. Evaluation of these divisions depends partly on their profits. If there are interdivisional transfers, then divisional profits cannot be determined until the transfer price is set. Establishing a transfer price (Chapter 18) precedes performance evaluation (Chapter 19). The following questions usually generate lively discussion. ‘Should accountants limit the internal/financial category or should we expand our role to become information specialists? What are the costs and benefits of such an expansion? How will this decision affect the prosperity of accountants in the 21st century?’ Accountants’ responsibility for items related to safety, health and the environment can provoke contentious debate.

Evaluating management control systems Correcting student misconceptions

Some accounting students believe number-crunching skills are more important than interpersonal skills or understanding how accounting numbers affect people’s behaviour. Point out that computers can crunch numbers, but they cannot evaluate and choose management control systems. Accountants earn reasonably high salaries because they have the interpersonal and analytical skills necessary to evaluate and implement accounting systems, as well as the ability to interpret outputs of these systems. The behavioural issues covered in this chapter and throughout the text are very relevant to students’ future careers. Example

McDonald’s promotes Q, S, C & V (quality, service, cleanliness and value) as shared objectives. Top management reinforces the importance of these objectives by designing the performance evaluation system around these four dimensions.

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Points to stress

This discussion recognises that information asymmetry underlies the major advantages and disadvantages of decentralisation. Lower-level managers have superior information regarding their jobs and if appropriately used in decision making, the company as a whole will benefit (called flexibility gain). However, the lower-level managers may use their information (to which top management is not privy) to improve their own unit’s performance, even at the expense of the profitability of the organisation as a whole. Thus, decentralisation engenders costs in the form of top management’s loss of control over subordinates. Curriculum linkage

Students who have taken a management course should be familiar with advantages and disadvantages of decentralisation. However, decision making is rarely either totally centralised or totally decentralised. How far the decisions are pushed downward depends on at least an implicit cost–benefit analysis. Decisions most likely to be decentralised are those with a primarily local (divisional) effect (e.g. product selection). Decisions affecting several divisions (e.g. long-term financing) are more likely to be centralised. If participation in budgeting increases employees’ commitment to achieve the budget (see Chapter 14), then participation in a wide variety of decisions (i.e. decentralisation) should increase employees’ commitment to those decisions and to the organisation. Points to stress

Interdivisional transfers (and transfer pricing) are a major source of suboptimal decisions. The selling division wants a high price, but the buying division wants a low price. If both divisions act in their own best interests, their decisions will sometimes hurt the company as a whole. Teaching tips

Help students organise the transfer-pricing (TP) concepts by outlining a series of questions managers must address. The first is a policy question – should divisions be permitted to source externally, when internal goods are available? The second is an operational question – at what price will the transfer be made? This second question involves deciding: (1) Which type of TP method will be used (market, cost or negotiated)? (2) How is the exact TP determined once the method is selected? (3) How are disputes resolved (negotiation, arbitration or directives)? Ideally, a transfer price should: 1

Promote goal congruence (manager’s and organisation’s interests are aligned so that selecting an action in a manager’s best interest is also in the organisation’s best interest);

2

Motivate sellers to hold down costs and buyers to use inputs efficiently;

3

Allow subunit managers the autonomy to make their own decisions (if the company is decentralised).

As you cover each transfer-pricing method, ask students how well the method satisfies each of these three criteria. It should become apparent that no single method consistently satisfies all three criteria.

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Points to stress

TP is most likely to be a problem when the seller is a profit or investment centre. If the seller is a cost centre, there is less (or no) incentive to maximise sales revenue and the potential for TP conflicts is thus reduced. TP allocates profits to subunits for (1) performance evaluation and (2) motivation. Profits are not allocated for product-costing purposes because product costs do not include a profit component.

Market-based transfer prices Points to stress

In perfectly competitive markets, market price represents the product’s fair market value. With market-based TP, profits approximate those that would occur if each subunit were freestanding. However, some products do not have perfectly competitive markets: market processes are not always available and a single market price may not exist. Moreover, if the seller has idle capacity, they may be willing to sell at a price above outlay cost, but below the market. Finally, if prices are temporarily depressed, it is not clear that the temporary windfall should accrue to the buyer at the expense of the seller. Correcting student misconceptions

Clarify the conflict caused by distress prices. If the seller receives very low (distress price) sales revenue, the seller may decide to produce other products, which may not be in the company’s long-term interest. Alternatively, if the TP is based on the long-term average market price, the buyer would prefer to buy externally. If management forces them to buy internally (at the longterm market price), autonomy will be violated.

Cost-based transfer prices Points to stress

If TP are based on actual costs, sellers can pass along costs of inefficiency to the buyers. Setting TP, based on budgeted rather than actual costs, can help motivate the seller to produce efficiently. However, even if sellers use budgeted-cost-based TP, if there is information asymmetry, sellers may still be able to pass on costs of inefficiency by budgeting high costs. Another rationale for using TP based on full cost is the following. If the selling subunit’s full cost exceeds the market price, the buying unit will prefer to outsource. While this may be suboptimal in the short run, it appears more reasonable in the long run. If the seller cannot produce at a competitive cost, management should consider reallocating resources elsewhere. Teaching tips

Students without negotiating experience usually do not recognise the incentives against sharing information. Because TP allocates profits across subunits, subunit managers often view each other as competitors and this limits their willingness to share information. Students can experience such incentives 270 © Pearson Education Limited 2012

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for secrecy (with plenty of opportunity for number crunching) through an innovative TP role play based on the cases in the book. Example

Companies may use different TP methods for different items: market-based TP for big ticket items, variable cost-plus for low-value items and periodic negotiations for midrange items. Companies may also allocate more purchasing, receiving and inspection costs to externally sourced items, if internal sourcing requires less of such activities (e.g. buying internally may require less negotiation and an internal source may be more reliable in delivering high-quality items in the right quantity at the right time). Recognising any extra costs from sourcing externally renders internal sourcing relatively more attractive.

Negotiated transfer prices Negotiated transfer prices typically fall between the ‘floor’ (incremental cost plus opportunity cost) and ‘ceiling’ (market price) prices. As the text points out, exactly where the negotiated transfer price falls within this range depends on the relative bargaining strength of the subunits. If performance evaluations are based on subunit operating income, using negotiated transfer prices means that relative negotiating strength will affect these evaluations.

A general guideline for transfer-pricing situations Correcting student misconceptions

The ‘general guideline’ yields the minimum TP the seller can accept and be as well off as under the next best alternative. It is a starting point for negotiations – not a ‘recommended’ TP. Teaching tips

Students should be familiar with the concept of opportunity cost from economics. In the TP context, opportunity cost is the profit the seller forgoes by selling to the sister subunit, rather than externally. Assume the seller has no idle capacity and can sell all they produce at €4. Outlay cost is €1.00. If the seller sells internally, the profit forgone (opportunity cost) is €3 (€4 revenue – €1 outlay cost). Alternatively, if the seller has excess capacity with no alternative use, no profit is forgone by selling internally (opportunity cost is zero).

Solutions to review questions 18.1

A management control system is a means of gathering and using information to aid and coordinate the process of making planning and control decisions throughout the organisation and to guide employee behaviour. The goal of the system is to improve the collective decisions within an organisation.

18.2

To be effective, management control systems should be: (a) closely aligned to an organisation’s strategies and goals, (b) designed to fit the organisation’s structure and

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the decision-making responsibility of individual managers and (c) able to motivate managers and employees to put in effort to attain selected goals desired by top management. 18.3

Motivation combines goal congruence and effort. Motivation is the desire to attain a selected goal specified by top management (the goal-congruence aspect) combined with the resulting drive or pursuit towards that goal (the effort aspect).

18.4

Chapter 18 cites five benefits of decentralisation: 1

Creates greater responsiveness to local needs

2

Leads to quicker decision making

3

Increases motivation

4

Aids management development and learning

5

Sharpens the focus of managers.

Chapter 18 cites four costs of decentralisation: 1

Leads to suboptimal decision making

2

Results in duplication of activities

3

Decreases loyalty toward the organisation as a whole

4

Increases costs of gathering information.

18.5

No. Organisations typically compare the benefits and costs of decentralisation on a function-by-function basis. For example, companies with highly decentralised operating divisions frequently have centralised income tax strategies.

18.6

No. A transfer price is the price that one subunit of an organisation charges for a product or service supplied to another subunit of the same organisation. The two segments can be cost centres, profit centres or investment centres. For example, the allocation of service department costs to production departments that are set up as either cost centres or investment centres is an example of transfer pricing.

18.7

Transferring products or services at market prices generally leads to optimal decisions when (a) the intermediate market is perfectly competitive, (b) interdependencies of subunits are minimal and (c) there are no additional costs or benefits to the organisation as a whole in using the market instead of transacting internally.

18.8

Reasons why a dual-pricing approach to transfer pricing is not widely used in practice include:

18.9

1

The manager of the division using a cost-based method does not have sufficient incentives to control costs.

2

This approach does not provide clear signals to division managers about the level of decentralisation the top management wants.

3

This approach tends to insulate managers from the frictions of the market place.

Yes. The general transfer-pricing guideline specifies that the minimum transfer price equals the additional outlay costs per unit incurred up to the point of transfer plus the opportunity costs per unit to the supplying division. When the supplying division has idle capacity, its opportunity costs are zero; when the supplying division has no idle capacity, its opportunity costs are positive. Hence, the minimum transfer price will vary depending on whether the supplying division has idle capacity or not.

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18.10

Alternative transfer-pricing methods can result in sizeable differences in the reported operating income of divisions in different income tax jurisdictions. If these jurisdictions have different tax rates or deductions, the net income of the company as a whole can be affected by choice of the transfer-pricing method.

Solutions to exercises 18.11

Goals of public accounting firms. (10 min)

If public accounting firms stress that each individual should have a high percentage of chargeable time, individuals will attempt to both maximise the percentage of their time charged to clients and minimise the time spent on non-chargeable tasks. Many accounting firms now recognise that their goals (growth, profitability, intellectual challenge and so on) may not be promoted if all individuals focus on maximising the percentage of their day-to-day time charged to clients. Aspects critical to promoting goals that are not chargeable to clients include:

18.12

a

Bidding for new clients

b

Superiors providing training to juniors

c

Continuing education to keep personnel up to date

d

General public relations aimed at promoting the profile of a well-known, reputable and professional firm.

Decentralisation, goal congruence, responsibility centres. (15 min) 1

The environmental management organisation appears to be decentralised because managers of the environmental management group have considerable freedom to make decisions. They can choose which projects to work on and which projects to reject.

2

The environmental management group is a cost centre. The group is required to charge the operating divisions for environmental services at cost and not at market prices that would help the group earn a profit.

3

The benefits of structuring the environmental management group in this way are: i

The operating managers have incentives to carefully weigh and conduct cost– benefit analyses before requesting the environmental group’s services.

ii

The operating managers have an incentive to follow the work and the progress made by the environmental team.

iii The environmental group has incentives to fulfil the contract, to do a good job in terms of cost, time and quality and to satisfy the operating divisions in order to continue to get business.

The problems in structuring the environmental group in this way are: i

The contract requires extensive internal negotiations in terms of cost, time and technical specifications.

ii

The environmental group needs to continuously ‘sell’ its services to the operating divisions and this could potentially result in loss of morale.

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iii Experimental projects that have long-term potential may not be undertaken because operating division managers may be reluctant to undertake projects that are costly and uncertain whose benefits will only be realised well after they have left the division.

To the extent that the focus of the environmental group is on short-run projects demanded by the operating divisions, the current structure leads to goal congruence and motivation. Goal congruence is achieved because both operating divisions and the environmental group have an incentive to work towards the organisational goals of reducing pollution and improving the environment. The operating divisions will be motivated to utilise the services of the environmental group to achieve the environmental goals set for them by top management. The environmental group will be motivated to deliver high-quality services in a cost-effective way in order to continue to create a demand for their services. The one issue that top management needs to guard against is that experimental projects with long-term potential that are costly and uncertain may not be undertaken under the current structure. Top management may want to set up a committee to study and propose such long-run projects for consideration and funding by corporate management. 18.13

Transfer-pricing dispute. (20 min) 1

2

The company as a whole will not benefit if Division C buys on the outside market. Purchase costs from outsider, 1,000 units × €135

€135,000

Deduct: Savings in variable costs by reducing Division A output, 1,000 units × €120

120,000

Net cost (benefit) to company as a whole by buying from outside

€15,000

The company will benefit if C purchases from the outside supplier: Purchase costs from outsider, 1,000 units × €135 Deduct: Savings in variable costs, 1,000 units × €120 Savings due to A’s equipment and facilities being assigned to other operations Net cost (benefit) to company as a whole by buying from outside

3

€135,000 €120,000

18,000

138,000 €(3,000)

The company will benefit if C purchases from the outside supplier: Purchase costs from outsider, 1,000 units × €115 Deduct: Savings in variable costs by reducing

€115,000

Division A output, 1,000 units × €120 Net cost (benefit) to company as a whole by buying from outside

120,000

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The three requirements are summarised below (in thousands): (1)

Total purchase costs from outsider

(2)

(3)

€135

€135

€115

120

120

120

Total relevant costs if purchased from Division A Total incremental (outlay) costs if purchased from A Total opportunity costs if purchased from A

–

18

–

120

138

120

€15

€(3)

€(5)

Total relevant costs if purchased from A Operating income advantage (disadvantage) to company as a whole by buying from A

Goal congruence would be achieved if the transfer price is set equal to the total relevant costs of purchasing from Division A. 18.14

Transfer-pricing problem. (5 min)

The company as a whole would benefit in this situation if C purchased from outside suppliers. The €15,000 disadvantage to the company as a whole by purchasing from the outside supplier would be more than offset by the €30,000 contribution margin of A’s sale of 1,000 units to other customers. Purchase costs from outside supplier, 1,000 units × €135

€135,000

Deduct variable cost savings, 1,000 units × €120

120,000

Net cost to company as a whole by buying from outside

€15,000

A’s sales to other customers, 1,000 units × €155

€155,000

Deduct: Variable manufacturing costs, €120 × 1,000 units Variable marketing costs, €5 × 1,000 units Variable costs Contribution margin from A selling to other customers

18.16

€120,000 5,000 125,000 €30,000

Transfer-pricing methods, goal congruence. (30 min) 1

Alternative 1: Sell as raw lumber for €200 per 100 board-metres: Revenue Variable costs Contribution margin

€200 100 €100

Alternative 2: Sell as finished lumber for €275 per 100 board-metres: Revenue Variable costs: Raw lumber Finished lumber Contribution margin

€275 €100 125

225 €50

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Ilmajoki-Lumber will maximise its total contribution margin by selling lumber in its raw form. An alternative approach is to examine the incremental revenues and incremental costs in the Finished Lumber Division: Incremental revenues, €275 − €200 €75 Incremental costs 125 Incremental loss €(50)

2

Transfer price at 110% of variable costs: = €100 + (€100 × 0.10) = €110 per 100 board-metres Sell as raw lumber

Sell as finished lumber

Raw Lumber Division Division revenues Division variable costs Division operating income

€200 100 €100

€110 100 €10

Finished Lumber Division Division revenues Transferred-in costs Division variable costs Division operating income

€0 – – €0

€275 110 125 €40

The Raw Lumber Division will maximise reported divisional operating income by selling raw lumber, which is the action preferred by the company as a whole. The Finished Lumber Division will maximise divisional operating income by selling finished lumber, which is contrary to the action preferred by the company as a whole. 3

Transfer price at market price = €200 per 100 board-metres. Sell as raw lumber Raw Lumber Division Division revenues Division variable costs Division operating income

€200 100 €100

Finished Lumber Division Division revenues Transferred-in costs Division variable costs Division operating income

€0 – – €0

Sell as finished lumber €200 100 €100

€275 200 125 €(50)

The Raw Lumber Division will maximise divisional operating income by selling raw lumber, which is the action preferred by the company as a whole. The Finished Lumber Division will maximise divisional operating income by not further processing raw lumber; which is preferred by the company as a whole.

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18.17

Effect of alternative transfer-pricing methods on divisional operating profit. (30 min)

1 Internal transfers at market prices (Method A)

Internal transfers at 110% of full costs (Method B)

Mining Division Revenues: €90 × 400,000 units; €66a × 400,000 units

€36,000,000

€26,400,000

20,800,000

20,800,000

3,200,000

3,200,000

€12,000,000

€2,400,000

€60,000,000

€60,000,000

36,000,000

26,400,000

14,400,000

14,400,000

Deduct: Division variable costs: €52b × 400,000 units Division fixed costs: €8c × 400,000 units Division operating income Metals Division Revenues: €150 × 400,000 units Deduct: Transferred-in costs: €90 × 400,000 units; €66 × 400,000 units Division variable costs: €36d × 400,000 units Division fixed costs: €15e × 400,000 units Division operating income a b

c

6,000,000

6,000,000

€3,600,000

€13,200,000

€66 = €60 × 110%. Variable cost per unit in Mining Division = Direct materials + Direct manufacturing labour + 75% of Manufacturing overhead = €12 + €16 + 75% × €32 = €52. Fixed cost per unit = 25% of Manufacturing overhead = 25% × €32 = €8.

d

Variable cost per unit in Metals Division = Direct materials + Direct manufacturing labour + 40% of Manufacturing overhead = €6 + €20 + 40% × €25 = €36

e

Fixed cost per unit in Metals Division = 60% of Manufacturing overhead = 60% × €25 = €15

2

Bonus paid to division managers at 1% of divisional operating income will be as follows:

Mining Division manager’s bonus (1% × €12,000,000; 1% × €2,400,000) Metals Division manager’s bonus (1% × €3,600,000; 1% × €13,200,000)

Method A (Internal transfers at market prices)

Method B (Internal transfers at 110% of full costs)

€120,000

€24,000

36,000

132,000

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The Mining Division manager will prefer Method A (transfer at market prices) because this method gives €120,000 of bonus rather than €24,000 under Method B (transfers at 110% of full costs). The Metals Division manager will prefer Method B because this method gives €132,000 of bonus rather than €36,000 under Method A. 3

Arturo Tuzón, the manager of the Mining Division will appeal to the existence of a competitive market to price transfers at market prices. Using market prices for transfers in these conditions leads to goal congruence. Division managers acting in their own best interests make decisions that are also in the best interests of the company as a whole. Tuzón will further argue that setting transfer prices based on cost will cause him to pay no attention to controlling costs since all costs incurred will be recovered from the Metals Division at 110% of full costs.

18.18

Goal congruence, negotiated transfer prices. (20 min) 1

From the standpoint of Escuelas as a whole, the Mining Division should transfer all 400,000 units of toldine to the Metals Division. Since the market is competitive, each division can buy and sell as much as it wants in the open market. Transferring in-house will avoid the variable transactions costs of buying (€3 per unit) and selling (€5 per unit) the toldine in the open market.

2

If it were to transfer inside, the Mining Division would like to achieve at least the same revenue it could get by selling outside. If it sold outside, the Mining Division would get €85 per unit (price of €90 per unit − €5 of variable selling costs). The transfer price would have to be at least €85. If the Metals Division bought toldine from the outside market, it would have to pay €93 per unit (price of €90 per unit + €3 of variable purchasing costs). It would be willing to buy from the Mining Division if the cost of toldine was less than €93. Transfer prices greater than €85 and less than €93 would result in both division managers agreeing to transfer toldine from the Mining to the Metals Divisions while acting autonomously.

3

18.23

Yes, allowing both divisions to buy and sell in the open market and to negotiate the transfer price between themselves will have the following benefits: •

Encourage the management of the Mining Division to be more conscious of cost control.

•

Provide a more realistic measure of divisional performance while motivating actions that are in the best interests of Escuelas as a whole.

•

Save transactions costs for the divisions and the company.

•

Perhaps provide toldine to the Metals Division at a cost lower than the price its competitors would pay for toldine. Of course, where in the range between €85 and €93 per unit, the transfer price will eventually end up depends on the bargaining powers of the two divisions.

Question from the Chartered Institute of Management Accountants, Intermediate Level, Management Accounting – Decision Making, November 2003. (45 min) a

If its objective is to maximise the profit of its division, then division Q will wish to maximise the number of Comp1s it sells at the best possible price, while satisfying

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both its external (5000 units) and internal market (8000 units). The marginal cost for producing 13,000 Comp1s is shown below: £

£

25 × 13000

Materials

15 × 61,620(W1)

Labour

325,000 *

3 × 61,620

Overheads Total marginal cost

924,300 184,860 1,434,160

Units produced

13,000

Marginal cost per unit

110

*

Working 1 Y = axb Y = (20) (13,000 to the power of the log of the learning curve rate/log of 2) Y = (20) (13,0000.152) Y = 4.74 hours per unit Total labour hours 13,000 units × 4.74 hours per unit = 61,620 b i

An effective transfer-pricing system should conform to the following criteria.

Enable divisional and managerial performance measurement The verdict on divisional managers is predominantly determined by their divisions’ performance. In order for it to serve as a reasonable indicator of managerial performance, transfer-pricing system is required to be robust

Promote goal congruence As divisional managers are judged on their divisions’ performance, it is in their interest to seek the best transfer price for their division. Consequently, a transferpricing system is sought which is favourable for each division as well as the company as a whole.

Maintain divisional autonomy The right to set their divisional transfer price without the interference of head office will ensure that managers aren’t undermined and de-motivated and made to feel they have no control over their divisional performance. There is little point in granting autonomy to divisions if they are not free to set their transfer price.

Record transfers between divisions A practical application of transfer pricing is to aid in recording the transfer of goods and services between divisions.

Minimise the global tax liability In multinational companies, the transfer-pricing system can assist in transferring profits around the globe and therefore minimise the global tax liability.

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ii

Imperfect or non-existent markets for the intermediate product means that the marginal cost transfer prices can motivate both the supplying and receiving division managers to operate at output levels that will maximise over all company profits. Therefore, the correct transfer price to encourage optimum profits for the company as a whole (assuming there are no production constraints) is the marginal production cost of the intermediate product. However, if the transfer price for the intermediate product is set at marginal cost, the supplying division will be seen to under-perform and will report losses on the interdivisional transfers because of the total production costs having been deducted from a transfer price based on marginal cost. Obviously, the supplying division in this instance will not be happy with this transfer price, but of course the receiving division will be. The receiving division will obtain the intermediate product at marginal cost and therefore, all of the profit from the final output will be reported in its division.

iii The minimum transfer price that division Q would wish to charge would be equal to the external market price, that is, £150 per unit. Division Q’s objective will be to charge as high a transfer price as possible and division R’s objective will be to pay as little as possible for the components. Clearly, division R would wish to buy from division Q if the transfer price is less than £160 per unit.

If division Q sets a transfer price equal to £160 per unit, then division R will be indifferent as to whether it purchases internally or externally. However, from a group point of view, profit will be maximised from utilising the spare capacity within division Q and not purchasing the components from the external market. Therefore, agreement will need to be reached between division Q and division R and a transfer price negotiated, which is less than £160 per unit. Agreement on the transfer price of Comp1 will depend on the strength of the managers’ negotiation skills and whether or not equal bargaining power exists for the divisional managers.

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CHAPTER 19

Control systems and performance measurement Teaching tips and points to stress Financial and non-financial performance measures Points to stress

This section emphasises multidimensional performance evaluation. The balanced scorecard approach often includes profitability, customer satisfaction, innovation and productivity/ quality/time measures. This encourages companies to move beyond the traditional internal/ financial measures (e.g. ROI) to incorporate internal/non-financial measures (e.g. new product development time), external/financial measures (e.g. stock price) and external/non-financial measures (e.g. market share). The balanced scorecard approach encourages employees to adopt a balanced perspective and to take actions that are in the company’s long-run interests.

Different performance measures Curriculum linkage

Chapter 18 explains that transfer-pricing methods are evaluated on how well they meet three behavioural criteria: goal congruence (acting in one’s own self-interest also promotes organisational interest), management effort (to produce efficiently and use resources wisely) and subunit autonomy. These three criteria can also be used to assess alternative performance evaluation methods, as discussed in Chapter 19. Correcting students’ misconceptions

From the DuPont formula it appears that changing revenues would not affect ROI, since ‘Revenues’ in the numerator of the investment turnover ratio and the denominator of the income margin ratio cancel out: Revenues Income × Investment Revenues However, increasing revenues without increasing costs proportionally increases income, which in turn increases ROI. Teaching tips

Explain the intuition behind the two ROI components. Investment turnover tells us how many revenue euros are generated by each euro of investment. The goal is to make each investment euro ‘work harder’ to generate more sales. The income to revenue ratio (also called income

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margin) tells us how much of each revenue euro goes to income. The goal is to get higher income per revenue euro. The product of these two ratios, ROI, tells us how much income each euro of investment generates. Points to stress

In the Hôtels Desfleurs example, ROI is measured as operating income divided by total assets. This definition matches operating income, which is the entire income ‘pie’ (before it is split up between (a) creditors in the form of interest, (b) the government in the form of taxes and (c) investors in the form of dividends and increased R/E), with total assets, the entire amount of investment available to earn the entire income ‘pie’. What rate of return should management use to calculate residual income? Students who have studied finance should realise that the cost of capital is the appropriate rate of return. Conceptually, it should be the cost of capital for that particular business segment’s risk level. For example, an oil exploration segment might warrant a higher required rate of return than an oil refining segment. Generally, residual income (RI) is more likely to foster goal congruence than what ROI is. Managers evaluated on RI have incentives to accept all projects that cover more than the cost of capital. In contrast, managers evaluated on ROI will attempt to maximise the ROI rate, rather than the RI amount. These managers have incentives to reject projects with ROI below their division’s average ROI, even if the projects are expected to return more than the cost of capital. This preference for RI over ROI parallels the preference for NPV over IRR in capital budgeting (see Chapter 13). Chapter 19 discusses the economic value added (EVA®) measure, which is a specific variant of RI. EVA® defines income as the after-tax operating income, required rate of return as the weighted average cost of capital (WACC) and investment as the TA–CL. Since TA–CL = LTL + SE, ‘investment’ is defined as funds invested for the long term. Intuitively, EVA® is the income ‘pie’ available to creditors and stockholders (i.e. operating income minus taxes) minus the required return on funds invested for the long term by creditors and stockholders. Example

Very low levels of investment lead to very high investment turnover ratios that can dominate the ROI calculation – even if management of the few assets is economically less critical than management of income margin. Consider an accounting firm with €1,000,000 in revenue, €200,000 in operating income and €10,000 in PPE. The partners want to double their investment in PPE. Pre- and post-expansion ROIs follow: € 1, 000, 000 10, 000 € 1, 000, 000 20, 000

× ×

€ 200, 000 1, 000, 000 € 200, 000 1, 000, 000

= 100 × 0.2 = 200% = 50 × 0.2 = 10%

Spending 5% of one year’s income on PPE would halve ROI. But, ‘real’ performance has not deteriorated. Hence, ROS (20%) would probably be a more informative measure of the firm’s profitability. This example illustrates why firms in service industries often use ROS.

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Alternative performance measures Points to stress

If ‘investment’ is valued at discounted present value, then ‘income’ would be measured as the change in present value from one period to the next. Theoreticians have long advocated the present value approach on conceptual grounds. However, it is difficult to implement, because it is hard to project both the amount and timing of the firm’s future cash flows. There is also uncertainty about the appropriate discount (interest) rate. In addition, managers being evaluated are likely to be ones who are making cash flow projections also, which creates moral hazard problems. One way to mitigate these problems is to also compare actual to forecast amounts using post-investment audits. Students who have studied economics should have seen adjustments for changes in purchasing power. The concept is the same here, except that there are different price indices for different assets. Example

Students are often confused about the difference between current costs and general price-level adjusted costs. The cost of a calculator that adds, subtracts, multiplies and divides was €120 in 1972. A general price-level adjustment would value this asset in 1998 at about €439: 120 ×

1.535 (1995 CPI) 0.42 (1972 CPI)

This is very different from the current cost to purchase a calculator that performs the same function – about €7. Points to stress

The net book value method’s declining denominator works to increase ROI as assets age, ceteris paribus. Evaluating managers on the basis of net assets rather than gross assets exacerbates incentives for retaining old PPE rather than investing in new PPE.

Choosing targeted levels of performance and timing of feedback The discussion of benchmarks for performance evaluation points out that judicious selection of benchmarks or targets can help offset shortcomings with traditional, historical-cost-based ROI, RI or EVA® measures. For example, since older assets valued at historical cost inflate ROI (particularly if investment is defined as net rather than gross assets), management may set higher target ROIs for divisions with older assets. Points to stress

Lower-level managers who are responsible for day-to-day operations usually require more frequent feedback than senior executives who primarily exercise oversight over the lower-level managers.

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Distinction between managers and organisational units Points to stress

This section explains the implications of agency theory for designing managers’ compensation contracts. When owners cannot directly monitor managers’ actions, performance-based compensation can help align managers’ and owners’ interests (i.e. it helps induce goal congruence). The disadvantage is that performance-based compensation places more risk on the manager, since outcomes depend to some extent on non-controllable factors. People who decide to become entrepreneurs (owners) are generally more risk tolerant than those who decide to work for others (managers). It is more efficient for owners to bear risk than managers, since the latter demand a premium (extra compensation) for bearing risk. The objective of many executive compensation contracts is to provide the manager with incentives to work hard, while minimising the risk placed on the manager. Incentive compensation plans are most likely to be cost effective if: a

the owner and manager have different goals (e.g. owner wants profits, manager is work averse). If goals are identical, owners’ and managers’ interests are aligned, so incentive compensation is unnecessary;

b

the owner cannot monitor the managers’ actions. Otherwise, the owner would compensate the manager based on the manager’s actions, in order to reduce the risk shifted to the manager.

c

the manager has considerable control over the performance measure outcome. (If the manager has little control over the outcome, the incentive plan will place undue risk on the risk-averse manager and he will demand a premium for bearing the risk.)

When possible, owners use performance evaluation measures that are tightly linked to managers’ efforts. This is consistent with the notion that managers should be evaluated on the basis of factors they can affect, even if these factors are not completely controllable. For example, sales people obviously can affect the amount of sales revenue they generate. Sales people obviously affect the amount of sales they generate by deciding to work harder, but they cannot completely control the level of sales, because other factors such as the economy and competitors’ products also affect sales. Teaching tips

To help students understand why incentive compensation is becoming more popular, even if it places more risk on the manager, ask them to consider experiences they have had with government bureaucrats (e.g. obtaining driver’s licence, obtaining financial assistance at a university). The problems caused by the relative absence of incentive compensation should be immediately obvious. Points to stress

If managers are evaluated on a single number, they have incentives to subordinate everything else to minimise that number. For example, management might curtail advertising and maintenance to increase current year’s ROI. This is why performance evaluation should be

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based on a variety of factors, financial and non-financial, internal and external (e.g. the balanced scorecard approach). Teaching tips

Team-based incentives encourage employees to work together to achieve common goals. Individual-based incentive compensation rewards employees for their own performance, consistent with responsibility accounting. A mix of the two encourages employees to maximise their own performance, while working together in the firm’s best interests. You can help students experience individual and team-based compensation by giving a quiz individually and then giving the same quiz to teams of students, with each student’s grade to be an average of the two scores (let the students decide what percentage of their quiz grade is determined by the team quiz score). The team quiz score is usually better than the scores of individual members, which demonstrates the advantages of working in teams. Students also learn by trying to convince each other of the best answers and ill-prepared students may be embarrassed into preparing better in the future.

Solutions to review questions 19.1

The DuPont method highlights that ROI is increased by any action that increases investment turnover or income margin. ROI increases with: 1

increases in revenues,

2

decreases in costs or

3

decreases in investments,

while holding the other two factors constant. 19.2

Yes. Residual income is not identical to ROI. ROI is a percentage with investment as the denominator of the calculation. Residual income is an absolute amount in which investment is used to calculate an imputed interest charge.

19.3

Economic value added (EVA®) is a specific type of residual income measure that is calculated as follows: After-tax Economic value Weighted-average × Total assets minus = – ® operating income  cost of capital current liabilities  added (EVA )

19.4

Definitions of investment used in practice when computing ROI are: 1

Total assets available

2

Total assets employed

3

Working capital (current assets minus current liabilities) plus other assets

4

Stockholders’ equity.

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19.5

Present value is the asset measure based on DCF estimates. Current cost is the cost of purchasing an asset today that is identical to the one currently held (if identical assets can currently be purchased); it is the cost of purchasing the services provided by that asset if identical assets cannot currently be purchased. Historical-cost-based measures of ROI calculate the asset base as the original purchase cost of an asset minus any accumulated depreciation. Some commentators argue that present value is future oriented and current cost is oriented to current prices, while historical cost is past oriented.

19.6

Organisations often put the most skilful divisional manager in charge of the weakest division in an attempt to improve the performance of the weak division. Such an effort may yield results in years, not months. The division may continue to perform poorly when compared with other divisions of the organisation. But it would be a mistake to conclude from the poor performance of the division that the manager is performing poorly. A second example of the distinction between the performance of the manager and the performance of the subunit is the use of historical-cost-based ROIs to evaluate the manager even though historical cost ROIs may be unsatisfactory for evaluating the economic returns earned by the organisation subunit.

19.7

Moral hazard describes contexts in which an employee is tempted to put in less effort (or report distorted information) because the employee’s interests differ from the owner’s and the employee’s effort cannot be accurately monitored and enforced.

19.8

No, rewarding managers only on the basis of their performance measures, such as ROI, subjects managers to uncontrollable risk because managers’ performance measures are also affected by random factors over which the manager has no control. A manager may put in a great deal of effort, but her/his performance measure may not reflect this effort if it is negatively affected by various random factors. Thus, if managers are compensated on the basis of performance measures, they will need to be compensated for taking on extra risk. Hence, when performance-based incentives are used, they are generally more costly to the owner. The motivation for having some salary and some performance-based bonus in compensation arrangements is to balance the benefits of incentives against the extra costs of imposing uncontrollable risk on the manager.

19.9

Measures of performance that are superior (measures that change significantly with the manager’s performance and not very much with changes in factors that are beyond the manager’s control) are the key to designing strong incentive systems in organisations. When selecting performance measures, the management accountant must choose those performance measures that change with changes in the actions taken by managers. For example, if a manager has no authority for making investments, then using an investment-based measure to evaluate the manager imposes risk on the manager and provides little information about the manager’s performance. The management accountant might suggest evaluating the manager on the basis of costs or costs and revenues, rather than ROI.

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19.10

Benchmarking or relative performance evaluation is the process of evaluating a manager’s performance against the performance of other similar operations. The ideal benchmark is another operation that is affected by the same non-controllable factors that affect the manager’s performance. Benchmarking cancels the effects of the common non-controllable factors and provides better information about the manager’s performance.

Solutions to exercises 19.11

ROI and residual profit. (10–15 min)

ROI Operating profit

=

Operating profit Investment

=

ROI × Investment

[No. of menhirs sold (Selling price – Var. cost per unit)] – Fixed costs = ROI × Investment Let X = minimum selling price per unit to achieve a 20% ROI. 1

2

10,000 (X – €300) – €1,000,000 = 20% (€1,600,000) 10,000X = €320,000 + €3,000,000 = €4,320,000 X = €432 10,000 (X – €300) – €1,000,000 10,000X

X 19.12

=

15% (€1,600,000)

= =

€240,000 + €4,240,000

=

€424

€3,000,000

+

€1,000,000

+

€1,000,000

Pricing and return on investment. (30 min) 1

ROI

=

20%

=

Operating profit =

Operating profit Investment Operating profit €900,000,000

€180,000,000

Target revenues: Fixed overhead

€300,000,000

Variable costs, 1,000,000 × €1,320 Desired operating income Revenues

1,320,000,000 180,000,000 €1,800,000,000

Operating profit as a percentage of revenues is €180,000,0 00 or 10%. €1,800,000 ,000

The selling price per unit is €1,800,000,000 ÷ 1,000,000 units = €1,800.

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2 ROI at various sales volumes over 3 years 1,000,000*

Units sold Revenues, €1,800 per unit Variable costs, €1,320 per unit Fixed costs Total costs Operating profit Return on investment

€1,800** 1,320 300 1,620 € 180 20%

1,500,000*

500,000*

€2,700** 1,980 300 2,280 €420 46.67%

€900** 660 300 960 €(60) –6.67%

*Row not directly used in calculations. **All revenues, costs and operating profit are in millions of euros.

A summary analysis of these three cases follows: Volume 1,000,000 1,500,000 500,000

3

Operating Profit Revenues

×

Revenues Total Assets

10.00%

×

2

15.55%

×

3

–6.67%

×

1

Return on investment 20.00% 46.65% –6.67%

One year may often be too short a time span in the use of an operating income measure for gauging performance or for paying bonuses. For instance, motorcycle sales may be heavily influenced by general economic conditions that are not controllable by the division managers whose bonuses are significantly affected thereby. Also, some short-run savings in manufacturing costs may have long-run damaging effects. Examples include repairs, maintenance, quality control and exerting severe pressures on employees for productivity. Thus, the heir to the third manager may have much justification for being unhappy with any bonus plan that is tied solely to a one-year operating income measure.

19.14

Ethics, manager’s performance evaluation. (25 min) 1 Sales 1,800,000 x €2 Cost of goods sold Variable costs 1,800,000 x €0.50 Fixed costs (1,800,000 x €0.78*) Gross margin Selling and administrative costs Operating income Bonus at 15% of €646,000

€3,600,000 900,000 1,404,000 1,296,000 650,000 € 646,000 €96,900

*€1,950,000 ÷ 2,500,000 = €0.78.

2

No. Pirelli did not do as good a job as the numbers in requirement 1 suggest. For example, had he produced only 1,800,000 cups (the quantity of cups sold), fixed costs included as part of cost of goods sold would have increased to €1,950,000. Currently €0.78 × 700,000 units = €546,000 of fixed-overhead costs are stocked, 288 © Pearson Education Limited 2012

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which has the effect of increasing operating income. Note that since there was no opening stock, the fixed cost in stock can also be calculated as €1,950,000 – €1,404,000 (included in cost of goods sold) = €546,000. If the operating income is adjusted by this amount, 2005 profits would be €646,000 – €546,000 = €100,000 and Pirelli’s bonus would be 15% of 100,000 = €15,000, not €96,900. 3

19.16

Pirelli’s behaviour is not ethical. Professional managers are expected to take actions that are in the best interests of their shareholders. Pirelli’s action benefited himself at the cost of shareholders. Pirelli’s actions are equivalent to ‘cooking the books’, even though he achieved this by producing more stock than was needed, rather than through fictitious accounting. Some students might argue that Pirelli’s behaviour was not unethical – he simply took advantage of the faulty contract the board of directors had given him when he was hired.

Financial and non-financial performance measures, goal congruence. (25 min) 1

Operating income is a good summary measure of short-term financial performance. By itself, however, it does not indicate whether operating income in the short run was earned by taking actions that would lead to long-run competitive advantage. For example, Thor-Equip’s divisions might be able to increase short-run operating income by producing more product while ignoring quality or rework. Knut, however, would like to see division managers increase operating income without sacrificing quality. The new performance measures take a balanced scorecard approach by evaluating and rewarding managers on the basis of direct measures (such as rework costs, on-time delivery performance and sales returns). These motivate managers to take actions that Knut believes will increase operating income now and in the future. The non-operating income measures serve as surrogate measures of future profitability.

2

The semi-annual installments and total bonus for the Kari Division are calculated as follows: Kari Division Bonus Calculation for the year ended 31 December 2004 1 January 2011 to 30 June 2011

Profitability

(0.02) (€462,000)

€9,240

Rework

(0.02 × €462,000) – €11,500

(2,260)

On-time delivery

No bonus – under 96%

Sales returns

[(0.015 v €4,200,000) – €84,000] × 50%

Semi-annual installment

0 (10,500) (3,520)

Semi-annual bonus awarded

€0 1 July 2011 to 31 December 2011

Profitability

(0.02) (€440,000)

€8,800

Rework

(0.02 × €440,000) – €11,000

(2,200)

On-time delivery

96–98%

Sales returns

[(0.015 v €4,400,000) – €70,000] × 50%

Semi-annual installment

2,000 (2,000) 6,600

Semi-annual bonus awarded

€ 6,600

Total bonus awarded for the year

€ 6,600

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The semi-annual installments and total bonus for the Siri Division are calculated as follows: Siri Division Bonus Calculation for year ended 31 December 2004 1 January 2011 to 30 June 2011 Profitability

(0.02) (€342,000)

Rework

(0.02 × €342,000) – €6,000

On-time delivery

Over 98%

Sales returns

[(0.015 × €2,850,000) – €44,750] × 50%

€ 6,840 0 5,000 (1,000)

Semi-annual bonus installment

€10,840

Semi-annual bonus awarded

€10,840

1 July 2011 to 31 December 2011 € 8,120

Profitability

(0.02) (€406,000)

Rework

(0.02 × €406,000) – €8,000

0

On-time delivery

No bonus – under 96%

0

Sales returns

[(0.015 × €2,900,000) – €42,500] which is greater than zero, yielding a bonus of

3,000

Semi-annual bonus installment

€11,120

Semi-annual bonus awarded

€11,120

Total bonus awarded for the year

€21,960

3

The manager of the Kari Division is likely to be frustrated by the new plan as the division bonus is more than €20,000 less than in the previous year. However, the new performance measures have begun to have the desired effect – both on-time deliveries and sales returns improved in the second half of the year while rework costs were relatively even. If the division continues to improve at the same rate, the Kari bonus could approximate or exceed what it was under the old plan. The manager of the Siri Division should be as satisfied with the new plan as with the old plan as the bonus is almost equivalent. However, there is no sign of improvements in the performance measures instituted by Knut in this division; as a matter of fact, on-time deliveries declined considerably in the second half of the year. Unless the manager institutes better controls, the bonus situation may not be as favourable in the future. This could motivate the manager to improve in the future but currently, at least, the manager has been able to maintain his bonus without showing improvements in the areas targeted by Knut. Knut’s revised bonus plan for the Kari Division fostered the following improvements in the second half of the year despite an increase in sales: •

increase of 1.9% in on-time deliveries

•

€500 reduction in rework costs

•

€14,000 reduction in sales returns.

However, operating income as a percentage of sales has decreased (11–10%).

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The Siri Division’s bonus has remained at the status quo as a result of the following effects: •

an increase of 2.0% in operating income as a percentage of sales (12–14%)

•

decrease of 3.6% in on-time deliveries

•

€2,000 increase in rework costs

•

€2,250 decrease in sales returns.

This would suggest that there needs to be some revision to the bonus plan. Possible changes include:

19.17

•

Increasing the weights put on on-time deliveries, rework costs and sales returns in the performance measures whereas decreasing the weight put on operating income.

•

A reward structure for rework costs that are below 2% of operating income that would encourage managers to drive costs lower.

•

Reviewing the year in total. The bonus plan should carry forward the negative amounts for one six-month period into the next six-month period, incorporating the entire year when calculating a bonus.

•

Developing benchmarks and then giving rewards for improvements over prior periods and encouraging continuous improvement.

Risk sharing, incentives, benchmarking, multiple tasks. (20–30 min) 1 a

An evaluation of the three proposals to pay Manuel Belem, the general manager of the Portimão Division is as follows: i

Paying Manuel a flat salary will not subject him to any risk, but will provide no incentives for him to undertake extra physical and mental effort.

ii

Rewarding Manuel only on the basis of Portimão Division’s ROI would motivate him to put in extra effort to increase ROI because his rewards would increase with increases in ROI. But compensating Manuel solely on the basis of ROI subjects him to excessive risk, because the division’s ROI depends not only on his effort, but also on other random factors over which he has no control. For example, Manuel may put in a great deal of effort, but despite this effort, the division’s ROI may be low because of adverse factors (such as high interest rates or a recession) that he cannot control. To compensate Manuel for taking on uncontrollable risk, Amica must pay him additional amounts within the structure of the ROI-based arrangement. Thus, compensating Manuel only on the basis of performance-based incentives will cost Amica more money, on average, than paying him a flat salary. The key question is whether the benefits of motivating additional effort justify the higher costs of performance-based rewards. Furthermore, the objective of maximising ROI may induce Manuel to reject projects that, from the viewpoint of the organisation as a whole, should be accepted. This would occur for projects that would reduce Manuel’s overall ROI but which would earn a return greater than the required rate of return for that project.

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iii The motivation for having some salary and some performance-based bonus in compensation arrangements is to balance the benefits of incentives against the extra costs of imposing uncontrollable risk on the manager. b

Manuel’s complaint does not appear to be valid. The senior management of Amica is proposing to benchmark Manuel’s performance using a relative performance evaluation (RPE) system. RPE controls for common uncontrollable factors that similarly affect the performance of managers operating in the same environments (for example, the same industry). If business conditions for car battery manufacturers are good, all businesses manufacturing car batteries will probably perform well. A superior indicator of Manuel’s performance is how well he performed relative to his peers. The goal is to filter out the common noise to get a better understanding of Manuel’s performance. His complaint will only be valid if there are significant differences in investments, assets and the business environment in which Amica and Tiara operate. Given the information in the problem, this does not appear to be the case.

2

Superior performance measures change significantly with the manager’s performance and not very much with changes in factors that are beyond the manager’s control. If Manuel has no authority for making capital investment decisions, then ROI is not a good measure of his performance – it varies with the actions taken by others rather than the actions taken by him. Amica may wish to evaluate Manuel on the basis of operating income rather than ROI. ROI, however, may be a good measure to evaluate Portimão’s economic viability. Senior management at Amica could use ROI to evaluate if the Portimão Division’s income provides a reasonable return on investment, regardless of who has authority for making capital investment decisions. That is, ROI may be an inappropriate measure of Manuel’s performance but a reasonable measure of the economic viability of the Portimão Division also. If, for whatever reasons such as bad capital investments, weak economic conditions, etc., the Division shows poor economic performance, as calculated by ROI, Amica management may decide to shut down the Division even though they may simultaneously conclude that Manuel performed well.

3

19.18

There are two main concerns with Manuel’s plans. First, creating very strong sales incentives imposes an excessive risk on the sales force, because a salesperson’s performance is affected not only by his or her own effort, but also by random factors (such as a recession in the industry) that are beyond the salesperson’s control. If salespersons are risk averse, the firm will have to compensate them for bearing this extra uncontrollable risk. Second, compensating salespersons only on the basis of sales creates strong incentives to sell, but may result in lower levels of customer service and sales support (this is what happened at Sears car repair workshops where a change in the contractual terms of mechanics to ‘produce’ more repairs caused unobservable quality to be negatively affected). Where employees perform multiple tasks, it may be important to ‘blunt’ incentives on those aspects of the job that can be measured well (for example, sales) to try and achieve a better balance of the two tasks (for example, sales and customer service and support). In addition, the Division should try to better monitor customer service and customer satisfaction through surveys or through quantifying the amount of repeat business.

Relevant costs, performance evaluation, goal congruence. (30 min)

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This exercise illustrates the dysfunctional behaviour that could be motivated by arbitrary allocations of corporate overhead to profit-conscious divisional managers. 1

Without the €800,000 in sales from the low-margin product line in the Tampere Division, the second quarter operating statements (in thousands) will be: Net sales Cost of sales Divisional overhead Divisional contribution Corporate overhead Operating income

Tampere

Oulu

Kotka

Total

€1,200 450 150 600 288 € 312

€1,200 540 125 535 288 € 247

€1,600 640 160 800 384 € 416

€4,000 1,630 435 1,935 960 € 975

2

The company is worse off as a result of dropping the low-profitability line of products because it has lost €100,000 in contribution margin from the dropped product line with no reduction in corporate overhead. Total operating income decreases from €1,075,000 in the first quarter to €975,000 in the second quarter.

3

The Tampere Division manager’s performance evaluation measure (divisional operating income) is higher (€312,000 in the second quarter compared with €300,000 in the first quarter) as a result of dropping the low-profitability product line. The Tampere Division manager is able to show a €12,000 higher operating income because the €100,000 in lost contribution margin from the dropped product line is more than offset by the €112,000 reduction in corporate overhead that is charged to the Tampere Division. Tampere Division sales are now only 30% of corporate sales rather than the previous 41.7% of sales (so 30% of total corporate overhead costs of €960,000 equalling €288,000 are allocated to the Tampere Division in the second quarter, whereas 41.7% of €960,000 equalling €400,000 were allocated to the Tampere Division in the first quarter).

4

The easiest solution is to not allocate fixed corporate overhead to divisions. Then the problem of dysfunctional behaviour will not arise. But central management may want the division managers to ‘see’ the cost of corporate operations so that they will understand that the corporation as a whole is not profitable unless the combined divisions’ contribution margins exceed corporate overhead. In this case, an allocation basis should be chosen that is not manipulable or under the control of division managers. It must also have the property that the action taken by one division does not affect the corporate overhead allocations that get made to the other divisions (as occurred in the second quarter for the company). In general, a lump-sum allocation based on, say, budgeted net income or budgeted assets, rather than an allocation that varies proportionately with an actual measure of activity (such as sales or actual net income) will minimise dysfunctional behaviour. The allocation should be such that managers treat it as a fixed, unavoidable charge, rather than a charge that will vary with the decisions they take. Of course, a potential disadvantage of this proposal is that managers may try to underbudget the amounts that serve as the cost-allocation bases, so that their divisions get less of the corporate overhead charges.

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19.20

ROI, residual income, investment decisions, division manager’s compensation. (50 min) 1

Average investment in operating assets employed: Balance at 31 December 2011

€15,750,000

Balance at 31 December 2010 (€15,750,000 ÷ 1.05) Opening balance plus closing balance

€30,750,000

Average balance (€30,750,000 ÷ 2)

€15,375,000

ROI

= =

2

15,000,000

Income from operations before income taxes Average operating assets employed 15,375.000 1,845,000

=

0.12 or 12%

Income from operations before income taxes Minimum return on average operating assets employed: Average operating assets employed (€15,375,000) × Required rate of return on invested capital (0.11) Residual income

€1,845,000

1,691,250 €153,750

3

Yes. Frankfurt Steel’s management probably would have accepted the investment, if residual income were used. The investment opportunity would have lowered Frankfurt Steel’s 2011 ROI because the expected return (11.5%) was lower than the division’s historical returns (11.8% to 14.7%) as well as its actual 2011 ROI (12%). Management rejected the investment because bonuses are based, in part, on the performance measure of ROI. If residual income were used as a performance measure (and as a basis for bonuses), management would accept any and all investments that would increase residual income. Using residual income to reward management would create incentives for managers to accept all investments that have a rate of return in excess of 11%, a decision that is in the best interests of the company as a whole. The investment considered by management in 2011 had a rate of return of 11.5%.

4

Consider each of the four proposals that Frank Weissmann is considering: a

Pay division managers a flat salary independent of division RI: Paying division managers a flat salary has the advantage that it will not subject division managers to any uncontrollable risk. But, this arrangement also suffers from the disadvantage that it will not provide division managers with any incentives to undertake extra physical and mental effort.

b

Compensate managers only on the basis of division RI: The benefit of this arrangement is that managers would be motivated to put in extra effort to increase RI because managers’ rewards would increase with increases in RI. But compensating managers largely on the basis of RI subjects the managers to excessive risk, because each division’s RI depends not only on the manager’s effort but also on the random factors over which the manager has no control. A manager may put in a great deal of effort, but the division’s RI

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may be low because of adverse factors (high interest rates, recession), which the manager cannot control. To compensate managers for taking on uncontrollable risk, Weissmann must pay them additional amounts within the structure of the RI-based arrangement. Thus, using only performance-based incentives will cost Weissmann more money, on average, than paying a flat salary. The key question is whether the benefits of motivating additional effort justify the higher costs of performancebased rewards. Finally, rewarding a manager on the basis of division RI will induce managers to maximise the division’s RI, even if taking such actions are not in the best interests of the company as a whole. This is an important consideration, because the two divisions are vertically integrated with the output of the Frankfurt Steel Division used by the Tool and Die Machinery Division. For example, to maximise the Steel Division’s RI, the manager of the Steel Division may prefer to produce premium alloy steel plates demanded by outside customers, which generate a higher return for the division but hurt the interests of the Machinery Division and Faulkenheim GmbH as a whole. c

Compensate managers largely on the basis of company-wide RI: Rewarding managers on the basis of company-wide RI will motivate managers to take actions that are in the best interests of the company rather than actions that maximise a division’s RI. This issue is particularly relevant because the two divisions are vertically integrated and hence highly interdependent. A negative feature of this arrangement is that each division manager’s compensation will now depend not only on the performance of that division manager but also on the performance of the other division manager. For example, the compensation of the manager of the Frankfurt Steel Division will depend on the Machinery Division manager’s performance, even though the manager of the Steel Division may have little influence over the performance of the Machinery Division. Hence, evaluating division managers on the basis of company-wide RI will impose extra risk on them and increase the cost of compensating them.

d

Compensate each division manager using the other division’s RI as a benchmark: The benefit of benchmarking or relative performance evaluation is to cancel out the effects of common non-controllable factors that affect a performance measure. Taking out the effects of these factors provides better information about management performance. However, for benchmarking and relative performance evaluation to be effective, it is critical that similar non-controllable factors affect each division. It is not clear that the same non-controllable factors that affect the performance of the Steel Division (industry-wide steel capacity, for example) also affect the performance of the Tool and Die Machinery Division. If the non-controllable factors are not the same, then comparing the RI of one division with the RI of the other division will not provide any useful relative performance evaluation information, but will only add noise to division performance measures and hence, impose extra risk on the division managers. Faulkenheim would then have to compensate the managers for bearing this extra risk.

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A second factor for Weissmann to consider is the impact that benchmarking and relative performance evaluation will have on the incentives for the division managers of the Steel and Machinery divisions to cooperate with one another. Benchmarking one division against another means that a division manager will look good by improving his or her own performance or by making the performance of the other division manager look bad. 5

I would propose a compensation arrangement that builds on the various elements described in requirement 4. I would include: (i) a salary component to reduce the risk the division manager is subjected to; (ii) a bonus based on division residual income to provide managers with incentives (the motivation for having some salary and some performance-based bonus in compensation arrangements is to balance the benefits of incentives against the extra costs of imposing uncontrollable risk on the manager); (iii) a small bonus based on company-wide residual income to encourage cooperation and coordination among managers given the integrated and interdependent nature of the two divisions and (iv) a bonus based on the performance of each division manager relative to other steel and tool and die machinery companies. For reasons outlined in requirement 4, I would not use one division’s performance as a benchmark for the other division in this situation.

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PART V

QUALITY, TIME AND THE STRATEGIC MANAGEMENT OF COSTS

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CHAPTER 20

Quality and throughput concerns in managing costs Teaching tips and points to stress Quality as a competitive weapon This discussion of the quality movement links to the customer satisfaction, quality and cost management themes introduced in Chapter 1. The discussion also helps motivate students’ interest in the management accountant’s role in enhancing quality.

Correcting students’ misconceptions Students often mistakenly believe that in considering quality (or other) initiatives, the relevant ‘do nothing’ alternative will maintain the status quo. Such an assumption is unlikely to be accurate because the competitors are unlikely to remain at a standstill.

Points to stress Chapter 20 points out that quality encompasses quality of design, as well as conformance quality. Even if a product meets the manufacturing specifications (i.e. possesses conformance quality), it can still be of poor overall quality if it fails to satisfy customer needs and wants (i.e. has poor design quality). Historically, many Western managers paid relatively little attention to improving quality. Traditional cost accounting systems did not isolate/aggregate costs of poor-quality products. Since these costs were not visible, they were not included in the performance evaluation/reward system. An increasingly important role of management accounting is to compile and make these costs visible to top management. Today, most companies with a quality programme calculate the costs of quality. While quality costs occur in all value-chain functions, most prevention costs occur in R&D/design, whereas most appraisal and internal failure costs occur in manufacturing. External failure costs occur primarily in downstream functions: marketing, distribution and customer service. Prevention appraisal costs are most likely to be reported by accounting systems because they are accrual costs. Internal and external failure costs include many opportunity costs that are difficult to estimate and are typically not captured by accounting systems. If management fails to include all the opportunity costs in a cost of quality (COQ) analysis, they will underestimate failure costs and are likely to underinvest in prevention and appraisal. Accounting systems’ failure to report opportunity costs is likely to contribute to many managers’ underestimation of the costs of producing poor-quality products. Market research and focus groups can help estimate such opportunity costs. 298 © Pearson Education Limited 2012

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The acceptable proportion of defects depends on a cost–benefit analysis. High internal and external failure costs, relative to prevention and appraisal costs, shift the emphasis towards fewer defects. Historically, many companies have underestimated failure costs, partly because they have not considered lost contribution margin (CM) from lost sales due to customer ‘bad will’, or production capacity squandered on spoiled or reworked units. Poor quality can reduce CM in two ways: (a) lost sales due to customer ‘bad will’ and (b) lost sales from wasted production output when the company has a manufacturing constraint. Coverage of the theory of constraints (TOC) later in the chapter continues Chapter 10’s explanation that companies should maximise the CM/unit of the constraining (bottleneck) factor. One way to do this is to reduce the amount of the bottleneck resource consumed by spoiled and reworked units that reduce the time and resources otherwise available to produce good units. If managers’ performance is based on one or two criteria (e.g. quarterly profits), they will act to make their performance look better on these criteria, even though such actions may hurt the company’s long-run profitability (e.g. delaying maintenance). This is why many companies have revised their performance evaluation on several dimensions (e.g. a balanced scorecard approach).

Correcting students’ misconceptions These TOC definitions differ from conventional accounting definitions. TOC’s throughput CM = Sales + DM (rather than Sales − DM). TOC effectively assumes that DL and all OH items are fixed costs. TOC uses the term stock or investment to refer to productive assets, including stock, R&D and PPE. The main point of TOC is consistent with Chapter 10’s prescriptions. When faced with a constraint, the aim is to maximise the CM/unit of the constraining factor. TOC has a short-run orientation, as it considers all costs other than DM to be fixed. In the long run, of course, most such costs are not fixed.

Points to stress The objective is to keep the bottleneck working at capacity. Management should consider (1) giving the bottleneck full-time attendants and (2) running the bottleneck 24 hours a day. TOC suggests that the only place in the plant that should have stock is immediately before the bottleneck, to ensure that the bottleneck stays busy. The opportunity cost of lost throughput contribution arising from quality problems at the bottleneck is an element of internal failure cost. This type of opportunity cost arises only around the bottleneck or constrained resource. Successful quality programmes maintain that it is less expensive to do it right the first time than to fix it later. They focus on preventing poor quality by attacking quality drivers such as training and product design (designing the product to use fewer and more standardised parts, designing in tolerance for variations in the manufacturing process, etc.). This contrasts with traditional use of ex post quality control that relies on inspection, rework and customer service of defective products.

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Solutions to review questions 20.1

Quality costs (including the opportunity cost of lost sales because of poor quality) can be as much as 10–20% of sales revenues of many organisations. Quality-improvement programmes can result in substantial cost savings and higher revenues and market share from increased customer satisfaction.

20.2

Quality of design measures how closely the characteristics of products or services match the needs and wants of customers. Conformance quality measures whether the product has been made according to design, engineering and manufacturing specifications.

20.3

Exhibit 20.1 in Chapter 20 lists the following seven line items in the prevention costs category: design engineering, process engineering, quality engineering, supplier evaluation, equipment maintenance, manufacturing quality training and new materials.

20.4

An internal failure cost differs from an external failure cost on the basis of when the non-conforming product is detected. An internal failure is detected before a product is shipped to a customer, whereas an external failure is detected after a product is shipped to a customer.

20.5

No, companies should emphasise financial as well as non-financial measures of quality, such as yield and defect rates. Non-financial measures are not directly linked to bottomline performance, but they indicate and direct attention to the specific areas that need improvement. Tracking non-financial measures over time directly reveals whether these areas have, in fact, improved over time. Non-financial measures are easy to quantify and easy to understand.

20.6

Customer complaints, on-time delivery rate and delivery delays.

20.7

Process yields, defects per product line and employee turnover.

20.8

Two reasons why lines, queues and delays occur are: (1) uncertainty about when customers will order products or services – uncertainty causes a number of orders to be received at the same time causing delays; and (2) limited capacity and bottlenecks – a bottleneck is an operation where the work required to be performed approaches or exceeds the available capacity.

20.9

No. Adding a product when capacity is constrained and the timing of customer orders is uncertain causes delays in delivering all existing products. If the revenue losses from delays in delivering existing products and the increase in carrying costs of the existing products exceed the positive contribution earned by the product that was added, then it is not worthwhile to make and sell the new product, despite its positive contribution margin. Chapter 20 describes the negative effects (negative externalities) that one product can have on others when products share common manufacturing facilities.

20.10

The three main measures used in the theory of constraints are: 1

Throughput contribution equal to sales revenues minus direct materials costs.

2

Investments (stock) equal to the sum of materials costs of direct materials stock, work-in-progress stock and finished goods stock, research and development costs, and costs of equipment and buildings.

3

Other operating costs equal to all operating costs (other than direct materials) incurred to earn throughput contribution.

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Solutions to exercises 20.11

Cost of quality programme, non-financial quality measures. (15 min) 1

(i) Prevention cost: d

Labour cost of product designer of Zaccaria.

f

Seminar costs for ‘Supplier Day’, a programme aimed at communicating to suppliers the new quality requirements for purchased components.

(ii) Appraisal cost: a

Cost of inspecting products on the production line by Zaccaria quality inspectors.

(iii) Internal failure cost: c

Costs of reworking defective parts detected by Zaccaria quality assurance group.

g

Costs of spoiled parts.

(iv) External failure cost:

2

20.12

b

Payment of travel costs for a Zaccaria customer representative to meet with a customer who detected a defective product.

e

Cost of automotive parts returned by the customer.

Examples of non-financial performance measures Zaccaria could monitor include: •

First-pass calibration yield

•

Outgoing quality yield for each product

•

Percentage of returned merchandise

•

Customer report card

•

Competitive rank

•

On-time delivery.

Quality improvement, relevant costs and revenues, service. (25 min) 1

Additional costs of the new scheduling and tracking system are €160,000 per year.

2

Additional annual benefits of the new scheduling and tracking system are as follows: Additional annual sales from improving on-time performance €20,000 (95% − 85%) Contribution margin from additional annual sales 45% × €200,000 Savings in variable costs per year from fewer cartons Lost or damaged €60 (3,000 − 1,000) Total additional benefits

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€200,000 90,000 120,000 €210,000

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3

Since the expected benefits of €210,000 (requirement 2) exceed the costs of €160,000 (requirement 1), Colombe-Déménagements should invest in the new system. Of course, these calculations assume additional sales and contribution margin from better on-time delivery performance. As long as additional contribution margin of €40,000 (costs of €160,000 – variable cost savings of €120,000) can be realised (corresponding to additional sales of €40,000 ÷ 0.45 = €88,889), investing in the new system is beneficial. Students might also suggest that considering only the variable cost savings as a result of fewer cartons being lost or damaged underestimates these benefits. Reducing the amount of lost or damaged cartons could enhance ColombeDéménagements’ reputation and could lead to higher sales and contribution margin. Other students might argue that the new system may also reduce the time required to transport goods (service quality measure (a)). This too could lead to additional sales and greater contribution margin.

20.13

Theory of constraints, throughput contributions, relevant costs. (15 min) 1

Finishing is a bottleneck operation. Hence, producing 1,000 more units will generate additional throughput contribution and operating income. Increase in throughput contribution (€72 − €32) × 1,000 Incremental costs of the jigs and tools Net benefit of investing in jigs and tools

€40,000 30,000 €10,000

Salamanca should invest in the modern jigs and tools because the benefit of a higher throughput contribution of €40,000 exceeds the cost of €30,000. 2

20.14

The Machining Department has excess capacity and is not a bottleneck operation. Increasing its capacity further will not increase throughput contribution. There is therefore no benefit from spending €5,000 to increase the Machining Department’s capacity by 10,000 units. Salamanca should not implement the change to do set-ups faster.

Theory of constraints, throughput contribution, relevant costs. (15 min) 1

Finishing is a bottleneck operation. Hence, getting an outside contractor to produce 12,000 units will increase throughput contribution. Increase in throughput contribution (€72 − €32) × 12,000 Incremental contracting costs €10 × 12,000 Net benefit of contracting 12,000 units of finishing

€480,000 120,000 €360,000

Salamanca should contract with an outside contractor to do 12,000 units of finishing at €10 per unit because the benefit of higher throughput contribution of €480,000 exceeds the cost of €120,000. The fact that the costs of €10 are double Salamanca’s finishing costs of €5 per unit is irrelevant. 2

Operating costs in the Machining Department of €640,000 or €8 per unit are fixed costs. Salamanca will not save any of these costs by subcontracting machining of 4,000 units to Hunt Corporation. Total costs will be greater by €16,000 (€4 per unit × 4,000 units) under the subcontracting alternative. Machining more filing cabinets will not increase throughput contribution, which is constrained by the finishing capacity. Salamanca should not accept Hunt’s offer. The fact that Hunt’s costs of machining per unit are half of what it costs Salamanca in-house is irrelevant.

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20.16

Costs of quality analysis, non-financial quality measures. (20 min)

1 and 2 Sales

2012 €12,500,000 Percentage of sales Cost (2) = (1) ÷ (1) €12,500,000

Costs of quality Prevention costs Design engineering Preventive maintenance Training Supplier evaluations Total prevention costs

€240,000 90,000 120,000 50,000 500,000

Appraisal costs Line inspection Product-testing equipment Incoming materials inspection Product-testing labour Total appraisal costs

85,000 50,000 40,000 75,000 250,000

Internal failure costs Scrap Rework Breakdown maintenance Total internal failure costs

175,000 135,000 40,000 350,000

External failure costs Returned goods Customer support Product liability claims Warranty repair Total external failure costs Total costs of quality

145,000 30,000 100,000 200,000 475,000 €1,575,000

2011 €10,000,000 Percentage of sales Cost (4) = (3) ÷ (3) €10,000,000

4.0%

€100,000 35,000 45,000 20,000 200,000

2.0%

2.0%

110,000 50,000 20,000 220,000 400,000

4.0%

2.8%

250,000 160,000 90,000 500,000

5.0%

3.8% 12.6%

60,000 40,000 200,000 300,000 600,000 €1,700,000

6.0% 17.0%

Between 2011 and 2012, Alcazarquivir’s costs of quality have declined from 17% of sales to 12.6% . The analysis of individual costs of quality categories indicates that Alcazarquivir began allocating more resources to prevention activities – design engineering, preventive maintenance, training and supplier evaluations in 2012 relative to 2011. As a result, appraisal costs declined from 4% of sales to 2%, costs of internal failure fell from 5% of sales to 2.8% and external failure costs decreased from 6% of sales to 3.8%.

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3

20.17

Examples of non-financial quality measures that Alcazarquivir could monitor are: a

Number of defective grinders shipped to customers as a percentage of total units of grinders shipped.

b

Ratio of good output to total output at each production process.

c

Employee turnover.

Quality improvement, relevant costs and relevant revenues. (25 min) 1

Incremental costs over the next year of choosing the new lens = €50 × 20,000 copiers = €1,000,000.

2 Incremental benefits over the next year of choosing the new lens Costs of quality items Savings on rework costs €1,600 × 300 fewer copiers reworked Savings in customer-support costs €80 × 200 fewer copiers repaired Savings in transportation costs for parts €180 × 200 fewer copiers repaired Savings in warranty repair costs €1,800 × 200 fewer copiers repaired Opportunity costs Contribution margin from increased sales 100 × €6,000 Cost savings and additional contribution margin

3

€480,000 16,000 36,000 360,000

600,000 €1,492,000

Since the expected benefits of €1,492,000 (requirement 2) exceed the costs of the new lens of €1,000,000 (requirement 1), Braganza should introduce the new lens. Note that the opportunity cost benefits in the form of higher contribution margin from increased sales is an important component for justifying the investment in the new lens. The incremental cost of the new lens of €1,000,000 is greater than the incremental savings in rework and repair costs of €892,000. Investing in the new lens is beneficial provided it generates additional contribution margin of, at least, €108,000 (€1,000,000 − €892,000), that is, additional sales of at least €108,000 ÷ €6,000 = 18 copiers.

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20.18

Quality improvement, relevant costs and relevant revenues. (30 min)

One way to present the alternatives is via a decision tree as shown below.

Make T971 Implement new design

Do not make T971

Do not implement new design The idea is to first evaluate the best action that Carmody should take if it implements the new design (that is, make or not make T971). Carmody can then compare the best mix of products to produce if it implements the new design against the status quo of not implementing the new design. 1

Carmody has capacity constraints. Demand for V262 valves (370,000 valves) exceeds production capacity of 330,000 valves (3 valves per hour × 110,000 machinehours). Since capacity is constrained, Carmody will choose to sell the product that maximises contribution margin per machine-hour (the constrained resource). Contribution margin per machine-hour for V262 =

€8 per valve × 3 valves per hour = €24

Contribution margin per machine-hour for T971 =

€10 per valve × 2 valves per hour = €20.

Carmody should reject Clohisey’s offer and continue to manufacture only V262 valves. 2

Now, compare the alternatives of (1) not implementing the new design versus (2) implementing the new design. By implementing the new design, Carmody will save 10,000 machine-hours of rework time. This time can then be used to make and sell 30,000 (3 values per hour × 10,000 hours) additional V262 valves. The relevant costs and benefits of implementing the new design are as follows: The relevant costs of implementing the new design

€(315,000)

Relevant benefits: a

Savings in rework costs (€3a per V262 valve × 30,000 valves)

b

Additional contribution margin from selling another 30,000 V262 valves (3 valves per hour × 10,000 hours) because capacity previously used for rework is freed up (€8 per valve × 30,000 units)

240,000

Net relevant benefit (cost)

€15,000

a

90,000

Note that the fixed rework costs of equipment rent and allocated overhead are irrelevant because these costs will be incurred whether Carmody implements or does not implement the new design.

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Carmody should implement the new design since the relevant benefits exceed the relevant costs by €15,000. 3

20.20

Carmody should also consider other benefits of improving quality. For example, the process of quality improvement will help Carmody’s managers and workers gain expertise about the product and the manufacturing process that may lead to further cost reductions in the future. Improving quality within the plant is also likely to translate into delivering better-quality products to customers. The increased reputation and customer goodwill may well lead to higher future revenues through greater unit sales and higher sales prices.

Theory of constraints, throughput contribution, quality, relevant costs. (30–40 min)

Direct materials costs to produce 390,000 tablets = €156,000 €156,000 Direct materials costs per tablet = = €0.40 per tablet €390,000 Selling price per tablet = €1.00 1

Unit throughput contribution = Selling price − Unit direct materials costs = €1.00 − €0.40 = €0.60 per tablet Tablet making is a bottleneck operation. Hence, producing 19,500 more tablets will generate additional operating income. Additional operating income per contractor-made tablet

=

Unit throughput contribution

−

Additional operating costs per tablet

= €0.60 − €0.12 = €0.48 Increase in operating income, €0.48 × 19,500 = €9,360. Hence, Lappalainen should accept the outside contractor’s offer. Increase in operating income, €0.48 × 19,500 = €9,360. Hence, Lappalainen should accept the outside contractor’s offer.[AQ17] 2

Operating costs for the Mixing Department are a fixed cost. Contracting out the mixing activity will not reduce Mixing Department costs but will cost an additional €0.07 per gram of mixture. Mixing more direct materials will have no effect on throughput contribution since tablet making is the bottleneck operation. Therefore, Lappalainen should reject the company’s offer.

3

The benefit of improved quality is €10,000. Lappalainen is using the same quantity of direct materials as before, so it incurs no extra direct materials costs. The 10,000 extra tablets produced generate additional revenue of €10,000 (€1 × 10,000 tablets) a month. The modification costs €7,000 per month, which results in a net gain of €3,000.

4

Cost per gram of mixture =

€156, 000 = €0.78 per gram 200,000

Cost of 10,000 grams of mixture = €0.78 × 10,000 = €7,800 Benefit from better mixing quality

€7,800 per month

Cost of improving the mixing operation

€9,000 per month

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Since the costs exceed the benefits by €1,200 per month, Lappalainen should not adopt the proposed quality-improvement plan. 5

20.21

Compare the answers to requirements 3 and 4. The benefit of improving quality at the mixing operation is the savings in materials costs. The benefit of improving quality of the Tablet-Making Department (the bottleneck operation) is the savings in materials costs plus the additional throughput contribution from higher sales that result from relieving the bottleneck constraint.

Ethics and quality. (30–35 min) 2012

Sales

Costs of quality Prevention costs Design engineering

2011

€90,000,000 Percentage of sales Cost (2) = (1) ÷ (1) €90,000,000 €1,800,000

€80,000,000 Percentage of sales Cost (4) = (3) ÷ (3) €80,000,000

2.0%

€800,000

1.0%

2.0%

Appraisal costs On-line inspection Product testing Total appraisal costs

700,000 2,000,000 2,700,000

3.0%

600,000 1,000,000 1,600,000

Internal failure costs Scrap

2,160,000

2.4%

2,000,000

2.5%

External failure costs Warranty liability

2,250,000

2.5%

3,600,000

4.5%

€8,910,000

9.9%

€8,000,000

10.0%

Total costs of quality

2

Kiruna has made the correct shift in quality management by investing more in prevention and appraisal while reducing external failure costs. However, it still needs to reduce costs in all costs of quality categories by becoming more efficient in its prevention and appraisal activities and more effective in implementing these programmes to reduce failure costs.

3

Incorrect reporting of the costs of quality and various non-financial measures of quality with the goal of winning various quality awards is unethical. In assessing the situation, some elements of Ethical Guidelines that the management accountant could consider are listed below.

Competence

Clear reports using relevant and reliable information should be prepared. Preparing reports on the basis of incorrect costs of quality numbers in order to make the company’s quality performance look better than it is violates competence standards. It is unethical for Törnman to suggest that Lantto change the costs of quality and non-financial measures of quality numbers in order to make the plant’s performance look good.

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Integrity

The management accountant has a responsibility to avoid actual or apparent conflicts of interest and advise all appropriate parties of any potential conflict. Törnman’s motivation for wanting Lantto to revise the quality figures could well have been motivated by Törnman’s desire to please the plant manager. This action could be viewed as violating the responsibility for integrity. The Standards of Ethical Conduct require the management accountant to communicate unfavourable as well as favourable information. In this regard both Törnman’s and Lantto’s behaviour (if Lantto agrees to modify the costs of quality numbers) could be viewed as unethical. Objectivity

The management accountant’s standards of ethical conduct require that information should be fairly and objectively communicated and that all relevant information should be disclosed. From a management accountant’s standpoint, adjusting the quality numbers to make quality performance look good would violate the standard of objectivity. For the various reasons cited above, we should take the position that Törnman’s and Lantto’s behaviour (if Lantto goes along with Törnman’s wishes) is unethical. Lantto should indicate to Törnman that the costs of quality and non-financial measures of quality presented in the reports are indeed appropriate. If Törnman still insists on modifying the quality numbers and reporting better quality figures, Lantto should raise the matter with one of Törnman’s superiors, other than Töyrä, who happens to have a vested interest in this dispute. If, after taking all these steps, there is continued pressure to overstate quality performance, Lantto should consider resigning from the company, and not engage in unethical behaviour.

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CHAPTER 21

Accounting for just-in-time systems Teaching tips and points to stress Just-in-time systems Correcting students’ misconceptions

Many students believe JIT is simply a stock reduction tool. However, as the five major features of JIT reveal, JIT is a broad management philosophy that is much more extensive than simply a focus on stock reduction. Stock reduction is just one among many results of JIT. Example

As production processes changed, many conventional manufacturing companies made ‘quickfix’ accommodations in plant layout. The resulting flow of production was often illogical and haphazard, so it was difficult for management to see what was happening by walking around the plant. For such a company, a major benefit of JIT implementation is the complete reorganisation of the plant into manufacturing cells. For example, in a company that supplies bumpers to Toyota, ‘the goal is for a piece of raw steel to come in one end of (the) building and go out the other side the same day as a finished bumper. With the old layout, bumpers would be stamped, ride on forklifts to a storage area at the far end of the plant and – days later – return to the weld station. (After implementation of JIT,) bumpers go from (the) process of (stamping to) welding with only a brief stop between’. This streamlined production process reduces non-value-added activities (e.g. stock storage and moving) and makes value-added activities more visible and amenable to control. Correcting students’ misconceptions

JIT is not a panacea. If a company tries to implement JIT before straightening out its production process and supplier relations, extensive downtime is likely to occur. The resulting problems are not caused by JIT per se, but rather by inappropriate implementation of JIT. Points to stress

Management’s ability to reduce manufacturing lead time is to some extent a function of the production process. In automotive, computer and consumer electronics industries, companies such as Toyota, Hewlett-Packard, Siemens and Sony have significantly reduced manufacturing lead time. In contrast, producers of products such as wine or ocean liners are unlikely to reduce manufacturing lead time significantly. Recent research has shown that JIT adopters’ stock declines more than non-adopters’ stock, and this difference is most significant for WIP since it is totally within the adopters’ control. The

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more interesting question is whether this and other benefits outweigh the costs of JIT, thereby increasing adopters’ profitability. Early results are mixed, but evidence suggests that if the adopter has a major customer, that customer may have extracted any benefits of JIT in the form of price concessions. In contrast, adopters with no major customers were more likely to retain the financial benefits of JIT, and their profitability was enhanced relative to non-adopters (Balakrishnan, R., Linsmeier, T. J. and Venkatchalam M. (1996) ‘Financial benefits from JIT adoption: Effects of customer concentration and cost structure,’ The Accounting Review (April): 183–205). The subsection on product-costing benefits of JIT points out that JIT can increase the accuracy of product costing by (1) eliminating activities that generate indirect costs (e.g. warehousing, material handling), and (2) increasing direct tracing of costs formerly classified as OH (e.g. costs of set-ups and maintenance performed by multiskilled workers can be traced directly to the manufacturing cell).

Backflush costing Teaching tips

Backflush costing arose as an attempt to streamline and remove non-value-added activities from cost accounting systems. (Sequential tracking is non-value-added – it does not make much difference – provided that stocks are low or stable.) Ask students, ‘Are the simplifications in backflush costing inconsistent with the recent focus on obtaining more accurate product costs for internal decisions (e.g. ABC), and increased emphasis on more accurate cost allocations?’ Not necessarily. First, many managers spend their limited resources on developing more accurate product-cost data for management decision making (e.g. a multiple cost pool and multiple allocation base ABC system). Managers may not want to spend as much on complex ledger systems that are designed primarily to allocate manufacturing costs between stock and CGS accounts, since a fairly rough allocation may be ‘good enough’ for external reporting purposes, particularly if stocks are low or stable. Second, management sacrifices little accuracy if they use a detailed ABC system unit cost to calculate a relatively accurate budgeted conversion cost per unit, which is then used in the backflush costing system. Points to stress

In a JIT/backflush costing system, cost control shifts away from the accounting entries in the general ledger (e.g. variances) towards critical physical measures quickly available on the factory floor (e.g. percentage of defects, schedule attainment).

Managing goods for sale in retail organisations Points to stress

This focus on retail organisations illustrates the attention in Chapter 21 to the merchandising sector. Management accounting is not a synonym for manufacturing accounting. For example, the paper-thin net income percentage illustrates why retail grocers expect store managers to control shrinkage. An increase in sales volume (which contributes only a small profit margin)

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may have less effect on operating income than an improved shrinkage performance (where the grocer saves the entire cost of stock that formerly vanished). The advantages of the EOQ model are that it is very simple and it captures important trade-offs between ordering costs and carrying costs. However, the model is based on the simplifying assumption that the other three costs associated with goods for sale are irrelevant. This is valid if the purchase cost/unit is unaffected by the number of units ordered (e.g. there are no quantity discounts); if quality is unaffected by the number purchased (e.g. perishability is not an important consideration); and if no stockouts occur (e.g. the cost of stockouts is so high that management always maintains sufficient safety stock). Correcting students’ misconceptions

Carrying costs are higher than what students expect. Many companies believe that annual carrying costs exceed 30% of the stock purchase cost. Teaching tips

Students with a quantitative background will be interested in the derivative of the EOQ model. EOQ determines the order quantity (Q) that minimises the total purchase order and carrying costs:

DP

DP QC + Q 2

Using differential calculus to obtain a minimum of the TC function with respect to Q, d − DP C TC = 2 + = 0 Q dQ 2 C DP = 2 Q2

Q=

2 DP C

(Note also that the second derivative is positive.) Curriculum linkage

Students may be familiar with EOQ, safety stock and recorder points from finance courses. However, in those courses, the costs were assumed. Accountants help (1) to decide what costs should be included in these calculations as relevant costs and (2) to estimate the amounts of these costs. Particularly for low-value items, companies often use simple signals such as painted lines on a bin to prompt a reorder. The intuition behind the reorder point is that there is a need to reorder when the amount of stock on hand just equals that which is needed to cover sales that will occur during the purchase-order lead time.

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Points to stress

The EOQ model trades off order costs versus carrying costs, assuming that there are no stockouts. One reason for there being no stockouts is the existence of sufficient safety stock. Safety stock calculations trade off stockout costs versus carrying costs. Quantifying the opportunity cost component of stockout costs is necessarily subjective. A stockout may cause the loss of a whole series of orders, particularly if the customer uses JIT and ends up switching to another supplier. Estimation of EOQ models and safety stock levels requires data that most accounting systems do not routinely provide. In this case, the accountant must do a special analysis to estimate the opportunity cost of capital invested in stock and the lost CM from current and future sales lost due to stockouts. JIT adopters often strive to minimise global rather than local costs by employing total valuechain analysis (one of the five management themes introduced in Chapter 1). Suppliers and customers are considered as part of the value chain. In evaluating and choosing suppliers, quality and timely delivery become increasingly important as the emphasis shifts away from minimising purchase costs and towards minimising costs across the entire value chain (e.g. minimising the sum of production costs, warranty costs, opportunity costs from lost current or future sales due to quality or delivery problems, etc.). When a customer adopts JIT, the supplier’s reaction will depend on the supplier’s manufacturing process. If the supplier has already adopted (or is about to adopt) JIT, then the supplier is likely to prefer JIT customers. These customers want frequent small deliveries, which help smooth the supplier’s production. In contrast, if the supplier is a traditional large-batch manufacturer, it will be costly to deliver many small orders, unless the supplier also streamlines production. This explains why large JIT customers often encourage their major suppliers to adopt JIT. The EOQ model discussed in relation to purchasing from outside suppliers can also be used to determine optimal batch size by recognising that manufacturing set-up costs are analogous to ordering costs.

Stock costs and their management in manufacturing organisations Personal observation is often more effective in JIT plants than in traditional plants. A JIT plant’s production process layout is streamlined and logically laid out, and operations are not obscured by piles of stock or rework. Such plants are easier to evaluate visually than cluttered plants where the flow of production proceeds haphazardly across the plant.

Solutions to review questions 21.1

A demand-pull system (like a just-in-time production system) is one in which demand triggers each step of the production process, starting with customer demand for a finished product at one end of the process and working all the way back to the demand for direct materials at the other end of the process. Demand pulls a product through the production line. A push-through system, often described as a materials requirement

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planning (MRP) system, uses: (a) demand forecasts for the final products; (b) a bill of materials outlining the materials, components and subassemblies for each final product; and (c) the quantities of materials, components, subassemblies and product stocks to predetermine the necessary outputs at each stage of production. 21.2

21.3

21.4

21.5

21.6

The five major features of JIT production systems are: 1

Production is organised in manufacturing cells, a grouping of all the different types of equipment used to manufacture a given product.

2

Workers are trained to be multiskilled so that they are capable of performing a variety of operations and tasks.

3

Total quality management is aggressively pursued to eliminate defects.

4

Emphasis is placed on reducing set-up time and manufacturing lead time.

5

Suppliers are carefully selected to obtain delivery of quality-tested parts in a timely manner.

JIT can afford product costing by showing: 1

Lower investment in stock.

2

Reductions in carrying and handling costs of stock.

3

Lower investment in plant space for stock and production.

4

Reduction in set-up costs and total manufacturing costs.

5

Reductions in costs of waste and spoilage as a result of improved quality.

Companies adopting backflush costing often meet the following conditions: a

Management wants a simple accounting system.

b

Each product has a set of budgeted or standard costs.

c

Backflush costing yields approximately the same financial results as sequential tracking would generate.

Backflush costing systems can differ in both the number and the placement of trigger points for making journal entries in the accounting system: Example

Number of journal entry trigger points

Location of journal entry trigger points

1

2

1 2

Purchase of direct (raw) materials Completion of good finished units of product

2

2

1 2

Purchase of direct (raw) materials Sale of good finished units of product

3

1

1

Completion of good finished units of product

Five assumptions made when using the simplest version of the EOQ model are: 1

The same fixed quantity is ordered at each reorder point.

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2

Demand, ordering costs, carrying costs and the purchase-order lead time are certain.

3

Purchasing costs per unit are unaffected by the quantity ordered.

4

No stockouts occur.

5

Costs of quality are considered only to the extent that these costs are components of ordering costs or carrying costs.

21.7

Costs included in the carrying costs of stock are incremental costs for such items as insurance, rent, obsolescence, spoilage and breakage plus the opportunity cost of capital (or required return on investment).

21.8

Safety stock is held as a buffer against stockouts occurring because of unexpected increases in demand or lead time and unavailability of stock from suppliers. It is not a needless tie-up of capital in stock. The optimal safety stock trades off carrying and stockout costs.

21.9

Two cost factors that can lead organisations to make smaller and more frequent purchase orders are: 1

A decrease in the estimated cost of placing each purchase order.

2

An increase in the estimated cost of holding goods in stock.

Recognition of how costs of quality increase with higher stock levels is also motivating organisations to make smaller and more frequent purchase orders. 21.10

Advocates of JIT view stock system as a negative one. Stock obscures problems in production that should be solved. By allowing work in progress to accumulate, problems causing defective units are not immediately solved. Stock has a host of associated costs (warehouse facilities, insurance, breakage and so on) that do not directly contribute to the production or sale of high-quality goods or products. Stockrelated costs are regarded as wasteful and non-value-added.

Solutions to exercises 21.12

Backflush, second trigger is sale. (20 min) 1

Journal entries for August are as follows: Entry (a)

Entry (b)

Entry (d)

Inventory control Accounts payable control (raw materials and components purchased)

550,000

Conversion costs control Various accounts (such as Accounts payable control and Wages payable) (conversion costs incurred)

440,000

550,000

Cost of goods sold 900,000 Inventory control Conversion costs allocated (standard costs of 20,000 units sold at €45 per unit; direct materials €25 per unit; conversion costs, €20 per unit)

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500,000 400,000

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Entry (e)

21.13

Conversion costs allocated Cost of goods sold Conversion costs control

440,000

Backflush, one trigger point. (20 min) 1

Journal entries for August are as follows: Entry (b)

Entry (c)

Entry (d)

Entry (e)

Conversion costs control Various accounts (such as Accounts payable control and Wages payable) (conversion costs incurred)

440,000

Finished goods control Accounts payable control Conversion costs allocated (standard costs of 21,000 units of finished goods produced at €45 per unit; direct materials, €25 per unit; conversion costs, €20 per unit)

945,000

Conversion costs allocated Cost of goods sold Conversion costs control (underallocated conversion costs written off)

EOQ for a retailer. (15 min) 1

D = 20,000, P = €160, C = 20% × €8 = €1.60 EOQ =

440,000

525,000 420,000

Cost of goods sold 900,000 Finished goods control (standard costs of 20,000 units of finished goods sold at €45 per unit)

2

21.14

400,000 40,000

2DP 2(20,000) €160 = 2,000 metres C = €1.60

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900,000

420,000 20,000 440,000

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2

Number of orders per year:

3

Demand each working day

D = 20,000 = 10 orders EOQ 2,000 =

D = 20,000 Number of working days 250

= 80 metres per day = 400 metres per week Purchasing lead time = 2 weeks Reorder point = 400 × 2 = 800 metres 21.15

EOQ for manufacturer. (20 min) 1

Relevant carrying costs per part per year: Required annual return on investment 12% × 50 = £6 Relevant insurance, materials handling, breakage, etc. costs per year

2

Relevant carrying costs per part per year

£8

D = 12,000; P = £120; C = £8 EOQ for manufacturer is: 2 DP 2(12,000) × £120 = = 600 units £8 C 2

Total ordering and D 600 12,000 Q = × P + × C = × £120 + carrying costs 2 × £8 Q 2 600 = £2,400 + £2,400 = £4,800 where Q = 600 units, the quantity ordered.

3

Purchase lead time is half a month. Monthly demand is 12,000 units ÷ 12 months = 1,000 units per month. Demand in half a month is 12 × 1,000 units or 500 units. Hence, Keep-Kool should reorder when stock of CU29 falls to 500 units.

21.16

Choosing suppliers for JIT purchasing. (30 min) 1

Solution Exhibit 21.16 presents the costs to Manraj if he purchases the paper from Papyrus and if he purchases the paper from Suffolk Leaves. On the basis of the financial numbers, it costs Manraj €44,850 less to purchase the paper from Papyrus.

2

Other factors that Manraj should consider before choosing a supplier are: a

The supplier’s flexibility to supply different types of paper that Manraj may need from time to time.

b

The supplier’s ability to deliver printing paper at short notice if Manraj needs supplies urgently.

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c

The emphasis that the supplier places on continuous improvement in costs, quality and delivery.

d

Manraj’s confidence in building a long-run relationship with the supplier based on trust and the willingness to share confidential information with each other.

e

Manraj’s confidence in his own estimates and the need to perform sensitivity analysis.

Solution Exhibit 21.16

Annual relevant costs of purchasing from Papyrus and Suffolk Leaves Incremental costs of purchasing from Papyrus

Purchase costs £100 per box × 100,000 boxes £95 per box × 100,000 boxes Required return on investment a 15% per year × £100 × 200 boxes of average stock per year a 15% per year × £95 × 200 boxes of average stock per year Overtime and subcontracting costs No overtime necessary Overtime due to late deliveries (£30,000 × 10 jobs) Costs of poor quality and smudging Total relevant costs

Incremental costs of purchasing from Suffolk

£10,000,000 £ 9,500,000 3,000 2,850 0 0 £10,003,000

Difference in favour of Papyrus a Order quantity ÷ 2 = 400 ÷ 2 = 200. b The relevant costs of poor quality and smudging per job are:

300,000 b 245,000 £10,047,850

£44,850

Additional costs of printing paper (£110 per box × 400 boxes) Additional other direct materials (ink and so on) Additional variable printing overhead Total relevant costs of poor quality per job

£44,000 2,000 3,000 £49,000

Relevant costs of poor quality for five jobs during the year (£49,000 × 5)

£245,000

21.17

Stock management, ethics. (20 min) 1

Showing supplies purchased in 2005 as equipment increases Range-Tout’s 2005 operating profits by €2,700,000 as follows: Reduced supplies expense in 2005 Increased depreciation expense in 2005 (€3,000,000 ÷ 10) Net reduction in operating expenses/increase in profit

€3,000,000 (300,000) €2,700,000

Yes, as Jules Ballès states, costs related to revenue should be expensed in the period in which the revenue is recognised. Generally, supplies purchased for use in the current period will not provide benefits in future periods, and should be matched against the revenue recognised in the current period.

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21.18

2

The use of alternative accounting methods to manipulate reported earnings is unethical because it violates CIMA’s Ethical Guidelines. The competence standard is violated because of failure to comply with technical standards and lack of appropriate analysis. The integrity standard is violated because this action puts extreme management pressure on persons to carry out unethical duties, subverts the attainment of an organisation’s objectives and discredits the profession. The objectivity standard is violated because of the failure to communicate information fully and fairly.

3

Jules Ballès’ actions were appropriate. Upon discovering the change in the method of accounting for supplies, Ballès brought the matter to the attention of his immediate superior, Capus. Upon learning of the arrangement with Gènie du Bois, Ballès told Capus that the action was improper and requested that the accounts be corrected and the arrangement discontinued. Ballès clarified the situation with a qualified and objective peer (adviser) before disclosing Capus’s arrangement with Gènie du Bois to Range-Tout’s president, Capus’s immediate superior. It might be expected that contact with levels above the immediate superior should only be initiated with the superior’s knowledge, assuming that the superior is not involved. In this case, the superior is involved – therefore, Ballès has acted appropriately by approaching Nathalie Carotte without Capus’s knowledge.

Backflush journal entries and JIT production. (15–20 min) 1

Journal entries for April are as follows: Entry (a) Stock: Raw and In-progress control Accounts payable control (direct (raw) materials purchased) Entry (b) Conversion costs control Various accounts (such as Accounts and Wages payable control) (conversion costs incurred)

8,800,000 8,800,000 4,220,000 4,220,000

Entry (c) Finished goods control Inventory: Raw and In-progress control Conversion costs allocated (standard costs of finished goods produced)

12,500,000

Entry (d) Cost of goods sold Finished goods control (standard costs of finished goods sold)

11,900,000

8,500,000 4,000,000

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11,900,000

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2

3

21.19

Under an ideal JIT production system, if the manufacturing lead time per unit is very short, there conceivably would be zero stock at the end of each day. Entry (c) would be for €11,900,000 finished goods production, not €12,500,000. If the marketing department could only sell goods costing €11,900,000, the JIT production system would call for direct material purchases and conversion costs of even lower than €8,500,000 and €4,000,000, respectively, in entries (a) and (b).

JIT purchasing, choosing suppliers. (20–25 min) 1

Solution Exhibit 21.19 presents the net cash savings of €1,854 from purchasing the toys from Grano BV rather than from Henco. On the basis of these calculations, Sido should choose Grano.

2

Other factors that Sido should consider before choosing a supplier are: a

The reputation benefits of (i) having products available rather than out of stock when customers want to make purchases and (ii) supplying quality products that customers are satisfied with.

b

The supplier’s flexibility to supply cars at short notice if Sido needs supplies urgently.

c

The supplier’s commitment to continuously improve cost, quality and delivery performance.

d

Sido’s confidence in building a long-run relationship with the supplier based on trust and the willingness to share confidential information with each other.

e

The range of other products that the supplier can supply to Sido.

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Solution Exhibit 21.19

Annual relevant costs of purchasing from Grano and Henco

Relevant item

Incremental costs of purchasing from Grano

Incremental costs of purchasing from Henco

Purchasing costs €50 per unit × 4,000 units per year

€200,000 €196,000

€49 per unit × 4,000 units per year Inspection costs €20 per delivery × 50 deliveries

1,000 1,400

€28 per delivery × 50 deliveries Required return in investment 15% per year × €50 × 40* units of average stock per year

300 294

15% per year × €49 × 40* units of average stock per year Outlay carrying costs (insurance, material handling, breakage, etc.) €11 per unit per year × 40* units of average stock per year

440

€10 per unit per year × 40* units of average stock per year

400

Stockout costs €25 per car × 20 cars

500

€26 per car × 150 cars

3,900

Customer return costs €21 per car returned × 40 cars returned

840 2,940

€21 per car returned × 140 cars returned €203,080

Total annual relevant costs Annual difference in favour of Grano

↑

€204,934 €1,854

↑

*Order quantity ÷ 2 = 80 ÷ 2 = 40

21.20

JIT production, relevant benefits, relevant costs. (20 min) 1

Solution Exhibit 21.20 presents the annual net benefit of €154,000 to Turun Telelaitos of implementing a JIT production system.

2

Other non-financial and qualitative factors that Turun should consider in deciding whether it should implement a JIT system include: a

The possibility of developing and implementing a detailed system for integrating the sequential operations of the manufacturing process. Direct materials must arrive when needed for each subassembly so that the production process functions smoothly.

b

The ability to design products that use standardised parts and reduce manufacturing time.

c

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d

Willingness of suppliers to deliver smaller and more frequent orders.

e

The confidence of being able to deliver quality products on time. Failure to do so would result in customer dissatisfaction.

f

The skill levels of workers to perform multiple tasks such as minor repairs and maintenance, and quality testing and inspection.

Solution Exhibit 21.20

Annual relevant costs of current production system and JIT production system for Turun Telelaitos Incremental costs under current production system Relevant items

Annual tooling costs Required return on investment 12% per year × €900,000 of average stock per year 12% per year × €200,000 of average stock per year Insurance, space, materials handling and set-up costs Rework costs Incremental revenues from higher selling prices Total net incremental costs

–

b c

€150,000

€108,000

24,000 140,000

200,000 350,000 – €658,000

Annual difference in favour of JIT production a

Incremental costs under JIT production system

a b

280,000 c (90,000) €504,000 €154,000

€200,000 (1 – 0.30) = €140,000 €350,000 (1 – 0.20) = €280,000

€3 × 30,000 units = €90,000

21.21

Just-in-time systems, ethics. (30 min) 1

Plant profitability in the first year after implementation and in subsequent years based on Eluard’s report will be as follows: First year after implementation

Annual expected benefits: Lower investment in stocks Reductions in set-up costs Reduction in costs of waste, spoilage and rework Higher revenues from responding faster to customers Total annual expected benefits Annual expected costs of JIT implementation Operating profit (loss) from JIT implementation

Subsequent years

€290,000 110,000

€ 350,000 150,000

200,000

250,000

180,000 780,000 950,000 €(170,000)

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300,000 1,050,000 750,000 € 300,000

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On the basis of Eluard’s report, it appears that Electro-Sons should implement JIT. It costs €170,000 in the first year but results in higher profits of €300,000 in subsequent years. In the long run, the benefits appear to clearly outweigh the costs. 2

Noailles is correct in characterising some of the financial benefits as ‘soft’. She is probably referring to operating income from higher revenues as a result of responding faster to customers. Higher profits from higher revenues are much harder to predict than cost savings. Cost savings are internal to the firm. The benefits from higher revenues depend on the reactions of customers and the responses of competitors. If the revenue benefits are not realised, losses in the first year after JIT implementation will increase to €350,000 (presently estimated loss of €170,000 plus €180,000). Furthermore, no net benefit will accrue in subsequent years (currently estimated operating profit of €300,000 minus the €300,000 loss in operating profits if the ‘soft’ revenue benefits are not realised). Without the revenue gains, JIT does not appear to be worthwhile. Students might also raise questions as to whether Eluard has correctly estimated the likely cost savings. For example, suppose set-up costs include a labour component. Then, even if set-ups are performed more efficiently, set-up cost savings may not occur if labour agreements make dismissal of workers difficult.

3

It is unfortunate that the first year of JIT implementation (when costs of JIT implementation are likely to exceed benefits) happens to coincide with Anna de Noailles’ last year with Electro-Sons. In this sense, it does appear that Noailles is being unfairly penalised if she implements JIT – she would bear the costs while the incoming manager would get the benefits. Noailles should indicate these circumstances to the senior management at ElectroSons and see if she can renegotiate the terms. For example, she might ask senior management to evaluate her performance after adjusting for the decline in plant profitability resulting from implementing JIT. Asking Eluard to change the numbers to make the JIT programme look worse and to postpone implementation is, hence, unethical. Any attempt by Eluard to use alternative numbers to manipulate the benefits from JIT implementation is unethical because it violates the Standards of Ethical Conduct for Management Accountants. The competence standard is violated because of failure to comply with technical standards and lack of appropriate analysis. The integrity standard is violated because it subverts the attainment of an organisation’s objectives and discredits the profession. The objectivity standard is violated because of the failure to communicate information fully and fairly. The Standards of Ethical Conduct for Management Accountants describes the steps that Eluard should take to resolve the ethical conflict. •

If Eluard is certain that her numbers are correct, she should inform Noailles of this.

•

If Noailles continues to pressure her, Eluard should present the situation to the next higher level of manufacturing, the vice-president, for resolution.

•

If Eluard does not receive a satisfactory response, she should continue to approach successive higher levels, including the Audit Committee and the Board of Directors.

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•

Eluard should clarify the concepts of the issue at hand in a confidential discussion with an objective adviser, that is, a peer.

•

If the situation is still unresolved after exhausting all levels of internal review, Eluard will have no recourse but to resign and submit an informative memorandum to an appropriate representative of the organisation.

Unless legally bound (which does not appear to be the case in this situation), it is inappropriate to have communication about this situation with authorities and individuals not employed or engaged by the organisation. 21.22

Effect of different order quantities on ordering costs and carrying costs, EOQ. (30 min) 1

A straightforward approach to this requirement is to construct the following table for different purchase-order quantities. D: Demand

26,000

26,000

26,000

26,000

26,000

Q: Order quantity

300

500

600

700

900

Q/2: Average stock in units

150

250

300

350

450

D/Q: Number of purchase orders

86.67

52

43.33

37.14

28.89

(D/Q) % P: Annual ordering costs

€6,240

€3,744

€3,120

€2,674

€2,080

(Q/2) % C: Annual carrying costs Total relevant costs of ordering and carrying stock

1,560

2,600

3,120

3,640

4,680

€7,800

€6,344

€6,240

€6,314

€6,760

↑

Minimum cost D = 26,000 units Q = order quantity P = €72 C = €10.40

EOQ =

2 × 26, 000× €72 2DP = 360,000 = 600 packages C = €10.40

The shape of the total relevant cost function for Rève Andalou is relatively flat from order quantities 500 to 700. 2

When the ordering cost per purchase order is reduced to €40: EOQ =

2 × 26, 000× €40 €10.40

= 200,000 = 447.2 packages rounded off to 447

packages The EOQ drops from 600 packages to 447 packages when Rève Andalou’s ordering cost per purchase order drops from €72 to €40. 21.23

JIT production, operating efficiency. (30 min)

This problem is based on an actual situation for a German company.

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1

2

The key features of JIT production are: a

Production is organised in manufacturing cells.

b

Workers are trained to be multiskilled so that they are capable of performing a variety of operations and tasks.

c

Total quality management is aggressively pursued to eliminate defects.

d

Emphasis is placed on reducing set-up time and manufacturing lead time.

e

Suppliers are carefully selected to obtain delivery of quality-tested parts in a timely manner.

Two main patterns are: (i) Stuttgart in the January–March quarter is the more efficient plant. Frankfurt is the more efficient plant in the October–December quarter. Consider the ratio of Frankfurt for each manufacturing variable:  Stuttgart  January–March

April–June

Manufacturing lead time

1.11

1.06

0.88

0.77

Total set-up time for machines Total production time

1.09

1.03

0.94

0.83

Number of units requiring rework Total units started and completed

1.20

1.06

1.01

0.68

July–September

October–December

A rate greater than 1 indicates that Frankfurt is less efficient than Stuttgart. All three ratios in January–March (and in April–June, although to a lesser degree) show Frankfurt to be the less efficient plant. However, in the last quarter, Frankfurt is clearly the more efficient plant – it has a faster manufacturing lead time, a lower percentage set-up time and a lower percentage of total units started and completed requiring rework. (ii) Frankfurt achieves major improvements in operating efficiency during 2007. Stuttgart’s performance is relatively static. Consider trends in each variable, where the value in January–March 2011 is scaled to be 100: January–March Manufacturing lead time Frankfurt Stuttgart Total set-up time for machines Total production time Frankfurt Stuttgart

April–June

July–September

October–December

100.0 100.0

94.6 98.8

80.4 101.2

67.4 97.6

100.0 100.0

95.2 101.1

84.1 98.1

75.2 99.8

100.0 100.0

92.1 104.5

80.5 95.9

55.0 98.0

Number of units requiring rework Total units started and completed Frankfurt Stuttgart

Major improvements in operating efficiency have occurred with the implementation of JIT.

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3

Reasons why the Frankfurt plant may find it cost effective to simplify its job-cost records include: a

Materials control can be best accomplished by Kurunmäki’s personal observations.

b

Work in progress constitutes a lower percentage of total costs of production.

c

The reduction in detail can be associated with rework. Reduce the percentage of jobs with rework, and then reduce the need for detailed record keeping of those costs.

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CHAPTER 22

Strategic management accounting and emerging issues Teaching tips and points to stress Accounting as an information and communication system provides the organisation with a means to implement an organisation-wide strategy and the tools by which to evaluate the success of that strategy. To be deemed successful, any endeavour has to be evaluated by some meaningful measure(s). The balanced scorecard here, too, provides what is useful. Though all of the factors are incorporated in the evaluation, the one measure – operating income – serves a profit-seeking organisation the best. With the analysis format presented in Chapter 22, using the three components of growth, price recovery and productivity, operating income of the current year in comparison with the previous year will yield specific information for judging the success of a cost-leadership or product differentiation strategy. Operating income is, of course, the product of the accounting system and its use demands that the cost or management accountant understand its purpose in the specific situation as well as the broader context of strategy implementation and evaluation. A helpful discussion of capacity needs comes at the end of the chapter. Strategic management that may include reengineering (an across-functions organisation-wide approach) will cause change within an organisation. One of those changes may be more effective and efficient use of existing capacity, thereby causing excess. Identifying and managing unused capacity is addressed. Chapter 22 concludes with the expanded view of the role of cost accounting for an organisation. To fully grasp the significance and vital role of management accounting, one needs to look at the whole of the organisation. This is covered by the case study problems that follow the chapter.

Solutions to review questions 22.1

Strategy describes how an organisation matches its own capabilities with the opportunities in the marketplace in order to accomplish its overall objectives.

22.2

Two generic strategies are: (1) product differentiation, an organisation’s ability to offer products or services that are perceived by its customers to be superior and unique relative to those of its competitors and (2) cost leadership, an organisation’s ability to achieve lower costs relative to competitors through productivity and efficiency improvements, elimination of waste and tight cost control.

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22.3

The four key perspectives in the balanced scorecard are: (1) financial perspective – this perspective evaluates the profitability of the strategy, (2) customer perspective – this perspective identifies the targeted market segments and measures the organisation’s success in these segments, (3) internal business process perspective – this perspective focuses on internal operations that further both the customer perspective by creating value for customers and the financial perspective by increasing shareholder wealth and (4) learning and growth perspective – this perspective identifies the capabilities in which the organisation must excel in order to achieve superior internal processes that create value for customers and shareholders.

22.4

Reengineering is the fundamental rethinking and redesign of business processes to achieve improvements in critical measures of performance such as cost, quality, service, speed and customer satisfaction.

22.5

A good balanced scorecard design has several features:

22.6

1

It tells the story of a company’s strategy by articulating a sequence of cause-andeffect relationships.

2

It helps to communicate the strategy to all members of the organisation by translating the strategy into a coherent and linked set of understandable and measurable operational targets.

3

It places strong emphasis on financial objectives and measures in for-profit companies. Non-financial measures are regarded as part of a programme to achieve future financial performance.

4

It limits the number of measures to only those that are critical to the implementation of the strategy.

5

It highlights suboptimal trade-offs that managers may make when they fail to consider operational and financial measures together.

Pitfalls to avoid when implementing a balanced scorecard are: 1

Do not assume the cause-and-effect linkages to be precise; they are merely hypotheses. An organisation must gather evidence of these linkages over time.

2

Do not seek improvements across all of the measures all of the time.

3

Do not use only objective measures in the scorecard.

4

Do not fail to consider both costs and benefits of different initiatives before including these initiatives in the scorecard.

5

Do not ignore non-financial measures when evaluating managers and employees.

22.7

Engineered costs result from a cause-and-effect relationship between the cost driver, output and the (direct or indirect) resources used to produce that output. Discretionary costs arise from periodic (usually) annual decisions regarding the maximum amount to be incurred. There is no measurable cause-and-effect relationship between output and resources used.

22.8

SMA is a form of management accounting in which the emphasis is placed on information that relates to factors external to the firm, as well as non-financial information and internally generated information.

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22.9

SMA practice is organisation-specific because all the factors that are generated in the analysis are very specific to the company and it is only by being specific to the company that the true strategic objectives and actions can be prescribed.

22.10

SMA’s potential is affected by strategic product costing and performance measurement; the firm’s product markets and competitive market forces; and the assessment of organisational strengths over a certain length of time.

Solutions to exercises 22.12

Strategy, balanced scorecard. (30 min) 1

Meredith Ltd follows a product differentiation strategy in 2012. Meredith’s D4H machine is distinct from its competitors and generally regarded as superior to competitors’ products. To succeed, Meredith must continue to differentiate its product and charge a premium price.

2

Balanced Scorecard measures for 2012 are as follows: Financial perspective

(1) Increase in operating income from charging higher margins, (2) price premium earned on products. These measures indicate whether Meredith has been able to charge premium prices and achieve operating income increases through product differentiation. Customer perspective

(1) Market share in high-end special-purpose textile machines, (2) customer satisfaction, (3) new customers. Improvements in these customer measures are leading indicators of superior financial performance. Internal business process perspective

(1) Manufacturing quality, (2) new product features added, (3) order delivery time. Improvements in these measures are expected to result in more satisfied customers and, in turn, superior financial performance. Learning and growth perspective

(1) Development time for designing new machines, (2) improvements in manufacturing processes, (3) employee education and skill levels, (4) employee satisfaction. Improvements in these measures have a cause-and-effect relationship with improvements in internal business processes, which in turn lead to customer satisfaction and financial performance.

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22.15

Balanced scorecard. (40 min) 1

The market for colour laser printers is competitive. Lee’s strategy is to produce and sell high quality laser printers at a low cost. The key to achieving higher quality is reducing defects in its manufacturing operations. The key to managing costs is dealing with the high fixed costs of Lee’s automated manufacturing facility. To reduce costs per unit, Lee would have to either produce more units or eliminate excess capacity. The scorecard correctly measures and evaluates Lee’s broad strategy of growth through productivity gains and cost leadership. There are some deficiencies, of course, that subsequent assignment questions will consider. It appears from the scorecard that Lee was not successful in implementing its strategy in 2012. Although it achieved targeted performance in the learning and growth and internal business process perspectives, it significantly missed its targets in the customer and financial perspectives. Lee has not had the success it targeted in the market and has not been able to reduce fixed costs.

2

Lee’s scorecard does not provide any explanation of why the target market share was not met in 2012. Was it due to poor quality? Higher prices? Poor post-sales service? Inadequate supply of products? Poor distribution? Aggressive competitors? The scorecard is not helpful for understanding the reasons underlying the poor market share. Lee may want to include some measures that get at these issues. These measures would then serve as leading indicators (based on cause-and-effect relationships) for lower market share. For example, Lee should measure customer satisfaction with its printers on various dimensions of product features, quality, price, service and availability. It should measure how well its printers match up against other colour laser printers on the market. This is critical information for Lee to successfully implement its strategy.

3

Lee should include a measure of employee satisfaction in the learning and growth perspective and new product development in the internal business process perspective. The focus of its current scorecard measures is on processes and not on people and innovation. Lee considers training and empowering workers as important for implementing its high-quality, low-cost strategy. Therefore, employee training and employee satisfaction should appear in the learning and growth perspective of the scorecard. Lee can then evaluate if improving employee-related measures results in improved internal business process measures, market share and financial performance. Adding new product development measures to internal business processes is also important. As Lee reduces defects, Lee’s costs will not automatically decrease because many of Lee’s costs are fixed. Instead, Lee will have more capacity available to it. The key question is how Lee will obtain value from this capacity. One important way is to use the capacity to produce and sell new models of its products. Of course, if this strategy is to work, Lee must develop new products at the same time when it is improving quality. Hence, the scorecard should contain some measure to monitor progress in new product development. Improving quality without developing and selling new products (or downsizing) will result in weak financial performance.

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4

22.16

Improving quality and significantly downsizing to eliminate unused capacity is difficult. Recall that the key to improving quality at Lee SA is training and empowering workers. As quality improvements occur, capacity will be freed up, but because costs are fixed, quality improvements will not automatically lead to lower costs. To reduce costs, Lee’s management must take actions such as selling equipment and dismissing employees. But how can management dismiss the very employees whose hard work and skills led to improved quality? If it did dismiss employees now, will the remaining employees ever work hard to improve quality in the future? For these reasons, Lee’s management should first focus on using the newly available capacity to sell more products. If it cannot do so and must downsize, management should try to downsize in a way that would not hurt employee morale, such as through retirements and voluntary redundancies.

Balanced scorecard, ethics. (40 min) 1

Yes, the Household Products Division (HPD) should include measures of employee satisfaction and customer satisfaction even if these measures are subjective. For a maker of kitchen dishwashers, employee and customer satisfaction are leading indicators of future financial performance. There is a cause-and-effect linkage between these measures and future financial performance. If HPD’s strategy is correct and if the scorecard has been properly designed, employee and customer satisfaction information is very important in evaluating the implementation of HPD’s strategy. HPD should use employee and customer satisfaction measures even though these measures are subjective. One of the pitfalls to avoid when implementing a balanced scorecard is not to use only objective measures in the scorecard. Of course, HPD should guard against imprecision and potential for manipulation. Patricia Conley appears to be aware of this. She has tried to understand the reasons for the poor scores and has been able to relate these scores to other objective evidence such as employee dissatisfaction with the new work rules and customer unhappiness with missed delivery dates.

2

Incorrect reporting of employee and customer satisfaction ratings to make divisions performance look good is unethical. In assessing the situation, the Ethical Guidelines for Management Accountants (summarised in Exhibit 1.7) that the management accountant should consider are listed below. Competence

Clear reports using relevant and reliable information should be prepared. Preparing reports on the basis of incorrect employee and customer satisfaction ratings in order to make the division’s performance look better than it is violates competence standards. It is unethical for Conley to change the employee and customer satisfaction ratings in order to make the division’s performance look good. Integrity

The management accountant has a responsibility to avoid actual or apparent conflicts of interest and advise all appropriate parties of any potential conflict. Conley may be tempted to report better employee and customer satisfaction ratings to please Emburey. However, this action violates the responsibility for integrity. The Ethical Guidelines require the management accountant to communicate unfavourable as well as favourable information.

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Objectivity

The management accountant’s standards of ethical conduct require that information should be fairly and objectively communicated and that all relevant information should be disclosed. From a management accountant’s standpoint, modifying employee and customer satisfaction ratings to make division performance look good would violate the standard of objectivity. Conley should indicate to Emburey that the employee and customer satisfaction ratings are, indeed, appropriate. If Emburey still insists on reporting better employee and customer satisfaction numbers, Conley should raise the matter with one of Emburey’s superiors. If, after taking all these steps, there is continued pressure to overstate employee and customer satisfaction ratings, Conley should consider resigning from the company and not engage in unethical behaviour. 22.17

Downsizing. (60 min) 1

The downsizing plan would be acceptable as the required subsidy is less than 20% of the current subsidy, €15,000 compared to €16,700, which is calculated as follows: Under downsizing plan Annual revenue: [(150 sandwiches × €3.60) + €230 beverages/desserts] × 250 days Cost of supplies: €192,500 × 50% Cost of downsizing plan: Wages and fringe benefitsa Utilities and equipment maintenance Annual cost of supplies Total costs Annual revenue Mayfair downsizing plan subsidy a

€192,500 €96,250 €81,250 30,000 96,250 207,500 192,500 €15,000

€65,000 + (25% × €65,000) = €81,250

Under current cafeteria plan Annual revenues: [(100 starters × €4) + (80 salads/sandwiches × €3) + €200 beverages/dessert] × 250 days Cost of supplies (60% × €210,000)

€210,000 €126,000

Calculation of subsidy limitation Current operation Wages and fringe benefits [€110,000 + (25% × €110,000)] Utilities and equipment maintenance Cost of supplies (€210,000 × 60%) Total costs Annual revenue Mayfair current operations subsidy

€137,500 30,000 126,000 293,500 210,000 €83,500

Mayfair Corporations subsidy limitation 20% of current subsidy (20% × €83,500)

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€16,700

Bhimani, Horngren, Datar and Rajan, Management and Cost Accounting, 5th Edition, Instructor’s Manual

2

The Wilco Foods proposal is more advantageous to Mayfair Ltd than the downsizing plan as the subsidy at the projected volume is €5,140 less than the downsizing plan: €15,000 compared to €9,860. The calculations are as follows: Revenue to Mayfair: Wilco revenuea Less: Breakeven salesb Revenues in excess of breakeven sales

€251,500 48,000 €203,500

Revenues payable to Mayfairc (€203,500 × 0.04) Plus: Rentd Total payments to Mayfair

€8,140 12,000 20,140

Cost to Mayfair: Fixed costs (utilities and equipment maintenance) Mayfair’s Wilco Foods proposal subsidy

30,000 €9,860

a

[(66 starters × €5) + (94 sandwiches/salads × €4) + €300] × 250 days

b

(€1,000 monthly payment × 12 months) ÷ (1 − 75%) contribution margin

c

Revenues in excess of breakeven sales × 4%

d

€1,000 monthly payment × 12 months

22.18

Question from the Chartered Institute of Management Accountants, Intermediate Level, Management Accountancy – Performance Management, November 2003. (45 min) 1

The balanced scorecard is a technique for assessing performance that recognises the importance of both financial and non-financial measures. The performance perspectives are: 1

2

3

4

Customer, for example a

Percentage of deliveries on time;

b

Percentage of orders fulfilled accurately.

Internal, for example a

The length of the production cycle;

b

The length of time to introduce new products.

Innovation a

The length of the production cycle;

b

The length of time to introduce new products.

Financial a

Profit as a percentage of sales;

b

Return on capital employed.

E plc is placing too much emphasis on the financial perspective. Comparing its actual performance against an internal target – it should use the balance scorecard approach to provide fuller, more rounded assessment of its performance.

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2 a

Total quality management (TQM) is a philosophy based on the ideas of continuous improvement and getting it right the first time. E plc would initially review the alternative services that it provides to its customers and consider how it may improve.

b

The likely costs to be incurred by E plc will include: •

Additional training costs to increase the awareness of employees as to how to use machinery, handle materials and work-in-progress;

•

Supervision/testing expenditures so that E plc can ensure that the items delivered to customers are of good quality.

As a consequence, the benefits anticipated by E plc would include: •

Lower wastage of damaged components;

•

Faster turn around of customer orders;

•

Fewer customer complaints in respect of being delivered poor quality items.

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Page:

20 The solution to exercise 2.16 (Representative cost driver column) does not match the exercise 2.16 in the pdf. Please check and confirm.

[AQ1]

Page: 51 Please check if the symbol € under the heading 'Solution Exhibit 4.18A' should be deleted.

[AQ2]

Page: [AQ3]Please confirm if June 2007 should be June 2010 in step 4 of Solution Exhibit 4.19.

53

Page: 59 ‡† [AQ4] Please confirm the correct placement of the footnote indicators (*, , ) under Solution Exhibit 4.22C and in similar instances. Page: 84 Please confirm if there should be a space between Nkr and the digits following it as used in other chapters (chapter 4). [AQ5]

Page: 91 [AQ6]Please confirm if the euro symbol should be used before '121 per litre' and in similar instances in Solution Exhibit 6.20. Page: 96 [AQ7]Please confirm if the number '1' should be retained in the row 'Deduct expected separable costs to complete and sell' in section 6.23. Page: 123 [AQ8]Please confirm if the list number '2' just above 'Contract B' under section 8.18 can be removed. Page: 126 [AQ9]'skr' is represented both as 'SKr' and 'Skr' in section 8.23. Please confirm which one to follow. Page:

130

[AQ10]Should

the 'X' in section 8.26 be italicised?

Page: [AQ11]

178 The solution for exercise 12.21 is not given. Please check and provide.

Page: [AQ12]The

202 meaning of the sentence 'If the extra sales' profits more than...' is not clear. Please

check. Page: [AQ13]

215 Please confirm if this is acceptable.

Page:

216 [AQ14]The solution to exercise 15.8, states 'Chapter 15 uses the phrase ‘continuous improvement

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standard costs’; however, only a part or variant of it ('continuous improvement; 'continuous improvement budgeted cost') is found in the pdf. Please check. Page:

234 SFr 62,400 SFr 62,400 [AQ15] The fraction in solution to exercise 16.12 is changed to . Confirm 1,040 ∞ 4 1,040 × 4 if this is correct. Page:

241 Please confirm if the part 'a' inserted for 'Direct-cost variances' in solution to exercise 16.22 is correct. [AQ16]

Page:

306 sentence 'Increase in operating income, €0.48 × 19,500 = €9,360. Hence, Lappalainen should accept the outside contractor’s offer.' is repeated in the section 20.20. Please check. [AQ17]The

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