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CHAPTER 9 COST APPLICATIONS: THEORY AND APPLICATIONS

SOLUTIONS

REVIEW QUESTIONS 9.1 9.2 9.3 9.4 Profit margin. Contribution margin equals revenues less variable costs, and profit margin equals contribution margin less allocated capacity costs. Direct estimation, and cost allocations. The direct estimation approach involves systematically examining each cost account to evaluate whether (and how much) a decision would change a capacity cost. An advantage of this approach is that it can be very accurate. However, it is tedious and timeconsuming, and is subject to the biases and incentives of the decision maker. To calculate income in accordance with GAAP, and to influence behavior. Absorption costing. All product costs direct materials, direct labor, as well as variable and fixed manufacturing overhead. Sales volume does not affect the fixed manufacturing overhead expensed on the income statement. Under variable costing, the entire amount of fixed overhead is expensed, regardless of sales volume. As sales volume increases, the amount of fixed manufacturing overhead expensed on the income statement also increases (and vice-versa). This occurs because, under absorption costing, fixed manufacturing overhead travels with the units produced and sold. When inventory levels do not change that is, when sales = production. They might do this when there is uncertainty about the final cost e.g., it allows the government and the supplier to share the risk of cost overruns. To protect its suppliers from the risk of cost over-runs, so that they make the necessary investments and supply DoDs requirements. To increase profits, as the Ryan Supply Systems example illustrates.

9.5 9.6 9.7 9.8

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9-2 9.13 9.14 9.15 Allocations can act like a tax for example, organizations might allocate costs based on labor hours to encourage divisions to automate. Controllability and incentives. Income reported under absorption costing = income reported under variable costing + fixed manufacturing costs in ending inventory fixed manufacturing costs in beginning inventory.

DISCUSSION QUESTIONS 9.16 In such production facilities, all costs that are traceable directly to each product line need not be allocated among products. In other words, many indirect costs become direct costs, and costing a product become simpler and more accurate. The disadvantage is that when a production line is idle because of temporary lull in demand, it cannot be used to make other products. That is, dedicating production lines can often lead inefficient utilization of capacity. Supplying a product with a negative profit margin product may be necessary to keep a large customer of the profitable products from going elsewhere. Making a negative profit margin product may also be good for business if it brings good reputation in the market place. For example, a restaurant can establish reputation in a community by catering to large not-for-profit charity events at or below cost so as to develop a clientele. Eight to ten years for the automobile industry, two to three years for the toy industry, three to five years for the computer industry, and ten to fifteen years for the computer industry would be reasonable estimates. To validate this assumption, the company would have to keep track of the consumption of the capacity resource and the activity volume as measured in units of the cost driver for a number of periods (say, a week or a month), and then use the High-Low or regression techniques that we learned in Chapter 4 to evaluate the association. There are costs and benefits. As a shareholder, you can get a better idea of a firms cost structure and its operating leverage if GAAP allows variable costing for financial reporting. On the other hand, firms may not choose to follow variable costing because they may lose competitive edge by revealing their cost structure to competition (from this perspective it is not in the shareholders best interests as well). Research and development expenditures are typically not unit level costs. They are either firm-level costs or product-level costs. Moreover, benefits from research and development are uncertain both in terms of timing and magnitude. Finally, research and development costs are not readily identifiable with current production, just as material and labor costs are. So it does not make sense to inventory these costs!

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9-3 9.22 Yes. The cost pool is the original cost of the machine less salvage value. The cost object is either the product(s) or the division(s) whose profitability is being measured. The cost driver is the useful life of the asset being depreciated. The denominator volume is the expected number of years of useful life. Yes. The firms inventory will increase if production exceeds sales during the period. Consider a firm using First-in First-out (FIFO) inventory flow assumption, and assume that fixed costs have increased drastically from prior period to current period. In this case, because all fixed costs are expensed under variable costing, and the lower prior period fixed costs flow through to the income statement under absorption costing, income can be higher under absorption costing. If cost uncertainty is high and there is no assurance of cost recovery through cost reimbursement contracts, the risk has to be borne by the producer or the service provider. In this case, it will be difficult to induce the producer or the service provider to undertake the necessary investment. On the other hand, once there is assurance of cost reimbursement there is a natural incentive to overstate the costs. This is a necessary evil that must be tolerated to ensure socially desirable projects (such as key defense initiatives) are undertaken. The charity might wish to choose procedure that would allocate more costs against noncharity related taxable revenues so as to save on taxes, and use these tax savings for other presumably charitable causes. Not really. Strictly speaking, in competitive markets the prices are set by the market forces. It is the firms overall profitability that matters. As long as the two products are earning positive contribution margins and more capacity is allocated to the product that makes the more profitable use of capacity, allocation of capacity costs is not necessary. In many firms (especially service and IT firms), people are the most valuable resource. Getting rid of good talent and people with valuable firm-specific experience just because of incentives arising from a cost allocation procedure can hurt the company in the long run. Should the need arise in the future for similar work force in the future it is a lot more costly to recruit and train new people to the level where they become as efficient as those who occupied their jobs previously. To avoid being allocated overhead costs based on labor consumption, the product line managers natural incentive would be to outsource labor intensive activities, even if outsourcing may be costlier from the firms perspective. For example, the manager might prefer outsourcing parts with high labor content. Outsourcing reduces labor costs as well as the overhead that is allocated based on labor costs, but it might increase material costs because of the higher prices to be paid for the parts. However, the net result on the line profit may be positive. Yes. From a performance evaluation perspective, the allocated costs will be treated by the manager as if they are variable costs. By finding ways in which to reduce the costs allocated to his/her unit, the manager can paint a better picture of his/her performance. FOR INSTRUCTOR USE ONLY

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9.29

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9-4 Thus, in making short-term decisions, the managers natural incentive would be to not treat allocated costs as fixed costs even if they are truly fixed. 9.30 Most governments permit some form of accelerated depreciation of long-term assets to allow higher tax deductions in the initial years of the assets lives to induce investment and growth in their economies. As we know, depreciation is in essence allocation of an assets cost over its useful life. Some governments levy taxes on imported foreign goods to protect local industries from foreign competition. This is much like taxing labor via cost allocation to promote automation. Even arbitrary allocations can induced desired behavior so long as these allocations are not used for planning and decision making.

EXERCISES 9.31 This question is useful in pointing out that revenues do not equal profit. For a factory worker, wages paid are the compensation for that persons effort and skill. The employer will provide (almost always) the required tools, the jobs, and so on. The worker is not responsible for procuring work. Employees also are not liable for the general maintenance of the facility, or other overhead items. In contrast, many plumbers and electricians work as independent contractors. The rate they charge is the revenue for the business. Before they can determine profit, this revenue must pay for all business expenses. For instance, the plumber may not work for the entire day. Part of the day has to be spent on developing the business. In addition, there are expenses such as paying for accounting, leasing an office and so on. The person also is responsible for wage-related taxes such as the employer portion of social security tax. Small businesses recover such overhead charges by allocating the cost to work done in proportion to labor hours expended. This choice of an allocation basis makes sense because labor is their primary product. However, rather than confuse the customer with an overhead charge and a profit, the entire amount is rolled into a single chargeable rate per labor hour. Often, the net pay for a plumber or electrician (i.e., the amount they take home) is not dramatically different than that for a similarly skilled factory worker. 9.32 a. The following table provides the required income statements. Contribution Margin Statement Amount (current year) Revenue $1,500,000 Cost of Goods sold (25% of sales) 375,000 Contribution $1,125,000 Fixed costs 900,000 Profit before taxes $ 225,000 Item

Amount (next year) $1,700,000 425,000 $1,275,000 900,000 $ 375,000

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9-5 Notice that fixed costs remain at $900,000 even though the volume of operations has increased. This is a reasonable assumption while fixed costs might increase some, they are not likely to increase dramatically because of a modest increase in sales.

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9-6

b.

The following table provides the required statement. Contribution Margin Statement Item Amount (current year) Revenue $1,500,000 Cost of Goods sold (25% of sales) 375,000 Contribution $1,125,000 Fixed costs 900,000 Profit before taxes $ 225,000

Amount (next year) $2,800,000 700,000 $2,100,000 1,600,000 $ 500,000

c. Our view of fixed costs changes based on the volume of operation. David seems to have a normal range of operations of about $1.5 million. His fixed costs of $900,000 support operations at this level. However, the capacity provided by this expenditure is unlikely to support a much higher volume of sales. For instance, David might need to make more trips, spend more on stocking and tracking inventory, hire additional sales persons, open a branch outlet, and so on. All of these actions contribute to higher fixed costs. This problem reinforces that fixed costs are fixed only for a given volume of operations and for a given time frame. These costs do become controllable if we significantly change the volume of operations or consider a long time frame. In Davids case, estimating the higher fixed cost might be hard. One reasonable approach is to say that fixed costs are 60% of sales revenue ($900,000/$1,500,000). Then, at a volume of $2.8 million in sales, David would estimate fixed costs at $1,680,000. Note: Part (b) provides an estimate of $1.6 million toward fixed costs. The difference underscores that using an allocation to project capacity costs assumes that the underlying relation would be the same. In Davids case, it is likely that, because of scale economies, fixed costs do not increase proportionately with sales volume. Methods such as direct estimation are better equipped to deal with such effects, but require more effort and expertise. 9.33 a. Each additional member from Acme pays $60 but would trigger additional variable costs of $35 per month. Thus, each Acme member would generate a contribution of $60 -$35 = $25 per month. The 200 additional members therefore increase Hercules contribution margin by 200 members $25 per member per month = $5,000 per month.

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9-7

b. No, the answer in (a) is not a preferred way for Tom and Lynda to evaluate the proposal. The method would be correct if the costs and benefits associated with the proposal would be realized in the short-term. That is, accepting or denying the proposal would not change the magnitude of capacity or fixed costs. However, accepting the proposal will almost surely change fixed costs. The proposal would increase membership by 20% (1,000 to 1,200 members) which means considerably more usage of the facilities. For example, cardio and strength training equipment would see more wear and tear, and more yoga classes might need to be scheduled. This means that costs associated with machine repair and replacement, as well as instructor salaries (fixed costs) would increase. Tom and Lynda must consider this change to make an effective decision. c. In this context, allocating the fixed costs over members might provide a better estimate of the long-term cost per member. The allocation is $40,000/1,000 = $40 per member per month. Added to the $35 in variable costs, the total cost of servicing is $75 per member per month. This estimate is a better approximation of the long-run cost of a member. With this estimate, Hercules would actually lose $15 per Acme member, of $3,000 per month if it accepts the proposal. Note: The $75 is just an estimate. It is likely that not all costs (e.g., rental for building) would increase proportionately with membership, even in the long run. Such factors (which loosely correspond to scale economies) would lower the actual cost below $75 per member. However, research shows that operating close to capacity increases both fixed and variable costs more than proportionately when facilities operate close to capacity. Thus, the true cost might well exceed $75 per member per month. Tom and Lynda would do well to make the decision as if the cost were about $75 per month but could be lower (maybe $70) or higher (maybe $80). Note that the decision does not change within this qualitatively estimated range. 9.34 a. As reported in the following table, the value of Charlies ending inventory equals the sum of the materials cost, the labor cost, and the allocated overhead cost. Materials cost Given Labor cost Given Overhead cost 100% of labor cost Total cost of ending inventory b. The change in the allocation basis will trigger a change in the amount of overhead cost allocated to the inventory account. However, to determine the revised inventory value, we first need to figure out Charlies overhead rate using materials $. $5,000 7,500 7,500 $20,000

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9-8 Because the rate = total overhead cost/total material $, we need to compute the total overhead cost. We can use the fact that the labor $ based overhead rate is 100% of labor cost and the fact that labor cost is $30,000 to determine that Charlies overhead cost is $30,000. Using this estimate, we can compute: Step 1: Overhead rate per materials $ = $30,000/$24,000 = $1.25 per materials $. Step 2: In turn, we can use this rate to compute the value of Charlies ending inventory. Materials cost Given $5,000 Labor cost Given 7,500 Overhead cost 125% of materials cost 6,250 Total cost of ending inventory $18,750 c. Charlie will report $1,250 more in income if he uses labor $ as the allocation basis. To see why, notice that the allocation serves to partition the total overhead cost of $30,000 between inventory and the cost of goods sold. Changing the allocation basis from labor $ to materials $ reduces the portion allocated to inventory from $7,500 to $6,250. Thus, the change must increase the portion allocated to the cost of goods sold from $22,500 (= $30,000 - $2,500) to $23,750 (= $30,000 - $6,250). Because the change does not affect any other item in the income statement, using materials $ as the allocation basis reduces Charlies reported income by $1,250. 9.35 a. Under GAAP, inventoriable cost comprises variable manufacturing costs (e.g., materials and labor) plus an allocation for fixed manufacturing costs. Inventoriable cost does not include any selling or administrative costs these costs are treated as period expenses. Precision allocates fixed manufacturing costs to products using units produced as the allocation basis. Thus, we have: Step 1: We first calculate the allocation rate by dividing the costs in the cost pool by the denominator volume. Plugging in the numbers from the problem: $11,750,000/5,875,000 units = $2.00 per unit.

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9-9

Step 2: With this rate in hand, we can determine inventoriable cost for each kind of bearing: Model 6203 $1.00 3.00 2.00 $6.00 Model 6210 $1.75 4.00 2.00 $7.75 Model 30207 $3.00 7.00 2.00 $12.00

Materials cost Labor cost Allocated overhead Inventoriable cost

Again, we emphasize that selling and administrative costs are not included in inventoriable costs. b. This change in the allocation basis will change the overhead rate that we use to allocate fixed manufacturing costs. Step 1: Compute the allocation rate Plugging in the numbers from the problem, $11,750,000/$23,500,000 = $0.50 per labor $. Step 2: Allocate costs With this rate in hand, we can determine inventoriable cost of each bearing: Model 6203 $1.00 3.00 1.50 $5.50 Model 6210 $1.75 4.00 2.00 $7.75 Model 30207 $3.00 7.00 3.501 $13.50

Materials cost Labor cost Allocated overhead Inventoriable cost


1

$1.50 = $3.00 $0.50/ labor $; $2.00 = $4.00 $0.50/ labor $; $3.50 = $7.00 $0.50/ labor $.

In each case, we compute the allocated overhead as the labor cost of each bearing rate per labor $. Notice again that we do not allocate fixed SG&A costs to determine inventoriable costs. c. We find that the inventoriable cost for 6203 has decreased, the cost for 30207 has increased, and there is no change in the cost for 6210. To understand the difference, notice that when Precision allocates fixed manufacturing costs using units, each bearing gets an equal share of overhead. However, when Precision allocates by labor cost, allocated overhead is proportional to each bearings labor cost.

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9-10

The average bearing consumes $4 of labor (= $23,500,000/5,875,000 bearings). There will be no change due to the change in the allocation basis only if each kind of bearing actually did consume $4 per bearing in labor costs. However, this equivalence is not true. Thus, bearings with lower than average labor cost (e.g., 6203) will experience a reduction in reported cost if Precision changes it allocation basis from units to labor cost. Conversely, bearings with higher than average labor cost (e.g., 30207) will experience an increase in reported cost. Note: While the inventoriable cost of each individual bearing changes depending on the allocation basis chosen, the total fixed manufacturing costs allocated to all bearings will be $11,750,000 regardless of the allocation basis chosen. 9.36 a. Horizon would report the following income and inventory numbers under variable costing: Revenue Variable costs Manufacturing Selling and administrative Contribution Margin Fixed Costs Manufacturing Selling and administrative Profit before taxes 1,600 $50 1,600 $16/unit 1,600 $6/unit $80,000 $25,600 9,600 $44,800 $24,000 10,000 $10,800

Given Given

Cost of Ending Inventory = $6,400


(400 units (=2,000-1,600) $16 variable manufacturing cost per unit)

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b. Horizon would report the following income and inventory numbers under absorption costing: Revenue Cost of Goods Sold Variable manufacturing Fixed manufacturing Gross Margin Period Costs Variable selling and administrative Fixed selling and administrative Profit before Taxes Cost of Ending Inventory = $11,200
(400 units ($16 variable manufacturing cost per unit + $12 allocated fixed manufacturing cost per unit)). 1 : $12 = $24,000 total fixed costs/2,000 units produced.

1,600 $50 1,600 $16 1,600 $121

$80,000 $25,600 19,200 $35,200 9,600 10,000 $15,600

1,600 $6 Given

c. We reconcile the income reported under the two formats as follows:


Income reported under variable costing + fixed overhead in ending inventory - fixed overhead in opening inventory = Income reported under absorption costing 400 units $12 allocated fixed manufacturing cost per unit Given $10,800 4,800 0 $15,600

Notice that the difference in income under the two approaches corresponds to the difference in ending inventory ($4,800 = $11,200 $6,400).

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9-12

9.37 a. The following table provides Creative Tiles contribution margin statement and ending inventory value under variable costing:
Creative Tiles Contribution Margin Statement & Ending Inventory Value Revenue/Cost per unit Sales volume (in units) Production volume (in units) Revenue Variable costs Direct materials Direct labor Marketing & sales Contribution Margin Fixed costs Manufacturing Marketing & sales Profit before taxes Inventory: Units in ending inventory Value per unit Value of ending inventory $450 $70 $140 $50 $190 13,500 15,000 $6,075,000 $945,000 1,890,000 675,000 $2,565,000 $1,500,000 625,000 $440,000 1,500 $210 $315,000

$70 + $140

b. Under absorption costing, we must allocate fixed manufacturing costs. Creative uses batches s the allocation basis to perform this allocation. Given total fixed manufacturing costs of $1,500,000 and 15,000 batches produced, we have the overhead rate as: $1,500,000/15,000 batches = $100 per batch.

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9-13

Creative Tiles Gross Margin Statement & Ending Inventory Value Revenue/Cost per unit Sales volume (in units) 13,500 Production volume (in units) 15,000 Revenue $450 $6,075,000 Cost of Goods Sold Direct materials $70 $945,000 Direct labor $140 1,890,000 Allocated fixed manufacturing costs $100 1,350,000 Total Cost of Goods Sold $310 $4,185,000 Gross Margin $140 $1,890,000 Period Costs Variable marketing and sales $50 $675,000 Fixed marketing and sales 625,000 Profit before Taxes $590,000 Units in ending inventory 1,500 Inventoriable cost per unit $70+$140+$100 $310 Value of Ending Inventory $465,000

c. As detailed in the text, the income reported under the two formats differs because of their differing treatment of fixed manufacturing costs. We expense these costs under variable costing, whereas we allocate them under absorption costing. Moreover, under absorption costing, fixed overhead travels with the units produced, first passing through inventory and then to cost of goods sold. If any units stay in inventory, the associated overhead cost also stays in inventory, temporarily boosting reported income. We can reconcile the income reported under the two formats as follows: Item Income reported under variable costing + fixed overhead in ending inventory - fixed overhead in opening inventory = Income reported under absorption costing Calculation 1,500 units $100 per unit 0 units $100 per unit Amount $440,000 $150,000 0 $590,000

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9-14

9.38 Lets compute the taxes paid if Shah uses garments as the allocation basis: Cost per garment = $660,000 / (20,000 + 20,000) = $16.50 per garment. Costs allocated to Europe = 20,000 garments $16.50 / garment = $330,000. Costs allocated to India = 20,000 garments $16.50 / garment = $330,000. We cannot compute the tax directly as we do not have data relating to income. However, we can calculate the tax savings as the overhead cost is an allowable deduction to income. Thus, the allocation scheme will result in a tax shield of ($330,000 40%) + ($330,000 30%) = $231,000. Next, let us compute the tax shield if Shah were to allocate overhead cost using labor hours as the allocation basis. Denominator volume = (20,000 garments 7 hours) + (20,000 garments 4 hours) = 220,000 hours. Cost rate per hour = $660,000 / 220,000 hours = $3 per hour.

Costs allocated to Europe = 20,000 garments 7 hours / garment $3 / hour = $420,000. Costs allocated to India = 20,000 garments 4 hours / garment $3 / hour = $240,000. Thus, the allocation scheme will result in a tax shield of ($420,000 40%) + ($240,000 30%) = $240,000. Changing the allocation basis from garments to labor hours would therefore save Shah Company, $240,000 - $231,000 = $9,000 in taxes paid. 9.39 a. Bradshaws decision is a long-term decision because it changes the nature of its product portfolio. Such a decision needs to consider the change in capacity costs, because capacity costs are controllable over the long-term. Allocations are a crude way of measuring the change in the firms capacity costs. The usual mandate to recover full costs is then pricing from a long-term perspective, which is suitable for product planning and portfolio decisions.

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9-15

b. Let us begin by constructing the income statement. The allocation rate is $1,400,000/300,000 units = $4.67 per unit. We have (rounding numbers to the nearest $): Standard 250,000 $3,500,000 2,000,000 $1,500,000 1,167,500 $ 332,500 Deluxe 50,000 $900,000 450,000 $450,000 233,500 $ 216,500 Total 300,000 $4,400,000 2,450,000 1,950,000 1,401,000 $549,000

Number of units Revenue ($14 250,000; $18 50,000) Variable costs ($8 250,000; $9 50,000) Contribution margin Common fixed costs ($4.67 per unit) Profit before taxes

Let us repeat the exercise with the new product mix. Notice that the common cost for each segment now is the new product volume the allocation rate of $4.67 per unit. We have: Standard 150,000 Deluxe 150,000 Total 300,000

Number of units

Revenue $2,100,000 $2,700,000 $4,800,000 Variable costs 1,200,000 1,350,000 2,550,000 Contribution margin $900,000 $1,350,000 2,250,000 Common fixed costs* 700,000 700,000 1,400,000 Profit before taxes $ 200,000 $ 650,000 $850,000 * The new product mix consists of 50% Standard and 50% Deluxe. To avoid rounding errors, we can simply allocate 50% of the common fixed costs to each product (50% $1,400,000 = $700,000) c. Let us repeat the exercise with the new product mix. We have to compute the allocation rate for labor hours though. Using the data for the current year, we have total cost = $1,400,000 and total labor hours = (2 hrs 250,000 units) + (50,000 units 4 hours per unit) = 700,000. Thus, the rate is $2 per labor hour ($1,400,000/700,000). With this rate, the following table provides the projected income statement. Notice that the common cost for each segment now is the new product volume number of labor hours per product the allocation rate of $2 per labor hour.

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9-16

Number of units Revenue Variable costs Contribution margin Common fixed costs ($2 2 150,000; $2 4 150,000) Profit before taxes

Standard 150,000 $2,100,000 1,200,000 $900,000 600,000 $ 300,000

Deluxe 150,000 $2,700,000 1,350,000 $1,350,000 1,200,000 $ 150,00

Total 300,000 $4,800,000 2,550,000 2,250,000 1,800,000 $450,000

d. We believe that the pessimistic estimate in part (c) is likely more accurate than the optimistic estimate in part (b). This is because the allocation in part (b) assumes that each product, whether it is standard or deluxe, consumes the same amount of capacity resource. This is not likely a good assumption because the deluxe product takes twice the amount of labor taken to make a standard product. While some costs surely vary by units, other costs (perhaps the majority of costs) bear a closer relation to labor hours. Thus, neither the estimate in part (b) nor the estimate in part (c) is likely to be accurate. However, the estimate in part c (using labor hours as the basis) is likely more accurate. Based on this analysis, Bradshaw might rethink its decision to alter its product mix. 9.40 a. Under GAAP, inventoriable costs include both variable and fixed manufacturing costs, but exclude variable and fixed selling and administrative costs. While we have information about the variable manufacturing costs per unit, we need to allocate fixed manufacturing costs. Step 1: First, let us compute the overhead rates in the two departments. Fabrication Assembly = $66,000 / 12,000 machine hours = $5.50 per machine hour. = $39,000 / 6,000 labor hours = $6.50 per labor hour.

Step 2: With the information from step 1, we can compute the cost of the product: Materials cost Labor cost Fabrication Overhead Assembly Overhead Inventoriable cost $50.00 42.00 5.50 13.00 $110.50 given given 1 machine hour $5.50 / machine hour 2 labor hours $6.50 / labor hour

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9-17

b. The inventoriable cost computed under absorption costing will understate the true long-term cost of a product as it ignores SG&A costs. To determine the long-term profitability of a product, we need to include all controllable costs. For the product in question, this means that we should probably add $11 ($5 of variable selling costs + $6 of fixed selling costs), as both the variable and fixed selling and administrative expenses are controllable over an extended horizon. For example, if Boston drops the product in question, it will no longer incur the shipping costs, sales commissions, and advertising costs associated with selling and marketing the product. 9.41 a. As per GAAP, Atsuko should value her inventory as the total of materials cost, labor cost, and allocated manufacturing overhead. Selling and administrative expenses are treated as period costs and, thus, are not included in the value of ending inventory. We determine the allocated overhead in two steps; 1. Calculate the overhead rate. For Atsuko, dividing total manufacturing overhead of $525,000 by total labor cost of $1,050,000 means that her overhead rate is $0.50 per labor dollar. 2. Determine the portion allocated to inventory. Atsukos inventory has $62,500 of labor content. Multiplying this amount by $0.50 per labor dollar, she will allocate $31,250 to the inventory. Thus, combining $50,000 materials + $62,500 labor + $31,250 allocated overhead, Atsuko will value her inventory at $143,750. b. The following table computes Atsukos reported income. Revenue - Materials - Labor cost - Overhead cost = Gross Margin - Selling and administrative costs = Profit before taxes 3,300 pairs $750 per pair ($700,000 - $50,000) ($1,050,000 - $62,500) ($525,000 - $31,250) $343,750 Given $2,475,000 650,000 987,500 493,750 250,000 $93,750

Notice that the total cost of materials and labor is split between cost of goods sold (in the income statement) and the inventory account (in the balance sheet). The manufacturing overhead cost is split in a like fashion.

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9-18 c. The key to answering this question lies in recognizing that the manufacturing overhead has a large fixed component, which does not change in response to volume. However, the cost will be split between inventory (a balance sheet account) and cost of goods sold (an income statement account) in proportion to the number of units. (For simplicity, we use units as the allocation basis the argument holds for other allocation bases as well). Thus, if Atsuko increases her production, she will have more units in inventory. In turn, the greater number of units in inventory will attract a greater share of the fixed overhead cost. By arithmetic, the amount recorded in the cost of goods sold for overhead expenses will decrease, causing reported income to increase. Thus, Atsuko can increase reported income by increasing production. More generally, including allocated manufacturing overhead when valuing inventory provides an incentive to over-produce because such over production temporarily boosts reported income. 9.42 a. Contribution margin is price less all variable costs. For Xenon, variable costs include materials, labor, and variable overhead. We know the cost of materials and labor but need allocations to determine the cost of variable overhead. Total variable overhead costs = 1/3 of total overhead = 1/3 $1,500,000 = $500,000. Dividing through by the total labor cost, we have: Variable overhead per labor $ = $500,000/$1,000,000 = $0.50/labor $. Because the pump has $30 of labor cost, Xenon will allocate $30 $0.50 = $15 toward variable overhead. Collecting this information, we have: Sales Price Given Materials Labor Variable overhead Equals: b. Gross Margin is price less all manufacturing related costs, including variable and fixed overhead. We know the cost of materials and labor but need allocations to determine the cost of variable and fixed overhead. Contribution margin $90.00 per unit 12.00 Given 30.00 Given 15.00 $30.00 $0.50 / labor $ 33.00 per unit

Less:

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9-19 From part [a], we know that variable overhead rate is $0.50 per labor $. Additionally, total fixed overhead costs = 2/3 of total overhead = 2/3 $1,500,000 = $1,000,000. Dividing through by the total labor cost, we have: Fixed overhead per labor $ = $1,000,000/$1,000,000 = $1.00/labor $. Because the pump has $30 of labor cost, Xenon will allocate $30 $1.00 = $30 per pump toward fixed overhead. Collecting this information, we have: Less: Sales Price Materials Labor Variable overhead Fixed overhead = Inventoriable cost Gross Margin 12.00 30.00 15.00 30.00 Per Pump $90.00 Given Given Given $30.00 $0.50/labor $ $30.00 $1.00/labor $ 87.00 $3.00

Equals:

Note: While the gross margin on Xenons pump is lower than its contribution margin, this is not always the case. For example, the gross margin could exceed the contribution margin if allocated fixed manufacturing costs are less than variable selling costs. c. Now, Xenon has to compute two separate fixed overhead rates, corresponding to the two cost pools. We have: Costs Denominator Rate Volume Materials related pool $240,000 $600,000 $0.40 / materials $ Labor related pool $760,000 $1,000,000 $0.76 / labor $ Using these rates, we compute: Less: Sales Price Materials & components Labor Variable overhead Fixed overhead (materials) Fixed overhead (labor) = Inventoriable cost Gross Margin 12.00 30.00 15.00 4.80 22.80 Per Pump $90.00 Given Given Given $30.00 $0.50 / labor $ $12.00 $0.40 / material $ $30.00 $0.76 / labor $ 84.60 $5.40

Equals: d.

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9-20 We can understand the difference in gross margins (inventoriable costs) by appealing to the property that the allocated cost is proportional to the driver volume in a cost object. When Xenon allocates cost using labor $, the overhead allocated to the pump is a multiple of the labor $ in the pump. The percent of overhead allocated to the pump equals the percent labor contained in the pump. Globally, materials cost is 60% of labor cost (60% = $600,000/$1,000,000), meaning that an average product has $0.60 of materials cost for each $1 of labor cost. However, the pumps only have $12 of materials for $30 of labor, meaning that pumps use proportionately less materials than the average product ($12/$30 = 40%). The ratio of the pumps materials cost to total materials cost is therefore smaller than the ratio of the pumps labor cost to total labor cost. Thus, when Xenon breaks out some overhead (in this case $240,000) and allocates this amount using materials $, the amount allocated to the pumps will decrease. Naturally, inventoriable cost also decreases, thereby increasing gross margin. 9.43 This problem demonstrates the arbitrary nature of allocations for some common costs. In this case, the demand for the allocation is driven by a reimbursement consideration. There is no underlying economics of the production process that can help guide the decision, nor is there is a control role. Thus, because the sole objective is to split the cost between two cost objects, Shibin must subjectively choose the allocation basis. The following schemes come to mind: 1. Equal split of cost because both schools derive the same benefit. Under this scheme, Shibin will seek a reimbursement for $250 from each of the two schools. 2. Allocate $400 to State University and $100 to Prestige, arguing that State University would have paid $400, if Prestige had not invited Shibin for an interview. Prestige is only responsible for the incremental cost. 3. Split the cost as per perceived ability to pay. Arguably, as a private Ivy League school, Prestige has greater financial resources relative to State University, a statesupported school. Thus, Shibin may submit expenses of, for example, $350 to Prestige and $150 to State University. Overall, there is no clear winner among the candidate mechanisms. The choice depends on perceptions of fairness, equity, and ability to bear.

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9-21

9.44 a. The following table provides the required computations. Allocation Using Budgeted hours Step 1: Determine the allocation rate Total cost in cost pool Denominator volume Rate per unit of cost driver $6,000 80 hours (40+40) $75 per hour Allocation Using Pams Sales Allocation Using Clients Sales

$6,000 $125,000 (100,000+25,000) $0.048/$ of Pams sales to client $4,800 $1,200 $6,000

$6,000 $250 million (50m + 200m) $24/million of client sales $1,200 $4,800 $6,000

Step 2: Determine the cost allocated to each client Apollo $3,000 Troy $3,000 Total allocated $6,000

Notice that the cost allocated to each client differs markedly depending on the allocation basis chosen. b. Pam faces a sticky problem, with no obvious solution. The one thing that is clear is that she cannot double-bill her clients. That is, it would be unethical for Pam to charge both clients for the entire $6,000 cost of the common work. She must allocate this cost among the two clients. However, there is no obvious allocation basis. All else being the same, Pam prefers to allocate more to Apollo as the choice increases her reimbursement. Pams likely goal of increasing her wealth and building a longer client list also push her in this direction. However, this action penalizes an existing client for a new one. The ability to bear criterion suggests a greater allocation to Troy. However, neither company is likely to care much about a $6,000 cost. Ultimately, Pam has to make a subjective decision about the choice for an allocation basis. An equal split seems as good as any other choice. Moreover, such a split is easy to explain and is a defensible action, should a client challenge the cost.

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9-22

PROBLEMS 9.45 a. We can understand the rationale for Brians actions. As we learned in Module II, firms cannot control capacity costs in the short-term. That is, these costs are not relevant for short-term decisions. Moreover, Brians firm is a setting of excess capacity, meaning that capacity has zero opportunity cost. With these facts, contribution margin is the right measure to maximize profit in the short-term. However, the italicized short-term is crucial, as we will see next. b. We also can understand the rationale for the VPs actions. The VP might be considering longer-term effects in nixing the deal. For instance, reducing the price now might make it much harder to raise prices once demand picks up. Likewise, knowledge of a price cut for this customer might lead other customers to demand similar concession, leading to lower profitability. Finally, perhaps the VP knows that capacity is likely to become more fully utilized in the near future (i.e., she knows the deals in works by ALL sales persons, unlike Brian, who only knows the deals he is working on), meaning that she might have a finer estimate of the opportunity cost of capacity. Thus, we can justify the VPs actions if we adopt a long-term view. Note: This problem links back to the big-picture presented in the part opener. 9.46 a. Let us begin by calculating the total number of machine hours that Catlow uses. We have: (2,900 units 2 hours / unit) + (1,400 units 3 hours / unit) = 10,000 hours. Given the overhead rates: Expected variable costs for the year = 10,000 hours $20 / hour = $200,000 Expected fixed costs for the year = 10,000 hours $30 per hour = $300,000 Thus, during the current year, total expected overhead = $500,000. We can also use the rates to project capacity costs (overhead) for the new product mix. Under this mix, we have: (3,400 Alpha units 2 hours /unit) + (2000 Beta units 3 hours/unit) = 12,800 hours The expected overhead is (12,800 hours $20 / hour) - $256,000 for variable overhead, and $384,000 (= 30 12,800) for fixed overhead, or $640,000 in total.

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9-23 b. The estimate in part (a) is likely understated. This is because we need 12,800 hours and each machine could only provide 2,000 hours. Thus, we need to expand capacity from 5 to 7 machines. This change would not affect the variable overhead (which is only proportional to actual machine hours consumed). However, the purchase of 2 additional machines would substantially increase fixed overhead costs. Currently, each machine costs 2,000 hours $30 per hour = $60,000 in fixed overhead. With 7 machines, we will have $420,000 of overhead. Thus, total overhead is more likely to be $256,000 + $420,000 = $676,000. Why does expected overhead increase? We will need to buy 7 machines or 14,000 hours of capacity even though we only need 12,800 hours. The additional purchase occurs because we can only buy capacity in increments of 2,000 hours. The fixed overhead relates to the cost of capacity supplied in the form of machine hours. The machine cost would not decrease because we do not plan to fully use the machine. Such fine-tuning of capacity cost estimation is possible only if we perform direct estimation. In this case, we analyzed the individual nature of the machines to determine the increase in costs. While refining the analysis this way leads to greater accuracy, doing so is costly. In particular, we need to collect data on more drivers and perform more analysis to assign costs to drivers. This is a difficult and subjective exercise. We trade off accuracy in estimation with the ease in obtaining the estimate. 9.47 a. Let us begin by calculating unit contribution and profit margins. Item Price Unit Contribution margin Unit profit margin Variable cost = (1- CMR) * price Allocated fixed cost = Contribution margin profit margin Standard $130 $65 $25 $65 $40 Custom $175 $105 $65 $70 $40

Comparing the allocated fixed cost for the Standard and the Custom products, it seems that Sunder employs the number of units as the allocation basis. This is the mechanism that would lead to an identical allocated amount for each product. (If Sunder used machine hours instead, the custom product should receive twice the allocation received by the standard product.) Also notice that Sunders total profit is (75,000 $25) + (25,000 $65) = $3,500,000. b. We now need to calculate the rate per machine hour. For this calculation, we need the total overhead cost and the total number of machine hours.

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9-24 We can use the allocated rate per unit (in part a) to back out total overhead. The rate is $40 per unit and there are 100,000 units (= 75,000+25,000). Thus, the overhead cost must be 100,000 $40 = $4,000,000. We compute total machine hours as (75,000 standard 2 hours /unit) + (25,000 deluxe 4 hours /unit) = 250,000 hours. Combining the two estimates, we have the rate per machine hour as $16 per machine hour. Thus, we have: Item Price Variable cost Unit Contribution margin Allocated fixed cost (2 hours $16 ; 4 hours $16) Unit profit margin Standard $130 $ 65 $ 65 $ 32 $ 33 Custom $175 $ 70 $105 $ 64 $ 41

Notice that the profit margin for the standard product has increased from $25 to $33 while that for the custom product has decreased from $65 to $41. However, Sunders total profit is still (75,000 * $33) + (25,000 * $41) = $3,500,000. This equivalence emphasizes that the allocation only divides the cost. The total is unaltered. c. The following table provides the required information. Notice that we treat capacity costs as controllable for this decision. As the number of units changes, the capacity costs change proportionately because the rate per unit stays the same. Item New Units Profit Margin per unit Total profit Standard 50,000 $ 25 $1,250,000 Custom 50,000 $ 65 3,250,000

Thus, Sunder expects to make $4,500,000 in profit with the new product mix. Also, notice that total capacity costs stay at $4,000,000 although we changed the mix. We get this result because the total number of units did not change even though the mix changed. Further, our allocation scheme is as if each unit consumes the same amount of capacity resources, regardless of the type of product. Based on this projection, changing the product mix appears to be a good idea as it increases expected profit.

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9-25

d. The following table provides the required information. Notice that we treat capacity costs as controllable for this decision. As the number of units made changes, the capacity costs change proportionately because the rate per unit stays the same. Item New Units Profit Margin per unit Total profit Standard 50,000 $ 33 $1,650,000 Custom 50,000 $ 41 2,050,000

Thus, Sunder expects to make $3,700,000 in profit with the new product mix. Also notice that total capacity costs increases to $4,800,000. Total machine hours are (50,000 2) + (50,000 4) = 300,000 hours, and the rate is $16 per machine hour. Even though the total number of units did not change, the change in mix increased the number of machine hours, increasing the total expected capacity cost. While switching product mix still increases profit, the idea is not so compelling now. The change in results underscores the importance of picking the right driver to estimate the change in capacity costs. In this instance, machine hours probably are better suited as deluxe products seem to require more work than standard products do.

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9-26

9.48 :a. Number of customers Number of pickups per week Revenue* Variable costs* Contribution margin Traceable fixed costs Segment margin Common fixed costs Profit before taxes * Residential Revenue = 200 ($800,000/500 customers) Commercial Revenue = 300 ($1,200,000/100 customers) * Residential Variable costs = 200 ($140,000/500 customers) Commercial Variable costs = 300 ($240,000/100 customers) Residential 200 200 $320,000 56,000 $264,000 150,000 $114,000 NA Commercial 300 300 5 = 1,500 $3,600,000 720,000 $2,880,000 225,000 $2,655,000 NA Total 500 1,700 $3,920,000 776,000 3,144,000 375,000 $2,769,000 1,100,000 $1,669,000

b. Let us first construct the allocation rates. We have $1.1 million in common fixed costs and $2 million in total revenue. Thus, the allocation rate (for charging to segments) is $1.1/$2.0 = 55% of revenue. With this rate, we have the current income statement as: Residential 500 500 $800,000 $140,000 $660,000 150,000 $510,000 440,000 $70,000 Commercial 100 500 $1,200,000 $240,000 $960,000 225,000 $735,000 660,000 $75,000 $ Total 600 1,000 $2,000,000 $380,000 1,620,000 375,000 $1,245,000 1,100,000 145,000

Number of customers Number of pickups per week Revenue Variable costs Contribution margin Traceable fixed costs Segment margin Common fixed costs ($800,000.55;$1,200,000.55) Profit before taxes

Now, let us re-do the income statement, except let us assume that both segment and common fixed costs vary in proportion to sales revenue. That is, sales revenue is the driver for fixed costs. Then, as we calculated above, the rate for common fixed costs is 55% of revenue. With respect to traceable fixed costs, the rates are $150,000/$800,000 = 18.75% for residential customers and $225/$1,200 = 18.75% for commercial customers.

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9-27

With these rates, we have: Residential 200 200 $320,000 56,000 $264,000 60,000 $204,000 176,000 $ 28,000 Commercial 300 300 5 = 1,500 $3,600,000 720,000 $2,880,000 675,000 $2,205,000 1,980,000 225,000 Total 500 1,700 $3,920,000 776,000 3,144,000 735,000 $2,409,000 2,156,000 $253,000

Number of customers Number of pickups per week Revenue Variable costs Contribution margin Traceable fixed costs ($320,000.1875;$3,600,000.1875) Segment margin Common fixed costs ($320,000.55;$3,600,000.55) Profit before taxes

While profit increases relative to current levels, it is substantially lower than the estimate in part (a). The key difference, of course, is framing the problem as a long-run instead of a short-term problem. This change means that fixed costs are potentially controllable, and we estimate the new level using sales revenue as the cost driver. c. Now, let us re-do the income statement, except let us assume that both segment and common fixed cost vary in proportion to the number of pickups. That is, pickups are the driver for fixed costs. Then, the rate for common fixed costs is $1,100,000/1,000 = $1,100 per weekly pick up. With respect to traceable fixed costs, the rates are $150,000/500 = $300 per weekly residential pickup and $450 per weekly commercial pickup. With these rates, we have: Residential 200 200 $320,000 56,000 $264,000 60,000 $204,000 220,000 $ (16,000) Commercial 300 300 5 = 1,500 $3,600,000 720,000 $2,880,000 675,000 $2,205,000 1,650,000 $ 555,000 Total 500 1,700 $3,920,000 776,000 3,144,000 735,000 $2,409,000 1,870,000 $539,000

Number of customers Number of pickups per week Revenue Variable costs Contribution margin Traceable fixed costs* Segment margin Common fixed costs* Profit before taxes

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9-28

d. The estimate in part (a), $1,669,000, is not reliable. The estimate assumes that capacity costs would not change either in response to the change in the product mix or the change in sales volume. This assumption seems odd because it is likely that commercial and residential customers differ in terms of their resource demands. For example, commercial clients need five times as many pickups as residential clients. The estimates in parts (b) and (c) compute the expected change in capacity costs by using allocations. However, they differ in terms of the driver used. It is difficult to uniquely identify the single best driver some costs might be driven by sales volume while others might more closely relate to the number of pickup. Thus, neither measure is completely accurate although we expect that the number of pickups is a better estimate than sales revenue. N&Ns management could be quite confident that the change in the nature of the business would increase their profit. The best estimate might be a weighted average of the estimates in parts (b) and (c), where the weights correspond to managements belief that the underlying activity (pickups or revenue) is the true driver of capacity costs. 9.49 Allocations of capacity costs to products and a mandate to recover full cost in prices are among the most contentious of issues in firms. At some level, Paul has a valid point. On an incremental basis, it is likely that the firms capacity costs would not change because of this product. As Paul argues, the accounting departments cost would not change. However, such an incremental methodology is most appropriate for short-term decisions only. Over the long-term, capacity costs are controllable. For instance, adding 10 such products would change the cost in accounting. The allocation is a way, albeit a crude way, of measuring the change in the firms capacity costs. The mandate to recover full costs is then pricing from a long-term perspective, which is suitable for product planning and portfolio decisions. For such decisions, we should consider capacity costs as being controllable, and the allocations in the product cost sheet are a rough estimate of how these costs would change if the firm were to add the new product. 9.50 a. The total capacity cost for Waymire is $13,500,000 and the firm has 135,000 labor hours. Thus, the current rate for allocating capacity costs is $100 per labor hour (=$13,500,000/135,000). With the change in product mix, Waymire only expects 121,500 labor hours. Thus, if it uses labor hours as the sole driver, its expected capacity cost would be 121,500 labor hours $100 per labor hour = $12,150,000.

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9-29

b. The total capacity cost for Waymire is $13,500,000 and the firm has 81,000 machine hours. Thus, the current rate for allocating capacity costs is $166.67 per machine hour (=$13,500,000/81,000). With the change in product mix, Waymire expects only 132,300 machine hours. Thus, if it uses machine hours as the sole driver, its expected capacity cost would be 132,300 machine hours $166.67 per machine hour = $22,050,441. The total capacity cost for Waymire is $13,500,000 and the firm has $162 million in revenue. Thus, the current rate for allocating capacity costs is $13.5 million / $162 million per revenue dollar = 8.33%. With the change in product mix, Waymire expects revenue of $175,000,000. Thus, its expected capacity cost would be $175 million 8.33% = $14,583,333. Comparing the estimates of capacity underscores the importance of a good allocation scheme. In general, it is difficult to capture the variations in resource consumption using a single activity driver. This deficiency is particularly troublesome when we use the allocated amount to estimate the change in capacity costs. c. It seems reasonable to use different drivers for different types of costs. The following is one possible grouping (using the four available drivers only): Item Materials handling and inventory Supervision Payroll Factory administration Machine depreciation Machine operations Sales offices Travel and other customer development Selling administration With this grouping, we have the following rates. Item Amount Driver units Materials related costs $2,400,000 $48,000,000 $2,700,000 135,000 Labor related costs $4,860,000 81,000 Machine related costs $3,540,000 $162 million SG&A costs $13,500,000 NA Total Driver Materials $ Labor hour Labor hour Labor hour Machine hours Machine hours Revenue Revenue Revenue

Rate / driver unit $0.05 per material $ $20 per labor hour $60 per machine hour 2.185% of revenue NA

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9-30

With the new rates, we have the estimated capacity costs as: Rate / driver unit Item Materials related costs Labor related costs Machine related costs SG&A costs Total $0.05 per material $ $20 per labor hour $60 per machine hour 2.185% of revenue NA Projected Driver units $52,000,000 121,500 hours 132,300 hours $175,000,000 NA Projected amount $2,600,000 2,430,000 7,938,000 3,823,750 $16,791,750

d. The analyses in parts (a) and (b) use allocations to approximate the change in capacity costs. The analysis in part (c) refines the allocation by considering the nature of the costs being allocated and picking an appropriate driver. In this way, the analysis moves closer to direct estimation, where we consider individual accounts. For example, it is possible that the item payroll is not related to the number of labor hours but to the number of people employed. Likewise, the cost of the item, factory administration might be better estimated if we use both labor and machine hours as the drivers. While refining the analysis this way brings us closer to direct estimation and potentially greater accuracy, doing so is costly. In particular, we need to collect data on more drivers and perform more analysis to assign costs to drivers. This is a difficult and subjective exercise. Thus, we trade off accuracy in estimation with the ease in obtaining the estimate. 9.51 a. We compute LuAnnes margin as: Revenue Manufacturing costs Marketing costs Margin $400,000 320,000 54,000 $26,000 Given @80% of sales revenue @13.5% of sales revenue

We compute the Bettys margin at $22,750 = 6.5% $350,000, where 6.5% is the margin (= 100% - 80% - 13.50%). Thus, LuAnne has the higher margin under the old system.

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9-31

b. Under the revised allocation system, marketing cost is allocated based on orders. Hence, we need to compute the cost per order and determine the margins. Step 1: Determine the rate. Marketing cost per order = Total cost / Total number of orders We need to calculate both figures as neither is provided to us. Total marketing cost = 13.50% of total revenue = 0.1350 $60 million = $8,100,000. Total orders = Total revenue/Average order size = $60 million/$8,000 = 7,500 orders. Thus, we have: Marketing cost per order = $8,100,000/7,500 = $1,080 per order. Step 2: Use the rate to determine allocated costs. We can compute the margins as: Other salesperson $350,000 280,000 37,800 $32,200

Item Revenue Manufacturing costs Marketing costs (this is step 2 of the allocation) Margin

LuAnne $400,000 320,000 64,800 $15,200

Detail Given @80% of revenue 60 orders $1,080 per order; 35 orders $1,080 per order

Observe that LuAnne now generates less than half the margin generated by Betty. c. It is difficult to answer the question with the data provided as the answer depends on the nature and composition of marketing costs. The old system assumes that marketing costs are proportional to revenue. This assumption is probably true for many marketing expenses such as after-sales service or shipping. However, the assumption is probably not true for other expenses such as invoicing and sales calls. The revised system makes the opposite assumption that all marketing costs are related to the number of orders and not sales volume. Thus, both systems are probably inaccurate. Ideally, we would like to partition marketing costs into two pools costs that relate to revenue and costs that relate to order processing. We can then use sales revenue as the cost driver for the first pool and orders as the driver for the other pool. This kind of a refined allocation, with two cost pools, is likely to generate a more accurate estimate. Balakrishnan, Managerial Accounting 1e FOR INSTRUCTOR USE ONLY

9-32

We hasten to note, however, that there is a limit to such refinements. We are still dealing with large pools (in $ terms) when we go from one to two pools. Once we go past a few pools (the exact number depends on the nature of the problem such the magnitude of the costs, the number of cost objects, and correlations among cost drivers), we increase the chance for measurement error. Thus, it is possible that any further increase in the number of cost pools might decrease accuracy in reported costs. d. The manager can use this information to focus her sales persons efforts on the right mix of sales and activities. For instance, LuAnnes ranking drops because her average order size ($6,667 = $400,000/ 60 orders) is smaller than the average of $8,000. LuAnne therefore imposes higher demands on organizational resources for the same sales volume. The allocation is one way of sensitizing LuAnne to the financial implications of her choices. Allocating some (or all) of the cost using orders as the allocation basis will motivate LuAnne to consider order volume as well when dealing with customers. For instance, under the accountants scheme, LuAnne incurs a fixed cost of $1,080 per order and generates a contribution margin of 20% over manufacturing costs. Thus, LuAnne should refuse to take any order less than $5,400 (= $1,080 / 0.2) as this is the breakeven order size. Carefully crafted allocations, when coupled with incentive compensation, can help encourage desired activities and penalize undesired actions. 9.52 In this setting, the objective is to set prices proportional to the damage inflicted on the road due to use. Logic tells us that vehicle weight and distance traveled are two important criteria in determining damage done. Thus, we can view the pricing scheme as an allocation of the road cost to vehicles. Viewed in this light, a flat charge per vehicle assumes equal damage from all vehicles and is easy to implement. We only need to install booths at entrances to the toll way and automating the toll-collection is relatively simple. Adjusting the flat rate by vehicle category adjusts for weight. The scheme does not discriminate among empty and loaded trucks. Implementing the scheme is still relatively straightforward but may require a person to collect the differing toll amounts. The third allocation basis, using actual weight, is yet more sophisticated. As a continuous metric, we would term it a duration driver. There are likely significant measurement costs as the toll authority must have a mechanism to weigh each vehicle using the toll way. The final scheme is perhaps best at estimating the cost inflicted on the toll way. However, the scheme is also the most difficult from an implementation perspective. For instance, we need to monitor where a vehicle enters and exits a toll way.

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9-33 This problem highlights some of the tradeoffs involved in choosing an allocation basis. Simple drivers such as the number of vehicles (which count and are sometimes termed count drivers) are easy to implement but are inaccurate. More complex drivers which account for weight (called duration drivers as they account for characteristics) are often more accurate measures of resources consumed. However, measuring duration drivers may impose higher costs and have greater measurement error. Overall, the choice is judgmental, as evidenced by the many observed schemes for collecting tolls. 9.53 a. An equal assessment implicitly assumes that each household derives equal benefit from the improvement. The use of linear feet of road front ties the cost to the work done. The idea here is that the cost is proportional to the linear feet of pipe laid and that homeowners own the pipe that runs through their property. The use of property value is based on the assumed ability to pay. The notion is that persons owning more expensive homes have greater ability to pay for the upgrade and should be charged accordingly. All of the metrics are somewhat arbitrary. All of them are easy to implement and have some reasonable justification. Ultimately, cities make the choice based on political considerations, with ability to pay often being the dominant criterion. b. It is more common to assess sidewalks based on linear feet of road front. Unlike sewer lines, it is possible to partition sidewalks into discrete pieces that belong to the homeowner. Indeed, in many cities, the homeowner is responsible for maintaining the sidewalk (e.g., shoveling snow). The key distinction between sewer lines and sidewalks appears to be in the ability to trace the cost to the individual homeowner. As sidewalks can be installed piece-meal, there is ample justification to attach the cost of the sidewalk for a given home to that home. In contrast, sewer lines are a public good and the entire system needs to be completed before benefits are realized. 9.54 Payroll Processing. There appear to be two types of costs in this category. The first relates to payroll processing and the second relates to employee hiring and firing. Both expenses are part of operating the business and therefore should be allocated to individual branches for the purpose of evaluating branch profitability. The answer is less clear for managerial performance evaluation. The cost of payroll processing is not controllable by the manager except via his or her influence on the payroll. Thus, the allocation makes sense if Maggie wants the managers to pay attention to payroll costs. However, there are likely more direct mechanisms, such as boundary controls that specify wages and staffing strength, for controlling payroll expense. In a like fashion, we can argue for allocating some payroll costs based on the number of new employee hires. While more direct controls are also available (e.g., Maggie speaking with the branch to reduce turnover), this allocation sensitizes the branch managers to the cost of turnover. Balakrishnan, Managerial Accounting 1e FOR INSTRUCTOR USE ONLY

9-34

Advertising. The cost of corporate advertising can be allocated to branches using sales $ as the basis. The problem text indicates a direct sales effect. Because sales are recorded at the branch level, it seems reasonable to allocate the associated costs as well for evaluating branch performance. The logic is less compelling if the purpose is to evaluate managers. The branch managers have little control over the cost and, thus, would see the allocation as being arbitrary. Moreover, it is unclear what performance-evaluation purpose the allocation would serve. Purchasing and Inventory Handling. This cost resembles the cost of payroll in terms of its controllability by branch managers. Thus, a similar logic applies. The cost must be allocated to branches for profitability assessments. Allocating at least a portion of the cost based on the number of deliveries and using it for managerial performance evaluation sensitizes managers to the cost of poor forecasting. However, as with payroll, more direct mechanisms (e.g., all extra deliveries must be approved by Maggie) may suffice to provide the required control. This problem highlights three issues. The reason for the allocation determines if it makes sense for the firm to allocate the cost. Taking advertising as an example, the allocation is justifiable for assessing branch performance but not managerial performance. Allocations can modify behavior. If Maggie allocates personnel costs by the number of hires and fires, and uses the cost in managerial performance evaluation, branch managers have an incentive to be more careful in their hiring and firing. However, please note that mere allocation is not enough. The allocated cost must also influence managerial compensation for the allocation to provide the correct incentives. Allocations are but one tool in the portfolio of controls available to management. Given Yin-Yangs size, direct mechanisms may work better and be more cost effective than cost allocations to modify managerial behavior. It is easier to conceive of a role for such control-related allocations in larger firms.

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9.55 a. There are at least two salient reasons that trigger the demand for a cost allocation in this setting. 1. Inventory Valuation. The problem indicates that a typical project spans many years. Great Lakes needs to value the inventory of parcels in its possession at year end to determine the income reported for a given year. The overall cost (purchase plus development) must be allocated to individual parcels for this financial accounting purpose. 2. Cost Justification. For political purposes, it is likely that Great Lakes will wish to sell the parcel for the school at cost. Indeed, Great Lakes might even wish to choose a basis that allows it to show a loss from the sale to the school board. Similarly, Great Lakes probably deals with the same set of builders when selling its many properties. The allocated cost may be shared with the builders to help build the case for the price charged. b. Great Lakes could use many allocation bases (or cost drivers) to determine the cost allocated to each parcel. The following is a representative list. 1. 2. 3. 4. Area Desirability (Qualitative) Frontage (i.e., the linear feet of road abutting a property) Estimated sales price.

In addition, Great Lakes may choose to sub-divide the $1.4 million of development cost into smaller cost pools. It could then employ a separate driver for each cost pool. c. Great Lakes has competing motives in its choice of allocation bases. The following criteria seem important: 1. Postpone realizing the gain from sale. For instance, suppose the project has three stages to be sold in turn. Then, the firm can allocate in a way that leads to least cost charged to Stage III, that would only become available after substantial portions in stages I and II have been sold. This mechanism reduces the present value of the taxes paid by postponing the recognition of income to later periods. 2. Increasing the cost allocated to the schools to maximize political benefit. 3. Increase the cost allocated to homebuilders and retail space to justify higher prices. 4. Defensibility in public. The allocation scheme must make sense if there is a possibility that the scheme might be subject to public scrutiny.

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9-36 9.56 a. During April, Quick Test produced 1,250 units, selling 750 of these units. These 750 units plus the 750 units in opening inventory comprise the total of 1,500 units sold. Under variable costing, the 500 units in ending inventory (=1,250 750) would be valued at the variable manufacturing costs. Thus, the value of the ending inventory under variable costing = $25,000 = $50 500 units. b. The table below provides the required computation: Total COGS $105,000 Less: Cost of units from BI 45,000 = Cost of units from this month $60,000 Cost per unit $80 Less: Unit variable cost (mfg) 50 Equals Allocated fixed cost/unit $30 Units made in April 1,250 Fixed costs in April $37,500 This comprises mfg. costs only Given $60,000/750

1,250 units $30/unit

c. The following table provides the required statement. Quick Test Enterprises Contribution Margin Statement April Sales volume (in units) Production volume (in units) Revenue $100 1,500 Variable Costs Manufacturing costs $33,750* + (750 $50/unit) SGA costs $18,000 (total) - $12,000 (fixed) Contribution Margin Fixed Costs Manufacturing From part [c] Marketing & sales Given Profit before Taxes * $45,000 total costs - $11,250 in allocated fixed costs

1,500 1,250 $150,000 71,250 6,000 $72,750 $37,500 12,000 $23,250

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d. We reconcile the income reported under the two formats as follows: Income reported under variable costing + fixed overhead in ending inventory - fixed overhead in opening inventory = Income reported under absorption costing 9.57 Understanding the purpose for this allocation helps us define the costs and benefits of such mechanisms. The purpose is to convey to faculty the opportunity cost of using staff time for special projects. The absence of allocations conveys the message that the resource has no cost. The benefit of allocating $50 per hour is sensitizing faculty to the resources cost. While the project is supposed to be done only when time becomes available, it is easy to conceive of faculty applying pressure to get their project done, the Centers staff feeling personal responsibility for meeting promised schedules, and so on. Thus, even though there is no direct additional cost to the college, we conceive of an opportunity cost stemming from delays in the Centers regular work and/or degradation in the efficiency of their service. The arbitrary charge of $50 per hour is an attempt to measure this opportunity cost and to convey its magnitude to the faculty seeking to use the staff for special projects. The cost of charging faculty $50 per hour is that faculty may not use the resource as much. When the Centers workload is low, meaning excess capacity is available, the opportunity cost of available time is zero. The $50 charge therefore over-estimates opportunity cost, and thus promotes inefficient resource usage. Students may reasonably wonder about the feasibility of implementing a charge only when the staff is busy and/or sticking to the norm of doing the projects only when time becomes available. Both modifications aim to better measure the opportunity cost of staff time. However, we anticipate practical difficulties in implementing either modification. Whether the staff is busy is subjective, and few persons would admit to having substantial slack time. Similarly, it may be difficult to adhere to the norm of doing projects only when slack time becomes available. Overall, we support the Directors request to charge faculty for the center. The actual charge per hour must necessarily be subjectively determined. 500 units $30 per unit $11,250 (given) $23,250 15,000 11,250 $27,000

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9.58 a. The purpose appears to be to elicit the true benefits (only known by the divisions) to acquiring the software. If such an allocation did not take place, each division would claim considerable benefits and the firm might wind up acquiring software whose costs exceed the real benefits derived by the divisions. The allocation sensitizes the managers to the cost of the purchase, thereby modifying their behavior and estimates regarding realized benefits. b. This is a difficult problem, with no obvious solution. The difficulty arises because there is uncertainty about the number of cost objects (divisions) that should be charged. Additionally, the allocation scheme would influence the division managers estimates of benefits. For instance, an allocation scheme based on estimated benefits gives incentives to reduce the estimate. If all managers lowball, it is possible that total estimates are too low for the software to be acquired even though it would have been desirable absent these agency conflicts and strategic effects. The following four allocation schemes come to mind: 1. Equal allocation to all four product divisions. This method has the benefit of being transparent and easy to implement. However, the allocation is quite arbitrary and has little correlation with the true benefits realized by each division. Thus, the decision to acquire must be made prior to obtaining the data about benefits! 2. Allocate in proportion to benefits received. This scheme has the benefit that we could condition the decision to acquire the software on the estimated demands. However, the scheme also provides manages with incentives to lowball because such action shifts the costs from their division onto other divisions. As argued earlier, such strategic behavior could lead to the firm foregoing profitable opportunities. 3. Allocate by division size. This gets at the fact that different divisions might realize different benefits (here the assumptions is that benefits are proportional to, for example, revenue or assets in place). However, this method has the same faults as the equal allocation method in terms of eliciting demand information. 4. Allocate only to divisions A and B. Charge Divisions C & D only if they subsequently use the system, giving appropriate credit to A and B. This scheme is more complex than the earlier schemes but begins to get at the timing issue. Again, there are incentives for C & D to lowball their estimates (after all, the software has already been bought). Additional problems like the one illustrated below in Part [c] also arise.

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c. The division manager has a point. However, if this becomes common practice, none of the divisions would then become the first user, severely accentuating the underinvestment problem. Overall, we do not know of any easily implemented solution to this problem. Indeed, this situation is the subject of ongoing academic research. 9.59 The following table identifies the costs and benefits of each allocation basis. Notice that we have to apportion the common cost in some way among the users of The Peninsula. The problem is that the parks, ponds, trails, and landscaping are public goods, with the benefits being shared by all. Basis Property value Advantages This ability to bear criterion imposes costs on those most able to bear it. The assumption is that persons living in more expensive homes would be able to afford more. This method attempts to measure usage. The method is fair if all parties derive similar benefits from the common facilities. Disadvantages The retail stores might get affected the most as their value is often quite large. The scheme may wind up taxing these stores in favor of homeowners. Retail stores benefit from this method as their head count is zero! Nevertheless, they too derive benefits because of increased volume and because their customers and employees would also use the common facilities. The implicit assumption is faulty. The method is also regressive in that a condo and a large store would be treated on equal footing, ignoring differences in usage and the ability to pay.
Some costs (e.g., landscaping) still need to be allocated. All fees do is to reduce the magnitude of the problem. Further, there may be significant administrative costs associated with designing and administering a fee-based scheme.

Head count

Equal division

This method is simple and easy to implement. It assumes that each household / store gets similar benefits from the park, regardless of its size.

Fee-based to the extent possible.

This is perhaps the most equitable method because it allows the consumer to pay only for facilities used.

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9.60 In all three instances, there is a business related and a non-business related cost and benefit. The total cost, however, is common, requiring Jean-Pierre to allocate the cost among the two purposes. For situation [a], we believe the Jean-Pierre should seek reimbursement for $5,000, the business class fare. The travel afforded him an opportunity to increase his personal enjoyment as well. This is akin to someone getting frequent flyer miles for traveling on business, and using the miles to take a vacation or obtain an upgrade. (We note that some firms have policies that appropriate the miles.) The firm did not incur incremental costs due to Jean-Pierres actions. If anything, there is an incremental benefit because JeanPierre might have been in a better state of mind when traveling with his spouse. The situation in [b] is somewhat similar to that in [a], except that Jean-Pierre could claim an extra $650 of reimbursement. We believe that Jean-Pierre should not seek reimbursement for the additional $350. This expense stems purely from private considerations, and the cost is accordingly not reimbursable. Reimbursable amounts in situation [c] range from a low of the coach fare ($1,800) to the entire amount ($5,000). Arguments for charging $5,000 include the idea that the firm is willing to spend that amount on Jean-Pierre, and it is really up to him as to how he spends it. For example, many would claim the entire per-diem allowance for meals even if their actual expense were lower. On the other hand, the firm pays for business-class travel because of the conveniences it provides. Jean-Pierre would be better able to transact business if he traveled in business class. One can argue that charging $5,000 in this case is akin to taking the shuttle bus from the airport to the hotel but charging for a taxi fare. Overall, we believe that Jean-Pierre should have discussed his choice with his boss and/or with the Human Resources Department before acting. He should certainly disclose the benefit ex post and act per his firms directions. In any case, it is clear that Jean-Pierre should not charge for the extra day of hotel and meal expenses. These expenses stem solely from private concerns.

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9.61 a. The following table lists the kinds of actions that you could take in response to the allocation so as to reduce the amount allocated to you. Item 1 Actions Division managers can reduce head-count by removing people from the firms payroll and hiring them back as consultants. This action reduces the units of cost drivers in the division, reducing the corporate expense allocated to it. The action might actually increase total costs rather than reduce them. As a freelancer, a consultant would typically charge more than the firm would pay for an employee. Further, there are additional coordination costs incurred for dealing with external persons (e.g., security and confidentiality issues, dealing with invoices and payments, etc.). 2 We can reduce the reported cost for the board by using components that perform multiple functions in place of individual, function-specific components . For example, think of an integrated stereo system rather than a system with a separate amp, CD player, tuner, and speakers. This action reduces the number of components, reducing reported cost. The cost-benefit tradeoff is unclear. On the one hand, individual components might increase product functionality and allow for better design. This might, in turn, increase the products demand/price, thereby increasing product profitability. However, dealing with many components could increase overhead costs (more suppliers, more deliveries and so on). 3 We can reduce the reported cost for the board by using components common to this and other products rather than components unique to this product. This action reduces the number of unique components, reducing reporting cost. The cost-benefit tradeoff is unclear as it similar to that in situation [b]. On the one hand, unique components might increase product functionality and allow for better design. This might, in turn, increase the products demand/price, thereby increasing product profitability. However, dealing with many more components could increase overhead costs. Each unique component might trigger substantial costs such as developing and certifying a vendor and setting up a part number. 4 We can reduce the reported cost for our product by making the components ourselves. This action substitutes labor cost for materials cost, thereby reducing the amount of overhead allocated to our product. This action likely increases total costs. The action requires more work to be done at the plant, and will increase demand for labor hours. In turn, overhead costs might Balakrishnan, Managerial Accounting 1e FOR INSTRUCTOR USE ONLY

9-42 also increase. Ideally, as we learned in Chapter 5, make-or-buy decisions should consider all relevant costs and benefits. The product manager will over-estimate materials costs, thereby increasing the chances of an erroneous decision. 5 We can reduce the reported cost for our product by outsourcing components rather than making them ourselves. This action substitutes materials cost for labor cost, thereby reducing the amount of overhead allocated to our product. This action likely increases total costs, as in situation [d]. Ideally, as we learned in Chapter 5, make-or-buy decisions should consider all relevant costs and benefits. The firms allocation system might cause the product manager to over-estimate labor costs, thereby increasing the chances of an erroneous decision. b. Item 1 Actions A firm incurs many costs associated with keeping an employee on the payroll, particularly if the payroll is centrally administered. Allocating corporate expenses to divisions based on head count is one way to sensitize division managers to the hidden costs associated with head count. Unfortunately, unless the allocation is done carefully, the charge likely over-estimates the true cost of adding employees, thereby encouraging dysfunctional behavior. Increasing the number of components increases manufacturing costs as each component must be inserted into the board. Further, the firm has to maintain more items. The allocation sensitizes design engineers to downstream manufacturing costs. However, as argued earlier, the effort can backfire as the new design might compromise product functionality. Dealing with many more components increases overhead costs. Each unique component might trigger substantial costs such as developing and certifying a vendor, setting up a part number, and so on. The choice of the driver sensitizes design engineers to these costs that are often hidden from them. The tradeoff, of course, is that the attention to the count of unique parts might compromise product functionality and design. Consistent with earlier choices, this choice sensitizes product managers to the overhead cost consequences of increasing materials cost and labor cost. Unless the allocation is carefully done, it is easy to overestimate this cost impact. Then, because the product managers would view the allocated cost as a variable cost, they could easily be misled into making erroneous make-or-buy decisions.

4,5

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9.62 a. The allocation serves to determine each persons share of the bill. The cost is a joint cost (visualize the wine being shared), triggering the need for an allocation. We implicitly allocate costs every time we share a meal, in a restaurant, with friends and family. (Sometimes, the allocation is all the cost to one person, the host, and none to the guests.) There are several considerations. Equity in payment seems important, and is the source of Julies frustration. Ease of computation is another consideration. Particularly with family style meals, it may be impossible to determine consumption or other equitable allocation bases. Ability to bear may be a third. Particularly if the friends had differing economic abilities, we expect the well-off friend to contribute more. Of these considerations, only the first two would seem to apply in the situation described in the problem. b. The following schemes come to mind. 1. Julie and/or Becky could be given an ad hoc adjustment because of the lower cost triggered by their food and drink choices. 2. Split out the cost of the liquor and the food. Divide each pool equally among the friends who consumed liquor and food, respectively. 3. Track the cost of the entre for each person. Subjectively add estimates for the amount of liquor and other food (e.g., dessert) consumed. 4. Approximate split. That is, every one looks at the bill, estimate their share and adds a percentage (say 20%) to cover tax and tip. If theres slight over-contribution, it usually goes to the waiter. If theres an under-contribution, then often everyone chips in a small amount. And if theres significant under-contribution, then the problem gets addressed rather than fall unfairly on someones shoulders. The first scheme makes a move toward a more equitable split among the friends. However, the scheme is not perfect. For instance, consider a friend who begged off dessert because of a diet, or another who did not consume the main course because he was watching his protein intake. Both of these persons could also claim an adjustment, with each adjustment making the scheme more complex and ad hoc. The second scheme is a modification that tries to capture the cost differences between liquor and food. The third scheme takes the second scheme to a logical extreme. However, it is computationally difficult and involves much subjectivity. Such a scheme defeats the purpose of having a shared meal and can ruin the evening. Scheme 4, which is a compromise, often works well in casual settings Overall, something like scheme 1 may be the best compromise between equity and ease of computation. c.

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9-44 In this particular instance, we would be surprised if the front-end agreement influenced the bill in any way. After all, the friends are on their way to becoming highly paid professionals and probably would not skimp on a celebratory dinner. Nevertheless, allocation methods can influence behavior. The human tendency is to order more liberally when the cost is being split equally (that is, when you bear only a part of the cost of your actions) compared to when you will bear the entire cost of your actions. This tendency is exacerbated in groups where one person is perceived as consuming more than his or her fair share.

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MINI-CASES 9.63 a. This is a classic short-term decision of the sort that we considered in Chapters 4 and 5. Accepting or not-accepting the job will not substantively affect CGs capacity costs. Thus, these costs are not relevant for this decision. CG is also in a situation of excess supply of capacity with respect to this decision. The machines would be idle during weekdays, and there is no opportunity cost to using them for this job. The only clearly relevant cost for CG is the variable cost of $0.02 per page. One could argue that we should consider the machine cost as well. Over its life, the cost per machine hour is: Total cost of machine Total hours available Cost per hour Cost per page hour) Because 20 hours is such a small fraction of the machines 12,000 hour useful life, we would not consider the machine cost to be relevant for this decision. Moreover, CGs overall machine costs are unlikely to change substantively because of this decision. Thus, $0.02 is the minimum price that can be charged without lowering profitability . Of course, this does not mean that $0.02 is the right bid. The marketing manager should charge what the market will bear, also taking into account long-term strategic issues. For example, this might be a good opportunity to get CGs foot in the door with respect to the catalog business. b. We disagree with the marketing managers logic because we view this decision as spanning the medium term. That is, the firm is entering a new market and will have to adjust capacity resources to account for the additional demand. Consequently, the pricing decision for the catalogs must consider the cost of capacity resources consumed by catalogs. These costs include variable costs, the costs for the machine, and the costs of support staff. $4,000,000 12,000 $333.33 per hour $0.0167 per page ($333.33 / 20,000 pages per

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c. We agree with the accountants argument. We can compute the cost of the capacity resources as: Machine cost $4,000,000/12,000 hours = = $333.33 / hour, $0.0167 / page ($333.33/ hour/20,000 pages per hour) $562.50 / hour $0.0281 / page ($562.50/ hour/20,000 pages per hour) $0.0448 / page

Support cost $2,250,000/4,000 hours

= = = =

Total overhead cost

Adding the variable cost of $0.02 per page gives a total cost of $0.0648 per page, which yields a price of $0.071 per page (= $0.0648 1.10), and is comparable to the current market price of $0.07 per page. Two points warrant discussion. First, notice that we computed the cost per machine hour using the cost over the life of the machine. An alternate method is to employ the annual cost of $1,000,000 (= $4,000,000/expected life of 4 years), then divide it into the expected use of 4,000 hours per year to obtain a rate of $250 per hour or $0.0125 per page. We believe that this alternate method is faulty because the machines useful life will decrease if we use it for an additional 1,000 hours each year. That is, the useful life only be 3 years (= 12,000 hours total life/4,000 hours each year) rather than four years as projected with existing production. Second, notice that we use the total cost of the support staff when computing the overhead rate for this cost pool. An alternate method is to employ the $250,000 incremental cost only to compute the rate as $250,000/1,000 hours or $1,000 per hour (= $0.0125 per page). We do not believe this alternate method is correct because CG is adding an additional product line it is not incremental, or temporary, business. Thus, the catalog product must cover its full share of the support costs and not just the incremental costs.

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d. Let us examine each cost component separately to evaluate this argument. The variable cost per page has not decreased. The cost of the machinery per page also has not decreased. Prior to introducing catalogs, the annual cost of machinery was $1,000,000 and the annual usage was 3,000 hours. These data yield a rate of $333.33 per machine hour. With the catalogs, the annual cost is $1,333,333 ($4,000,000 over three years) and annual usage 4,000 hours, again yielding a rate of $333.33 per hour. The support cost per hour has decreased, however. Prior to catalogs, the cost was $2 million for 3,000 hours, leading to a rate of $666.66 per hour. With catalogs, the rate is $562.50 per hour ($2,250,000 / 4,000 hours). The reduction occurs because the incremental production of 1,000 hours does not proportionately increase support overhead costs. The marginal rate for the new production is $250,000/1,000 hours = $250 per hour, which is lower than the average rate.

Such reduction in rates could occur for two reasons. First, the additional production consumed the excess capacity present earlier (thus, not as much was needed in incremental cost). Second, scale economies resulted in marginal cost being lower than average cost. In either case, we would argue for a beneficial cost impact on the cost of producing magazines. That is, we see both the magazines and the catalogs benefiting from better utilization of excess capacity and/or scale economies. Strategic considerations should guide whether we should support the marketing managers move to share the cost reduction with customers. 9.64 a. Income Statement - March All of the units sold in March were produced in March as there is no opening inventory in March. Thus, knowing that fixed manufacturing costs were $750,000 and 1,500 units were produced, we determine the fixed cost per unit as $500 per unit = $750,000/1,500 units.

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The total inventoriable cost under absorption costing is therefore $200 of variable manufacturing cost + $500 of allocated fixed manufacturing costs = $700 per unit. We have: Total for March 0 units 1,500 units 1,000 units 500 units

Detail Opening inventory (units) Units made Units sold Ending inventory Revenue Cost of Goods Sold Gross Margin Selling and Administrative Costs Profit before Taxes Ending Inventory Value $1,000 per unit 1,000 units sold $700 per unit * 1,000 units sold

$1,000,000 700,000 $300,000 $100,000 + ($25 per unit 1,000 units sold) 125,000 $175,000 $700 per unit 500 units in ending inventory $350,000

* $700 = $200 variable cost + $500 fixed cost allocation, ($500 = $750,000/1,500units) Income Statement - April 1,250 units were sold in April but we do not know how many units were produced. However, we do know that Emily began with an inventory of 500 units (value = $350,000, as determined in part [a]) and ended with 0 units. Thus, Units sold + Units in ending inventory - Units in opening inventory = Units produced 1,250 0 500 750

Of the units sold in April, 500 came from opening inventory, with the remaining 750 coming from current period production. We have to add the costs of these units to determine the cost of goods sold. Units in opening inventory were valued at $700 per unit. Let us therefore determine the cost per unit for Aprils production. Variable manufacturing cost Fixed manufacturing cost Total cost per unit $200 1,000 $1,200 $750,000/750 units

The total cost of goods sold for April is: Units from opening inventory $350,000 Units from current production $900,000 April COGS $1,250,000 Balakrishnan, Managerial Accounting 1e 500 units $700 per unit 750 units $1,200 per unit

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Total selling and administration costs for April are $100,000 + ($25 per unit 1,250 units) = $131,250. With this data we have: Total for April 500 units 750 units 1,250 units 0 units $1,250,000 1,250,000 $0 131,250 ($131,250) $0

Detail Opening inventory (units) Units made Units sold Ending inventory Revenue $1,000 per unit 1,250 units sold Cost of Goods Sold $1,250,000, as calculated above Gross Margin Selling and Administrative Costs $131,250, as calculated above Profit before Taxes Ending Inventory Value b. With the data provided, we have:
Detail Sales volume (in units) Production volume (in units) Revenues Variable Costs Manufacturing costs Marketing costs Contribution Margin Fixed Costs Manufacturing Marketing & sales Profit before Taxes $1,000 1,000; $1,000 1,250 $200 1,000; $200 1,250 $25 1,000; $25 1,250 $775 1,000; $775 1,250 March 1,000 1,500 $1,000,000 200,000 25,000 $775,000 750,000 100,000 ($75,000)

0 units in inventory

April 1,250 750 $1,250,000 250,000 31,250 $968,750 750,000 100,000 $118,750

Note that the pattern of income reported under variable costing conforms to our intuition, developed from CVP models (i.e., income increases in sales). This correspondence always holds because, like the CVP model, the variable costing income statement partitions costs into fixed and variable costs.

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c. We can reconcile the income reported under the two formats as follows: Item Income reported under variable costing + Fixed overhead in ending inventory - Fixed overhead in opening inventory Calculation 500 units $500 per unit; 0 $250,000 0; 500 units $500 per unit $0 ($250,000 ) 0 March ($75,000) April $118,750

d. Under both variable costing and absorption costing, Emilys profit over the two months equals $43,750. The difference in the income for each month arises because of the differing treatment of fixed manufacturing costs. Under variable costing, the entire $750,000 of monthly fixed costs is expensed in the income statement. In contrast, the cost is allocated to units under absorption costing. This allocation means that the cost could be part of the inventory cost. The reconciliation adjusts for the flow of fixed overhead costs via the inventory account. Emily began March with zero inventories and ended April with xero inventories. Thus, the flow of costs into inventory equaled the costs out of inventory for the two month period. That is, there is no chance for fixed manufacturing costs to stay in the inventory account. Because the sole difference between the methods is whether fixed manufacturing costs stay in inventory or not, the profits must coincide over this period. 9.65 a. There are several possible schemes: 1. Allocate the $7 million already spent to the military application and split the balance equally between the two applications. 2. Allocate $9 million (its stand alone cost comprising of $7 million already spent plus the $2 million to be spent) to the military application and the remainder of $1 million to the civilian application. 3. Allocate the $10 million equally to the two applications because they appear to possess similar revenue characteristics. Choosing among these methods is difficult, as we can argue both for and against each of the mechanisms. The first mechanism best matches up the intent of the cost flow with the application. The initial $7 million was spent for the military application and thus it seems fair to allocate it as such. The remaining cost benefits both systems and thus is equally split. The downside of this method is that it seems to give the civilian application a free ride. Balakrishnan, Managerial Accounting 1e FOR INSTRUCTOR USE ONLY

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The second allocation treats the civilian product as a by-product and only charges it the incremental cost of tailoring the technology for civilian use. The benefit is that the firm gets the maximum reimbursement for developmental expenses, but at the cost of creating the perception of over-charging the military application. The final mechanism may be perceived by many to be most equitable but is not as profitable. Ultimately, strategic considerations would dictate the choice. We believe that most managers would choose method 2 because it is well within the initial estimate provided to the government. That is, management would view the civilian application as found money, or an unexpected bonus. In addition, government contracts often consider the possibility of such civilian applications when negotiating contracts. b. The following table shows the cost allocated to each of the two applications under the three methods. Overhead allocated to civilian application Overhead allocated to military application $2.73 million (=$15 million $0.1818 / dollar) $3 million (= $15 million $0.20 / labor dollar) $909,000 ( = $15 million $0.0606/ materials $) $2 million (= $15 million $0.1333 / labor $) $2.909 million

Total of Rate per unit of Total allocation allocation basis overhead cost basis Method 1 (Allocate based on materials cost) $6 million (= $33 million $0.1818 for $3.27 million (= $2 million + $4 (= $18 million each materials $18 million million) + $15 million) $ (rounded) $0.1818 / dollar) Method 2 (Allocate based on labor cost) $6 million (= $30 million $0.20 for each $2 million + $4 (= $15 million labor $ million) + $15 million)

$3 million (= $15 million $0.20 / labor dollar) $1.091 million (= $18 million $0.0606/materials $) $2 million (= $15 million $0.133333/ labor $) $3.091 million

Method 3 (Allocate using two cost pools) $2 million of $33 million $0.0606 for materials(= $18 million each materials related + $15 million) $ (rounded) overhead $4 million of $30 million $0.1333 for labor-related (= $15 million each labor $ overhead + $15 million) (rounded) Total

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The choice among the mechanisms depends on the firms goals. From a decision making perspective, method 3 seems to provide the best mapping between the cost of resources consumed by, and the overhead allocated to, each product. From a reimbursement perspective, method 2 is preferred because it allocates the maximum overhead to the military application, thereby increasing C3s revenue and profit. c. We would be hard pressed to argue that this behavior is outside the norms for ethical behavior. In particular, the government contracted for a certain output and negotiated the price for that output. The civilian application is an unanticipated externality. For an example, we observe that federal funds support many research projects at universities. Yet, the federal government lays no claim to any commercially viable inventions produced in the research endeavor. (Note: Existing legislation such as the Bayh-Dole Act governs the governments claim to profits from the invention.) 9.66 a. Evaluate the merits of the firms choice to continue allocating overhead based on labor hours, although the strategy is to foster automation. What is the impact on the accuracy of reported product cost? What counter-veiling benefits, if any, does the allocation mechanism provide? There are costs and benefits associated with the firms choice to allocate overhead based on labor hours, even as the firm encourages automation. The cost is that labor hours may not appropriately measure resource consumption in an automated environment. (The man-machine ratio would have to be the same across all processes for this allocation to be even somewhat reasonable.) Thus, the allocated cost will poorly measure the opportunity cost of consumed resources, possibly leading to poor decisions. The benefit stems from the induced behavior. Product managers such as Karl and Bjorn will view the allocation as a tax that increases the cost of labor. Thus, they will seek to reduce their products labor content, which is behavior consistent with the firms strategy. Suppose the firms product market prevents cost-based pricing (for example, competition is fierce, rendering market price uncontrollable by any one firm). Then, the benefit from the induced behavior may outweigh the potential for poor pricing decisions. b. Karls strategy reduces the amount of overhead allocated to Bjorns product line by reducing the number of labor hours consumed. Outsourcing a products components will result in the associated costs being classified as materials costs, which do not attract an overhead charge. Instead, if Bjorn were to make the product, he would incur both the cost of the raw materials and the cost of labor required to convert the raw material into the component. The latter cost would attract an overhead charge. We see other examples of similar behavior. When overhead is allocated based on head Balakrishnan, Managerial Accounting 1e FOR INSTRUCTOR USE ONLY

9-53 count (i.e., the number of employees), division managers have incentives to lay off staff and to rehire the same persons as consultants. The change affects the count of full time employees (consultants are not employees) and thereby reduces the amount of overhead allocated to the division. c. Suppose Bjorn follows Karls advice and out-sources some components that are currently in-sourced. We believe that this action is not likely to change, to any measurable degree, the firms overall expenditure on overhead items. All that Bjorns actions would accomplish is to reduce the overhead charged to his product line. The overhead that he avoids will now be charged to other divisions within the firm. A popular analogy is squeezing a balloon at one end. The action reduces the amount of air at that end but does not reduce the total volume of air in the balloon. Chapters 9 and 10 discuss action strategies that accomplish a real reduction in the amount of overhead expenditure. We also believe that Bjorns actions will increase the firms overall expenditures. By outsourcing, the firm avoids the materials and labor cost. However, the price paid to the supplier must cover not only the cost of materials and labor but also the suppliers overhead cost and its profit. Thus, the price to outsource likely exceeds the variable cost of making the component in house, increasing the firms overall expense. Nevertheless, Bjorn may be tempted to take this action because it would reduce the amount of overhead charged to his division. From Bjorns perspective, the overhead charge is a variable cost. It is very possible for the companys overhead charge to be large (particularly if it is based on labor hours in an automated environment). Overhead rates of 200 or 400% of labor cost are not unknown. Given such a charge, Bjorn may prefer to outsource because it reduces his total cost. From the companys perspective, the calculation may go the other way because the firm would ignore the overhead cost as being not relevant for the comparison. d. We would be hard pressed to argue that Karls recommendation is unethical. In an ideal setting, Bjorns and the firms goals would be perfectly aligned and employee actions would benefit the firm as well. However, as we learned in Chapter 1, individual and organizational goals differ. Such differences inevitably lead to slippage of the sort described in this problem. (We termed this the agency conflict.) While firms employ control mechanisms such as boundary controls and performance evaluations to reduce the slippage, it may be prohibitively expensive to eliminate it altogether. Seen in this context, Bjorns behavior falls within ethical norms, although it may not advance organizational goals. From a positive perspective, one hopes that the firms management understands the incentives created by their chosen allocation mechanism. The fact that they have implemented the mechanism suggests that they consider the costs to be less than the benefits, with one of the costs being product managers outsourcing components.

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