Management Accounting Concepts and Techniques

Dennis Caplan, Oregon State University

capland@busoregonstateedu
http!""denniscaplan#atco$com"TOChtm
Table o# Contents
Ch
%
&


'
(
)
*
+


,
-
%.
%%
%&
%'


%(
%)
%*
%+
%,


%-
&.
&%
&&
&'
&(


/art %! 0ntroduction
Management accounting de#ined, described, and compared to #inancial accounting
1elevant concepts #rom management and operations management, and a brie# history o# management
accounting
/art &! Microeconomic #oundations o# management accounting
1elevant cost analysis
Cost behavior
Cost2volume2pro#it
3le4ible budgeting
Cost variances #or direct materials and labor

/art '! /roduct costing and cost allocations
/roduct costing
5ormal costing
Standard costing
Activity2based costing
Allocation o# service department costs
The role o# cost in setting prices

/art (! Determining the cost o# inventory
6or72in2process
Alternative inventory valuation methods
3i4ed manu#acturing overhead
Cost variances #or variable and #i4ed overhead
8oint products

/art )! /lanning tools and per#ormance measures #or pro9ects and divisions
Capital budgeting
Operating budgets
:udgetary incentive schemes
Divisional per#ormance measures
Trans#er pricing
Corporate social responsibility

3ive2page summary o# 7ey concepts
;lossary
This site is maintained by Dennis Caplan, University at Albany (State University of New York) !rofessor Caplan may
be "onta"ted at d"aplan#$amailalbanyed$ Sol$tions to the end%of%"hapter materials will be sent via email to any
instr$"tor listed in &ames 'asselba"k(s A""o$ntin) *a"$lty Dire"tory
+ana)ement A""o$ntin) Con"epts and Te"hni,$es Copyri)ht- .//0 +ost re"ent $pdate- November .//1
C<A/T=1 %(! 6or72in2/rocess

Chapter Contents!
- Equivalent unit calculations
- Exercises and problems

=quivalent unit calculations!
How does a company that uses an assembly-line or batch manufacturing process determine the cost of work-in-process at period-
end, when there are hundreds or thousands of units of inventory at varying stages of completion? The answer relies on the concept
of an equivalent unit !or example, four units that are each half-finished are equivalent to two complete units Eight units that are
each "#$ finished are also equivalent to two complete units %n both examples, the cost accounting terminology is that there are
two equivalent units in work-in-process &imilarly, if two units are #'$ complete, and four units are "#$ complete, there are still
91
two equivalent units in work-in-process (hat does it mean for a unit of inventory to be #'$ complete? %t means that #'$ of the
inputs required to make the unit have been incurred

%n some manufacturing environments, materials enter the production process early, while labor and other inputs are incurred more
evenly throughout the process !or example, an apparel manufacturer cuts all of the fabric for the batch at the beginning of the
production process, while sewing operator labor is incurred more-or-less evenly from the time the fabric is cut until the garments
are completed %n this situation, companies frequently calculate equivalent units separately for materials and conversion costs
)labor and overhead* %n fact, companies can calculate equivalent units separately for as many different types of inputs as desired,
breaking materials and labor into subcategories However, the additional accuracy of the cost accounting information thus
obtained seldom +ustifies the additional costs to track it

The following nine examples illustrate how equivalent units are used to calculate the cost of work-in-process, beginning with a
simple setting and progressing to more complicated scenarios Each example involves a company that assembles personal
computers from purchased components ,s shown in some of these examples, the company-s assumption about inventory flow is
relevant

=4ample %!

:eginning 0nventory
Activity during the $ee7
=nding
0nventory
Units '.' units made and shipped out )ie, sold*

'
Costs
incurred
/'01aterials2
3onversion costs2
/.,4''
45'

0 Throughout these examples, the box for 6costs incurred7beginning inventory8 reports the beginning balance in the (%9
account for the week

>uestion! (hat is the cost per unit for each unit made and sold?

Ans$er!
Total costs2 /.,4'' : /45' ; /",<5'
3ost per unit2 /",<5' = .' units ; /"<5 per unit

&ince there is no ending inventory, there is no work-in-process, and no equivalent unit calculations are necessary The cost of
ending inventory is >ero

&ince .' units were sold, the cost of goods sold is /"<5 x .' ; /",<5'

=4ample &! This example introduces ending work-in-process

:eginning 0nventory
Activity during the $ee7
=nding
0nventory
Units '.' units started, 4 units completed
and shipped out

. partially finished unit
Costs
incurred
/'1aterials2
3onversion costs2
/.,4''
45'


>uestion! (hat is the cost of goods sold? (hat is the cost of ending work-in-process?

Ans$er!
?nable to determine without knowing the extent to which the partially-finished unit is completed

=4ample '! &ame as Example ", but with additional information about the status of ending work-in-process

:eginning
0nventory

Activity during the $ee7
=nding
0nventory
Units '.' units started, 4 units completed
and shipped out
. partially finished unit, #'$ complete
with respect to both materials and
conversion costs

Costs /'1aterials2 /.,4''
92
incurred 3onversion costs2 45'

>uestions! (hat is cost of goods sold? (hat is the cost of ending work-in-process?

Ans$er!
Total costs2 /.,4'' : /45' ; /",<5'

Equivalent units2 4 completed units : . unit #'$ complete ; 4# equivalent units

3ost per unit2 /",<5' = 4# units ; /"44 per equivalent unit

3ost of goods sold2 4 units were sold, so the cost of goods sold is /"44 x 4 ; /",@4.

(ork-in-process2 /"44 per unit x . unit #'$ complete ; /.54#'

=4ample (! This example separates materials from conversion costs )labor and overhead*

:eginning
0nventory

Activity during the $ee7
=nding
0nventory
Units '.' units started, 4 units completed
and shipped out
. partially finished unit, .''$ complete
with respect to materials and 5'$
complete with respect to conversion
costs

Costs
incurred
/'1aterials2
3onversion 3osts2
/.,4''
45'


>uestions! (hat is cost of goods sold? (hat is the cost of ending work-in-process?

Ans$er!

Equivalent ?nits
1aterials2

3onversion costs2

3ost per equivalent unit
1aterials2
3onversion costs2
Total2

3ost of goods sold2

(ork-in-process
1aterials2
3onversion costs2
Total2

.' units )4 sold plus . unit in (%9 .''$ complete with respect to materials*
45 units )4 sold plus . unit in (%9 5'$ complete with respect to conversion
costs*

/.,4'' = .' equivalent units ; /.4' per equivalent unit
/45' = 45 equivalent units ; /.'' per equivalent unit
/.4' for materials : /.'' for conversion costs ; /"4'

/"4' x 4 units sold ; /",@.'


/.4' x . unit .''$ complete ; /.4'
/.'' x . unit 5'$ complete ; /5'
/.4' : /5' ; /"A'

=4ample )! This example introduces beginning inventory

:eginning 0nventory
Activity during the $ee7
=nding
0nventory
Units . completed unit .' units started and completed .' units
shipped out
. unit finished, but not yet
shipped out

Costs
incurred
/A'' beginning balance in
finished goods inventory
1aterials2
3onversion 3osts2
/.,4''
45'


>uestions! (hat is cost of goods sold? (hat is the ending balance in finished goods inventory?

93
Ans$er! ,lthough total costs to account for is easily calculated )/A'' : /.,4'' : /45' ; /A,.5'*, it is impossible to determine
the break-out between cost of goods sold and finished goods inventory without knowing the company-s inventory flow
assumption

=4ample *! Bata and questions are the same as in Example # ,ssume the company uses the !%!C )first in, first out* inventory
flow assumption

Ans$er! The cost per unit for production this week is /"<5, as calculated in Example .

3ost of goods sold2


Ending balance in finished goods2
,ll costs are accounted for2
). unit at /A''* : )4 units at /"<5*
; /A'' : /",##@ ; /",<#@

. unit at /"<5 ; /"<5
/",<#@ : /"<5 ; /A,.5'

=4ample +! Bata and questions are the same as in Example # ,ssume the company uses the D%!C )last in, first out* inventory
flow assumption

Ans$er!
3ost of goods sold2 .' units at /"<5 ; /",<5'

Ending balance in finished goods2 . unit at /A'' ; /A''

,ll costs are accounted for2 /",<5' : /A'' ; /A,.5'

=4ample ,! Bata and questions are the same as in Example # ,ssume the company uses the weighted average method for
calculating cost of goods sold

Ans$er! The weighted average method averages between the cost of goods on hand at the beginning of the period, and the cost of
goods produced during the period

Total costs to account for2

Total equivalent units2

3ost per equivalent unit2

3ost of goods sold2

Ending balance in finished goods2

,ll costs are accounted for2
/A,.5'

. unit from beginning inventory : .' units made ; .. units
/A,.5' = .. units ; /"<#5#

.' units at /"<#5# ; /",<#5#'

. unit at /"<#5# ; /"<#5#

/",<#5#' : /"<#5# ; /A,.5'
=4ample -! This example has partially finished units in both beginning inventory and ending inventory ,ssume the company
uses the weighted average method

:eginning
0nventory

Activity during the $ee7
=nding
0nventory
Units . unit that is #'$ complete with
respect to both materials and
conversion costs
The . unit coming into the period is completed .'
units are started and completed . unit is started
but not completed
. unit "'$ complete with
respect to both materials and
conversion costs

Costs
incurred
/.#' beginning balance in work-in-
process
1aterials2
3onversion costs2
/.,4''
45'


>uestions! (hat is the cost of each unit made? (hat is the cost of ending work-in-process? %f each unit completed is also sold,
what is cost of goods sold?

Ans$er!
Total costs to account for2

Total equivalent units2

/.#' : /.,4'' : /45' ; /",44'

.. units finished during the period plus one unit that is "'$ complete ;
.." units
94

3ost per equivalent unit2

Ending work-in-process2

3ost of goods sold2

/",44' = .." equivalent units ; /"@@4@

/"@@4@ per unit x . unit "'$ complete ; /#AA4

/"@@4@ x .. units ; /"4A@#@

5ote! Cne might think that the calculation of equivalent units needs to include the beginning inventory that is #'$ complete
However, we would be double-counting if we did so, because the unit that is #'$ complete in beginning inventory is one of the
.. units identified as finished during the period in the equivalent unit calculation %n the schedule below, the costs to account for
are highlighted in green, and the physical units to account for are highlighted in yellow

:eginning
0nventory

Activity during the $ee7
=nding
0nventory
Units . unit #'$ complete with
respect to both materials
and conversion costs
The % unit coming into the period is
completed %. units are started and
completed . unit is started but not
completed
% unit &.? complete with
respect to both materials
and conversion costs

Costs
incurred
@%). beginning balance in
(%9
1aterials2
3onversion costs2
@%,-..
-(.


=4ercises and /roblems!

%(2%! %n applying the weighted-average method for equivalent unit cost calculations, which of the following information do you
not need to know?

),* 9roduction costs incurred during the period

)E* The equivalent units in beginning work-in-process inventory

)3* The cost of beginning work-in-process inventory

)B* ,ll of the above must be known, in order to calculate the cost per equivalent unit

%(2&!
AA &ix units were in beginning work-in-process )(%9* at the beginning of 1ay These units were .''$ complete with respect to
direct materials, and #'$ complete with respect to conversion costs Buring the period, these six units were completed, and
another eight units were started ,t the end of the period, four of these eight units were completed, and the other four units were
.''$ finished with respect to direct materials, and F#$ complete with respect to conversion costs !ollowing is pertinent cost
information2
Eeginning (%9 3osts added in 1ay
Birect 1aterials /@'' /A,@''
3onversion costs /@'' /","''

3alculate the cost per equivalent unit, using the weighted-average method

:A "#' units were in beginning work-in-process at the beginning of &eptember These units were .''$ complete with respect to
direct materials, and #'$ complete with respect to conversion costs ,t the end of &eptember, .'' units were in ending work-in-
process These units were <'$ complete with respect to direct materials, and 5'$ complete with respect to conversion costs <'
units were started during the period How many units were transferred out of the (ork-in-9rocess account and into the !inished
Goods account during &eptember?

%(2'!
AA , company starts the week with >ero units of work-in-process inventory and >ero units of finished goods inventory The
company starts and completes production of nine units The company starts a tenth unit, but it is not complete by the end of the
week %t is @'$ complete with respect to both materials and conversion costs /.,4'' in materials was transferred during the week
from raw materials inventory to work-in-process inventory /45' in conversion costs was incurred and debited to work-in-process
inventory during the week 3alculate the cost per equivalent unit for units transferred from (%9 to finished goods inventory

:A , company starts the week with >ero units of work-in-process inventory and >ero units of finished goods inventory The
company starts and completes production of nine units The company starts a tenth unit, but it is not complete at the end of the
week %t is .''$ complete with respect to materials and #'$ with respect to conversion costs /.,4'' in materials was transferred
during the week from raw materials inventory to work-in-process inventory /45' in conversion costs was incurred and debited to
95
work-in-process inventory during the week 3alculate the cost per equivalent unit for units transferred from (%9 to finished goods
inventory

CA The company starts the week with >ero units in finished goods inventory, and one unit in work-in-process The one unit in (%9
is @'$ complete with respect to both materials and conversion costs, and it is carried at a cost of /.#' Buring the week, the
company completes this one unit, starts and completes ten more units, and starts production of yet another unit, but this last unit is
only A'$ complete with respect to both materials and conversion costs at the end of the week The company incurred /",<5' in
materials and conversion costs during the week )ie, this was the cost transferred into (%9 during the week* (hat is the cost of
each unit transferred to finished goods inventory during the week, using the weighted-average method?

%(2(! The factory started the period with .' units These units were 5'$ complete with respect to materials, and #'$ complete
with respect to conversion costs The cost of this beginning (%9 was /.'' with respect to materials, and /F' with respect to
conversion costs Buring the period the factory completed these .' units, and started production of another @ units Cf the @ units
started during the period, " were finished, and 5 were still in (%9 at the end of the period These 5 units were #'$ complete with
respect to materials and "#$ complete with respect to conversion costs 1anufacturing costs incurred during the period were
/",F'' for materials and /.,"A' for conversion costs 3alculate the cost per equivalent unit using the weighted-average method

%(2)!
% %n the mixing department, all the direct materials are added at the beginning of the processing Eeginning work-in-process
inventory consists of ",''' units with a direct materials cost of /A.,<@' Buring the period, .#,''' units are started and
direct materials costing /"#',''' are charged to the department %f there are .,''' units in ending inventory, what is the
cost per equivalent unit using the weighted-average method?

),* /.#4A
)E* /.#@A
)3* /.5<A
)B* /.@#<

& The molding department started .#,"#' units in &eptember and finished .@,@"# units %f the ending work-in-process
inventory was #'' units, what was the beginning work-in-process inventory?

),* <F# units
)E* .,AF# units
)3* ",AF# units
)B* .,<F# units

' ,lex 3ompany has .#,''' units in ending work-in-process inventory, which are .''$ complete with respect to materials
and @'$ complete with respect to conversion costs The cost per unit for the month for materials is /A'' and for
conversion is /.A' (hat is the value of the ending work-in-process using the weighted-average method?

),* /@5,#''
)E* /A<,F''
)3* /5#,F<'
)B* /#@,F''

%(2*! The factory has >ero beginning inventory, starts and completes 5'' units, and starts production of another "'' units, but
these "'' units are not finished at the end of the period These "'' units are #'$ complete with respect to materials, and A'$
complete with respect to labor and overhead Buring the period, the factory spent /.',''' on materials and /5,@'' on labor and
overhead 3alculate the cost per equivalent unit using the weighted-average method

%(2+! Hent 9lastics began the period with #' units that were .''$ complete with respect to materials and #'$ complete with
respect to conversion costs Buring the period, Hent began production of another .'' units ,t the end of the period, there were @'
units, .''$ complete with respect to materials and #'$ complete with respect to conversion costs 3alculate the equivalent units
produced during the period with respect to conversion costs )5ote2 This is not the denominator in the weighted-average method
for determining the cost of production Iather, it is a measure of the level of production activity during the period*

%(2,! @' units were in beginning (%9 These units were #'$ complete with respect to materials and conversion costs #' units
were in ending (%9 These units were also #'$ complete with respect to materials and conversion costs Buring the period, 4'
units were transferred from (%9 to !inished Goods How many units were started during the period?

%(2-! JH% company started "''A with .'' units in beginning work-in-process )(%9* that were .''$ complete with respect to
materials and #'$ complete with respect to conversion costs The cost of this beginning (%9 was /#,''' for materials and /A,'''
for conversion costs Buring "''A, JH% complete these .'' units, and started another .'' units ,t the end of "''A, JH% had #'
96
units in ending (%9 that were .''$ with respect to materials and .'$ complete with respect to conversion costs JH% incurred
materials costs of /5,''' and conversion costs of /.,#'' in "''A 3ompute the cost per equivalent unit using the weighted-
average method

%(2%.! The factory has >ero beginning inventory, starts and completes .'' units, and starts production of another "'' units, but
these "'' units are not finished at the end of the period These "'' units are .''$ complete with respect to materials, but only
#'$ complete with respect to labor and overhead Buring the period, the factory spent /A,''' on materials and /<,''' on labor
and overhead 3alculate the cost per equivalent unit

%(2%%! The factory started the period with "' units on hand These units were .''$ complete with respect to materials and #'$
complete with respect to conversion costs The factory shipped "'' finished units to the warehouse The factory ended the period
with 5' units These 5' units were .''$ complete with respect to materials and "'$ complete with respect to conversion costs
Each unit requires one yard of fabric How many yards of fabric did the factory need to move from the storeroom to the factory
floor during the period )this is also the number of units started during the period*?
CHAPTER 15: Alternative Inventory Valuation Methods

Chapter Contents:
- Introducton
- Absorpton Costng
- Varabe Costng
- Absorpton Costng and Varabe Costng compared
- Income Statement presentaton
- Numerca Exampe of Absorpton Costng and Varabe Costng
- Absorpton Costng and Generay Accepted Accountng Prncpes
- The vaue chan
- Throughput Costng
- Exercses and probems

Introduction:
Ths chapter addresses the queston: What costs are captazed as the cost of nventory? In other
words, what costs consttute the debt baance on the baance sheet for nventory, and the debt
baance on the ncome statement for cost of goods sod? The answer to ths queston determnes the
extent to whch the matchng prncpe s honored for producton costs.

The foowng tabe ustrates three aternatve rues for determnng whch costs are captazed. A
three are used n managera accountng practce. The three methods are absorption costin,
variable costin, and throuhput costin. The coored bars dentfy the costs that each method
captazes as nventory.

Cost Cateory Cost Classi!cation Absorption Costin Variable Costin Throuhput Costin
Drect materas

Drect, varabe costs
Drect abor

Drect, varabe costs
Varabe manufacturng
overhead

Indrect, varabe
costs

Fxed manufacturng
overhead

Indrect, xed costs
A non-manufacturng
costs
Drect and ndrect,
varabe and xed.


As the tabe ndcates, non-manufacturng costs are never captazed as part of the cost of nventory.
The three methods dher wth respect to ther treatment of one or more categores of manufacturng
97
costs, but they a agree that non-manufacturng costs shoud not be debted as part of the cost of
nventory.

For externa nanca reportng under Generay Accepted Accountng Prncpes, as we as for tax
reportng, companes are requred to use absorpton costng (aso caed "ull costin). Hence, there s
no choce from the above tabe for externa nanca reportng.

For nterna reportng purposes, survey data suggests that approxmatey haf of manufacturng
companes use absorpton costng and approxmatey haf use varabe costng. Throughput costng s a
reatvey recent phenomenon, and does not seem to be used extensvey yet.

Absorption Costin:
The theoretca |ustcaton for absorpton costng s to honor the matchng prncpe for a
manufacturng costs. Fxed manufacturng overhead costs are ony ncurred wth the expectaton that
the resources represented by these costs w be used n the producton of nventory. Hence, these costs
shoud be matched aganst the revenue generated from the sae of that nventory.

Absorpton costng requres computng an overhead rate for appyng a manufacturng overhead to
unts produced durng the perod (or ese two overhead rates, one for varabe manufacturng overhead
and one for xed manufacturng overhead; or ese mutpe overhead rates f the company uses actvty-
based costng). There are mportant ssues reated to choosng the denomnator n the overhead rate
for xed manufacturng overhead, whch are dscussed n the next chapter of ths book.

Variable Costin:
The theoretca |ustcaton for varabe costng s that xed manufacturng overhead (FMOH) w be
ncurred n the short-run regardess of how much nventory s produced. In many companes, even f a
factory s de, a sgncant porton of the FMOH s unavodabe n the short run. For ths reason, FMOH s
treated as a perod expense.

Varabe costng used to be caed direct costin wth some frequency, but ess so today. Drect
costng s a partcuary confusng name, because the mpcaton s that ony drect manufacturng costs
are captazed, whereas n fact, varabe manufacturng overhead s aso captazed. Even the name
"varabe costng" s perhaps ess than dea, because not a varabe costs are captazed: non-
manufacturng costs are not captazed as part of the cost of nventory under any crcumstances.

Under varabe costng, the cost of endng nventory conssts of drect manufacturng costs (usuay
materas and abor) and varabe manufacturng overhead. Hence, these are the costs for whch
varabe costng honors the matchng prncpe, and nothng ese s captazed as part of the cost of
nventory.

Absorption Costin and Variable Costin Co#pared:
The only dherence between absorpton costng and varabe costng s the treatment of xed
manufacturng overhead (FMOH). Under absorpton costng, FMOH s aocated to unts produced, so
that there s a tte bt of FMOH ncuded n the cost of every unt of nventory. Under varabe costng,
FMOH s treated as a perod expense, appearng on the ncome statement as a ump-sum n the perod
ncurred.

Comparng ncome under absorpton costng to ncome under varabe costng, the foowng
observatons can be made:
- When there are begnnng and endng nventores, absorpton costng and varabe
costng w generally resut n dherent nventory vauatons for begnnng nventory,
dherent nventory vauatons for endng nventory, and dherent ncomes, but it is
possible for the nventory baances and ncome to be the same under the two methods.
98
- If begnnng and endng nventory eves are zero, absorpton costng and varabe
costng w aways resut n the same ncome.
- If begnnng nventory s zero and endng nventory s postve, absorpton costng
w aways resut n hgher ncome than varabe costng, and a hgher vauaton for
endng nventory.
- If begnnng nventory s postve and endng nventory s zero, absorpton costng
w aways resut n ower ncome than varabe costng, and a hgher vauaton for
begnnng nventory.
- When nventory eves are ncreasng from perod-end to perod-end, as woud be
expected when the company s growng, absorpton costng will generally resut n hgher
endng nventory vauatons than varabe costng, and aso hgher ncome n each perod.
The reason s that absorpton costng postpones recognzng ever-ncreasng amounts of
xed manufacturng overhead on the ncome statement, because ncreasng amounts of
xed manufacturng overhead are captazed as endng nventory.

Over the fe of the company (or from any pont n tme at whch there s zero nventory to any other
pont n tme at whch there s zero nventory), the sum of ncome over a perods must be equa under
the two methods. The dherence between absorpton costng and varabe costng s ony a tmng
dherence: the queston of when xed manufacturng overhead s taken to the ncome statement.

Inco#e $tate#ent Presentation:
Absorpton costng, varabe costng and throughput costng are each assocated wth an ncome
statement format:

Absorpton costng uses a ross #arin inco#e state#ent, whch starts wth revenues and
subtracts cost of goods sod to derve gross margn, then subtracts non-manufacturng costs to
derve operatng ncome. Vrtuay every ncome statement presented n connecton wth
externa nanca reportng uses a gross margn format. Gross margn ncome statements
separate manufacturng costs from non-manufacturng costs, whch s hepfu for certan types of
anayses.

Varabe costng uses a contribution #arin inco#e state#ent, whch starts wth revenues
and subtracts varabe costs (varabe manufacturng costs reated to unts sod, pus a varabe
non-manufacturng costs) to derve contrbuton margn, then subtracts a xed costs
(manufacturng and non-manufacturng) to derve operatng ncome. Contrbuton margn
ncome statements factate cost-voume-prot anayss. It shoud be emphaszed that under
varabe costng, not a varabe costs appear on the ncome statement n the perod ncurred.
Varabe manufacturng costs that have been ncurred to make nventory that hasnt been sod
yet appear on the baance sheet as part of the cost of nshed goods nventory.

Throughput costng starts wth revenues and subtracts drect matera costs assocated wth
unts sod to derve throuhput #arin, then subtracts a other costs.

These ncome statement formats do not dene the costng methods. The costng methods are dened
by whch manufacturng costs are captazed, as ndcated n the tabe at the begnnng of ths chapter.
It s possbe, for exampe, to cost nventory and determne ncome usng the rues of absorpton
costng, but to then present the data n a contrbuton margn format by makng certan
recasscatons.

%u#erical E&a#ple o" Absorption Costin and Variable Costin:
Foowng s nformaton about the operatons of Utmate DNA, Inc., for the year ended December 31,
2006.

Drect materas used n producton $300,000
99
Drect abor costs ncurred
Varabe manufacturng overhead costs ncurred
Varabe non-manufacturng costs ncurred
Fxed manufacturng overhead costs ncurred
Fxed non-manufacturng costs ncurred
$100,000
$ 50,000
$ 40,000
$ 80,000
$ 20,000

There was no begnnng nventory. 100 unts were produced, and 50 unts were sod at a prce of
$20,000 per unt. The varabe non-manufacturng costs consst of two tems: a saes commsson pad
for unts sod, and a transportaton cost to shp nshed product from the factory to varous warehouses
where product s stored unt t s sod.

Re'uired: Prepare a Contrbuton Margn ncome statement, usng Varabe Costng.

Varabe manufacturng costs:
In tota: $300,000 materas + $100,000 abor + $50,000 varabe O/H = $450,000
Per unt: $450,000 100 unts = $4,500 per unt

Ultimate DNA, Inc.
Income Statement
For the Year Ended December 31, 2006
&ales
Varabe Costs
Manufacturng ($4,500 per unt x 50 unts)
Non-manufacturng
Contrbuton Margn
Fxed Costs
Manufacturng
Non-manufacturng
Operatng Income
$1,000,000

225,000
40,000
735,000

80,000
20,000
$635,000

The ony costs matched to revenues are the varabe manufacturng costs. A other costs are expensed
as ncurred.

Re'uired: Prepare a Gross Margn ncome statement, usng Absorpton Costng.

Fxed and varabe manufacturng costs:
In tota: $450,000 varabe (from above) + $80,000 xed = $530,000
Per unt: $530,000 100 unts = $5,300 per unt

Ultimate DNA, Inc.
Income Statement
For the Year Ended December 31, 2006
&ales
Manufacturng COGS ($5,300 per unt x 50 unts)
Gross Margn
Non-manufacturng Costs
Varabe
Fxed
Operatng Income
$1,000,000
265,000
735,000

40,000
20,000
$675,000

The matchng prncpe s honored for a manufacturng costs (xed and varabe), but not for any of the
non-manufacturng costs.
100

Re'uired: Cacuate the cost of endng nventory under Varabe Costng.

$4,500 per unt x 50 unts = $225,000

Ony varabe manufacturng costs are captazed. A other costs are expensed as ncurred.

1equired! 3alculate the cost of ending inventory under ,bsorption 3osting?

/#,A'' per unit x #' units ; /"@#,'''

Cnly manufacturing costs )fixed and variable* are capitali>ed ,ll non-manufacturing costs are expensed as incurred

?nder both Jariable and ,bsorption 3osting, all non-manufacturing costs are expensed as incurred !or example, the variable
non-manufacturing costs include a sales commission for units sold, and a transportation cost incurred for all units shortly after
they are manufactured Even though the transportation cost includes shipping costs for units in the warehouse and not yet sold,
this cost cannot be capitali>ed as part of the cost of inventory, because the transportation cost is not a manufacturing cost, and
inventory is ready for sale at the time it leaves the factory

Absorption Costin and (enerally Accepted Accountin Principles:
In 2004, the Fnanca Accountng Standards Board ssued Statement of Fnanca Accountng Standards
(SFAS) No. 151, to amend and carfy generay accepted accountng prncpes for the cacuaton of
nventores under absorpton costng. The Boards stated purpose for ssung the new standard was to
mprove the comparabty of cross-border nanca reportng, by agnng U.S. GAAP wth the
Internatona Accountng Standards Boards Statement No. 2.

SFAS No. 151 was the rst new pronouncement on absorpton costng ssued by a U.S. accountng
standard-settng body n fty years. Unt SFAS No. 151, nether the Fnanca Accountng Standards
Board nor ts predecessor, the Accountng Prncpes Board, had speccay addressed absorpton
costng n a broad-based way. Rather, each board had ncorporated GAAP that exsted at the tme the
board was founded. Usng ths geneaogy, pror to SFAS No. 151, GAAP for absorpton costng coud be
traced to Accountng Research Buetn (ARB) No. 43, ssued n 1953 by the Commttee on Accountng
Procedure (the predecessor to the Accountng Prncpes Board).

Key provsons of ARB No. 43, Chapter 4 on nventory prcng, ncuded the foowng:

A ma|or ob|ectve of accountng for nventores s the proper determnaton
of ncome through the process of matchng approprate costs aganst
revenues.
- ARB No. 43, Chapter 4,
Statement No. 2

As apped to nventores, cost means n prncpe the sum of the appcabe
expendtures and charges drecty or ndrecty ncurred n brngng an
artce to ts exstng condton and ocaton.
- ARB No. 43, Chapter 4,
Statement No. 3

The denton of cost as apped to nventores s understood to mean
acquston and producton cost, and ts determnaton nvoves many
probems. . Under some crcumstances, tems such as de facty
expense, excessve spoage, doube freght, and rehandng costs may be
so abnorma as to requre treatment as current perod charges rather than
as a porton of the nventory cost.
- ARB No. 43, Chapter 4
Dscusson of Statement No. 3
101

SFAS No. 151 amends ARB No. 43 by emnatng the "so abnorma" crteron n ths ast paragraph.
Hence, tems such as de facty expense and excessve spoage must now be recognzed as current-
perod charges.

Wth respect to de facty expense, SFAS No. 151 requres xed producton overhead to be aocated to
nventory based on the "norma capacty" of the producton facty. The Statement denes norma
capacty: "norma capacty refers to a range of producton eves, and s the producton eve expected
to be acheved over a number of perods or seasons under norma crcumstances, takng nto account
the oss of capacty resutng from panned mantenance." The Statement notes that some varaton n
producton eves from perod to perod s expected, that norma capacty w vary based on busness-
specc and ndustry-specc factors, and that these varatons w estabsh the range of norma
capacty. Fxed manufacturng overhead can be aocated based on the actua eve of producton when
actua producton approxmates norma capacty. The Statement observes that |udgment s requred to
determne when a producton eve s abnormay ow (.e., outsde the range of the expected varaton
n producton). Exampes of factors that mght cause an abnormay ow producton eve ncude
sgncanty-reduced customer demand, abor and materas shortages, and unpanned facty or
equpment downtme.

Athough SFAS No. 151 conveys the vew of the Fnanca Accountng Standards Board that the new
pronouncement woud not ead to sgncant changes n nventory accountng practce, some
companes nanca statements may be ahected. There s some evdence that pror to SFAS No. 151,
companes dd not appy absorpton costng n the same manner. The vagueness n the wordng of ARB
No. 43 seemed to permt aternatve treatments. Furthermore, because ARB No. 43 dd not requre
companes to dscose how they apped absorpton costng, nformaton was generay not avaabe
about the extent to whch these aternatve treatments were empoyed.

Survey data on ths ssue was provded n two artces that appeared n Management Accounting by
Mchae Schh (February 1987) and Steve Landekch (March 1973). These surveys dentfy factory
deprecaton reated to excess manufacturng capacty as an exampe of xed overhead that some but
not a companes treated as a perod expense. Under SFAS No. 151, "The amount of xed overhead
aocated to each unt of producton s not ncreased as a consequence of abnormay ow producton or
de pant." Hence, f the survey data n Schh and Landekch was st descrptve of practce n 2004,
some companes w have had to change ther accountng treatment for de capacty for nventory
costs ncurred durng sca years begnnng after |une 15, 2005 (the ehectve date of SFAS No. 151).

Another area that Schh and Landekch dented where companes dhered n ther appcaton of
absorpton costng s the decson of whether to aocate corporate servce department costs. Under
ARB No. 43, the decson not to aocate these costs seemed |usted by materaty and expedency,
rather than on theoretca grounds. SFAS No. 151 states that under most crcumstances, genera and
admnstratve expenses shoud be ncuded as perod charges, except for the porton of such expenses
that may be ceary reated to producton. Ths wordng seems to contnue to aow some attude, and
so companes mght contnue to dher n ther treatment of these costs.
The Value Chain:
The value chain s the sequence of actvtes that add vaue n a company. The foowng tabe provdes
a typca st of actvtes n the vaue chan of a manufacturng rm, athough some manufacturers
mght outsource some of these actvtes.
Value Chain "or a Manu"acturin
)ir#
Research and deveopment
Manufacturng
Marketng
Dstrbuton
Saes
102
Customer servce

For many ndustres, manufacturng costs consttute the ma|orty of costs ncurred n the vaue chan.
For companes n these ndustres, the decson to captaze most or a manufacturng costs as
nventory, and to run these costs through the ncome statement when the reated nventory s sod,
provdes the benets of the matchng prncpe that are dscussed n ntroductory nanca accountng
courses.

However, there are some ndustres n whch manufacturng costs are sma reatve to one or more of
the other actvtes n the vaue chan. For exampe, pharmaceutca companes ncur arge research and
deveopment (R&D) costs. Under a three costng methods that are dscussed n ths chapter, R&D does
not become a part of the cost of nventory. In most stuatons, R&D s expensed when ncurred for
nanca reportng purposes, whch ceary fas to honor the matchng prncpe n a sgncant way.
Large expendtures are ncurred and taken to the ncome statement for many years before any revenue
s reazed for that drug, and then after the drug s approved by the Food and Drug Admnstraton,
revenue s generated for many years wth no drecty-reated ohsettng R&D expendtures. The actua
manufacturng cost of the drug can be qute sma reatve to the R&D expendtures that were ncurred
to brng the drug to market. Of course, the stuaton s somewhat more compcated for arge
pharmaceutca companes, because there are numerous drugs at varous stages n ther fecyces, so
that R&D on some pro|ects ohset revenue from drugs for whch the R&D s aready compete, and aso,
there are many R&D pro|ects that never resut n a saeabe product.

Another ndustry n whch manufacturng costs are sma reatve to some of the other actvtes n the
vaue chan s the soft drnk ndustry. The ngredents and processes used n the manufacture of soft
drnks are fary nexpensve, and there are few barrers to entry. Consequenty, soft drnk companes
spend arge amounts on marketng and advertsng. These marketng ehorts are antcpated to provde
ong-term benets by turnng consumers nto fe-ong Coca-Coa

or Peps

drnkers. However, these

costs are not captazed as part of the cost of nventory or as any other type of asset; rather, they are
expensed when ncurred (sub|ect to the usua accrua accountng practces).

Throuhput Costin:
Aso caed super*variable costin, throughput costng s a reatvey new deveopment. Throughput
costng treats a costs as perod expenses except for drect materas. In other words, the matchng
prncpe s honored ony for drect materas.

A company shoud probaby meet two crtera before t chooses throughput costng. The rst crteron
reates to the nature of the manufacturng process. Throughput costng ony makes sense for
companes engaged n a manufacturng process n whch most abor and overhead are xed costs.
Assemby-ne and contnuous processes that are hghy automated are most key to meet ths
crteron. For exampe, thrty factory empoyees mght be requred to work a gven shft, regardess of
whether the machnery s set at fu capacty or ess. The second crteron s that management prefers
cost accountng nformaton that s hepfu for short-term, ncrementa anayss, such as whether the
company shoud accept a one-tme speca saes order at a reduced saes prce. In ths respect, a
companys choce of throughput costng s a ogca extenson of the companys choce of varabe
costng over absorpton costng.

Eyahu Godratt, who deveoped the theory of constrants, advocates throughput costng n hs popuar
busness nove The Goal. Athough throughput costng has not ganed wde acceptance, Godratts
support for t has been nuenta.

E&ercises and Proble#s:

15*1: Whch of the foowng tems account for the dherence n ncome between Varabe Costng and
Absorpton Costng when nventory eves are changng? (Check a that appy.)
103

(A) Fxed manufacturng costs
(B) Fxed non-manufacturng costs
(C) Varabe manufacturng costs
(D) Varabe non-manufacturng costs

15*+: At a producton eve of 100 unts, the per unt cost under Absorpton Costng s $8, whch
conssts of $2 of drect materas, $2 of drect abor, $2 of varabe manufacturng overhead, and $2 of
xed manufacturng overhead. Cacuate the Absorpton Costng per unt cost assumng the producton
eve s ncreased to 200 unts?

15*,: Hanks Hot Dog Factory manufactures hot dogs. The factorys cost structure s as foows: xed
manufacturng costs per month are $8,000. Varabe manufacturng costs are $0.40 per hot dog. Fxed
non-manufacturng costs are $7,000 per month. Varabe non-manufacturng costs consst of a $0.20
saes commsson for every hot dog sod. The saes prce per hot dog s $2.20.

Re'uired: If the company begns the month wth zero nventory, makes 10,000 hot dogs, and ses
7,000 hot dogs, what s the tota cost of nventory on the Baance Sheet at the end of the month under
Varabe Costng? What s ncome (oss) for the month under Varabe Costng?

%)2(! The Esquimau 9ie 3ompany makes and sells the famous Esquimau 9ie ice cream bar The company-s cost structure is as
follows2 fixed manufacturing overhead is /#,''' monthly Jariable manufacturing costs are /.5' for each Esquimau 9ie !ixed
non-manufacturing costs are /A,''' monthly There are no variable non-manufacturing costs The company begins the month with
no inventory, makes ",''' Esquimau 9ies, and sells .,''' Esquimau 9ies for /.' per pie

AA (hat is the cost of ending inventory under ,bsorption 3osting?

:A (hat is the cost of ending inventory under Jariable 3osting?

CA (hat is income under ,bsorption 3osting?

DA (hat is income under Jariable 3osting?

15*5: The Impatents-To-Go Sk Fower Company began operatons on |anuary 1, 2004. Whch of the
foowng crcumstances ensures that the companys net ncome w be the same under Absorpton
Costng as under Varabe Costng for 2005, ts second year of operatons?

(I) The company has no nventory on |anuary 1, 2005, and no nventory on December 31,
2005.

(II) The company ncurred no xed manufacturng overhead n 2005, and has no nventory
on December 31, 2005.

(III) The company ncurred no xed manufacturng overhead n 2004, and has no nventory on
December 31, 2005.

(A) I ony

(B) I and II are each sumcent

(C) I and III are each sumcent

(D) I, II and III are each sumcent

%)2*! The !oster 3ompany has variable and fixed manufacturing costs, and also some variable and fixed non-manufacturing costs
!or the year "''#, the company has >ero beginning inventory, and positive ending inventory (hich statement is true?

104
),* %ncome in "''# is the same under both ,bsorption 3osting and Jariable 3osting

)E* %ncome in "''# is higher under ,bsorption 3osting than under Jariable 3osting

)3* %ncome in "''# is lower under ,bsorption 3osting than under Jariable 3osting

)B* ?nable to determine, from the information given, whether income is higher or lower under ,bsorption 3osting
than under Jariable 3osting

%)2+! C-Erien and Hwang started "''@ with >ero inventory, produced .'' units of product, and sold 4' units They incurred the
following costs2 variable manufacturing costs of /.' per unitK fixed manufacturing costs of /",'''K variable non-manufacturing
costs of a /" sales commission per unit soldK and fixed non-manufacturing costs of /F''

AA (hat will the "''@ year-end balance sheet show for ending inventory if the company uses Jariable 3osting?

:A 3alculate net income for "''@ under Jariable 3osting The sales price is /#' per unit

15*-: |ohn Smth owned a our m. He started 1803 wth no nventory, produced 50 tons of our, and
ended the year wth ve tons of our. Saes were $22,500. He had no varabe manufacturng overhead.
Hs ony drect cost was gran, for whch he pad $8,000. Non-manufacturng varabe costs were $5,000,
non-manufacturng xed costs were $4,000, and manufacturng xed costs were $6,000.

A. What was Smths contrbuton margn for 1803?

(A) $9,500

(B) $10,300

(C) $10,800

(D) The answer depends on whether Smth uses Absorpton Costng or Varabe Costng

/. What was operatng ncome for 1803 under Varabe Costng?

(A) Loss of $500

(B) Income of $800

(C) Income of $900

(D) Income of $300

%)2-! The following information pertains to Eoo> ,udio, a manufacturer of high-end speakers for home audio systems Each
6?nit8 is actually two speakers )ie, a pair of speakers* The sales price per unit is /.,#'' in both years Eeginning inventory in
"''5 was >ero

&..(
?nits manufactured
?nits sold
Birect manufacturing costs )materials and labor*
Jariable manufacturing overhead
!ixed manufacturing overhead
Jariable non-manufacturing overhead
!ixed non-manufacturing overhead

#,'''
5,#''
/",''','''
#'','''
.,''','''
#','''
.'','''

&..)
?nits manufactured
?nits sold
Birect manufacturing costs )materials and labor*

5,'''
5,.''
/.,@'','''
105
Jariable manufacturing overhead
!ixed manufacturing overhead
Jariable non-manufacturing overhead
!ixed non-manufacturing overhead
5'','''
.,''','''
5','''
.'','''

1equired!
AA 9repare a contribution margin income statement for "''#, using variable costing, assuming the company uses !%!C

:A 9repare a gross margin income statement for "''#, using absorption costing, assuming the company uses !%!C

CA 3ompute cost-of-goods-sold for "''#, using absorption costing, assuming the company uses D%!C

%)2%.! The ,rcata Eicycle 3ompany began operations on Lanuary ., "''' with no inventory The company makes one product, a
touring bike !ollowing is information for production and sales for ,rcata-s first two years of operations

)or the year +000 )or the year +001
Unts produced
Unts sod
Seng prce per unt
Drect materas per unt
Drect abor per unt
Saes commsson per unt
100
85
$2,000
$100
$60
$20
100
80
$2,000
$90
$60
$20

%n each year, total variable manufacturing overhead was /#','''K total fixed manufacturing overhead was /@','''K and total fixed
non-manufacturing overhead was /"',''' There were no variable non-manufacturing costs other than sales commissions

A. How many unts are n endng nventory at the end of 2001?

/. Usng FIFO (Frst-n Frst-out) and Absorpton Costng, what s the cost of endng nventory on the
Baance Sheet at the end of 2001?

C. Usng Varabe Costng and LIFO, what s ncome for 2001?

15*11: Onen Corporaton makes |ust one product: a hydrauc pump that ses for $1,000 per unt. In
May, Onen started wth zero unts n begnnng nventory, manufactured 400 pumps, and sod 350
pumps. The varabe manufacturng cost s $600 per unt, whch conssts of $300 n drect materas,
$200 n drect manufacturng abor, and $100 n varabe manufacturng overhead. The xed
manufacturng overhead costs are $50,000. The ony varabe non-manufacturng cost s a warehousng
fee ncurred each tme a unt s manufactured, and ths fee s $60 per unt. Fxed non-manufacturng
costs are $70,000.

A. What w appear on the baance sheet at the end of May for the cost of endng nventory under
Varabe Costng?

/. Prepare an ncome statement for May usng Varabe Costng. Use a contrbuton margn format for
the ncome statement.

C. What w appear on the baance sheet at the end of May for the cost of endng nventory under
Absorpton Costng?

1. Prepare an ncome statement for May usng Absorpton Costng. Use a Gross Margn format for the
ncome statement.

E. Cacuate operatng ncome for May under Throughput Costng.

%)2%&! 3laypool 3orporation can make three models of barbecue grills !ollowing is information about production cost and sales
demand for one year, which is the company-s planning hori>on

106
/ortable Standard Delu4e
&ales price
1aximum sales demand
Eeginning inventory
%nputs2
Birect materials
Birect labor
1etal-working time
!ixed manufacturing overhead
/5'' per unit
.,''' units
>ero

/<# per unit
.' hours per unit
" hours per unit
/A,''' in total
/"'' per unit
#'' units
>ero

/5' per unit
5 hours per unit
. hour per unit
/.,''' in total
/<'' per unit
5'' units
>ero

/"<' per unit
.# hours per unit
A hours per unit
/#,''' in total

The capacity of the factory is determined by the metal-working machine This machine can run ",''' hours annually The table
shows how much time each unit requires on this machine The company anticipates that at the end of this year, this machine will
have to be replaced

The factory has a single production line, and must retool the line when switching from one model of grill to another The out-of-
pocket cost to retool is /#,''' each time production is switched 9roduction downtime for retooling is determined by the
downtime on the metal-working machine, which is .'' hours There is no need to run more than one production-run of any one
product annually )meaning that even if all three models are produced, total downtime on the metal-working machine is only " x
.'' hours ; "'' hours for the year*

The average labor wage rate is /.# per hour The variable overhead rate is the same for all three products %t is /"' per hour on the
metal-working machine )eg, /5' for each portable grill*

The fixed overhead in the table shows product-level costs These costs are incurred if any amount of that model is produced %f no
units of that model are produced, these costs are completely avoidable !acility-level fixed manufacturing overhead costs are
/A',''' per year These costs are unavoidable

1equired!
AA (hat is the most profitable product? Explain your reasoning

:A (hat is the profit-maximi>ing product mix? ,ssuming that the company uses this product mix, show an income statement
for each product produced

CA (ithout regard to your answers to parts , and E, assume that the company decides to produce only the portable heater
Halfway through the year, the metal-working machine breaks down, in+uring the machine operator, and prompting the
labor union to call a strike The machine cannot be repaired or replaced for the rest of the year, and in any case, the
workers remain on strike Buring the first six months, the company produced #'' portable heaters, and by the end of the
year, the company sold 5'', leaving .'' units in ending finished goods inventory Jalue this ending inventory for
financial reporting purposes, in accordance with &!,& .#.

%)2%'! M!N &candinavia is a new affiliate of M!N %nternational M!N &candinavia manufactures bell-bottom +eans in a single
manufacturing facility !ollowing is pertinent data for "''#, its first year of operations )hence, there is no beginning inventory*

Factory capacty: 250,000 |eans per year
Unts manufactured n 2005: 192,000 |eans
Varabe manufacturng costs: $10 per |ean
Fxed manufacturng overhead costs: $1,344,000
S. G. & A. expenses: $2 per |ean (ths s a saes commsson)
Saes: 150,000 |eans at $25 per |ean

Saes demand, saes prce, and varabe costs are a expected to reman unchanged n 2006 from
2005. Fxed manufacturng overhead costs are expected to ncrease by 10%.

Re'uired:
Cacuate 2005 ncome and pro|ected 2006 ncome under Absorpton Costng, under each of the
foowng sets of assumptons:

A. The company accounts for nventory usng FIFO, aocates xed manufacturng
overhead costs based on unts produced, manufactures enough unts n 2006 to
pan for 60,000 unts n endng nventory at the end of the year.
107

/. The company accounts for nventory usng FIFO, aocates xed manufacturng
overhead costs based on unts produced, manufactures at capacty n 2006.

C. The company accounts for nventory usng LIFO, aocates xed manufacturng
overhead costs based on unts produced, manufactures enough unts n 2006 to
pan for 60,000 unts n endng nventory at the end of the year.

1. The company accounts for nventory usng LIFO, aocates xed manufacturng
overhead costs based on unts produced, manufactures at capacty n 2006.

Cacuate 2005 ncome and pro|ected 2006 ncome under Varabe Costng, under FIFO, assumng the
company manufactures enough unts n 2006 to pan for 60,000 unts n endng nventory at the end of
the year.

%)2%(! ,>tech %ndustries makes only one product %n "''., the company started the year with >ero beginning inventory The
company reported the following results for "''# and "''@2

&..) &..*
?nits made
?nits sold
,verage unit sales price
Jariable manufacturing costs
!ixed overhead manufacturing costs
Jariable non-manufacturing costs
!ixed non-manufacturing costs
"'
.<
/.,'''
.,5''
A,#''
.<'
4''
.'
F
/.,'''
F''
A,#''
4'
4''

AA How many units are in ending inventory at the end of "''@?

:A 3alculate the cost of ending inventory at the end of "''@, assuming the company uses ,bsorption 3osting, and the !%!C )first-
in, first-out* inventory flow assumption

CA 3alculate operating income for "''@, assuming the company uses ,bsorption 3osting, and the D%!C )last-in, first-out*
inventory flow assumption

DA 3alculate operating income for "''@, using either !%!C or D%!C )whichever you prefer*, assuming the company uses Jariable
3osting

=A 3alculate the cost of ending inventory at the end of "''@, assuming the company uses Jariable 3osting, using either !%!C or
!%!C )whichever you prefer*

3A ,ssume the company uses ,bsorption 3osting (hat is the Gross 1argin in "''#?

;A ,ssume the company uses Jariable 3osting (hat is the contribution margin )ie, the total contribution margin* for "''#?

%)2%)! %n Luly, Eorder %ndustries made .,''' units of its sole product, and sold <'' units There were no beginning inventories %ts
net income for the month using Jariable 3osting was /"',''' %ts net income for the month using ,bsorption 3osting was
/"5,''' %ts contribution margin for the month was /#',''', and its gross margin for the month was also /#',''' &ales revenue
for the month was /"'',''' Eorder is on an actual costing system )ie, overhead is allocated using a rate and allocation base that
are based on actual amounts* There are no fixed direct costs

A. How much xed manufacturng overhead was ncurred durng the month?

:A How much fixed non-manufacturing overhead was incurred during the month?

C. What was the per unt varabe manufacturng cost for the month?

DA (hat was the total variable non-manufacturing costs incurred during the month?

=A (hat is the cost of ending inventory under ,bsorption 3osting?
108

3A (hat is the cost of ending inventory under Jariable 3osting?

%)2%*! 3opernicus %nternational uses Jariable 3osting, and the weighted-average inventory flow assumption The company
started the period with >ero finished goods and .'' units of work-in-process These units were A'$ complete with respect to
materials and F'$ complete with respect to labor and variable manufacturing overhead The cost of this beginning work-in-
process was /.',''' in materials and /5',''' in labor and variable manufacturing overhead Buring the period, the company
completed these .'' units and started production of another #' units ,t the end of the period, of the #' units started during the
period, "' were finished, and A' were "'$ complete with respect to materials and #'$ complete with respect to labor and
variable manufacturing overhead 1anufacturing costs incurred during the period were /<,''' for materials and /A",''' for labor
and variable manufacturing overhead !ixed manufacturing overhead for the period was /F#,''' !ixed non-manufacturing costs
were /.',''' Jariable non-manufacturing costs were a /"' sales commission per unit sold <# units were sold, at an average
sales price of /",''' per unit

1equired!
AA 9repare a 3ontribution 1argin format income statement for the period

:A (hat are the balances in the work-in-process and finished goods inventory accounts at the end of the period?
C<A/T=1 %*! 3i4ed Manu#acturing Overhead

Chapter Contents!
- ,lternative denominator levels
- 9roduction incentives
- The allocation of fixed overhead and management decision-making
- ,nnie-s &oup 3ompany
- Exercises and problems

Iecall the steps to product costing2

. %dentify the cost ob9ectK
" %dentify the direct costs associated with the cost ob+ectK
A %dentify overhead costsK
5 &elect the cost allocation base for assigning overhead costs to the cost ob+ectK
# Bevelop the overhead rate per unit for allocating overhead to the cost ob+ect

This chapter focuses on steps OA through O# for fixed manufacturing overhead

Alternative denominator levels!
%t is possible to allocate overhead separately for fixed overhead and for variable overhead, and there are sometimes good reasons
to do so (hen fixed and variable manufacturing overhead are allocated separately, there are important issues related to how the
denominator of the fixed overhead rate is calculated ,lternative denominator choices are2

Theoretical capacity! This measure of factory capacity assumes .''$ efficiency .''$ of the time %t is analogous to the E9,
miles-per-gallon estimates that are determined for new automobilesK nobody actually achieves this gas mileage in day-to-day
driving, but the E9, estimates are useful for comparison shopping

/ractical capacity! This measure of factory capacity reduces theoretical capacity for anticipated unavoidable operating
interruptions, including routine maintenance

5ormal capacity! This denominator-level concept measures the level of factory activity that satisfies average customer demand
over an intermediate period of time %t frequently averages over seasonal or cyclical fluctuations in demand ,s discussed in the
previous chapter, Generally ,ccepted ,ccounting 9rinciples now require companies to allocate fixed production overhead based
on the 6normal capacity8 of the production facilities for external financial reporting purposes The definition of normal capacity
provided here is similar in concept to the definition provided in &!,& No .#., although the definition in the pronouncement
provides some latitude and encompasses a range of production levels

:udgeted production! This denominator-level concept has been introduced previously %t is the level of factory activity budgeted
for the upcoming period

Eecause fixed costs, by definition, do not depend on the level of output, the numerator in the fixed overhead rate is not expected to
differ across these four denominator choices &ince there is no cause-and-effect relationship in the short run between the
109
estimation of the numerator and the quantity of the allocation base in the denominator, the larger the denominator, the smaller the
amount of fixed overhead costs that are allocated to each unit of product

This situation contrasts with variable overhead %n fact, for variable overhead, the numerator cannot be estimated until the
denominator is estimated !or example, an apparel factory cannot accurately estimate electricity expense for the coming year until
it predicts the amount of time the machines will run, and this estimate depends on the pro+ected level of production Hence, for
variable overhead, the allocation base is chosen, then the quantity of the allocation base is estimated, and then variable overhead
costs are estimated

/roduction 0ncentives!
1any accounting writers have emphasi>ed the effect that the allocation of fixed overhead can have on managerial incentives to
overproduce (hen fixed overhead is allocated to product, the greater the production level, the lower the fixed cost per unit The
lower fixed cost per unit might increase perceived profitability, but is the company really more profitable?

The answer to this question depends on what happens to the additional inventory %f the company is producing more inventory
than it can sell, and is consequently stockpiling finished goods inventory, then clearly the company is not more profitable This
situation arises in Eliyahu Goldratt-s business novel The Goal )coauthored with Leff 3ox* !actory management in the novel is so
committed to maximi>ing output and minimi>ing per-unit production cost, that they rent a warehouse to store large quantities of
excess inventory

Cn the other hand, if the factory can sell all of the goods that it produces, then as production increases, the factory really does
become more profitable !urthermore, when fixed costs are allocated to product, this increased profitability is reflected in the
lower per-unit cost

The key question, then, is whether managers, companies, or factories with incentives to overproduce can stockpile inventory
without negative repercussions %t would seem that in the business environment of the past several decades, this risk has been
overrated Excess inventory is highly visible, physically and on the balance sheet, both for managerial accounting and financial
reporting purposes Hence, while it is important for managers and management accountants to be aware that the allocation of fixed
overhead can provide incentives to overproduce, the risk posed by these incentives probably need not dictate the decision of
whether to allocate fixed overhead for management accounting purposes )Iecall from 3hapter .# that for financial accounting
purposes, companies must allocate fixed manufacturing overhead*

The Allocation o# 3i4ed Overhead and Management Decision2Ma7ing!
, more difficult question than perverse production incentives is whether the allocation of fixed overhead assists or hinders
sourcing, marketing and pricing decisions This question, which can be characteri>ed as a debate of the merits of absorption
costing versus contribution margin analysis, has probably generated more controversy than any other issue in management
accounting !ollowing are three views from prominent accounting faculty

%n the second edition of his textbook Managerial Accounting )copyright "''5*, Lames Liambalvo, Bean of the Eusiness &chool at
the ?niversity of (ashington, states that the ma+or limitation of activity-based costing is that most companies use ,E3 to develop
the full cost of products )3hapter @, p "'<* Liambalvo also offers only one answer to the question of why G,,9 requires
absorption costing2 that 6company managers may be concerned that variable cost information will prove helpful to competitors8
)3hapter #, p .@4* %t is clear from these statements and others in his textbook that 9rofessor Liambalvo perceives little benefit
from absorption costing for managerial decision-making

Iobert Haplan, 9rofessor at Harvard ?niversity, participated in a 9anel Biscussion on contribution margin analysis at the ,nnual
1eeting of the ,merican ,ccounting ,ssociation 9rofessor Haplan, who was one of the most persuasive early advocates of
activity-based costing and one of the originators of the Ealanced &corecard )discussed in 3hapter "5*, commented2

%nterestingly, many companies have resisted for the most part the attempts by academic accountants to convince
them to ignore their fixed costs P 1ost companies persist in performing full cost allocations
- Journal of Management Accounting Research, .44' )!all*, p 5

%n fact, surveys suggest that for internal reporting purposes, approximately #'$ of companies use variable costing and #'$ use
absorption costing

%n .4<4, Lohn &hank )now 9rofessor Emeritus at Bartmouth ?niversity* participated in the same panel discussion as Eob Haplan
9rofessor &hank-s comments included the following2

% now believe at the broadest possible level that my QformerR support for the contribution margin concept was
misplaced and short-sighted P % have been looking for some big successes from contribution margin analysis
for "# years, and % have come up empty P %n fact, it almost seems to be axiomatic, and let me call it &hank-s
,xiom
110

S %f the problem is small enough so that contribution margin analysis is relevant then it
can-t have a very big impact on a company
S ,nd if the possible impact in a decision setting is ma+or, if it can really affect a
company in a ma+or way, then it-s silly to consider most of the factors to be fixed

P Not only can % find no notable big successes from contribution margin concepts in the real world, % can point
to many examples of what % consider to be notable failures from the application of the contribution margin
mind-set P % believe that more than one entire industry has competed itself to the brink of insolvency using
contribution-based pricing
- Journal of Management Accounting Research, .44' )!all*, p .F

9rofessor &hank refers to the trucking and airline industries in the years following their deregulation as two examples to illustrate
his point %f an airplane is about to leave the gate with empty seats, the marginal cost of adding additional passengers to fill those
seats is almost >ero )a small increase in fuel consumption, and a few bags of pret>els, perhaps* Hence, an airline applying
contribution margin analysis will make every effort to try to fill the plane to capacity, including offering deeply-discounted, last-
minute fares However, it is an open question as to whether the numerous bankruptcies and near-bankruptcies that have occurred
in the airline industry in the years following deregulation resulted from a 6contribution margin mind-set,8 as 9rofessor &hank
suggests, or rather from the underlying economic characteristics of the industry Given overcapacity in the industry, the fact that
airlines have high fixed costs and low variable costs, and the fact that airlines have difficulty differentiating the services that they
offer from their competitors, it is not clear that any one airline would have improved its situation using a full costing approach to
pricing

AnnieBs Soup Company!
The following fictional example illustrates the general nature of the debate between contribution margin analysis and absorption
costing

,nnie-s &oup 3ompany manufactures twelve types of soup in its facility in Eureka, 3alifornia Each soup is produced on its own
equipment, in a portion of the facility dedicated exclusively to it The facility is running at F'$ of capacity

,nnie-s &oup 3ompany has traditionally reported the full cost of products for internal performance evaluation purposes, allocating
facility-level costs to each product based on machine hours ,nnie-s philosophy is to encourage product managers to set sales
prices that will support the company-s overall profit targets, and she believes that full costing supports this ob+ective %f facility-
level costs were not allocated, then each product might show a profit, yet the company as a whole could show a loss

The product manager of the cream soup line has proposed a new product2 a cream spinach soup that would be called ,nnie-s
?ltimate &pinach soup The product manager admits that initial demand for this product probably would not support a sales price
that would cover the full cost of the product including an allocation of facility-level costs However, the product manager
convinces ,nnie that because the facility has excess capacity, the new soup should be required to meet only its marginal costs
)unit-level, batch-level and product-level costs in the cost hierarchy, but not facility-level costs* ,t a sales price of /.F# per can
to retailers, without an allocation of facility-level costs the profit margin would be /'"# per can, but with facility-level costs
allocated to ?ltimate &pinach soup, it would be pro+ected to show a loss of /'"# per can

The product manager-s argument persuades ,nnie to approve the production of ?ltimate &pinach soup, and to evaluate it, at least
initially, based on a cost that excludes facility-level costs

The following year, the product manager of the tomato-based soups proposes a new tomato bisque soup &he asserts that since the
latest soup introduced by the cream soup manager does not have facility-level costs allocated to it, neither should her new tomato
bisque ,nnie agrees

Three years pass The situation is now as follows The company has .5 soups Twelve soups have facility-level costs allocated to
them, two do not %s this situation acceptable, and if not, what should be done about it?

The current situation seems problematic ,nnie cannot directly compare profitability across all .5 soups ,s time passes, and as
the date each soup was introduced becomes less salient, it is increasingly difficult to view ,nnie-s ?ltimate &pinach &oup and the
Tomato Eisque as the 6marginal products8 %n any case, as discussed in 3aplan, 1elumad and Miv )The Benim !inishing
3ompany, Issues in Accounting Education, "''#*, it is not at all clear that contribution margin analysis can be effectively applied
by always treating the newest product as the marginal product

&hould ,nnie start allocating facility-level overhead to all .5 products? %f so, there is no obvious point in time at which to initiate
this allocation to the two new products !urthermore, if one of the new products shows a loss when facility-level costs are
allocated to it, and if the factory still has excess capacity, it is not clear that the unprofitable product should be dropped 1arginal
111
cost analysis applied to the decision of whether to drop a product is as relevant now as the initial marginal cost analysis that
supported introducing the product in the first place

&hould ,nnie stop allocating facility-level overhead to all .5 products, and convert to a variable costing approach to product
profitability analysis? The disadvantage of this approach is that without an allocation of facility-level costs, each of the .5
products could generate a positive contribution margin, which might be viewed positively by each of the product managers, yet
the company as a whole could still be unprofitable Iather, full costing helps ensure that product managers attempt to set sales
prices that support the company-s overall profitability goals

=4ercises and /roblems!

Discussion >uestion %*2%!
The Taos &ki and Tennis Iesort has a &ummer manager and a (inter manager These managers receive a substantial portion of
their income in the form of a bonus based on profitability They constantly argue about how certain costs should be allocated
across the two seasons !or example, they both wanted a new espresso bar constructed, and they convinced the owner to build it
by agreeing to have the construction cost depreciated over the life of the building, and to have each year-s depreciation expense
allocated between the &ummer season and the (inter season for purposes of calculating each manager-s profits This convinced
the owner that the managers really believed the espresso bar would cover its costs However, although the two managers agreed
that these fixed costs should be allocated, and although they believe that the incremental revenue will more than cover the costs,
including the cost to build the espresso bar, they can-t agree on how to allocate depreciation expense between the two seasons The
summer manager suggests splitting depreciation expense #'T#', since the number of visitors is about the same for each season
The (inter manager suggests splitting depreciation expense F'TA' )F'$ to &ummer*, since this roughly represents the length )in
days* of each season

The best way for the owner to resolve this dispute is to

),* Not allocate depreciation expense at all, since the cost of the building was relevant before it was built, but is
irrelevant now that it is a sunk cost

)E* ,llocate depreciation #'T#', since all else equal, this will not favor either manager

)3* ,llocate depreciation F'TA', because this method is consistent with depreciating the entire cost of the building
over its useful life

)B* ,llocate the cost based on actual espresso bar revenues, since this allocates costs on an 6ability to bear8 basis, and
recogni>es the fact that guests are more likely to buy coffee when the weather is cooler, so that the &ummer
manager is not penali>ed

Discussion >uestion %*2&!
The Eernalillo Tortilla !actory manufactures a variety of packaged 1exican food products in a large factory in Northern New
1exico %n general, each product has its own equipment, factory personnel, and product manager 1any of these products are
currently very popular, and in the short-term, there is not enough space in the factory to meet consumer demand (hich of the
follow statements are true?

),* ,llocating fixed manufacturing overhead to production will encourage product managers to set sales prices on
individual products that will help achieve the company-s overall profitability goals

)E* ,llocating fixed manufacturing overhead to production using factory square feet as the allocation base will assist
management in determining the most profitable product mix

)3* ,llocating fixed manufacturing overhead to production during the year will provide product cost information that
is more consistent with the company-s year-end financial statements )prepared in accordance with Generally
accepted ,ccounting 9rinciples* than would treating fixed manufacturing overhead as a period expense

)B* !ixed manufacturing overhead costs are sunk in the short-run, and hence, are independent of the level of
production Therefore, there is no purpose in allocating these costs to production

%*2'! 1ilwood 1ills makes decorative woodcut prints Each design is run in a single batch once during the year 1ilwood 1ills
allocates machine set-up costs using set-up hours as the allocation base !ollowing is budgeted information for next year for two
of the company-s numerous designs2 Bull and Matador and Dogs Playing Poker

Eull Bogs
112
Number of woodcuts
Birect materials cost
Birect labor cost
Number of machine set-up hours
9ounds of material
Hilowatt hours
#,'''
/"#,'''
/.5,'''
."'
#,'''
",'''
.#,'''
/AA,'''
/.@,'''
.#'
.','''
A,'''

AA (hat is the anticipated effect of making the #,''' 6Eull8 woodcuts in two batches instead of one, holding all else constant, if
machine set-up costs are variable, in a linear fashion, in the number of setups?

),* The unit cost of 6Eull8 will increase, and the unit cost of 6Bogs8 will decrease

)E* The unit cost of 6Eull8 will increase, and the unit cost of 6Bogs8 will remain unchanged

)3* The unit cost of 6Eull8 will decrease, and the unit cost of 6Bogs8 will remain unchanged

)B* The unit cost of both 6Eull U 1atador8 and 6Bogs8 will remain unchanged


:A (hat is the anticipated effect of making the #,''' woodcuts of 6Eull8 in two batches instead of one, holding all else constant,
if machine set-up costs include both fixed and variable components?

),* The unit cost of 6Eull8 will increase, and the unit cost of 6Bogs8 will decrease

)E* The unit cost of 6Eull8 will increase, and the unit cost of 6Bogs8 will remain unchanged

)3* The unit cost of 6Eull8 will decrease, and the unit cost of 6Bogs8 will remain unchanged

)B* The unit cost of both 6Eull U 1atador8 and 6Bogs8 will remain unchanged


%*2(! The not-for-profit health clinic &hots-V-?s provides various types of vaccinations and other shots, especially flu shots, to
the public for free or for a nominal fee The clinic is funded by several local governmental agencies as well as by a number of
charitable organi>ations &ince different donors wish to fund different types of shots, the clinic determines the full cost of each
type of shot, by adding overhead to the direct costs, and then provides this information to current and prospective donors

!ollowing are actual and budgeted costs for &hots-V-?s for "''A2

Actual :udgeted
Number of patient visits
Number of shots administered

!ixed overhead2 salaries, rent for the facility, insurance,
depreciation

Jariable overhead2 nursing staff hoursly wages, utilities,
disposable supplies

3ost of hypodermics )a direct cost*

3ost of medications )a direct cost*
#,'''
@,'''


/45,'''


/@@,'''

/.,'''

/A','''
5,'''
5,#''


/..','''


/5',#''

/F#'

/"','''

,ssume the clinic allocates fixed overhead separately from variable overhead, and allocates fixed overhead using the number of
shots as the allocation base 3linic management believes that the facility could deliver as many as F,''' shots per year (hich of
the following overhead rates will result in underallocated fixed overhead for the year?

% ,ctual level of activity in the denominator, and actual costs in the numerator

%% Eudgeted level of activity in the denominator, and budgeted costs in the numerator

%%% 9ractical capacity in the denominator, and budgeted costs in the numerator

),* %%% only
113

)E* %% and %%% only

)3* %% only

)B* % only

)E* neither %, %%, nor %%%

%*2)! The 3arl-3arlson 3orporation uses ,bsorption 3osting, begins the year with >ero inventory, and has both fixed and variable
manufacturing costs Ielative to the benchmark in which the company produces the same number of units that it sells, which of
the following statements is true?

),* Ey producing above its sales level, the company will increase the total cost of ending inventory on the balance
sheet, and will also increase net income

)E* Ey producing above its sales level, the company will increase the total cost of ending inventory on the balance
sheet, but will not affect net income

)3* Ey producing above its sales level, the company will increase the total cost of ending inventory on the balance
sheet, but will decrease net income

)B* None of the above statements can be made with certainty, unless the actual costs and unit volumes are known

%*2*! !or the year "''5 )his first year of operations*, Harvey 1udd sold F,#'' units at /A#' per unit, and produced .',''' units,
of his sole product, a combination espresso machine and rug steamer !actory capacity is .#,''' units Cther information for the
year included the following2

Birect manufacturing labor
Jariable manufacturing overhead
Birect materials
Jariable selling expense )a sales commission*
!ixed non-manufacturing expenses
!ixed manufacturing overhead
/F#','''
5'','''
@'','''
5'','''
5'','''
<'','''

1equired! Cn Lanuary ., "''#, Harvey predicts that his sales demand and cost structure )total fixed cost and variable cost per
unit* will remain exactly the same in "''# as it was in "''5 Harvey doesnWt want to change his sales price, uses !%!C for
financial reporting, and wants to show the same profits under Jariable 3osting as under ,bsorption 3osting in "''# %s there an
attainable production level that will accomplish this goal? %f so, what is that production level?

%*2+! !or the year "'54, its first year of operations, 1ontgomery &cott Enterprises sold F,#'' units at /A#' per unit, and produced
.',''' units, of its sole product, a &huttlecraft navigational device Cther information for the year included2

Birect manufacturing labor /F#','''
Jariable manufacturing overhead 5'','''
Birect materials @'','''
Jariable selling expenses 5'','''
!ixed administrative expenses 5'','''
!ixed manufacturing overhead <'','''

Cn Lanuary ., "'#', &cott uses a new software program, Econ-forecast, which predicts that his sales demand and cost structure
will remain exactly the same in "'#' as it was in "'54 &cott doesn-t want to change his sales price, uses D%!C for financial
reporting, and wants to show >ero profits )ie, wants to break even* in "'#' %s there a production level under absorption costing
that will accomplish this goal? %f so, what is it?

%*2,! The Eureka 3ompany began operations on Lanuary ., "''# with no inventory The company makes one product, an electric
lawn mower !ollowing is information for production and sales for "''#, and pro+ected information for "''@2

Actual #or &..) /ro9ections #or &..*
?nits produced
?nits sold
&elling price per unit
Birect materials per unit
.4'
.''
/",#''
/.4'
To be determined )by you*
".'
/",@''
/""'
114
Birect labor per unit
Jariable non-manufacturing costs2
&ales commission per unit
/F'

/5'
/F'

/5#

!actory capacity is "'' units per year %n "''#, total variable manufacturing overhead was /<#,#''K total fixed manufacturing
overhead was /"'','''K and total fixed non-manufacturing overhead was /A',''' There were no variable non-manufacturing
costs other than the sales commissions The total fixed costs and the per-unit variable overhead costs are expected to be the same
in "''@ as in "''# The company uses D%!C )Dast-in, !irst-out* and ,bsorption 3osting

A. Prepare a Gross Margn format ncome statement for 2005.

/. Is there a producton eve for 2006 that w aow the company to earn prots of $100,000 n
2006, f a goes accordng to pan? If so, what s that producton eve?

%*2-! The (ell-1anaged 1anufacturing 3ompany is concerned about how much income it will report for the year ending
Becember A., "''@ %t is now mid-November, and the estimated )pro forma* income statement for the year, calculated on a
Jariable 3osting basis, is as follows2

&ales
Jariable costs2
1anufacturing costs
&elling and administrative costs
3ontribution margin
!ixed costs2
1anufacturing costs
&elling and administrative costs
Cperating income
#',''' units

/"'','''
.'','''


/A'','''
.'','''
/F#','''


A'','''
/5#','''


5'','''
/ #','''


We-Managed began the year wth zero nventory and was antcpatng endng the year wth zero
nventory. However, the managers have been promsed a bonus f ncome s at east $100,000
cacuated accordng to Generay Accepted Accountng Prncpes. One of the managers wants to
ncrease ncome by ncreasng producton, even though the eve of saes for the year w not be
ahected.
1equired!
AA (hat is the cost per unit of inventory, and operating income, using ,bsorption 3osting, assuming the company
has no inventory at year-end, as planned?
:A How much inventory would have to be produced for ending inventory, in order to raise income to /.'','''? %n
other words, what would the balance in ending inventory have to be?
CA Cne manager believes that producing unneeded inventory to generate income is a bad idea (hat do you think?
CHAPTER 12: Cost Variances "or Variable and )i&ed 3verhead

Chapter Contents:
- Cost varances for varabe overhead
- Cost varances for xed overhead
- The xed overhead spendng varance
- The xed overhead voume varance
- Addtona ssues reated to the voume varance
- Comprehensve exampe of xed overhead varances
- Exercses and probems

Cost Variances "or Variable 3verhead:
The formuas for spttng the exbe budget varance for varabe overhead nto a "prce" varance and
an "emcency" varance are the same as the formuas for drect materas and drect abor expaned n
Chapter 7. The "prce" varance for varabe overhead s caed the varabe overhead spendin
variance:

Spendng varance = PV = A4 x (AP - $P)

115
Emcency varance = EV = $P x (A4 - $4)

Where AP s the actua overhead rate used to aocate varabe overhead, and $P s the budgeted
overhead rate. The "45s" refer to the quantty of the aocaton base used to aocate varabe overhead,
so that A4 s the actua quantty of the aocaton base used durng the perod, and $4 s the standard
quantty of the aocaton base. The standard quantty of the aocaton base s the amount of the
aocaton base that shoud have been used (.e., woud have been budgeted) for the actua output unts
produced.

Gven the use of the aocaton base n these formuas for the cost varances for varabe overhead, the
meanng of these varances dhers fundamentay from the nterpretaton of the varances for drect
materas and drect abor. Consder a company that aocates eectrcty usng drect abor as the
aocaton base. A negatve varabe overhead emcency varance does not necessary mean that the
factory used more eectrcty than the exbe budget quantty of kowatt hours for the actua outputs
produced. Rather, the negatve varance teray means that the factory used more drect abor than
the exbe budget quantty for drect abor. If there s a cause-and-ehect reatonshp between the
aocaton base and the varabe overhead cost category (.e., f more drect abor hours mpes more
eectrcty used), then the negatve emcency varance suggests that more eectrcty was used than the
exbe budget quantty, but the emcency varance does not measure kowatts drecty.

Smary, a negatve spendng varance for varabe overhead does not necessary mean that the cost
per kowatt-hour was hgher than budgeted. Rather, a negatve spendng varance for varabe
overhead teray states that the actua overhead rate was hgher than the budgeted overhead rate,
whch coud be due either to a hgher cost per kowatt-hour, or more kilowatt hours used per unit of
the allocation base. Hence, what one mght thnk shoud be ncuded n the emcency varance (kowatt
hours requred per drect-abor-hour beng hgher or ower than budgeted) actuay gets ncuded as part
of the spendng varance.

Cost Variances "or )i&ed 3verhead:
Whereas the cost varances for drect materas, drect abor, and varabe overhead a use the same
two formuas, the cost varances for xed overhead are dherent, and do not use these formuas at a.

Aso, whereas cost varances for drect materas, drect abor, and varabe overhead can be cacuated
for ndvdua products n a mut-product factory, cost varances for xed overhead can ony be
cacuated for the factory or facty as a whoe. (More precsey, xed overhead cost varances can ony
be cacuated for the combned operatons to whch the resources represented by the xed costs appy.)

There are two xed overhead cost varances: the spendng varance and the voume varance.

The )i&ed 3verhead $pendin Variance:
The !&ed overhead spendin variance s the dherence between two ump sums:

Actua xed overhead costs ncurred Budgeted xed overhead costs

The xed overhead spendng varance s aso caed the !&ed overhead price variance or the !&ed
overhead budet variance.

The )i&ed 3verhead Volu#e Variance:
The !&ed overhead volu#e variance s aso caed the production volu#e variance, because ths
varance s a functon of producton voume. The voume varance attaches a doar amount to the
dherence between two producton eves. The rst producton eve s the actua output for the perod.
The second producton eve s the denomnator-eve concept n the budgeted xed overhead rate,
expressed n unts. As dscussed n the prevous chapter, there are two common choces for ths
denomnator:
116

(1) budgeted producton
(2) factory capacty

The nterpretaton of the voume varance depends on whch of these two denomnators are used, but n
ether case, the producton voume varance s the dherence between budgeted xed overhead (a ump
sum), and the amount of xed overhead that woud be aocated to producton under a standard costng
system usng ths xed overhead rate.

The volu#e variance 6ith budeted production in the deno#inator o" the overhead rate:
Frst we use budgeted producton to cacuate the voume varance. In ths case:


voume
varanc
e

= (

budgeted xed overhead

x

unts produced

)

budgeted xed
overhead budeted production

The term n parenthess equas the amount of xed overhead that woud be aocated to producton
under a standard costng system, when budgeted producton s the denomnator-eve concept.


Snce

budgeted xed overhead budgeted producton = budgeted overhead rate

the above expresson for the voume varance s agebracay equvaent to the foowng formua:

voume varance = (unts produced budgeted producton) x budgeted overhead rate

Ths formua for the voume varance ustrates the statement above; that the voume varance
attaches a doar amount to the dherence between two producton eves. In ths case, the two
producton eves are actua producton and budgeted producton. The nterpretaton of the voume
varance, when budgeted producton s used n the denomnator of the overhead rate, s the foowng.
When actua producton s ess than budgeted producton, the voume varance represents the xed
overhead costs that are not aocated to product because actua producton s beow budget. In ths
case, the voume varance s unfavorable. When actua producton s greater than budgeted
producton, then the voume varance represents the addtona xed overhead costs that are aocated
to product because actua producton exceeds budget. In ths case, the voume varance s favorable.

The ntuton for when the voume varance s favorabe and when t s unfavorabe s the foowng. If
the company can produce more unts of output usng the same xed assets (.e., the resources that
comprse xed overhead), then assumng those addtona unts can be sod, the company s more
protabe. When xed overhead s aocated to producton, ths greater protabty s reected n a
ower per-unt producton cost, because the same amount of tota xed overhead s spread over more
unts. On the other hand, f fewer unts are produced than panned, then the same xed overhead s
spread over fewer unts, the per-unt producton cost s hgher, and the company s ess protabe. Ths
hgher or ower protabty that arses from changes n producton eves s not an artfact of the
accountng system. Even f the company uses Varabe Costng, and expenses xed overhead as a
ump-sum perod cost, when the company makes and ses fewer unts than panned usng the same
xed overhead resources, t reay s ess protabe than was budgeted, and when the company makes
and ses more unts than panned usng the same xed overhead resources, t reay s more protabe
than was budgeted.

The volu#e variance 6ith "actory capacity in the deno#inator o" the 37H rate:
Next we use factory capacty to cacuate the voume varance. In ths case:
117

voume
varanc
e

= (

budgeted xed overhead

x

unts produced

)

budgeted xed
overhead "actory capacity

Snce

budgeted xed overhead factory capacty = budgeted overhead rate

the above expresson for the voume varance s agebracay equvaent to the foowng formua:

voume varance = (unts produced factory capacty) x budgeted overhead rate

The nterpretaton of the voume varance, when factory capacty s used n the denomnator of the
overhead rate, s the foowng. Actua producton s amost aways beow capacty. The voume varance
represents the xed overhead costs that are not aocated to product because actua producton s
beow capacty. Hence the voume varance represents the cost of de capacty, and ths varance s
typcay unfavorable. For ths reason, ths voume varance s sometmes caed the idle capacity
variance. In the unkey event that the factory produces above capacty (whch can occur f the
concept of practca capacty s used, and actua down-tme for routne mantenance, etc., s ess than
expected), then the voume varance represents the addtona xed overhead costs that are aocated
to product because actua producton exceeds capacty. In ths case, the voume varance s favorable.

Additional Issues Related to the Volu#e Variance:
Under what crcumstances woud a company cacuate the voume varance usng budgeted producton
as the denomnator-eve concept, and under what crcumstances woud a company use factory
capacty as the denomnator-eve concept?

The use of budgeted producton n the cacuaton of the voume varance attaches a ump sum benet
or cost to actua producton eves that exceed or fa short of budgeted producton eves. For ths
reason, many companes consder ths cacuaton of the voume varance to be an mportant
performance measure for the factory manager and marketng managers responsbe for makng and
marketng the product.

The use of factory capacty n the cacuaton of the voume varance provdes an ndcaton of how ow
the per-unt cost can go, f demand equas or exceeds factory capacty. If senor management woud ke
product managers to make prcng and operatng decsons based on a ong-term expectaton that
demand for the product w equa or exceed factory capacty, even though current or short-term
demand s beow capacty, cacuatng the per-unt cost n ths manner w encourage product
managers to take ths ong-run perspectve. For exampe, consder the aunch of a new product ne n a
new factory. If xed overhead s aocated based on budgeted producton, then product managers mght
fee pressured to set saes prces that w cover fu product costs at ntay-ow producton eves, but
these saes prces mght be too hgh to generate sumcent nta consumer nterest n the product for a
successfu product aunch.

Another reason to use factory capacty n the denomnator of the xed overhead rate, and n the
cacuaton of the voume varance, s that dong so soates the cost of de capacty. Often, the decson
to bud a factory that s arger than current demand warrants s a strategc decson made at hgh eves
wthn the organzaton. If the xed overhead assocated wth ths factory s aocated based on
budgeted or actua producton, the per-unt cost of every unt manufactured ncudes a sma porton of
the cost of ths strategc decson, and the cost reports of factory managers and the product protabty
statements of product managers are negatvey ahected by ths unused capacty. Some companes
prefer to soate the cost assocated wth ths strategc decson, and to ether show the cost of de
capacty as separate ne-tems on the cost reports and prot statements of the factory manager and
118
product managers, or remove ths cost entrey from these performance reports, and report t ony at
the corporate eve.

Aocatng xed overhead usng actua producton can provde managers short-run ncentves to
overproduce, because as producton ncreases, the per-unt cost decreases. Smary, cacuatng the
voume varance usng budgeted producton n the denomnator of the overhead rate can provde
managers short-run ncentves to overproduce, because as producton exceeds budget, the voume
varance becomes ncreasngy favorabe. For ths reason, some companes choose not to aocate xed
overhead at a. However, the use of factory capacty n the denomnator of the xed overhead rate
accompshes the same ob|ectve, because t soates the voume varance such that the performance
reports of these managers need not be ahected by t.

We have assumed, throughout ths secton, that xed overhead s aocated based on unts of output.
However, we saw n the chapter on actvty-based costng that unts of producton s often a poor choce
of aocaton base n a mut-product factory, and many companes that use standard costng systems
use aocaton bases that are more sophstcated, such as drect abor hours or drect materas doars.
The queston mght arse, how does the use of a dherent aocaton base, such as drect abor hours,
ahect the cacuaton of the voume varance? The answer s: Not at all. Because of the way n whch
standard costng systems work, the amount of xed overhead that w be aocated to product does not
depend on the choce of aocaton base.

For exampe, assume that a one-product company budgets two drect abor hours to make each unt,
and assume that f xed overhead s aocated based on output unts, the budgeted xed overhead rate
s $10 per unt. Then usng drect abor hours as the aocaton base, the budgeted xed overhead rate
s $5 per drect abor hour. Because of the mechancs of standard costng systems, no matter whether
the $10-per-unt rate s used, or the $5-per-drect-abor-hour rate s used, $10 of xed overhead w be
aocated to every unt produced, no matter how many drect abor hours are actuay used per unt. (If
ths fact s not obvous to you, refer back to Chapter 10 on standard costng.) Therefore, for the purpose
of cacuatng the voume varance, we mght as we use the easest aocaton base, whch s unts-of-
output.

It s mportant to recognze that even though most manufacturng companes use a standard costng
system, and even though the cacuaton of the xed overhead voume varance rees on the concept of
standard costng, companes can cacuate the voume varance even f they do not use a standard
costng system. In ths case, the cacuaton s dentca to the dscusson above, but the company w
not be abe to obtan the requred nformaton from the cost accountng system tsef, but rather, w
need to make a separate cacuaton.

Co#prehensive E&a#ple o" )i&ed 3verhead Variances:
The Coachman Company makes pencs. The pencs are sod by the box. Foowng s nformaton about
the companys ony factory:

/udet Actual Capacity
Number of boxes
Drect abor hours
Machne hours
Fxed overhead
10,000
200
500
$40,000
12,000
250
650
$42,000
20,000



The outputs here are boxes of pencs. The nputs are drect abor hours and machne hours. Frst we
cacuate a xed overhead rate usng actua amounts, and output unts as the aocaton base:

$42,000 12,000 boxes = $3.50 per box.

Usng ths overhead rate, every box of pencs s costed at the varabe cost of producton pus $3.50 n
aocated xed overhead.
119

Next we cacuate a xed overhead rate usng budgeted costs, and budgeted output unts as the
denomnator-eve concept:

$40,000 10,000 boxes = $4.00 per box.

Next we cacuate a xed overhead rate usng budgeted costs, and factory capacty as the
denomnator-eve concept (expressed n terms of output unts).

$40,000 20,000 boxes = $2.00 per box.

The advantage of usng capacty n the denomnator s that ths denomnator-eve concept shows how
ow the xed cost per unt can go, and hence, how ow the tota cost per unt can go, as producton
ncreases.

The xed overhead spendng varance s cacuated as foows:

$42,000 actua $40,000 budgeted = $2,000 unfavorabe.

Next, we cacuate the voume varance usng capacty as the denomnator-eve concept:

voume varance = ($2.00 per box x 12,000 boxes) $40,000 = $16,000 unfavorabe

or equvaenty:

voume varance = $2.00 per box x (12,000 boxes 20,000 boxes) = $16,000 unfavorabe

If the company uses a standard costng system, the amount of overaocated or underaocated xed
overhead s the dherence between actua xed overhead ncurred, and xed overhead aocated to
product, cacuated as foows:

actua xed overhead xed overhead aocated

$42,000 ($2.00 per box x 12,000 boxes)

= $42,000 $24,000 = $18,000 underaocated

Ths $18,000 of underaocated xed overhead s equa to the sum of the $2,000 unfavorabe xed
overhead spendng varance and the $16,000 unfavorabe voume varance.

Next, we cacuate the voume varance usng budgeted producton as the denomnator-eve concept:

voume varance = ($4.00 per box x 12,000 boxes) $40,000 = $8,000 favorabe

or equvaenty:

voume varance = $4.00 per box x (12,000 boxes 10,000 boxes) = $8,000 favorabe

If the company uses a standard costng system, the amount of overaocated or underaocated xed
overhead s the dherence between actua xed overhead ncurred, and xed overhead aocated to
product, cacuated as foows:

actua xed overhead xed overhead aocated
120

$42,000 ($4.00 per box x 12,000 boxes)

= $42,000 $48,000 = $6,000 overaocated

Ths $6,000 of overaocated xed overhead s equa to the sum of the $2,000 unfavorabe xed
overhead spendng varance (whch dd not change when we changed the denomnator-eve concept
from capacty to budgeted producton) and the $8,000 favorabe voume varance.

To ustrate that the choce of aocaton base does not ahect the cacuaton of the voume varance, we
recacuate the voume varance assumng the company aocates overhead usng machne hours as the
aocaton base and budgeted producton as the denomnator-eve concept. The budgeted overhead
rate s now

$40,000 500 machne hours = $80 per machne hour.

Snce the standard for machne tme s one hour for every twenty boxes (derved from the budget
coumn n the box at the begnnng of the exampe), the standard costng system w aocate xed
overhead as foows:

/udeted overhead rate x (standard inputs allo6ed for actua outputs acheved)

= $80 per machne hour x (12,000 boxes 20 boxes per machne hour)

= $80 per machne hour x 600 machne hours = $48,000

And the voume varance s

xed overhead aocated to product budgeted xed overhead

= $48,000 $40,000 = $8,000 favorabe, as before.


E&ercises and Proble#s:

%+2%! !ollowing is selected information about the Hopi 9opcorn company ,ll information represents total amounts, not per unit
amounts

Static :udget Actual 1esults
?nits made and sold
Birect materials costs
Birect materials used in production
!ixed overhead
.''
/#,'''
.,''' pounds
/A,'''
#'
/",F''
5#' pounds
/5,'''

Hopi had no beginning or ending inventory of either finished product or raw materials Hopi allocates fixed overhead using units
of output as the allocation base, and a budgeted overhead rate with budgeted production in the denominator

1equired! 3alculate the fixed overhead volume variance

12*+: Border Constructon Company s a road-pavng company. Such companes are characterzed by
hgh xed costs n pant and equpment. The company aocates xed overhead to ts |obs based on
mes of road paved. The company has an unfavorabe xed overhead spendng varance, and
overaocated xed overhead. Ths set of facts s consstent wth

8A. Unexpected capta expendtures and the use of practca capacty n the
denomnator of the xed overhead rate.
121

8/. An unexpected decrease n xed overhead costs, the use of budgeted actvty n
the denomnator of the xed overhead rate, and an unexpected ncrease n busness.

8C. An unexpected ncrease n appropratons by the State Legsature for road work,
resutng n more busness for the company, and unexpected capta expendtures.

81. The use of actua mes n the denomnator of the xed overhead rate, actua
xed overhead costs n the numerator, and sgncant unexpected capta expendtures.

12*,: Assume the foowng nformaton for the Centerve 2 pant of Poypar, whch manufactures ony
buty.

Budgeted xed overhead
Pant producton capacty
Budgeted buty producton
Actua buty producton
$12,000,000
1,000,000 tons of buty
500,000 tons of buty
600,000 tons of buty

Re'uired:
A. Usng budgeted buty producton n the denomnator of the xed overhead rate, cacuate the
xed overhead voume varance.

/. Usng pant capacty n the denomnator of the xed overhead rate, cacuate the xed overhead
voume varance.

C. In one or two sentences, nterpret what each of these varances represents.

%+2(! Xellow 3ompany budgeted fixed manufacturing overhead of /.,''',''', but actually incurred fixed manufacturing
overhead of /.,"'',''' The company expected to produce .'',''' units of product, but actually produced <',''' units The
company allocates fixed overhead using a budgeted rate, based on budgeted production in the denominator

1equired!
AA 3alculate the fixed overhead spending variance %s this variance favorable or unfavorable?

:A 3alculate the fixed overhead volume variance %s this variance favorable or unfavorable?

CA 3alculate the overallocated or underallocated fixed overhead

12*5: The Putonum Frutcake Company aocated varabe overhead based on pounds of drect
materas. The company's producton eve (unts of output) and drect materas prces (cost per pound)
n 1957 were exacty as panned n the statc budget for that year, but the company used more pounds
of drect materas per unt of output than panned. Ths set of crcumstances certany resuted n

(I) an unfavorabe varabe overhead emcency varance.

(II) an unfavorabe exbe budget varance for varabe overhead.

(III) an unfavorabe statc budget varance for varabe overhead.


(A) (I), (II) and (III)

(B) nether (I), (II) nor (III) need be true

(C) (I) ony

122
(D) (I) and (II) ony

12*9: Foowng s nformaton about December producton at the Doorstop Frutcake Company, and the
prncpa ngredent used n the manufacture of frutcakes: our. A our purchased durng the month
was used n producton. There was no our on hand at the begnnng of the month. Fxed manufacturng
overhead was budgeted at $90,000, but was actuay $100,000. Fxed manufacturng overhead s
aocated usng pounds of our as the aocaton base. The factory expects to be operatng at capacty
n December.



# of Frutcakes produced

Pounds of our used

Cost of our

Actua

Budget

1,150

1,200

5,980

6,000

$2,840.50

$3,000.00

If the company aocates varabe overhead based on pounds of our, the varabe overhead emcency
varance w be

(A) Zero

(B) Unfavorabe

(C) Favorabe

(D) Unabe to determne from the nformaton provded

12*2: Whch of the foowng scenaros mght not resut n an unfavorabe producton voume varance?

I. Actua producton s beow practca capacty, when budgeted producton s used n the
denomnator to cacuate the overhead rate.

II. Actua producton s beow practca capacty, when practca capacty s used n the
denomnator to cacuate the overhead rate.

III. Actua producton s beow budget, when budgeted producton s used n the denomnator
to cacuate the overhead rate.

IV. Actua producton s above budget, when practca capacty s used n the denomnator to
cacuate the overhead rate.

),* % and %J

)E* % only

)3* %, %%, %%% and %J

)B* % and %%%

12*-: Assume the foowng nformaton for the Pttsed factory of Carnege Stee.

Budgeted xed overhead
Producton capacty
Budgeted producton
$12,000,000
1,000,000 tons
500,000 tons

123
A. Assume we are at the begnnng of the year. If the voume varance w be cacuated usng
pant capacty n the denomnator of the xed overhead rate, what woud the pant manager
have to do to ensure that the producton voume varance w be zero?

/. Agan, assume we are at the begnnng of the year. If the voume varance w be cacuated
usng budgeted producton n the denomnator of the xed overhead rate, what woud the pant
manager have to do to ensure that the producton voume varance w be favorabe?

C. Assume that we are at the begnnng of the year, and that the factory manager s tod that the
producton voume varance, favorabe or unfavorabe, w be recorded at the corporate eve,
and not on the factory ncome statement that forms the bass for the managers performance
revew. Assume aso that the factory manager s gven the choce of the denomnator-eve
concept for cacuatng the voume varance (actua, budget, or practca capacty), but that the
manager must make the choce at the begnnng of the year, knowng ony the nformaton n
the tabe at the start of ths queston, but not knowng actua producton or actua xed
overhead costs. What denomnator-eve concept do you thnk the factory manager w choose,
and why? Woud your answer change f, nstead of budgetng producton of 500,000 tons,
producton was budgeted for factory practca capacty of 1,000,000 tons?

12*:: If a factory s on a Standard Costng System, and has overaocated xed overhead, whch of the
foowng statements s certany true?

(A) The factory made more unts than panned.

(B) The factory has a favorabe spendng varance.

(C) The factory has a favorabe producton voume varance.

(D) The actuay amount spent for xed overhead was ess than the amount of xed
overhead aocated to nventory.

12*10: The Large and Expensve Wdget Company aocates overhead based on drect abor hours. If
the company uses more tota drect abor hours than panned, but the actua abor wage rate s the
same as the budgeted abor wage rate, whch of the foowng statements mght not be true?

(A) There w be an unfavorabe statc budget varance for abor.

(B) The abor wage rate varance w be zero.

(C) There w be an unfavorabe abor emcency varance.

(D) The abor emcency and overhead emcency varances w be n the same drecton (.e.,
ether both varances w be favorabe, they w both be unfavorabe, or they w both be
equa to zero).

12*11: McConne McDowe McOueen Enterprses makes cotton shrts n a snge factory n Cod Sprng,
VT. The company uses a Standard Costng System. The company aocates xed and varabe overhead
separatey. Varabe overhead s aocated usng drect abor hours as the aocaton base. Fxed
overhead s aocated based on output unts (.e., the aocaton base s shrts), and factory practca
capacty s the denomnator-eve concept. Practca capacty s 2,000 shrts per month. Foowng s
budgeted and actua nformaton for the month.

Static :udget
0n#ormation
Actual 1esults

9roduction
124
Number of shirts

Birect 1aterials
3ost per yard of fabric
Xards of fabric per shirt

Birect labor
Birect labor cost for all of the shirts
Hours of direct labor for all of the shirts

Jariable Cverhead
!ixed Cverhead
.,"''


/5#'
"''


/"F,'''
A,'''

/.<,'''
/.#,'''
.,'''


/5"'
"#'


/A','''
A,5''

/.<,#''
/.',#''

1equired!
AA 3alculate the spending and efficiency variances for variable overhead

:A 3ompute the fixed overhead volume variance %s it favorable or unfavorable?

CA 3ompute the spending variance for fixed overhead

DA 3ompute the amount of underallocated or overallocated fixed overhead

%+2%&! Di, Dee and Devy %ndustries makes widgets in its factory located in the 1arina &hores district of &eattle The company uses
a standard costing system !ollowing is budgeted and actual information for the month

Static :udget 0n#ormation
Actual 1esults


(idgets produced

Birect materials2 copper fibers


Birect labor


Jariable overhead
)allocated based on machine hours*

!ixed costs
)allocated based on units of output, and budgeted
production in the denominator*

1achine hours

.,'''

.#,''' pounds for a total
cost of /A.,#''

.,''' hours for a total cost
of /4,'''

/.<,'''


/#@,'''



<''

4''

.",@'' pounds for a total
cost of /"#,"''

4#' hours for a total cost of
/<,'F#

/.5,##A


/#F,'''



@A'

1equired! 3alculate the variances for variable and fixed overhead

12*1,: NPX Company reports the foowng nformaton for October:

Static :udget Actual 1esults
9roduction
Birect labor
Jariable overhead
!ixed overhead
1achine hours
.''' units
"' minutes per unit
/A,AAA
/5F,'''
"''
.,.'' units
.# minutes per unit
/A,@@@
/5F,'''
""'

N9Y allocates overhead based on direct labor hours, using a standard costing system, and allocates fixed overhead using the
denominator-level concept of budgeted production

AA How much of the flexible budget variance for variable overhead is due to the fact that N9Y produced more units than planned?

125
:A The variable overhead efficiency variance is /4.F favorable )rounded to the nearest dollar* Iecalculate the variable overhead
efficiency variance assuming the company allocates overhead based on machine hours instead of labor hours

CA 3alculate the variable overhead spending variance assuming the company allocates variable overhead based on machine hours
instead of labor hours

DA 3alculate the fixed overhead spending variance %s it favorable or unfavorable?

=A How much of the fixed overhead spending variance is due to the fact that production was higher than planned?

3A 3alculate the fixed overhead volume variance

;A How much of the fixed overhead volume variance is due to the fact that production was higher than planned?

<A 3alculate the amount of overapplied or underapplied fixed overhead

12*1;: The Eectrc Sound Opera Company makes three modes of an eectronc keyboard. Budgeted
and actua nformaton for the year foows:

Model A Model / Model C Total
Unts produced:
actua
budgeted

Drect materas (per unt)
actua
budgeted

Drect abor (per unt)
actua
budgeted

Cost driver in"o:
number of parts (per unt)
actua
budget

drect abor hours (per unt)
actua
budget

tota square feet (budget = actua)

3verhead costs:
Labor Support (varabe overhead)
actua
budget

Materas Support (varabe
overhead)
actua
budget

Fxed Overhead
actua
budget


315
275


$50
$52


$24
$20



32
32


3.50
4

3,000



450
400


$76
$73


$56
$50



56
56


4.60
5

6,000




226
300


$100
$105


$38
$40



43
43


4.50
5

10,000


991
975


















19,000



$ 535,000
$ 600,000


$ 780,000
$ 860,000


$1,250,000
$1,000,000


126
Tota Overhead
actua
budget
$2,565,000
$2,460,000
5otes!
C%A The company uses a Normal 3osting &ystem
C&A Total square feet refers to the square feet of factory floor space used in the production of each model of product %t is
expressed as total square feet for that model, not square feet per unit
C'A Jariable manufacturing overhead is divided into two cost pools, one for labor support and one for materials support

AA ,ssume that the Dabor &upport overhead cost pool is allocated based on direct labor hours )labor hours is the allocation base*,
that the 1aterials &upport overhead cost pool is allocated based on number of parts )parts is the allocation base*, and that the
!ixed Cverhead cost pool is allocated based on square feet 3alculate the cost per unit for each 1odel ,

:A Now assume that the Jariable Cverhead Dabor &upport cost pool is allocated to product based on direct labor dollars 3alculate
the variable overhead spending and efficiency variances for this overhead cost pool category

CA 3alculate the fixed overhead production volume and spending variances, assuming that fixed overhead is allocated using
output units as the allocation base, and budgeted production as the denominator-level concept

12*15: Sverstream Company makes trave traers. The foowng nformaton pertans to the
companys Oho Dvson, whch manufactures and markets ony one mode of traer: the 32-foot
Ambassador traer. Foowng s budgeted and actua nformaton for the Oho Dvson for 2004:

/udeted Actual


Traers manufactured n 2004
Traers sod n 2004
Saes prce per traer

Drect materas costs (a varabe
costs):
Aumnum
Stee
Other
Tota materas costs

Drect abor costs (a varabe costs)
Varabe overhead manufacturng costs
Fxed overhead costs:
Manufacturng xed overhead
Non-manufacturng xed
overhead

Per Unt






$4,000
$2,000
$4,000
$10,000

$5,000
$8,000
Tota

1,000
1,000
$45,000


$4,000,000
$2,000,000
$4,000,000
$10,000,000

$5,000,000
$8,000,000

$10,000,000
$2,000,000


800
600
$45,000


$3,400,000
$1,600,000
$3,800,000
$8,800,000

$3,800,000
$6,400,000

$11,000,000
$2,100,000

Additional in"or#ation:
The Oho Dvson started the year wth no nventory of nshed traers or drect materas.

Drect abor standard: 250 hours per traer
Actua drect abor hours ncurred: 195,000 hours
The budgeted quantty of aumnum: 100 bs. per traer
The budgeted cost of aumnum: $40 per b.
The actua quantty of aumnum purchased 84,000 bs.
The actua quantty of aumnum used 82,927 bs.
The output capacty of the factory: 2,000 traers

The dvson aocates overhead based on drect abor hours. The ony non-manufacturng costs are
certan xed overhead costs, as shown above.

Calculate the "ollo6in:

127
A. The exbe budget varance for varabe manufacturng overhead.

/. The varabe manufacturng overhead spendng varance.

C. The varabe manufacturng overhead emcency varance.

1. Recacuate the varabe manufacturng overhead rate, assumng the company appes varabe
overhead based on pounds of aumnum, nstead of drect abor hours.

E. Usng the overhead rate cacuated n part (D), recacuate the varabe manufacturng overhead
spendng varance.

). Usng the overhead rate cacuated n part (D), recacuate the varabe manufacturng overhead
emcency varance.

(. Usng the overhead rate cacuated n part (D), recacuate the varabe manufacturng overhead
exbe budget varance.

H. The xed manufacturng overhead spendng or budget varance.

I. The exbe budget varance for xed manufacturng overhead.

<. The xed manufacturng overhead producton voume varance, assumng the voume varance
s cacuated based on budgeted producton.

=. The xed manufacturng overhead producton voume varance, assumng the voume varance
s cacuated based on factory capacty.

>. The amount of overapped or underapped xed manufacturng overhead, f the company
appes overhead based on budgeted producton.
C<A/T=1 %,! 8oint /roducts

Chapter Contents!
- Befinition and overview
- Ieasons for allocating common costs
- ,lternative methods for allocating common costs
- 3onclusion
- Exercises and problems

De#inition and Overvie$!
%n some production processes, particularly in agriculture and natural resources, two or more products undergo the same process up
to a split2o## point, after which one or more of the products may undergo additional processing ,n oil company drills for oil and
obtains both crude oil and natural gas , second-growth forest is harvested, and lumber of various grades are milled , farmer
maintains a herd of dairy cows, and after the cows are milked, the milk naturally separates into skim and cream or can be
separated into various products characteri>ed by the amount of milkfat &ome of these products then constitute raw materials in
the manufacture of other products such as butter and cheese

!ollowing are some important terms2

Common costs! These costs cannot be identified with a particular +oint product Ey definition, +oint products incur common costs
until they reach the split-off point

Split2o## point! ,t this stage, the +oint products acquire separate identities 3osts incurred prior to this point are common costs,
and any costs incurred after this point are separable costs

Separable costs! These costs can be identified with a particular +oint product These costs are incurred for a specific product, after
the split-off point

The characteristic feature of +oint products is that all costs incurred prior to the split-off point are common costs, and cannot be
identified with individual products that are derived at split-off !urthermore, the costs incurred by the dairy farmer to feed and
care for the cows do not significantly affect the relative amounts of cream and skim obtained, and the costs incurred by the lumber
128
company to maintain and harvest the second-growth timber do not significantly affect the relative quantities of lumber of various
grades that are obtained

1easons #or Allocating Common Costs!
Given the lack of a cause-and-effect relationship between the incurrence of common costs and the relative quantities of +oint
products obtained, any allocation of these common costs to the +oint products is arbitrary 3onsequently, there is no management
accounting purpose served by the allocation of these common costs Diterally, there is no managerial decision that becomes better
informed by such an allocation 3onsider the possibilities2

. 3an the allocation of common costs prompt the manager to favor some +oint products over other +oint products and to
therefore change the production process, and hence the quantities of +oint products obtained?

5o Ey definition, the relative quantities obtained from the +oint process are inherent in the production process itself, and
cannot be managed %n fact, the manager probably does have strong preferences for some +oint products over others
)high-grade lumber over low-grade lumberK cream over skim milk*, but the manager-s preferences are irrelevant

" 3an the allocation of common costs prompt the manager to change the sales prices for the +oint products, or to change
decisions about whether to incur separable costs to process one or more of the +oint products further?

5o The decision to sell a +oint product at split-off or to process it further depends only on the incremental costs and
revenues of the additional processing, not on the common costs %n fact, the common costs can be considered sunk at the
time the additional processing decision is made ,s for pricing, most +oint products are commodities, and producers are
generally price-takers To the extent that the producer faces a downward sloping demand curve, determining the optimal
combination of price and production level depends on the variable cost of production, but this calculation would have to
be done simultaneously for all +oint products, in which case no allocation of common costs would be necessary

A 3an the allocation of common costs inform the manager that the entire production process is unprofitable and should be
terminated? !or example, does this allocation tell the dairy farmer whether the farmer should sell the herd and get out of
the dairy business?

5o &uch an allocation is unnecessary for the decision of whether to terminate the +oint production process !or this
decision, the producer can look at the operation in its entirety )total revenues from all +oint products less total common
costs and total separable costs*

Xet despite the fact that allocating common costs to +oint products serves no decision-making purpose, it is required for external
financial reporting %t is necessary for product costing if we wish to honor the matching principle for common costs, because these
common costs are manufacturing costs !or example, if the dairy sells lowfat milk shortly after split-off, but processes high
milkfat product into cheese that requires an aging process, the allocation of common costs is necessary for the valuation of ending
inventory )work-in-process for cheese* and the determination of cost-of-goods sold )lowfat milk*

Alternative Methods #or Allocating Common Costs!
Here are four methods of allocating common costs2

. /hysical measure! ?sing this method, some common physical measure is identified to describe the quantity of
each product obtained at split-off !or example2 the weight of the +oint products, or the volume 3ommon costs are
then allocated in proportion to this physical measure This method presumes that the quantities of all +oint products
can be expressed using a common measure, which is not always the case !or example, crude oil is a liquid, while
natural gas is, naturally, a gas, and volumes of liquids and gasses are not normally measured in the same units

" Sales value at split2o##! %f a market price can be established for the products that are obtained at split-off,
common costs can be allocated in proportion to the sales value of the products at split-off The sales value of each
+oint product is derived by multiplying the price per unit by the number of units obtained !or example, if the dairy
farmer obtains "' gallons of cream, and if cream can be sold for /A per gallon, then the sales value for cream is /@'
%f the farmer also obtains 5' gallons of skim milk that sells for /" per gallon, then the sales value of skim milk is
/<' The total value of both products is /.5', and 5A$ )/@' = /.5'* of common costs would be allocated to all "'
gallons of cream This method can be used whether or not one or more of the +oint products are actually processed
further, as long as a market price exists for the product obtained at split-off %n other words, even if the farmer does
not sell any cream, but processes all of the cream into butter, the fact that there is a market price for cream is
sufficient for the farmer to be able to apply this method of common cost allocation

A 5et 1ealiDable Ealue! The net reali>able value of a +oint product at split-off is the sales price of the final
product after additional processing, minus the separable costs incurred during the additional processing %f the +oint
product is going to be sold at split-off without further processing, the net reali>able value is simply the sales value at
129
split-off, as in the previous method ?nder the net reali>able value method of common cost allocation, common costs
are allocated in proportion to their net reali>able values ,s with the previous method, the allocation is based on the
total value of all quantities of each +oint product obtained )the net reali>able value per unit, multiplied by the number
of units of each +oint product*

5 Constant ;ross Margin /ercentage! This method allocates common costs such that the overall gross margin
percentage is identical for each +oint product The gross margin percentage is calculated as follows2

Gross 1argin 9ercentage ; )&ales Z 3ost of Goods &old* = &ales

3ost of Goods &old for each product includes common costs and possibly some separable costs The application of
the 3onstant Gross 1argin 9ercentage requires solving for the allocation of common costs that equates the Gross
1argin 9ercentage across all +oint products

Conclusion!
The choice of method for allocating common costs should depend on the ease of application, the perceived quality of information
reported to external parties, and the perceived fairness of the allocation when multiple product managers are responsible for +oint
products However, as discussed above, the allocation of common costs is arbitrary, and no method is conceptually preferable to
any other method ,ll methods of allocating common costs across +oint products are generally useless for operational, marketing,
and product pricing decisions

=4ercises and /roblems!

%,2%! Her> 3orporation processes soybeans into soybean oil and other products in a +oint process The common costs allocated to
soybean oil are /"'' per gallon The soybean oil can either be sold for /.4' or processed into margarine The cost to process one
gallon of soybean oil into margarine is /."' Each gallon of soybean oil yields A pounds of margarine, which sells for /'<' per
pound

AA (hat is the net benefit of processing the soybean oil into margarine, relative to selling the soybean oil at the split-off point?

),* , gain of /."' per gallon of soybean oil processed
)E* , gain of /.A' per gallon of soybean oil processed
)3* , loss of /'<' per gallon of soybean oil processed
)B* , loss of /'F' per gallon of soybean oil processed

:A (hat should Her> 3orporation do?

),* 9rocess the soybean oil into margarine
)E* &ell the soybean oil at the split-off point
)3* &top producing soybean oil
)B* Her>-s best course of action cannot be determined from the information provided

%,2&! , +oint process produces a batch of product that consists of # lbs of 3ompound Y, " lbs of 3ompound X and A lbs of
3ompound M 3ommon costs to produce one batch are /@'

3ompound Y sells for /5 per pound 3ompound X sells for /"' per pound 3ompound M sells for /.' per pound, but can be
processed further into 3ompound MM 3ompound MM sells for /.< per pound, and the additional processing costs are /4 per
batch

1equired! How much +oint cost would be allocated to each pound of 3ompound Y, if +oint costs are allocated using the Net
Ieali>able Jalue method of +oint cost allocation?

%,2'! Iyan 3ompany makes two products from a +oint process and has the following information2

?nits 9roduced &ales value per unit at
split-off
Total additional
processing costs
beyond split-off
&ales value per unit after
additional processing
9roduct , @',''' /"' /A'',''' /"F
9roduct E A',''' /.. /A'',''' /.4

The common costs incurred to produce the two products to the split-off point are /<'','''

130
AA (hat common costs will be allocated to each unit of 9roduct , using the relative sales value at split-off as the allocation
method?

:A (hich products should be processed further?

CA (hat common costs will be allocated to each unit of 9roduct E using the net reali>able value method of +oint cost
allocation )and assuming that NIJ is calculated based on the profit-maximi>ing production choice*

%,2(! 1ichael Hearns is a commercial fisherman and he has +ust returned from a trip off the coast of ,laska 1ichael has
calculated the cost of his trip at /F",''' This entire amount represents +oint costs with respect to the different types of fish that
1ichael caught 1ichael-s nets yielded a catch of .,''' pounds of salmon, .,''' pounds of halibut, and ",''' pounds of flounder
&almon sells for /5 per pound, halibut for /A per pound, and !lounder for /. per pound

1equired! ,llocate the +oint costs to the three types of fish based on their relative sales value

%,2)! %n harvesting maple syrup, two grades of maple syrup are obtained from a +oint process (e will call these two grades of
syrup Grade , syrup and Grade M syrup The common costs are /#' to obtain .' gallons of Grade , syrup and .# gallons of
Grade M syrup Grade , can be sold at the split-off point for /" per gallon, or alternatively, /. of additional processing costs can
be incurred per gallon and Grade , can then be sold for /@#' per gallon Grade M can be sold at split-off for /. per gallon, or
alternatively, /'#' of additional processing costs can be incurred per gallon, and Grade M can then be sold for /A#' per gallon

CAA 3alculate the common costs allocated to all .# gallons of Grade M syrup, allocating common costs based on physical
quantities

C:A 3alculate the common costs allocated to each gallon of Grade , syrup using the net reali>able value method of +oint cost
allocation

%,2*! The Tara Bairy incurs +oint costs of /..' per day in order to obtain #' gallons of raw milk This raw milk is then separated
to obtain "' gallons of cream and A' gallons of skim milk The dairy allocates +oint costs based on physical quantities 3alculate
the +oint costs that would be allocated to cream

%,2+! Loint costs are /F"' Loint products are .'' feet of product ,, .'' feet of product E, and "'' feet of product 3 9roduct ,
sells for /5 per foot at the split off point, but for /. of additional processing costs, can be sold for /@ per foot 9roduct E sells for
/A per foot, but for /" of additional processing costs, can be sold for /5 per foot 9roduct 3 sells for /. per foot, and cannot be
processed further

1equired! ,llocate the +oint costs to the three products based on Net Ieali>able Jalue
C<A/T=1 %-! Capital :udgeting

Chapter Contents!
- Cverview
- Time value of money
- 9ayback period
- Net present value
- %nternal rate of return
- Net present value and internal rate of return, compared
- The discount rate
- ,ccounting rate of return
- Bepreciation expense, income taxes, and capital budgeting
- 9resent value tables
- Exercises and problems

Overvie$!
3apital pro+ects involve the acquisition of assets that generate returns over multiple periods Examples are the construction of a
factory or the purchase of a new machine %n this context, a dollar saved is as good as a dollar earned Hence, capital investments
that reduce operating expenses are equivalent to capital investments that generate additional revenues

This chapter describes four performance measures for capital pro+ects These performance measures can use budgeted data as a
planning tool, to decide whether to invest in a proposed capital pro+ect or for choosing among proposed pro+ects ,lso, these
performance measures can be used retrospectively, to evaluate a capital pro+ect against planned performance or against other
pro+ects

131
, characteristic feature of capital pro+ects is that the bulk of the cash outflows precede the cash inflows ,lthough a capital pro+ect
may involve cash outflows that occur over time, and cash inflows that vary from year to year, our discussion will often assume a
typical scenario in which there is a single cash outflow for the acquisition of the asset that occurs at the beginning of year one
)called 6time >ero8*, followed by a series of equal cash inflows that occur at the end of each year for the life of the pro+ect This
series of cash inflows is called an annuity

Time Ealue o# Money!
, dollar today is worth more than a dollar one year from now The reason for this appreciation is that cash is an asset, and like any
asset, it can be invested to earn a return over time The discount rate is a measure of the time value of moneyK it measures how
much more a dollar is worth today than a dollar one year from now !or example, if you are indifferent between receiving /.''
today and /."' one year from now, your discount rate is "'$ The time value of money has nothing to do with inflation, which
works in the opposite direction %nflation refers to the declining purchasing power of the dollar that occurs when prices of goods
and services rise over time

&oftware spreadsheet applications and financial calculators include present value functions that calculate the present value of any
amount received )or paid* at any time in the future These tools also provide the future value, for any point in time in the future, of
any amount received )or paid* today Eefore these electronic resources were commonplace, tables were widely available that
allowed one to easily calculate present values and future values for frequently-used discount rates and time periods ,lthough such
tables are unnecessary in practice today, we will use them in this chapter, because they visually illustrate the relevant concepts

Table . at the end of this chapter is a present value table %t provides present value factors for selected discount rates that range
from @$ to "'$, and time periods that range from one period to twenty periods %f the interest rates are expressed per annum, then
the time periods represent years !or example, to determine the present value of any amount Y received five years from now, at an
interest rate of <$ per annum, one would find the factor at the intersection of Iow # and the 3olumn for <$ )the factor is '@<'@*,
and multiply this factor by the amount Y

1any situations involve a stream of equal payments or receipts over a consecutive number of periods !or example, financing the
purchase of an automobile might require monthly payments of /.,''' for the next three years, or a proposed capital acquisition
might increase revenues by /.',''' every year for the next seven years &uch streams of cash inflows and outflows are called
annuities

&oftware spreadsheet applications and financial calculators include functions that calculate the present value and future value of
annuities ,gain, before these electronic resources were widely available, tables were used to calculate the present value or future
value of an annuity by multiplying the annual annuity amount by the factor in the table Table " at the end of this chapter is a
present value table for annuities %n order to use the table for an annuity of monthly payments or receipts )such as the example of
monthly payments for the financing of an automobile*, one can treat the rows as months if the interest rates in the column
headings are treated as monthly percentages !or example, if the annual interest rate on the car loan is "5$, the monthly interest
rate is "$, and one would need to use the column for "$ )which is not shown in Table ", but would have been included in tables
used by practitioners*

There is an important relationship between Table . and Table " The present value of any annuity can be calculated by using Table
. separately for each period over which the annuity occurs, and then summing these individual amounts Table " )or the annuity
present value function on a calculator* simplifies the task, by calculating the present value of the entire stream of payments or
receipts at once This relationship implies that one can always 6build8 Table ", row by row, by summing the entries for the
corresponding column in Table ., down to that row !or example2
132

Table .2 9resent value of /. received )or
paid* n years from now
N @$ F$ <$ 4$
.
"
A
5
'45A5
'<4''
'<A4@
'F4".
'4A5@
'<FA5
'<.@A
'F@"4
'4"#4
'<#FA
'F4A<
'FA#'
'4.F5
'<5.F
'FF""
'F'<5


Table "2 9resent value of an annuity of /. for
the next n years
N @$ F$ <$ 4$
.
"
A
5
'45A5
.<AA5
"@FA'
A5@#.
'4A5@
.<'<'
"@"5A
AA<F"
'4"#4
.F<AA
"#FF.
AA.".
'4.F5
.F#4.
"#A.A
A"A4F


'4A5@ : '<FA5 : '<.@A ; "@"5A

Hence, an annuity of /. for three years at F$ equals /"@"5A, which can be derived either by adding the three annual amounts
provided in Table ., or more simply by using the factor in row A of Table "

Next we examine four methods for evaluating capital pro+ects

/aybac7 /eriod!
The payback period measures the time required to recoup the initial investment in the capital asset 3onsider the following two
examples

/ro9ect 0nitial Cost Cash 0n#lo$s in Fear
% & ' ( ) * +
A /.',''' /",''' /",''' /.,''' /A,''' /",''' /.,#'' /'
: /.',''' /",''' /",''' /",''' /A,''' /",''' /",''' /",'''

The payback period for 9ro+ect , is five years, because the sum of cash inflows for years one through five is /.',''' and /.','''
is also the initial cost of the pro+ect The payback period for 9ro+ect E is greater than four years but less than five years, because
the sum of cash inflows through year four is /4,''', and the sum of cash inflows through year five is /..,''', while the initial
cost is /.',''' %n this situation, the payback period could be expressed as 5[ years

%f cash inflows are constant from year to year during the life of the pro+ect, the payback period can be calculated as follows2


;

%nitial %nvestment
9ayback 9eriod
,nnual 3ash %nflow

The payback period has two drawbacks !irst, it ignores the time value of money However, this drawback is somewhat mitigated
by the fact that, in any case, the payback period tends to favor pro+ects that recover the initial investment quickly The second
drawback is that the payback period ignores cash inflows that occur after the end of the payback period The following example
illustrates these issues2

/ro9ect 0nitial Cost Cash 0n#lo$s in Fear
% & ' ( ) * +
C /<,''' /",''' /",''' /.,''' /A,''' /' /' /'
D /<,''' /",''' /",''' /",''' /",''' /",''' /",''' /",'''

Eoth pro+ects have a payback period of four years However, 9ro+ect B is clearly preferred to 9ro+ect 3, both because 9ro+ect B
generates more cash inflows earlier during the payback period )/",''' in year three versus /.,''' for 9ro+ect 3, which is offset in
year four*, and because 9ro+ect B continues to generate returns after the payback period is over

133
The payback period is a heuristic , heuristic is a decision-aid that is easily understood and easily communicated, but that might
not always result in the best decision

5et /resent Ealue!
The net present value )5/E* of a capital pro+ect answers the following question2

(hat is the pro+ect worth in today-s dollars?

The N9J is the sum of the present value of all current and future cash inflows and outflows &ince the present value of a cashflow
that occurs today is its face value, the N9J of a pro+ect is the sum of any cashflows that occur at time >ero plus the present value
of all future cashflows

%n the typical scenario in which there is an initial cash outlay for the acquisition of an asset, followed by cash inflows throughout
the useful life of the asset, the N9J can be calculated as follows2

N9J


;

\

cash inflow
).:k*
n


] initial outlay

(here k is the discount rate, n is the number of periods from time >ero in which the cash inflow occurs, and the summation is over
the n periods of the life of the pro+ect %f the cash inflows are an annuity over the life of the pro+ect, the numerator in the above
equation can be moved outside of the summation to obtain the following2


N9J


;

annual cash inflow x \

.


] initial outlay
).:k*
n

The summation now depends only on k and n2

\

^^.^^^
).:k*
n
%t is exactly this term that is provided in a present value table for annuities )see Table " at the end of this chapter*, where k
represents the discount rate in the column heading, and n represents the number of years )the row*
^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^

=4ample! The &unrise Eakery is considering purchasing a new oven The oven will cost /.,#'', and the owner anticipates that
the oven will increase the bakery-s future net cash inflows by /<'' per year for the next five years (hat is the anticipated N9J of
this capital acquisition, if the bakery-s discount rate is .'$?

N9J ; )/<'' x AF4'<* Z /.,#'' ; /A,'AA Z /.,#'' ; /.,#AA

The factor AF4'< comes from Table "2 the intersection of the column for .'$ and row #
^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^

Eecause N9J provides an absolute measure of the return from the pro+ect, not a ratio, it tends to favor large pro+ects ,lso, the
N9J calculation implicitly assumes that free cash flows can be reinvested at the discount rate Bespite these potential drawbacks,
net present value is usually the most reliable criterion by which to +udge capital pro+ects on an individual basis

0nternal 1ate o# 1eturn!
The internal rate of return )%II* is the discount rate computed such that the net present value of the pro+ect equals >ero &oftware
spreadsheet applications and financial calculators usually include a function that calculates the %II The following example
illustrates how the %II was approximated prior to the widespread availability of these electronic tools
^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^

=4ample! The &unrise Eakery is considering an expansion to its outdoor dining space that would require an initial cash outlay of
/"@,''' and increase net cash inflows by /<,''' per year for four years The owner of the bakery does not anticipate any benefit
from this expansion after year four, because at that time she hopes to finance a ma+or renovation of the building that would expand
the indoor dining area into the location of the patio (hat is the %II of the proposed expansion to the current outdoor dining
space?
134

&etting the N9J equal to >ero in the N9J equation, and solving for the present value factor2

' ; )/<,''' x the present value factor* Z /"@,'''

_ present value factor ; A"#

Dooking in Iow 5 of Table " )since the life of the annuity is four years*, the closest factor to A"# is A"A4F in the column for 4$
Therefore, the %II is approximately 4$
^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^

Ielative to N9J, the advantage of %II is that it provides a performance measure that is independent of the si>e of the pro+ect
Hence, %II can be used to compare pro+ects that require significantly different initial investments

,n important drawback of %II is that it can induce managers to re+ect proposed pro+ects that shareholders would like the
company to accept !or example, if the manager is evaluated based on the average %II of all capital pro+ects undertaken, and if a
proposed capital pro+ect offers an %II that is above the company-s cost of capital, but below the average of all capital pro+ects
undertaken thus far, the proposed pro+ect would adversely affect the manager-s performance measure, although it would increase
economic returns to shareholders

%II implicitly assumes that free cashflows can be reinvested at the computed internal rate of return This assumption is analogous
to the assumption imbedded in the N9J calculation that free cashflows can be reinvested at the discount rate However, in the
context of %II, the assumption is more problematic than in the context of N9J if the %II is unusually high or low

5et /resent Ealue and 0nternal 1ate o# 1eturn, Compared!
There is an important and close relationship between N9J and %II The N9J is greater than >ero if and only if the %II is greater
than the discount rate This relationship implies that if a single proposed capital investment is considered in isolation, both N9J
and %II will provide the same answer to the question of whether or not the investment should be undertaken

However, N9J and %II need not provide the same answer if pro+ects that require different investments are compared 3onsider
the following example, comparing two pro+ects each with a one-year life ,ssume a .'$ discount rate in the N9J calculation %n
this simple setting with a one-year life, the %II is easily calculated as the profit divided by the initial investment

/ro9ect 0nitial
0nvestment
/ayout at end o#
year
5et /resent Ealue 0nternal 1ate o#
1eturn
A /.,''' /.,"''/4. Q).,"'' = ..* Z .,'''R "'$
: /.'' /"''/<" Q)"'' = ..* Z .''R .''$

Hence, N9J favors 9ro+ect ,, while %II favors 9ro+ect E (hat is the 6correct8 answer? The answer depends on the opportunity
cost associated with the additional /4'' required to finance 9ro+ect , compared with financing 9ro+ect E !or example, if the
company has /.,''' to invest and can replicate 9ro+ect E ten times, doing so would clearly be preferable to 9ro+ect , Cn the
other hand, if the company can earn only .$ on the /4'' additional funds available if 9ro+ect E is chosen over 9ro+ect ,, then the
company prefers 9ro+ect ,, calculated as follows2

/ro9ect 5/E 011
A /4., as determined above "'$, as determined above
: plus /4''
invested at .$
/< Q)/.,.'4 = ..* Z /.,'''R )/.,.'4 /.,'''* = /.,''' ; ..$

The /.,.'4 in the bottom row is the total payout at the end of the year from this option, calculated as /"'' from 9ro+ect E plus
/4'4 from the /4'' investment that earns .$ The N9J of /< is actually less than the N9J from 9ro+ect E alone, because the
N9J of the /4'' invested at .$ is negative

%n conclusion, N9J and %II need not rank pro+ects equivalently, if the pro+ects differ in si>e

The Discount 1ate!
The discount rate is critical in determining whether the N9J of a pro+ect is positive or negative )and equivalently, whether the
pro+ect %II is greater or less than the discount rate* However, the choice of discount rate is seldom obvious

%n most situations, the appropriate discount rate is the company-s cost of capital The cost of capital is a weighted average of the
company-s cost of debt and its cost of equity %nterest rates on borrowings provide information about the cost of debt Betermining
the cost of equity is more difficult, and constitutes an important topic in the area of finance The (eighted ,verage 3ost of 3apital
135
)(,33* is a concept from corporate finance that frequently serves as an appropriate discount rate for capital budgeting decisions
%n some cases, however, the company would benefit from distinguishing between the existing aerage cost of capital, and the
marginal cost of capital, because the cost of debt generally increases as companies become more highly leveraged

1any companies establish a company-wide hurdle rate, to communicate to managers the appropriate discount rate for investment
decisions Cften, the hurdle rate seems to exceed the company-s cost of capital, which encourages managers to act conservatively
in their capital budgeting decisions2 an outcome that is difficult to +ustify with finance theory

,nother option for the discount rate is the opportunity cost associated with the funds required for the capital pro+ect %n most
cases, the cost of capital and the opportunity cost should be approximately equal However, most of us pay a higher rate to borrow
funds than we earn on our financial investments Hence, if a decision-maker has cash to either invest in a capital pro+ect or invest
in the financial markets, an appropriate discount rate for the capital pro+ect is the opportunity cost of the earnings the decision-
maker would have earned in the financial markets This rate is probably lower than the cost of raising additional financing for the
pro+ect

Accounting 1ate o# 1eturn!
The accounting rate o# return )A11* is sometimes called the boo7 rate o# return Cf the four capital pro+ect performance
measures discussed in this chapter, the accounting rate of return is the only performance measure that depends on the company-s
accounting choices %t is calculated as follows2

,ccounting Iate of Ieturn

;
Average 0ncremental Annual
0ncome #rom the /ro9ect
Average 5et :oo7 0nvestment in the /ro9ect

%n the simple setting in which the capital pro+ect consists of the purchase of a single depreciable asset, the numerator is the
average incremental annual cash inflow )additional revenues or the reduction in operating expenses* attributable to the asset,
minus the annual depreciation expense The denominator is the net book investment in the asset, averaged over the life of the
asset
^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^

=4ample! , machine costs /.",''' and increases cash inflows by /5,''' annually for four years The machine has >ero salvage
value

Bepreciation expense ; /.",''' = 5 ; /A,''' per year

%ncremental income from the machine ; /5,''' Z /A,''' ; /.,''' per year

Eecause income from the machine is identical in each year of its four-year life, the average income over the life of the asset is also
/.,''' annually

!or the calculation of the Net Eook %nvestment in the denominator, even though the asset life is four years, five points in time
must be considered2 time >ero )the beginning of year one*, and the end of years one through four ,t the time the machine is
purchased )time >ero*, the net book investment equals the purchase price of /.",''' ,s the machine is depreciated, the
accumulated depreciation account balance increases, and the net book investment decreases

Fear <istorical Cost Accumulated Depreciation 5et :oo7 0nvestment
'
.
"
A
5
/.",'''
.",'''
.",'''
.",'''
.",'''
/ '
A,'''
@,'''
4,'''
.",'''
/.",'''
4,'''
@,'''
A,'''
'

The denominator in the accounting rate of return is calculated as

/.",''' : /4,''' : /@,''' : /A,''' : /' ; /@,'''
#

The accounting rate of return is

/.,''' ; .@F$
/@,'''

136
This calculation depends on the company-s depreciation method !or example, if the company used double-declining depreciation,
the accounting rate of return would exceed .@F$ )the numerator does not change, but the average net book investment
decreases*
^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^

(hen straight-line depreciation is used, the calculation of the denominator simplifies, because the average of any straight line is
the midpoint of that line The midpoint is calculated as

%nitial book value : ending book value
"

!or the numerical example above, the calculation is

/.",''' : /' ; /@,'''
"

Graphically, this is illustrated as follows2
%f the machine has a salvage value, and if the company accounts for that salvage value by decreasing the depreciable basis of the
asset, the salvage value has a counterintuitive effect on the denominator of the ,II calculation2 it actually increases the
company-s net book investment

!or example, assume that the machine in the example above has a salvage value of /5,''' %n this case, the annual depreciation
expense is )/.",''' Z /5,'''* = 5 ; /",''' The schedule of net book investment is as follows2

Fear <istorical Cost Accumulated Depreciation 5et :oo7 0nvestment
'
.
"
A
5
/.",'''
.",'''
.",'''
.",'''
.",'''
/ '
",'''
5,'''
@,'''
<,'''
/.",'''
.','''
<,'''
@,'''
5,'''

The denominator in the accounting rate of return is then calculated as

/.",''' : /.',''' : /<,''' : /@,''' : /5,''' ; /<,'''
#

The accounting rate of return is then

137
/5,''' /",''' ; "#$
/<,'''

,gain, because straight-line depreciation is used, the denominator can be calculated more simply as

%nitial book value : ending book value
"

which is now

/.",''' : /5,''' ; /<,'''
"

and graphically
To illustrate how the accounting rate of return depends on the company-s choice of accounting policies, assume that instead of
treating the salvage value as a reduction in the depreciable basis of the asset, the company treats the salvage value as income in the
year of disposal %n this case, the average annual income from the asset is calculated as follows2

/.,''' : /.,''' : /.,''' : /#,''' ; /",'''
5 years


The average net book investment is /@,''', as in the original example The accounting rate of return is now

/",''' ; AAA$
/@,'''

Hence, depending on how the company chooses to treat the salvage value of the machine, the accounting rate of return is either
"#$ or AAA$

The accounting rate of return can also be calculated year by year, instead of averaging over the life of the pro+ect %n this case, the
,II provides information about the impact of the pro+ect on the company-s )or division-s* return on investment, which is an
important performance measure discussed in 3hapter ""

Depreciation =4pense, 0ncome Ta4es, and Capital :udgeting!
Eecause net present value and internal rate of return focus on cashflows, and depreciation expense is not a cashflow, depreciation
does not enter N9J and %II calculations directly However, if income taxes are incorporated into the capital budgeting decision
138
)as should normally be the case*, then depreciation expense becomes relevant, because depreciation expense reduces taxable
income, and hence, reduces tax expense Cbviously, the capital budgeting analysis should incorporate depreciation expense as
determined for tax reporting purposes, not for financial reporting purposes, if there is a book-tax difference

The reduction in taxes generated by depreciation expense is sometimes called the depreciation ta4 shield

The effect of income taxes can also be incorporated into the payback period and the accounting rate of return in a straightforward
manner %n other words, any of these capital budgeting techniques can be applied on a pre-tax or a post-tax basis

=4ercises and /roblems!

%-2%!
AA , pro+ect requires an initial cash outlay of /<'', and returns /.,''' at the end of year A )nothing at the end of years . or
"* (hat is the approximately Net 9resent Jalue of this pro+ect, using a cost of capital of .'$?

:A , pro+ect requires an initial cash outlay of /#,''', and returns /.,''' at the end of each year from Xear . through Xear .'
(hat is the pro+ect-s approximate %nternal Iate of Ieturn

CA Iefer to the pro+ect in part )E* (hat is the 9ayback 9eriod of the 9ro+ect? ,lso, what is the ,ccounting Iate of Ieturn on
the average net investment, assuming that the /#,''' purchase price is for a machine that is depreciated using straight-
line depreciation over .' years, with >ero salvage value?

%-2&! , machine costs /5,''' )paid out at the beginning of year .*, and generates year-end net cash inflows of /",''' per year for
five years )this is the useful life of the machine* The machine has >ero salvage value The company uses straight-line depreciation
and a .'$ cost of capital

1equired!
AA (hat is the payback period for this pro+ect?

:A (hat is the net present value of this pro+ect?

CA (hat is the accounting rate of return for this pro+ect?

%-2'! , company purchases an asset for /5',''' The asset has a useful life of seven years The salvage value is expected to be
/.',''' !or purposes of computing the accounting rate of return )ie, the book rate of return*, what is the average net investment
in the asset?

%-2(! (hat is the net present value of a pro+ect that requires an initial cash outlay of /.,''', and returns /F,''' at the end of
seven years, using a discount rate of ."$?

%-2)! ,n investment of /5'' will yield a single, lump-sum payoff of /.,''' after .' years ,t a discount rate of F$, what is the
Net 9resent Jalue of this pro+ect?

%-2*! , machine that costs /.,''' will save /"'' in operating costs every year for the next seven years (hat is the approximate
%nternal Iate of Ieturn of this capital pro+ect?

%-2+! , pro+ect requires an initial investment of /#'', and will return /.'' per year for .. years ?sing a discount rate of 4$,
what is this pro+ect-s Net 9resent Jalue?

%-2,! , machine costs /#',''' )paid out at the beginning of year .*, and generates year-end net cash inflows of /<,<A5 per year
for ." years )this is the useful life of the machine* The machine has >ero salvage value The company uses straight-line
depreciation

1equired!
AA (hat is the internal rate of return?

:A (hat is the net present value, using a discount rate of .'$?

CA (hat is the accounting rate of return?

%-2-! ?sing an ..$ discount rate, what is the net present value of a pro+ect that requires cash outlays of /.',''' at the beginning
of years one, three and five, and provides cash inflows of /"',''' at the end of years one, three and five? Xou may assume that the
139
present value of a cashflow at the end of year Y is equivalent to the cashflow of an equivalent amount at the beginning of year Y :
. )eg, Becember A., "''# is the same as Lanuary ., "''@*

%-2%.! The &even !lags over the Dand of Enchantment amusement park plans to build a new roller coaster that will be faster,
higher, scarier and more thrilling than its existing roller coasters &even !lags uses a ."$ discount rate to evaluate capital
expenditures The cost to prepare the site and construct the new coaster is /##',''', and this expenditure will be incurred evenly
throughout "''F and "''< )which is equivalent to a single cash outlay of /##',''' incurred on Becember A., "''F* The new
coaster will be finished at the beginning of "''4 The operating costs for the new coaster will be /A',''' per year beginning
Lanuary ., "''4 )assume that the annual operating cost is incurred at the beginning of each year* The additional revenue due to
additional ticket sales are pro+ected to be /"'',''' per year for eight years )the pro+ected life of the coaster* from the time the
coaster opens at the beginning of "''4 through "'.@ )assume, for simplicity, that the annual revenue is received at the end of each
year* ,t the end of "'.@, the amusement park will pay /.#',''' to remove the coaster

1equired! 3alculate the net present value of the new roller coaster, as of Lanuary ., "''F

%-2%%! 3onsider a capital pro+ect with a one-year life The cash outlay for the equipment occurs at the beginning of year one, and a
single cash in-flow occurs at the end of year one The equipment has >ero salvage value &traight-line depreciation is used
%ndicate which of the following statements are true

AA %f the payback period is less than one, the net present value will be greater than >ero

:A The internal rate of return is half of the accounting )book* rate of return

CA The inverse of the payback period equals the internal rate of return plus one

DA The payback period is the inverse of the internal rate of return

=A %f the internal rate of return is greater than the discount rate, the net present value will be greater than >ero

%-2%&! 3onsider the following two possible capital pro+ects2

9ro+ect %nitial 3ost )incurred at beginning
of year .*
9ro+ect Dife &alvage
Jalue
9ositive annual cash flow
)received at the end of each
year*
, /"'','''.@ years /' /"<,'''
E /#@,'''.5 years /' /4,F<A

?sing the above information, it can be shown that the %nternal Iate of Ieturn of 9ro+ect E is higher than the %nternal Iate of
Ieturn of pro+ect ,

AA %s the N9J for 9ro+ect , higher than, equal to, or lower than, the N9J for 9ro+ect E, assuming a .'$ discount rate?

:A %s the 9ayback 9eriod for 9ro+ect , better than, equal to, or worse than, the 9ayback 9eriod for 9ro+ect E?

CA %s the ,ccounting Iate of Ieturn for 9ro+ect , higher than, equal to, or lower than, the ,ccounting Iate of Ieturn for
9ro+ect E, assuming straight-line depreciation?

DA %f the discount rate is ..$ instead of .'$, which pro+ect has the higher N9J?

=A %f the discount rate is .'$, and both pro+ects have a salvage value of /@@,''' )ie, the equipment for 9ro+ect E actually
appreciates*, which pro+ect would have the higher N9J?

%-2%'! , machine with a useful life of five years and a salvage value of /5,''' is purchased for /"',''' The benefit of the
machine is that it reduces normal cash operating expenses by /#,''' per year during the first two years of the machine-s life, and
by /5,''' for each of the following three years

1equired!
AA 3alculate the accounting rate of return for the pro+ect, assuming that the full /"',''' purchase price is depreciated using the
straight-line method, so that at the end of year five, the machine has a book value of >ero, and the salvage value is treated as
income in year five

:A 3alculate the accounting rate of return for the pro+ect, assuming that the net cost of the machine )purchase price less salvage
value* is depreciated using the straight-line method
140

%-2%(! 9lain Janilla %ndustries purchases a machine for /."',''' The machine has a six year life and a salvage value of >ero The
company depreciates the machine using the sum-of-the-years-digits method, which results in depreciation expense in each year as
follows2

Xear .
Xear "
Xear A
Xear 5
Xear #
Xear @
/A5,"<@
"<,#F.
"",<#F
.F,.5A
..,5"4
#,F.5
/."','''


The machine increases cash inflows to the firm by /A',''' in year one, /A#,''' in year two, /5',''' in year three, /A#,''' in
year four, and /"#,''' in year five

1equired! 3alculate the accounting rate of return from the investment in the machine


/1=S=5T EAGU= TA:G=S!
Table .2 9resent value of /. received )or paid* n years from now
n @$ F$ <$ 4$ .'$ ..$ ."$ .A$ .5$ .#$ "'$
.
"
A
5
#
@
F
<
4
.'
..
."
.A
.5
.#
.@
.F
.<
.4
"'
'45A5
'<4''
'<A4@
'F4".
'F5FA
'F'#'
'@@#.
'@"F5
'#4.4
'##<5
'#"@<
'54F'
'5@<<
'55"A
'5.FA
'A4A@
'AF.5
'A#'A
'AA'#
'A..<
'4A5@
'<FA5
'<.@A
'F@"4
'F.A'
'@@@A
'@""F
'#<"'
'#5A4
'#'<A
'5F#.
'555'
'5.#'
'A<F<
'A@"5
'AA<F
'A.@@
'"4#4
'"F@#
'"#<5
'4"#4
'<#FA
'F4A<
'FA#'
'@<'@
'@A'"
'#<A#
'#5'A
'#''"
'5@A"
'5"<4
'A4F.
'A@FF
'A5'#
'A.#"
'"4.4
'"F'A
'"#'"
'"A.F
'".5#
'4.F5
'<5.F
'FF""
'F'<5
'@544
'#4@A
'#5F'
'#'.4
'5@'5
'5""5
'A<F#
'A###
'A"@"
'"44"
'"F5#
'"#.4
'"A..
'"."'
'.45#
'.F<5
'4'4.
'<"@5
'F#.A
'@<A'
'@"'4
'#@5#
'#.A"
'5@@#
'5"5.
'A<##
'A#'#
'A.<@
'"<4F
'"@AA
'"A45
'".F@
'.4F<
'.F44
'.@A#
'.5<@
'4''4
'<..@
'FA."
'@#<F
'#4A#
'#A5@
'5<.F
'5AA4
'A4'4
'A#""
'A.FA
'"<#<
'"#F#
'"A"'
'"'4'
'.<<A
'.@4@
'.#"<
'.AFF
'."5'
'<4"4
'F4F"
'F..<
'@A##
'#@F5
'#'@@
'5#"A
'5'A4
'A@'@
'A""'
'"<F#
'"#@F
'""4"
'"'5@
'.<"F
'.@A.
'.5#@
'.A''
'..@.
'.'AF
'<<#'
'F<A.
'@4A.
'@.AA
'#5"<
'5<'A
'5"#.
'AF@"
'AA"4
'"45@
'"@'F
'"A'F
'"'5"
'.<'F
'.#44
'.5.#
'."#"
'..'<
''4<.
''<@<
'<FF"
'F@4#
'@F#'
'#4".
'#.45
'5##@
'A44@
'A#'@
'A'F#
'"@4F
'"A@@
'"'F@
'.<".
'.#4F
'.5'.
'.""4
'.'F<
''45@
''<"4
''F"<
'<@4@
'F#@.
'@#F#
'#F.<
'54F"
'5A"A
'AF#4
'A"@4
'"<5A
'"5F"
'".54
'.<@4
'.@"#
'.5.A
'.""4
'.'@4
''4"4
''<'<
''F'A
''@..
'<AAA
'@455
'#F<F
'5<"A
'5'.4
'AA54
'"F4.
'"A"@
'.4A<
'.@.#
'.A5@
'..""
''4A#
''FF4
''@54
''#5.
''5#.
''AF@
''A.A
''"@.

Table "2 9resent value of an annuity of /. received )or paid* each year for the next n years
n @$ F$ <$ 4$ .'$ ..$ ."$ .A$ .5$ .#$ "'$
.
"
A
5
#
@
F
<
4
.'
..
."
.A
'45A5
.<AA5
"@FA'
A5@#.
5"."5
54.FA
##<"5
@"'4<
@<'.F
FA@'.
F<<@4
<A<A<
<<#"F
'4A5@
.<'<'
"@"5A
AA<F"
5.''"
5F@@#
#A<4A
#4F.A
@#.#"
F'"A@
F54<F
F45"F
<A#FF
'4"#4
.F<AA
"#FF.
AA.".
A44"F
5@""4
#"'@5
#F5@@
@"5@4
@F.'.
F.A4'
F#A@.
F4'A<
'4.F5
.F#4.
"#A.A
A"A4F
A<<4F
55<#4
#'AA'
##A5<
#44#"
@5.FF
@<'#"
F.@'F
F5<@4
'4'4.
.FA##
"5<@4
A.@44
AF4'<
5A##A
5<@<5
#AA54
#F#4'
@.55@
@54#.
@<.AF
F.'A5
'4''4
.F."#
"55AF
A.'"5
A@4#4
5"A'#
5F.""
#.5@.
##AF'
#<<4"
@"'@#
@54"5
@F544
'<4"4
.@4'.
"5'.<
A'AFA
A@'5<
5...5
5#@A<
54@F@
#A"<"
#@#'"
#4AFF
@.455
@5"A#
'<<#'
.@@<.
"A@."
"4F5#
A#.F"
A44F#
55""@
5F4<<
#.A.F
#5"@"
#@<@4
#4.F@
@.".<
'<FF"
.@5@F
"A".@
"4.AF
A5AA.
A<<<F
5"<<A
5@A<4
545@5
#".@.
#5#"F
#@@'A
#<5"5
'<@4@
.@"#F
""<A"
"<##'
AA#""
AF<5#
5.@'5
55<FA
5FF.@
#'.<<
#"AAF
#5"'@
##<A.
141
.5
.#
.@
.F
.<
.4
"'
4"4#'
4F.""
.'.'#4
.'5FFA
.'<"F@
...#<.
..5@44
<F5##
4.'F4
455@@
4F@A"
.''#4.
.'AA#@
.'#45'
<"55"
<##4#
<<#.5
4.".@
4AF.4
4@'A@
4<.<.
FF<@"
<'@'F
<A."@
<#5A@
<F##@
<4#'.
4."<#
FA@@F
F@'@.
F<"AF
<'".@
<"'.5
<A@54
<#.A@
@4<.4
F.4'4
FAF4"
F#5<<
FF'.@
F<A4A
F4@AA
@@"<"
@<.'4
@4F5'
F..4@
F"54F
FA@#<
F5@45
@A'"#
@5@"5
@@'A4
@F"4.
@<A44
@4A<'
F'"5<
@''".
@.5""
@"@#.
@AF"4
@5@F5
@##'5
@@"A.
#F"5#
#<5F5
#4#5"
@'5F"
@."<'
@.4<"
@"#4A
142
C<A/T=1 &.! Operating :udgets

Chapter Contents!
- Cverview
- The sales budget
- 9ro forma income statement
- The production budget
- ,ccounts receivable and accounts payable budgets
- The cash budget
- 9ro forma balance sheet
- Exercises and problems

Overvie$!
, budget is a quantitative plan for the future that assists the organi>ation in coordinating activities ,ll large organi>ations budget
1any organi>ations prepare detailed budgets that look one year ahead, and budgets that look further into the future that contain
relatively less detail and more general strategic direction

The budget assists in the following activities2

- /lanning , budget helps identify the resources that are needed, and when they will be needed

- Control , budget helps control costs by setting spending guidelines

- Motivating =mployees , budget can motivate employees and managers Eudgets are more effective motivational
tools if employees and managers 6buy into8 the budget, which is more likely to occur if they participate in the
preparation of the budget in a meaningful way

- Communication , budget can provide either one-way )top-down* or two-way communication within the
organi>ation

, company-s overall budget, which is sometimes called a master budget, consists of many supporting budgets These supporting
budgets include2

- &ales budget
- 9ro forma income statement
- The production budget and supporting schedules
- Eudgets for capital assets and for financing activities
- Eudgets for individual balance sheet accounts and departmental expenses
- 3ash budget, including cash disbursements and cash receipts budgets
- 9ro forma balance sheet

There is a logical sequence for the preparation of these budgets The first step in a corporate setting is almost always to forecast
sales and to assemble a sales budget

The Sales :udget!
The individuals who are best able to forecast sales are usually the sales force and product managers Their ability to accurately
forecast sales depends on the nature of the industry and on characteristics of the product Bemand is seasonal for many products,
in which case each month-s forecast usually incorporates information about sales for the same month last year ,ccurately
forecasting sales of new products and fashion products can be difficult Bemand for some products is sensitive to macroeconomic
forces such as interest rates and foreign exchange rates Cn the other hand, given the seemingly arbitrary way in which most of us
decide where to eat lunch, restaurants can usually predict each day-s lunch revenue with astounding accuracy

1ost companies face a downward-sloping demand curve for their products, which implies that forecasting sales revenue requires
predicting sales volume at the planned sales price

/ro 3orma 0ncome Statement!
(ith planned sales prices, forecasted sales volumes, and an understanding of the cost structure of the business, the company can
assemble a pro forma income statement )an anticipated income statement for the upcoming period* This process is illustrated
below, in a simple one-product setting, for the Guess (ho Leans 3ompany The planned sales price is /5' per unit ,ssume that
the sales manager-s best guess of sales volume at this price is "',''' units for Cctober Then anticipated revenue for Cctober is
/<'',''' The company-s cost structure is characteri>ed by /A' of variable manufacturing costs per unit, and /.#',''' in fixed
manufacturing and &GU, )selling, general and administrative* costs This information is sufficient to complete the pro forma
income statement that is shown below
143

GUESS !" #EANS
$%" F"%&A '"N(%I)U(I"N &A%GIN
IN'"&E S(A(E&EN( F"% "'(")E%
0ncome Statement
Account
:udgeted amount
/er unit
Sale o# &.,...
units
Ievenue
Jariable manufacturing costs2
1aterials
Dabor
Cverhead
Total
3ontribution margin
!ixed costs2
1anufacturing overhead
&elling, general U admin
Total fixed costs
Cperating income

/5'

.#
.'
#
A'
/.'
/<'','''

A'','''
"'','''
.'','''
@'','''
"'','''

.'','''
#','''
.#','''
/#','''

The /roduction :udget!
The next step in the budgeting process is more complicated for manufacturing firms than for merchandising firms, because
manufacturing companies have three types of inventory accounts2 raw materials, work-in-process and finished goods However,
regardless of the number of asset accounts involved, the goal is to determine the required additions to each account )purchases or
transfers-in from an upstream account* The calculation to determine required additions is derived by expanding the Sources =
Uses equality as follows2

_ Eeginning balance : additions ; transfers out : ending balance

This calculation sometimes uses physical quantities, and sometimes uses dollar values, depending on which makes the most sense
under the circumstances

The beginning balance equals the ending balance for the prior period, which is available either from actual results )the ending
balance sheet*, or from another budget if the start of the period being budgeted is in the future

The ending balance is a target established by the company, and is usually based on anticipated activity for the following period
)that is, the period following the one for which the current budget is being prepared*

Transfers-out equals the demand for the asset derived from a previous step in the budgeting process2

- %f the asset account is finished goods inventory, the demand is based on cost of goods sold, as derived from the
pro forma income statement

- %f the asset account is work-in-process inventory, the demand is based on the additions to the finished goods
account, as calculated by applying the sources = uses equation shown above to the finished goods account

- %f the asset account is raw materials inventory, the demand is based on the additions to the work-in-process
account for materials, as calculated by applying the sources = uses equation shown above to the work-in-
process account

The unknown in the sources = uses equation is additions, which can be solved for, thus completing the production budget The
following table provides balance sheet information for Guess (ho Leans for &eptember A', which is the period +ust ended )This is
also the beginning balance for Cctober ., the period for which the budget is being prepared, because balance sheet amounts at the
end of the day on &eptember A' are the same as the opening balances on the morning of Cctober .* (e will use the information
in this table to budget for Cctober-s production Eecause Guess (ho Leans makes only one product, it is more convenient to use
physical quantities in the sources ; uses equations than dollars (e assume that the budget for Cctober is being prepared on
Cctober .
st

GUESS !" #EANS
)A*AN'E S!EE(
SE$(E&)E% 30 +(!E &"N(! #US( ENDED,
144

Assets

Amount

Giabilities

Amount
3ash
,ccounts Ieceivable

%nventory2
Iaw 1aterials ).,<'' yards*
(ork in 9rocess ).,#'' units*
!inished Goods )#,''' units*
Total inventory

9roperty, 9lant U Equipment, net of
accumulated depreciation

Total

/ @F,'''
@F@,'''


.A,#''
A#,'''
.#','''
.4<,#''


<<','''

/.,<".,#''
,ccounts 9ayable
Dine of 3redit


&tockholders- Equity2
3ommon stock
,dditional paid-in capital
Ietained earnings
Total



Total
/ "4#,'''
A5#,'''



.'','''
F",#''
.,''4,'''
.,.<.,#''



/.,<".,#''

1equired additions to #inished goods inventory!
Guess (ho Leans expects to sell "',''' units each month for the next two months )Cctober and November* The company would
like to have on hand, at the beginning of each month, "'$ of next month-s sales The company did not achieve this operational
goal for Cctober, because #,''' units are on hand on Cctober ., and expected sales are "',''' units, but the company came close
to its goal )"#$ versus "'$* ,t the end of Cctober, the company would like to have 5,''' units on hand )"'$ of "',''' units
expected to be sold in November*

Eeginning balance : additions ; transfers out : ending balance

_ #,''' units : additions ; "',''' units in expected sales : 5,''' units for desired ending inventory

_ additions ; .4,'''

Hence, Guess (ho Leans should plan to transfer out .4,''' units from work-in-process to finished goods inventory during the
month of Cctober

1equired additions to $or72in2process!
Guess (ho Leans would like to have on hand, at any point in time, .,"'' units in work-in-process The company has determined
that this level of work-in-process provides optimal efficiency on the production line ),s shown above, the level of work-in-
process is slightly higher than desired at the end of &eptember*

Eeginning balance : additions ; transfers out : ending balance

_ .,#'' units : additions ; .4,''' units transferred to finished goods : .,"'' units for desired ending (%9

_ additions ; .<,F''

Hence, Guess (ho Leans should plan to start production of .<,F'' units during the upcoming month of Cctober

1equired additions to ra$ materials!
Cn average, " yards of fabric are required for each unit of product Guess (ho Leans would like to maintain ",''' yards of fabric
on hand at any point in time )The company had less fabric on hand than desired at the end of &eptember*

Eeginning balance : additions ; transfers out : ending inventory

_ .,<'' yards : additions ; )" yards per unit x .<,F'' units* : ",''' yards desired in ending inventory on Cctober A.

_ .,<'' yards : additions ; AF,5'' yards : ",''' yards

_ ,dditions ; AF,@'' yards of fabric

Hence, Guess (ho Leans should plan to purchase AF,@'' yards of fabric during the month of Cctober ?sing the budgeted cost of
/F#' per yard, the expected expenditure for these fabric purchases is /"<",'''

Accounts 1eceivable and Accounts /ayable :udgets!

145
Accounts receivable!
To budget for the ending balance of accounts receivable, the company incorporates information about the rate at which receivables
are collected Guess (ho Leans makes all sales on credit, and past experience indicates that the following collection schedule can
be anticipated2

#'$ of sales are collected in the month of sale
A'$ of sales are collected in the month following the sale
"'$ of sales are collected two months following the sale

This collection schedule implies that on Cctober A., accounts receivable will consist of2

#'$ of Cctober sales
"'$ of &eptember sales
Nothing from sales that occurred prior to &eptember
)Eg, ,ugust sales would be collected in ,ugust, &eptember, and Cctober*

,ctual sales for &eptember were "#,''' units
,nticipated sales for Cctober are "',''' units

Therefore, the budget for accounts receivable at the end of Cctober can be calculated as follows2

#'$ of Cctober sales
"'$ of &eptember sales
"',''' units x /5' per unit x #'$ ; /5'','''
"#,''' units x /5' per unit x "'$ ; "'','''
/@'','''


However, this calculation does not incorporate information available about &eptember collections of &eptember sales and
&eptember collections of prior month sales 9ossibly, &eptember collections of &eptember sales differed from the #'$ that is
budgeted, or perhaps not all of ,ugust-s sales were collected by the end of &eptember This additional information would normally
be used to refine the budget of ,ccounts Ieceivable at the end of Cctober

Accounts payable!
To budget for the ending balance of accounts payable, the company incorporates information about the extent to which the
company makes purchases on credit Guess (ho Leans pays cash for all types of purchases except for fabric purchases The
company pays for fabric A' days after the fabric is purchased, on average

This payment policy implies that at the end of Cctober, accounts payable will consist of all Cctober purchases of fabric, and
nothing else %n the raw materials budget )see above*, we determined that /"<",''' would be incurred for fabric purchases in
Cctober Hence, this amount is the anticipated the balance in ,ccounts 9ayable on Cctober A.

The cash budget!
Cne of the most important components of the budgeting process for most organi>ations is the cash budget The cash budget
indicates how much cash the company will have on hand at the end of each period, and also indicates when the company will need
to borrow funds to cover temporary cash shortfalls, and when the company will have excess funds to invest in short-term financial
instruments 3ash flow is so important that in some organi>ations, cash balances are pro+ected for the end of each week, or even
on a daily basis

Cften, the cash budget is assembled from supporting schedules These schedules show, for the period being budgeted, anticipated
cash disbursements and cash receipts that arise from ).* operating activities, )"* additions and disposals of fixed assets, and )A*
financing activities

Cash receipts! the company anticipates that the only cash receipts that will occur in Cctober will come from collections of
receivables 3ash receipts in Cctober are based on anticipated collections of sales that were made in ,ugust and &eptember, and
anticipated sales for Cctober, and are pro+ected as follows2

monthly sales volume ?nit sales price $ collected in Cctober 3ollections in Cctober
,ugust
&eptember
Cctober
"",'''
"#,'''
"','''
/5'
/5'
/5'
"'$
A'$
#'$
/.F@,'''
A'','''
5'','''
/<F@,'''
3ash disbursements are anticipated as follows2

!abric purchases )for fabric acquired in &eptember* /"4#,'''
146
1anufacturing labor
1anufacturing variable overhead
!ixed manufacturing overhead )excluding non-cash items*
!ixed selling, general and admin overhead )excluding non-cash items*
3ash payments for capital acquisitions )from the capital budget*
9ayments of short-term borrowings
Total disbursements for Cctober
.<4,'''
45,#''
#','''
A#,'''
..','''
@','''
/<AA,#''


This information about receipts and disbursements is used to pro+ect the ending cash balance for the month, as follows2

Eeginning balance : cash receipts cash disbursements ; ending balance

/@F,''' : /<F@,''' /<AA,#'' ; /.'4,#''

/ro 3orma :alance Sheet!
The foregoing analysis can be used to assemble a pro forma balance sheet, pro+ecting the balance sheet at the end of the Cctober
The amounts in the pro forma balance sheet are derived as follows2

Cash! from the cash budget, shown above

Accounts receivable! from the accounts receivable budget, shown above

1a$ materials inventory! from the pro+ected ending inventory of ",''' yards multiplied by the budgeted price of /F#' per yard

6or72in2process inventory!

Eeginning balance
: !abric additions )AF,5'' yards x /F#' per yard*
: 1anufacturing labor )from the cash disbursements budget*
: 1anufacturing variable overhead )from the cash disbursements budget*
Transfers out to finished goods inventory ).4,''' units x /A' per unit*
Ending balance
/ A#,'''
"<',#''
.<4,'''
45,#''
#F','''
/ "4,'''


3inished goods inventory! from the pro+ected ending inventory of 5,''' units, multiplied by the budgeted cost of /A' per unit
)Note2 the company uses Jariable 3osting for internal reporting*

/roperty, plant H equipment, net o# accumulated depreciation!

Eeginning balance
: 3apital acquisitions )from the cash disbursements budget*
Bepreciation expense
Ending balance
/<<','''
..','''
@#,'''
/4"#,'''


The /@#,''' in depreciation expense reconciles to the non-cash portion of the /.#',''' in fixed manufacturing and fixed selling,
general and administrative costs shown on the pro forma income statement The difference of /<#,''' )ie, the cash portion of
these fixed costs* is shown on the cash disbursements budget as /#',''' for fixed manufacturing overhead and /A#,''' for fixed
selling, general and administrative overhead

Accounts payable! from the accounts payable budget, shown above

Short2term borro$ings! beginning balance of /A5#,''' less the anticipated payment of /@',''' as per the cash disbursements
budget

Common stoc7 and Additional paid2in capital! no change

1etained earnings! beginning balance of /.,''4,''' : Cctober income of /#',''', as per the pro forma income statement
GUESS !" #EANS
$%" F"%&A )A*AN'E S!EE(
"'(")E% 31
147
Assets Amount Giabilities Amount
3ash
,ccounts Ieceivable

%nventory2
Iaw 1aterials )",''' yards*
(ork in 9rocess ).,"'' units*
!inished Goods )5,''' units*
Total inventory

9roperty, 9lant U Equipment, net of
accumulated depreciation

Total

/.'4,#''
@'','''


.#,'''
"4,'''
."','''
.@5,'''


4"#,'''

/.,F4<,#''
,ccounts 9ayable
Dine of 3redit


&tockholders- Equity2
3ommon stock
,dditional paid-in capital
Ietained earnings
Total



Total
/"<",'''
"<#,'''



.'','''
F",#''
.,'#4,'''
.,"A.,#''



/.,F4<,#''

%t is interesting to note that whereas the pro forma income statement can be prepared early in the budgeting process )at least for
the results of operating activities*, the pro forma balance sheet is one of the last schedules to be prepared, because it depends on
information obtained from numerous supporting budgets and schedules

=4ercises and /roblems

&.2%! M!N anticipates sales of "',''' units in 1arch, A',''' units in ,pril, and 5',''' units in 1ay The company wants to have
"'$ of next month-s sales on hand at the end of the previous month %n fact, at the beginning of 1arch, the company has 5,'''
units on hand How many units should the company produce during ,pril?

&.2&! Xue Xeung %ndustries has sales of /.',''' in 1ay, /"',''' in Lune, and /A',''' in Luly The company collects "#$ of sales
in the month of sale, and the remaining F#$ in the following month 3alculate ,ccounts Ieceivable at Lune A'

&.2'! , merchandising company expects to sell A'' units in ,pril, 5'' units in 1ay, and #'' units in Lune The company plans to
have A'$ of each month-s sales, plus an additional #' units, on hand in inventory at the beginning of each month How many
units should the company plan to purchase in 1ay?

&.2(! `uolala is a merchandising company `uolala expects unit sales for the coming year as follows2

1arch .#,'''
,pril "A,'''
1ay A.,'''
Lune 5F,'''
Luly #@,'''

The average selling price is /"A per unit The company-s policy is to maintain month-end inventory levels at A'$ of next month-s
anticipated sales ,ll sales are made on credit, and expected collections are as follows2

F'$ collected in the month of sale
"'$ collected in the month following the sale
.'$ collected in the second month following the sale

3ost of goods sold equals <'$ of the sales price The company pays cash for all purchases of inventory, at the time of purchase

1equired!
AA How much inventory )how many units* will `uolala expect to purchase in Lune?

:A (hat will be the dollar amount of accounts receivable at the end of Luly?

CA How much should the company expect to pay )ie, credits to cash, debits to inventory* for purchases of inventory in 1ay?

DA (hat can the company expect to collect in receivables )ie, debits to cash, credits to accounts receivable* in Lune?

&.2)! The Gordon 3andy 3ompany is a wholesaler for peanut brittle and other candies Gordon-s sales of peanut brittle for the last
four months of "''@ are pro+ected as follows2

148
&eptember .#' cases
Cctober .F' cases
November .4' cases
Becember "A' cases

Eill Gordon, founder, 3hairman, 9resident, and 3hief Executive Cfficer of the company, plans to sell each case for /.#', which
represents a "#$ mark-up over cost )Note2 an item purchased for /. and sold for /.@' would represent a @'$ mark-up over
cost*

Eill manages his inventory purchases so that he has 5#$ of each month-s sales on hand at the beginning of the month Eill makes
all purchases on credit Eill pays @'$ of credit purchases in the month of purchase, and pays the remaining 5'$ in the month
following the purchase

Cn average, Eill-s customers pay cash at the time of purchase for #'$ of purchases, and buy the remaining #'$ on credit 3redit
purchases are paid to the Gordon 3andy 3ompany as follows2

5'$ in the month of purchase
A#$ in the month immediately following the purchase
"'$ in the second month following the purchase
#$ bad debt expense )Eill never collects this amount*

1equired! 3alculate the cash inflows from sales of peanut brittle and the cash outflows from purchases of peanut brittle, for
November

&.2*! 3alifornia 3oncepts sells hair products &ales of shampoo for the last half of "''# are pro+ected as follows2

&eptember2 .'' cases
Cctober2 ."' cases
November2 .A' cases
Becember2 .@' cases

3alifornia 3oncepts plans to sell each case for /"#, which represents a /F mark-up over cost The company manages its inventory
purchases so that it always has F'$ of each month-s unit sales on hand at the beginning of that month The company buys
inventory on credit The company pays for these credit purchases in the month following the purchase

Cn average, the company-s customers pay cash at the time of purchase for @'$ of their purchases, and buy the remaining 5'$ on
credit These credit purchases are paid to 3alifornia 3oncepts as follows2

A'$ in the month of purchase
5'$ in the month immediately following the purchase
A'$ in the second month following the purchase

1equired!
AA 3alculate ,ccounts Ieceivable for sales of shampoo as of the end of November, and ,ccounts 9ayable for purchases of
shampoo as of the end of November

:A 3alculate net cash flows in November

&.2+! 1ary Iiver Bistributors sells brandy and other alcoholic beverages &ales of brandy for the last four months of "''# are
pro+ected as follows2

&eptember .,F'' cases
Cctober .,4'' cases
November ",A'' cases
Becember ",<'' cases

The increase through the year arises due to the increasing popularity of brandy as the weather turns cold, and particularly the high
consumption around the holiday season

1ary Iiver plans to sell each case for /"#', which represents a A#$ mark-up over cost )Note2 an item purchased for /. and sold
for /.@' would represent a @'$ mark-up*

149
1ary Iiver manages its inventory purchases so that it always has 5'$ of each month-s sales on hand at the beginning of the
month The company buys all brandy on credit The company pays @'$ of credit purchases in the month of purchase, and pays the
remaining 5'$ in the month following the purchase

Cn average, 1ary Iiver-s customers pay cash at the time of purchase for "'$ of their purchases, and buy the remaining <'$ on
credit These credit purchases are paid to 1ary Iiver as follows2

#'$ in the month of purchase
"#$ in the month immediately following the purchase
"'$ in the second month following the purchase
#$ bad debt expense )1ary Iiver never collects this amount*

1equired! Eecause 6cash is king,8 1ary Iiver asks you to calculate the net cash inflows )receipts less disbursements* from sales
and purchases of brandy, in November
C<A/T=1 &%! :udgetary 0ncentive Schemes

Chapter Contents!
- %ntroduction
- Example of a budgetary incentive scheme
- Exercises and problems

,s discussed in 3hapter "', most budgets are built on sales forecasts, and hence, budgets are only as accurate as those forecasts
The sales force has the most accurate and complete information about future sales prospects Therefore, sales personnel are the
best source for the sales forecast, and one would expect the budgeting process to begin with input from the sales force

!urthermore, the success of most companies depends in large part on the ability of the sales force to generate sales %n order to
motivate sales personnel to work hard, many companies include sales commissions as an important component of sales personnel-
compensation packages2 the more they sell, the more they earn

!or many companies, and in many industries, a straight commission is not viewed as equitable &ome sales representatives have
6easier8 sales territories or product lines , fixed percentage commission applied to all members of the sales force seems unfair to
sales representatives who are assigned more difficult product lines or territories 1any companies solve this problem by paying
sales representatives a bonus based on actual sales relative to budgeted sales The budget can be tailored for each sales
representative, so that the difficulty of meeting and exceeding budget is comparable for all sales personnel &uch a bonus scheme
rewards sales representatives for incremental effort and sales volume, relative to some baseline

Taken together, the preceding three paragraphs create an obvious dilemma The company relies on the sales force to accurately
forecast sales for budgeting purposes, yet sales representatives, when asked for their forecasts, will budget conservatively %n so
doing, they give themselves easy targets that help ensure that they will maximi>e their bonuses

Cne possible solution to this dilemma is to not pay bonuses based on actual performance relative to budget ,n alternative
solution is to not ask the sales representatives for their forecasts, but simply to assign targeted sales goals Neither solution is
optimal, because the first solution limits the company-s ability to motivate the sales force using a bonus scheme that is generally
perceived as effective and fair, and the second solution ignores information that would materially assist in the budgeting process

Cne might wonder whether a better solution is possible %n fact, budgetary incentive schemes that simultaneously address these
two apparently conflicting ob+ectives have been used for at least "# years The example described in the rest of this chapter is
adapted from a bonus scheme that was used by %E1 in Era>il, as described in an article by Loshua Gonek that appeared in the
!arard Business Reie" in the .4F's However, the following example is set in the context of students in an accounting class,
not sales representatives working for a company

=4ample o# a :udgetary 0ncentive Scheme!
%nstructors want students to work hard and to study diligently for exams %f an instructor also wants students to predict their
performance on an upcoming exam, then the instructor faces the same dilemma as described above2 how does one encourage
students to provide accurate forecasts of future performance, and also provide incentives for students to exert maximum effort
after the forecasts have been delivered )%n the absence of an incentive mechanism to encourage accurate forecasts, students are
notoriously optimistic*

3onsider an exam with ten multiple choice questions, where credit on each question is 6all or nothing8 )no partial credit* Each
question is worth five points, for a total of fifty points Now consider the following extra credit opportunity related to that exam
Cne week before the exam, students are asked to forecast how many of the ten questions they will answer correctly ,fter the
exam, they receive extra credit based on the number of points indicated in the box at the intersection of their forecast )the column
150
headings in the table* and their actual score )the number in the far left-hand column of each row in the table* !or example, if a
student forecasts that she will answer six questions correctly, and actually answers seven questions correctly, she receives .A extra
credit points )the intersection of row F and column @* in addition to her score of A# )F questions x # points per question*, for a
total of 5< points

=IT1A C1=D0T ;10D 3O1 =IAM
3orecast =4am Score
Actual
=4am
Score
. % & ' ( ) * + , - %.
. -- -- -- -- -- -- -- -- -- -- --
% . " . -- -- -- -- -- -- -- --
& " A 5 A " . -- -- -- -- --
' A 5 # @ # 5 A " . -- --
( 5 # @ F < F @ # 5 A "
) # @ F < 4 .' 4 < F @ #
* @ F < 4 .' .. ." .. .' 4 <
+ F < 4 .' .. ." .A .5 .A ." ..
, < 4 .' .. ." .A .5 .# .@ .# .5
- 4 .' .. ." .A .5 .# .@ .F .< .F
%. .' .. ." .A .5 .# .@ .F .< .4 "'

This scheme encourages students to forecast accurately, and once the students have made their forecasts, to study hard for the
exam To see that the extra credit scheme achieves both ob+ectives, note the following2

(hen the student makes her forecast, she is choosing the column that will be used to determine her extra credit (ithin each
column, the numbers become larger as one moves down the table Therefore, once the forecast has been delivered, students want
to score as high as possible to maximi>e both the extra credit score and the total exam score

Now consider the question of whether students have incentives to forecast accurately ,t the time that the student makes her
forecast, she has an idea of what her actual score will be Hence, she has a best-guess of the row that will be used to determine her
extra credit %n any given row, the maximum bonus occurs in the column for which the row heading equals the column heading
!or example, if the student thinks she will answer five questions correctly, then her maximum extra credit from row 6#8 is ten,
which occurs in the column labeled 6#8 Therefore, if she thinks she will score five, she cannot expect to do better than to forecast
five, the same as her expected performance %f she intentionally forecasts low )choosing a column to the left of column #* or
forecasts high )choosing a column to the right of column #*, she can anticipate earning less than ten extra credit points if she
actually answers five questions correctly, as she predicts

This extra credit scheme is an example of a budgetary incentive scheme that encourages individuals to both forecast accurately,
and to exert maximum effort after the forecast has been delivered %mplicit in this scheme, and all such schemes, is a 6baseline8
performance level !or example, in the extra credit scheme, if the instructor anticipates that the median on the exam will be six,
then it is important that students have approximately the same expectation %f the exam turns out to be more difficult or easier than
anticipated, then students- forecasts will be 6high8 or 6low8 on average, and the amount of extra credit earned will be less than
otherwise would have been the case The extra credit scheme would still encourage accurate forecasts and maximum effort, but it
probably would not be perceived as 6fair8 after the scores are in Hence, this specific scheme and all such schemes rely on some
level of accuracy in management-s )or the instructor-s* information, but then uses that information to obtain still more accurate
information from the individuals who are best informed )sales representatives or students, as the case may be*

=4ercises and /roblems

&%2%! The table below represents a bonus scheme, in which the sales representative is given a quota )called the ob+ective*, is asked
to provide a forecast for her sales volume for the upcoming year, and then is given a bonus )expressed as a percentage of a baseline
bonus* based on a combination of her forecast and actual results The numbers in the grid represent the percentage of the baseline
bonus that the sales representative will receive !or example, if the sales representative is given a quota of A'' units and she
151
forecasts that she can sell @'' units, !TC ; "', and she will be working from the column with "' in the heading Then, if she sells
5#' units, her bonus will be calculated from the number at the intersection of the column labeled "' and the row labeled .# ),TC
; 5#'TA'' ; .#* The number in that box is ."', so she will receive ."'$ of the baseline bonus

3"O J #orecast K ob9ective
A"O J
Actual K
Ob9ective
. .) %. %) &. &) '. ') (. () ).
. -- -- -- -- -- -- -- -- -- -- --
.) @' A' -- -- -- -- -- -- -- -- --
%. 4' ."' 4' @' A' -- -- -- -- -- --
%) ."' .#' .<' .#' ."' 4' @' A' -- -- --
&. .#' .<' ".' "5' ".' .<' .#' ."' 4' @' A'
&) .<' ".' "5' "F' A'' "F' "5' ".' .<' .#' ."'
'. ".' "5' "F' A'' AA' A@' AA' A'' "F' "5' ".'
') "5' "F' A'' AA' A@' A4' 5"' A4' A@' AA' A''
(. "F' A'' AA' A@' A4' 5"' 5#' 5<' 5#' 5"' A4'
() A'' AA' A@' A4' 5"' 5#' 5<' #.' #5' #.' 5<'
). AA' A@' A4' 5"' 5#' 5<' #.' #5' #F' @'' #F'

1equired! Evaluate this bonus scheme, and discuss in two or three sentences how effective the incentives imbedded in this bonus
scheme are likely to be, in terms of motivating the sales representative to provide her best forecast of her sales volume for the
upcoming year, and to work hard to achieve and even exceed her forecasted sales volume, once her forecast has been made

&%2&! The table below represents a bonus scheme, in which the sales representative is given a quota )called the ob+ective*, is asked
to provide a forecast for her sales volume for the upcoming year, and then is given a bonus )expressed as a percentage of a baseline
bonus* based on a combination of her forecast and actual results The numbers in the grid represent the percentage of the baseline
bonus that the sales representative will receive !or example, if the sales representative is given a quota of A'' units and she
forecasts that she can sell @'' units, !TC ; "', and she will be working from the column with "' in the heading Then, if she sells
5#' units, her bonus will be calculated from the number at the intersection of the column labeled "' and the row labeled .# ),TC
; 5#'TA'' ; .#* The number in that box is .<', so she will receive .<'$ of the baseline bonus

3"O J #orecast K ob9ective
A"O J
Actual K
Ob9ective
. .) %. %) &. &) '. ') (. () ).
. -- -- -- -- -- -- -- -- -- -- --
.) -- A' @' A' -- -- -- -- -- -- --
%. A' @' 4' ."' 4' @' A' -- -- -- --
%) @' 4' ."' .#' .<' .#' ."' 4' @' A' --
&. 4' ."' .#' .<' ".' "5' ".' .<' .#' ."' 4'
&) ."' .#' .<' ".' "5' "F' A'' "F' "5' ".' .<'
'. .#' .<' ".' "5' "F' A'' AA' A@' AA' A'' "F'
') .<' ".' "5' "F' A'' AA' A@' A4' 5"' A4' A@'
(. ".' "5' "F' A'' AA' A@' A4' 5"' 5#' 5<' 5#'
() "5' "F' A'' AA' A@' A4' 5"' 5#' 5<' #.' #5'
). "F' A'' AA' A@' A4' 5"' 5#' 5<' #.' #5' #F'

1equired! Evaluate this bonus scheme, and discuss in two to four sentences how effective the incentives imbedded in this bonus
scheme are likely to be, in terms of motivating the sales representative to provide her best forecast of her sales volume for the
upcoming year, and to work hard to achieve and even exceed her forecasted sales volume, once her forecast has been made
CHAPTER ++: 1ivisional Per"or#ance Measures
Chapter Contents:
- Dvsona ncome
- Return on nvestment
- Resdua ncome
- Exercses and probems

Ths chapter dscusses three performance measures used to evauate dvsons and dvsona
managers. The term "dvson" n ths chapter s shorthand for any responsbty center that s treated
as a prot center or as an nvestment center. Investors and stock anaysts use anaogous measures to
evauate company-wde performance.
152

1ivisional Inco#e:
Dvsona ncome s a measure of dvsona performance that s anaogous to corporate net ncome for
evauatng overa company performance. Smar to reated-party transactons n the context of
nanca accountng, the cacuaton of dvsona ncome must consder transactons that occur
between dvsons, and between the dvson and corporate headquarters. One type of ntra-company
transacton s the transfer of goods between dvsons. These transfers, whch represent revenue to the
seng dvson and a cost of nventory to the buyng dvson, are dscussed n Chapter 23. Another type
of transacton s the recept of servces from corporate headquarters or from other responsbty
centers wthn the company. Exampes of such servces are human resources, ega, rsk management,
and computer support. In many companes, these servces are "charged out" to the dvsons that
utze them. These servce department cost aocatons were dscussed n Chapter 12.

Because dvsona ncome fas to account for the sze of the dvson, t s -suted for comparng
performance across dvsons of dherent szes. Dvsona ncome s most meanngfu as a performance
measure when compared to the same dvson n pror perods, or to budgeted ncome for the dvson.

Return on Invest#ent:
Return on invest#ent (R3I) s cacuated as:

Return on
Investment
= Dvsona Income
Dvsona Investment

The same ssues arse n determnng the numerator n ROI as arse n the prevous subsecton wth
respect to dervng dvsona ncome. As regards the denomnator, senor management must decde
whether and how to aocate shared assets among dvsons, such as servce departments at the
corporate eve, or shared manufacturng factes. Aso, management must decde how to vaue the
capta assets that comprse the dvsons nvestment. These assets can be vaued at ther gross book
vaue (the acquston cost), ther net book vaue (usuay the acquston cost mnus deprecaton
expense), or ess often, some other vauaton technque such as repacement cost, net reazabe vaue
or far market vaue. The cacuaton of the numerator shoud be consstent wth the choce of vauaton
technque n the denomnator. For exampe, f dvsona nvestment s cacuated usng gross book
vaue, then dvsona ncome n the numerator shoud not be reduced by deprecaton expense.

One advantage of usng gross book vaue nstead of net book vaue n the ROI cacuaton s that net
book vaue can dscourage dvsona managers from repacng od equpment, even f new equpment
woud be more emcent and woud ncrease the economc prots of the dvson. Ths dysfunctona
managera ncentve occurs because f the exstng equpment s fuy deprecated, but s st
functona, ts repacement can reduce the dvsons ROI by owerng the numerator (due to ncreased
deprecaton expense) and ncreasng the denomnator (because fuy deprecated assets have a net
book vaue of zero).

ROI can be broken down nto the foowng two components:

R3I

?

Dvsona Income

?

Dvsona Income

@

Dvsona Revenues
Dvsona Investment Dvsona Revenue Dvsona Investment

The rst term on the rght-hand sde s caed the return on sales (R3$). It s aso caed the
operatin pro!t percentae. Ths rato measures the amount of each doar of revenue that "makes
ts way" to the bottom ne. ROS s often an mportant measure of the emcency of the dvson, and the
dvsona managers abty to contan operatng expenses.

The second term on the rght-hand sde s caed the asset turnover ratio or the invest#ent
turnover ratio. Ths rato measures how ehectvey management uses the dvsons assets to
153
generate revenues. Interestngy, ths rato seems to hover around one for many companes n a wde
range of ndustres, partcuary n the manufacturng sector of the economy.

Breakng ROI nto these two components often provdes more usefu nformaton than ookng at ROI
aone, and t s an exampe of the type of nanca rato anayss that stock anaysts conduct n
evauatng company-wde performance. In ths context, two common speccatons for the denomnator
n the ROI cacuaton are assets and equty. The resutng ratos are caed return on assets (R3A)
and return on e'uity (R3E).

At the dvsona eve, ROI contros for the sze of the dvson, and hence, t s we-suted for comparng
dvsons of dherent szes. On the other hand, smar to the Interna Rate of Return for evauatng
capta pro|ects, ROI can dscourage managers from makng some nvestments that sharehoders woud
favor. For exampe, f a dvsona manager s evauated on ROI, and f the dvson s currenty earnng
an ROI n excess of the companys cost of capta, then the manager woud prefer to re|ect an addtona
nvestment opportunty that woud earn a return above the cost of capta but beow the dvsons
current ROI. The new nvestment opportunty woud ower the dvsons ROI, whch s not n the
managers best nterests. However, because the nvestment opportunty provdes a return above the
cost of capta, sharehoders woud favor t.

Residual Inco#e:
One way n whch nanca accountng practce fas to foow corporate nance theory s that the cost
of debt s treated as an expense n arrvng at net ncome, but the cost of equty s not. Speccay,
nterest expense appears as a deducton to ncome on the ncome statement, but dvdends are shown
on the statement of changes n sharehoders equty. Hence, net ncome s ahected by the companys
nancng strategy as we as by ts operatng protabty, whch can obscure the economc performance
of the rm.

A smpe souton to ths probem s to add back nterest expense (net of the tax ehect) to net ncome,
to arrve at operatng ncome after taxes. The performance measure caed residual inco#e makes
ths ad|ustment, and then goes one step further, by deductng a charge for capta based on the
organzatons tota asset base:

Resdua Income = Operatng Income (Investment Base x Requred Rate of Return)

The companys cost of capta s often approprate for the requred rate of return.

Resdua ncome s probaby the cosest proxy that accountng provdes for the concept of economc
prots; hence, resdua ncome probaby comes cose to measurng what sharehoders reay care about
(to the extent that sharehoders ony care about maxmzng weath). Resdua ncome can be cacuated
both at the corporate eve and at the dvsona eve. Many companes that use resdua ncome at the
dvsona eve do so because management beeves that resdua ncome agns ncentves of dvsona
managers wth ncentves of senor management and sharehoders.

One type of resdua ncome cacuaton s caed Economc Vaue Added. EVA was deveoped by the
consutng rm of Stern Stewart & Co., and s a regstered trademark of that rm. The cacuaton of EVA
ncudes a deducton for the cost of capta, and aso ad|usts accountng ncome to more accuratey
reect the economc ehect of transactons and the economc vaue of assets and abtes. In genera,
these ad|ustments move the ncome cacuaton further from the reabty-end of the reevance-versus-
reabty contnuum, and coser to the reevance-end of that contnuum.

Snce the 1990s, EVA has heped revve the popuarty of resdua ncome. However, t shoud be
emphaszed that athough Stern Stewart has obtaned trademark protecton on the term "EVA," the
concept of resdua ncome precedes EVA by amost haf a century, and t s n the pubc doman.
Anyone can use resdua ncome for any purpose whatsoever wthout voatng trademark, copyrght or
154
patent aw, and ths ncudes makng obvous ad|ustments to net ncome to more accuratey reect the
underyng economc reaty of the rm.

E&ercises and Proble#s:

++*1: The Purn Dog Food Company has two dvsons, the Puppy Chow Dvson and the Canne Eder
Dvson. Operatng resuts for the two dvsons are as foows:

Puppy Chow Dvson Canne Eder Dvson
Net Operatng Income $10,000 $ 6,000
Average Operatng Assets $50,000 $42,000

The requred rate of return, whch s equa to the cost of capta, s 10%.

Re'uired: A pro|ect wth a return of $20,000 on an nvestment of $130,000 exsts. If the dvsons are
evauated based on return on nvestment, whch dvson(s) woud ke to accept the pro|ect? If the
dvsons are evauated based on resdua ncome, whch dvson(s) woud ke to accept the pro|ect?

&&2&! Nummi 1otors operates two divisions2 the truck division and the car division Nummi-s hurdle rate )ie, the cost of capital*
is .'$ !ollowing is information about the two divisions2

Truck Bivision 3ar Bivision
Bivisional %ncome / . million / " million
Bivisional Cperating ,ssets /." million /.' million

AA 3alculate the truck division-s residual income

:A 3alculate the car division-s return on investment

++*,: A company has two dvsons: the Eastern dvson and the Western dvson. The cost of capta s
15%. Foowng s nformaton about the two dvsons:

Eastern 1ivision Aestern 1ivision
Dvsona prots
Dvsona nvestment
$ 100,000
1,000,000
$ 200,000
1,000,000

AA 3alculate each division-s residual income, and residual income for the company as a whole

:A 3alculate each division-s return on investment, and return on investment for the company as a whole

&&2(! %n .4<', the truck division of 1otown 1otors had return on sales of .#$ and an asset turnover ratio of #'$ &ales were
/.'' million 3alculate the division-s return on investment

&&2)! !ollowing is selected information from the "''# ,nnual Ieport of General 1otors )some small miscellaneous line-items
have been excluded, so that net income calculated from these numbers differs slightly from net income as per the annual report*2

&..) &..(
,utomotive and Cther Cperations
Ievenue
3CG&, &GU, and other

!inancing and %nsurance Eusiness
Ievenue
Expenses

%nterest expense
Net income tax benefit )increases income*

Total assets

/.#<,"".,''','''
.F#,A4#,''','''


A5,A<A,''','''
.<,AF",''','''

.#,F@<,''','''
#,<F<,''','''

5<',#A',''','''

/.@.,#5#,''','''
.@",'<F,''','''


A.,4F",''','''
.<,"@5,''','''

..,4<',''','''
4.@,''','''

5<",A5F,''','''
155
&hareholders equity .5,#4F,''',''' "F,A@',''','''

1equired! 3alculate G1-s pre-tax income, after-tax income, return on investment, and residual income for both "''# and "''5
3ombine both segments of the company for this exercise )automotive and financing* !or return on investment, use pre-tax
income in the numerator and total assets in the denominator !or residual income, use a F$ cost of capital, and a marginal tax rate
of A'$ to ad+ust for the tax effect of interest expense

&&2*! !ollowing is selected information from the "''# or "''@ financial statements of four airlines ,ll amounts are in '''-s

South$est Airlines Alas7a Airlines 3rontier Airlines Mid$est =4press
Ievenue
Cperating income
Net interest expense
9re-tax income
,fter-tax income
Total assets
&hareholders equity
/F,#<5,'''
<"','''
F#,'''
<F5,'''
#5<,'''
.5,".<,'''
@,@F#,'''
/",5.@,.''
.',<''
.<,F''
."5,"''
",A''
A,#..,4''
@"@,4''
/445,"FA
F,<4F
.",A4"
"',5@4
.A,4F.
4F',5A"
""<,FF@
/#"",4<4
@#,.@<
.5"
@#,'"@
@5,<<@
A#.,A55
.F,"#@

1equired! 3alculate IC% for each airline using net income and total assets Ereak out each airline-s IC% into return on sales and
the asset turnover ratio

&&2+! !ollowing is selected financial information for four companies for "''# )all amounts are in millions*2

Apple Computer /epsi Chevron The ;A/
Ievenue
Total assets
&hareholder equity
Cperating income
Net income
/.A,4A.
..,##.
F,5@@
.,@#'
.,AA#
/A",#@"
A.,F"F
.5,A"'
@,A<"
5,'F<
/.4<,"''
."#,<AA
@",@F@
"#,.4F
.5,'44
/.@,'"A
<,<".
#,5"#
.,F5#
.,..A

1equired! 3alculate each firm-s return on investment )net income on total assets*, return on sales, asset turnover ratio, and
residual income using an <$ cost of capital None of these firms incurred significant interest expense during the year

&&2,! !ollowing is selected segment information for "''# from the ,nnual Ieport for &tarbucks

United
States
)'''-s*
0nternational

)'''-s*
Unallocated
Corporate
)'''-s*
Total

)'''-s*
Ievenue
9re-tax earnings
%dentifiable assets
/#,AA5,5@'
45#,4"@
.,@AA,F".
/.,'A5,<5'
<@,5".
@'#,F#'
/ '
"A#,4'A
.,"F5,#45
/@,A@4,A''
F4@,555
A,#.5,'@#

The total column agrees to the company-s "''# income statement %n answering the following questions, because &tarbucks has
virtually no debt, interest expense can be ignored ,lso, assume a AA$ effective tax rate and a F$ cost of capital

1equired!
AA 3alculate post-tax return on investment and post-tax residual income for the ?nited &tates segment, the %nternational segment,
and for the company as a whole

/. Expan why corporate-eve resdua ncome s ess than the sum of the resdua ncome of the two
segments. Specuate as to the types of assets and expenses that are ncuded as unaocated corporate.
Identfy the advantages and dsadvantages of fang to aocate to the operatng dvsons sgncant
corporate-eve assets and expenses.
C<A/T=1 &'! Trans#er /ricing

!errari2
&hall we draw up the papers, or is our handshake good enough?

Iick2
%t-s certainly not good enough Eut since %-m in a hurry, it-ll have to do
156

!errari2
,h, to get out of 3asablanca and go to ,mericaa Xou-re a lucky man

Iick2
Ch, by the way, my agreement with &am-s always been that he gets "#$ of the profits That still goes

!errari2
Hmmm % happen to know that he gets .'$ Eut he-s worth "#$

Iick2
Bon-t forget, you owe Iick-s a hundred cartons of ,merican cigarettes

!errari2
% shall remember to pay itP to myself

!rom #asa$lanca, .45"

Chapter Contents!
- Befinition and overview
- Transfer pricing options
- 1arket-based transfer prices
- 3ost-based transfer prices
- Negotiated transfer prices
- &urvey of practice
- External reporting
- Bual transfer pricing
- Transfer pricing and multinational income taxes
- Cther regulatory issues
- Exercises and problems

De#inition and Overvie$!
, transfer price is what one part of a company charges another part of the same company for goods or services %n the excerpt
from #asa$lanca, Iick apparently loaned !errari .'' cartons of cigarettes for which he was never repaid Now that !errari owns
both the Elue 9arrot and Iick-s 3afb, he +okes about the fact that what was previously a debt that he owed to Iick, is now a 6debt8
from one nightclub that he owns to another nightclub that he owns %f !errari continues to transfer cartons of cigarettes between
the two clubs, he might wish to establish a 6transfer price8 for cigarettes, but knowing !errari, he won-t bother

(e will restrict attention to transfers that involve a tangible product, and we will refer to the two corporate entities engaged in the
transfer as divisions Hence, the transfer price is the price that the 6selling8 division charges the 6buying8 division for the product
Eecause ob+ects that float usually flow downstream, the selling division is called the upstream division and the buying division is
called the do$nstream division

Transferred product can be classified along two criteria The first criterion is whether there is a readily-available external market
price for the product The second criterion is whether the downstream division will sell the product 6as is,8 or whether the
transferred product becomes an input in the downstream division-s own production process (hen the transferred product
becomes an input in the downstream division-s production process, it is referred to as an intermediate product The following
table provides examples

An e4ternal mar7et
price is available
5o e4ternal mar7et
price is available

The do$nstream division
$ill sell Las isM
The (est 3oast Bivision of a
supermarket chain transfers oranges
to the Northwest Bivision, for retail
sale

, pharmaceutical company transfers a
drug that is under patent protection,
from its manufacturing division to its
marketing division
The do$nstream division
$ill use the trans#erred
product in its o$n
production process
,n oil company transfers crude oil
from the drilling division to the
refinery, to be used in the production
of gasoline
The 9arts Bivision of an appliance
manufacturer transfers mechanical
components to one of its assembly
divisions


Transfer pricing serves the following purposes
157

. (hen product is transferred between profit centers or investment centers within a decentrali>ed firm, transfer prices are
necessary to calculate divisional profits, which then affect divisional performance evaluation

" (hen divisional managers have the authority to decide whether to buy or sell internally or on the external market, the
transfer price can determine whether managers- incentives align with the incentives of the overall company and its
owners The ob+ective is to achieve goal congruence, in which divisional managers will want to transfer product when
doing so maximi>es consolidated corporate profits, and at least one manager will refuse the transfer when transferring
product is not the profit-maximi>ing strategy for the company

A (hen multinational firms transfer product across international borders, transfer prices are relevant in the calculation of
income taxes, and are sometimes relevant in connection with other international trade and regulatory issues

The transfer generates +ournal entries on the books of both divisions, but usually no money changes hands The transfer price
becomes an expense for the downstream division and revenue for the upstream division !ollowing is a representative example of
+ournal entries to record the transfer of product2

Upstream Division!
).* %ntercompany ,ccounts Ieceivable /4,'''
Ievenue from %ntercompany &ale /4,'''

)"* 3ost of Goods &old Z %ntercompany &ales /<,'''
!inished Goods %nventory /<,'''

)To record the transfer of #'' cases of #lear Mountain %pring &ater, at /.< per case, to the !lorida
marketing division, and to remove the #'' cases from finished goods inventory at the production cost
of /.@ per case*

Do$nstream Division!
).* !inished Goods %nventory /4,'''
%ntercompany ,ccounts 9ayable /4,'''

)To record the receipt of #'' cases of #lear Mountain %pring &ater, at /.< per case, from the bottling
division in Nebraska*


Trans#er /ricing Options!
There are three general methods for establishing transfer prices

. Mar7et2based trans#er price! %n the presence of competitive and stable external markets for the transferred product,
many firms use the external market price as the transfer price

" Cost2based trans#er price! The transfer price is based on the production cost of the upstream division , cost-based
transfer price requires that the following criteria be specified2

a ,ctual cost or budgeted )standard* cost
b !ull cost or variable cost
c The amount of markup, if any, to allow the upstream division to earn a profit on the transferred product

3. 5egotiated trans#er price! &enior management does not specify the transfer price Iather, divisional managers negotiate
a mutually-agreeable price

Each of these three transfer pricing methods has advantages and disadvantages

Mar7et2based Trans#er /rices!
1icroeconomic theory shows that when divisional managers strive to maximi>e divisional profits, a market-based transfer price
aligns their incentives with owners- incentives of maximi>ing overall corporate profits The transfer will occur when it is in the
best interests of shareholders, and the transfer will be refused by at least one divisional manager when shareholders would prefer
for the transfer not to occur The upstream division is generally indifferent between receiving the market price from an external
customer and receiving the same price from an internal customer 3onsequently, the determining factor is whether the downstream
division is willing to pay the market price %f the downstream division is willing to do so, the implication is that the downstream
division can generate incremental profits for the company by purchasing the product from the upstream division and either
reselling it or using the product in its own production process Cn the other hand, if the downstream division is unwilling to pay
158
the market price, the implication is that corporate profits are maximi>ed when the upstream division sells the product on the
external market, even if this leaves the downstream division idle &ometimes, there are cost savings on internal transfers compared
with external sales These savings might arise, for example, because the upstream division can avoid a customer credit check and
collection efforts, and the downstream division might avoid inspection procedures in the receiving department 1arket-based
transfer pricing continues to align managerial incentives with corporate goals, even in the presence of these cost savings, if
appropriate ad+ustments are made to the transfer price )ie, the market-based transfer price should be reduced by these cost
savings*

However, many intermediate products do not have readily-available market prices Examples are shown in the table2 a
pharmaceutical company with a drug under patent protection )an effective monopoly*K and an appliance company that makes
component parts in the 9arts Bivision and transfers those parts to its assembly divisions Cbviously, if there is no market price, a
market-based transfer price cannot be used

, disadvantage of a market-based transfer price is that the prices for some commodities can fluctuate widely and quickly
3ompanies sometimes attempt to protect divisional managers from these large unpredictable price changes

Cost2based Trans#er /rices!
3ost-based transfer prices can also align managerial incentives with corporate goals, if various factors are properly considered,
including the outside market opportunities for both divisions, and possible capacity constraints of the upstream division

!irst consider the case in which the upstream division sells the intermediate product to external customers as well as to the
downstream division %n this situation, capacity constraints are crucial %f the upstream division has excess capacity, a cost-based
transfer price using the variable cost of production will align incentives, because the upstream division is indifferent about the
transfer, and the downstream division will fully incorporate the company-s incremental cost of making the intermediate product in
its production and marketing decisions However, senior management might want to allow the upstream division to mark up the
transfer price a little above variable cost, to provide that division positive incentives to engage in the transfer

%f the upstream division has a capacity constraint, transfers to the downstream division displace external sales %n this case, in
order to align incentives, the opportunity cost of these lost sales must be passed on to the downstream division, which is
accomplished by setting the transfer price equal to the upstream division-s external market sales price

Next consider the case in which there is no external market for the upstream division %f the upstream division is to be treated as a
profit center, it must be allowed the opportunity to recover its full cost of production plus a reasonable profit %f the downstream
division is charged the full cost of production, incentives are aligned because the downstream division will refuse the transfer
under only two circumstances2

- !irst, if the downstream division can source the intermediate product for a lower cost elsewhereK

- &econd, if the downstream division cannot generate a reasonable profit on the sale of the final product
when it pays the upstream division-s full cost of production for the intermediate product

%f the downstream division can source the intermediate product for a lower cost elsewhere, to the extent the upstream division-s
full cost of production reflects its future long-run average cost, the company should consider eliminating the upstream division %f
the downstream division cannot generate a reasonable profit on the sale of the final product when it pays the upstream division-s
full cost of production for the intermediate product, the optimal corporate decision might be to close the upstream division and
stop production and sale of the final product However, if either the upstream division or the downstream division manufactures
and markets multiple products, the analysis becomes more complex ,lso, if the downstream division can source the intermediate
product from an external supplier for a price greater than the upstream division-s full cost, but less than full cost plus a reasonable
profit margin for the upstream division, suboptimal decisions could result

5egotiated Trans#er /rices!
Negotiated transfer pricing has the advantage of emulating a free market in which divisional managers buy and sell from each
other in a manner that simulates arm-s-length transactions However, there is no reason to assume that the outcome of these
transfer price negotiations will serve the best interests of the company or shareholders The transfer price could depend on which
divisional manager is the better poker player, rather than whether the transfer results in profit-maximi>ing production and sourcing
decisions ,lso, if divisional managers fail to reach an agreement on price, even though the transfer is in the best interests of the
company, senior management might decide to impose a transfer price However, senior management-s imposition of a transfer
price defeats the motivation for using a negotiated transfer price in the first place

Survey o# /ractice!
Ioger Tang )Management Accounting, !ebruary .44"* reports .44' survey data on transfer pricing practices obtained from
approximately .#' industrial companies in the 'ortune #'' 1ost of these companies operate foreign subsidiaries and also use
transfer pricing for domestic interdivisional transfers !or domestic transfers, approximately 5@$ of these companies use cost-
159
based transfer pricing, AF$ use market-based transfer pricing, and .F$ use negotiated transfer pricing !or international transfers,
approximately 5@$ use market-based transfer pricing, 5.$ use cost-based transfer pricing, and .A$ use negotiated transfer
pricing Hence, market-based transfer pricing is more common for international transfers than for domestic transfers ,lso,
comparison to an earlier survey indicates that market-based transfer pricing is slightly more common in .44' than it was in .4FF

Tang also finds that among companies that use cost-based transfer pricing for domestic andTor international transfers,
approximately 4'$ use some measure of full cost, and only about #$ or .'$ use some measure of variable cost

=4ternal 1eporting!
!or external reporting under Generally ,ccepted ,ccounting 9rinciples, no matter what transfer price is used for calculating
divisional profits, the effect should be reversed and intercompany profits eliminated when the financial results of the divisions are
consolidated Cbviously, intercompany transfers are not arm-s-length transactions, and a company cannot generate profits or
increase the reported cost of its inventory by transferring product from one division to another

Dual Trans#er /ricing!
?nder a dual transfer pricing scheme, the selling price received by the upstream division differs from the purchase price paid by
the downstream division ?sually, the motivation for using dual transfer pricing is to allow the selling price to exceed the purchase
price, resulting in a corporate-level subsidy that encourages the divisions to participate in the transfer ,lthough dual transfer
pricing is rare in practice, a thorough understanding of dual transfer pricing illustrates some of the key bookkeeping and financial
reporting implications of all transfer pricing schemes

%n the following example, the 3lear 1ountain &pring (ater 3ompany changes from a negotiated transfer price of /.< per case
)see the above example* to a dual transfer price in which the upstream division receives the local market price of /.4 per case, and
the downstream division pays /.F per case

Upstream Division!
).* %ntercompany IeceivableT9ayable /4,#''
Ievenue from %ntercompany &ale /4,#''

)"* 3ost of Goods &old Z %ntercompany &ales /<,'''
!inished Goods %nventory /<,'''

)To record the transfer of #'' cases of #lear Mountain %pring &ater, at /.4 per case, to the !lorida
marketing division, and to remove the #'' cases from finished goods inventory at the production cost
of /.@ per case*

Do$nstream Division!
).* !inished Goods %nventory /<,#''
%ntercompany IeceivableT9ayable /<,#''

)To record the receipt of #'' cases of #lear Mountain %pring &ater at /.F per case, from the bottling
division in Nebraska*

Corporate <eadquarters!
).* %nterco IeceivableT9ayable Z !lorida /<,#''
3orporate &ubsidy for Bual Transfer 9rice /.,'''
%nterco IeceivableT9ayable Z Nebraska /4,#''

)To record the transfer of #'' cases of #lear Mountain %pring &ater from Nebraska to !lorida, at a
dual transfer price of /.4T/.F per case*

#orporate %u$sidy for Dual Transfer Price is an expense account at the corporate level This account and the revenue account that
records the intercompany sale affect the calculation of divisional profits for internal reporting and performance evaluation, but
these accounts7as well as the intercompany receivableTpayable accounts7are eliminated upon consolidation for external
financial reporting To the extent that the !lorida Bivision has ending inventory, the cost of that inventory for external financial
reporting will be the company-s cost of production of /.@ per case %n other words, the transfer price has no effect on the cost of
finished goods inventory

Trans#er /ricing and Multinational 0ncome Ta4es!
(hen divisions transfer product across tax +urisdictions, transfer prices play a role in the calculation of the company-s income tax
liability %n this situation, the company-s transfer pricing policy can become a tax planning tool The ?nited &tates has agreements
with most other nations that determine how multinational companies are taxed These agreements, which are called bilateral ta4
treaties, establish rules for apportioning multinational corporate income among the nations in which the companies conduct
160
business These rules attempt to tax all multinational corporate income once and only once )excluding the double-taxation that
occurs at the !ederal and state levels* %n other words, the tax treaties attempt to avoid the double-taxation that would occur if two
nations taxed the same income &ince transfer prices represent revenue to the upstream division and an expense to the downstream
division, the transfer price affects the calculation of divisional profits that represent taxable income in the nations where the
divisions are based

!or example, if a ?&-based pharmaceutical company manufactures a drug in a factory that it operates in %reland and transfers the
drug to the ?& for sale, a high transfer price increases divisional income to the %rish division of the company, and hence,
increases the company-s tax liability in %reland ,t the same time, the high transfer price increases the cost of product to the ?&
marketing division, lowers ?& income, and lowers ?& taxes The company-s incentives with regard to the transfer price depend
on whether the marginal tax rate is higher in the ?& or in %reland %f the marginal tax rate is higher in the ?&, the company
prefers a high transfer price, whereas if the marginal tax rate is higher in %reland, the company prefers a low transfer price The
situation reverses if the drug is manufactured in the ?& and sold in %reland The general rule is that the company wants to shift
income from the high tax +urisdiction to the low tax +urisdiction

There are limits to the extent to which companies can shift income in this manner (hen a market price is available for the goods
transferred, the taxing authorities will usually impose the market-based transfer price (hen a market-based transfer price is not
feasible, ?& tax law specifies detailed and complicated rules that limit the extent to which companies can shift income out of the
?nited &tates

Other 1egulatory 0ssues!
Transfer pricing sometimes becomes relevant in the context of other regulatory issues, including international trade disputes !or
example, when tariffs are based on the value of goods imported, the transfer price of goods shipped from a manufacturing division
in one country to a marketing division in another country can form the basis for the tariff ,s another example, in order to increase
investment in their economies, developing nations sometimes restrict the extent to which multinational companies can repatriate
profits However, when product is transferred from manufacturing divisions located elsewhere into the developing nation for sale,
the local marketing division can export funds to 6pay8 for the merchandise received ,s a final example, when nations accuse
foreign companies of 6dumping8 product onto their markets, transfer pricing is often involved Bumping refers to selling product
below cost, and it generally violates international trade laws !oreign companies frequently transfer product from manufacturing
divisions in their home countries to marketing affiliates elsewhere, so that the determination of whether the company has dumped
product depends on comparing the transfer price charged to the marketing affiliate with the upstream division-s cost of
production

=4ercises and /roblems

&'2%! The 1cNabb 3ompany-s Eastern Bivision has capacity to produce "'',''' widgets annually The normal selling price is
/.4 per widget !ixed costs are /<'',''', and variable costs are /F per widget ,nother division of 1cNabb 3ompany would like
to buy some widgets from the Eastern Bivision

AA ,ssume the Eastern Bivision is operating at .''$ of capacity )demand from current customers exceeds the Eastern
BivisionWs production capacity* The (estern Bivision would like to purchase .',''' widgets from the Eastern Bivision,
and /" of the variable costs incurred by the Eastern Bivision could be avoided on each widget transferred (hat is the
lowest transfer price the Eastern Bivision should accept?

:A ,ssume that the Eastern Bivision is operating at <'$ of capacity The (estern Bivision would like to purchase "','''
widgets No variable cost would be avoided on the sale (hat is the lowest transfer price the Eastern Bivision should
accept?

CA ,ssume the Eastern Bivision is operating at 4#$ of capacity The (estern Bivision would like to buy 5',''' widgets in
an all-or-nothing deal )it is 5',''' or >ero* There would be no variable cost savings (hat is the lowest transfer price the
Eastern Bivision could accept to maintain its current profitability?

&'2&! The ?pstream Bivision of 3B3 makes an intermediate product at a variable cost of /5' per unit, but the cost is /." less per
unit on internal sales, due to reduced packaging requirements The Bivision can sell everything it can produce to the outside
market for /@' per unit )/@' is the market price for the intermediate product* The Bownstream Bivision can use the intermediate
product in its own manufacturing process Excluding the cost to the Bownstream Bivision of obtaining this intermediate product,
its variable production cost is /## per unit, and it sells its final product for /.'< per unit The Bownstream Bivision can buy the
intermediate product from an independent supplier for the market price of /@' per unit (hat is the range of transfer prices at
which the managers of both divisions would be willing to transfer product?

&'2'! The Engineering Bepartment of Electronics 1ega-3orporation transferred one of the widgets that it manufactured to the
Eastern Bivision of the company This transfer occurred using a transfer price of the Engineering Bepartment-s budgeted variable
cost of production The market price of the widget was /.'#
161

The Eastern Bivision didn-t do any work on the widget, but rather transferred the widget to the (estern Bivision This transfer
occurred using a transfer price of the Engineering Bepartment-s budgeted full cost of production

The (estern Bivision didn-t do any work on the widget either, but transferred the widget to the 3entral Bivision This transfer
occurred using a transfer price of the Engineering Bepartment-s actual full cost of production

The 3entral Bivision didn-t do any work on the widget either, but transferred the widget to the &outhern Bivision This transfer
occurred using a transfer price of the Engineering Bepartment-s actual full cost of production plus a .'$ mark-up

The &outhern Bivision didn-t do any work on the widget, but transferred the widget to the European Bivision This transfer
occurred using a dual transfer price The &outhern Bivision received its cost, and the European Bivision paid the market price

!ollowing is cost information for the widget and for the Engineering Bepartment

:udget Actual
Birect materials per unit
Birect labor hours per unit
Birect labor wage rate per hour
Jariable overhead per unit
/.'
.
/#'
/#
/."
.
/#'
/@

!ixed and variable overhead are allocated based on direct labor hours ,nnual fixed costs for the department were budgeted for
/.,''',''', but actual fixed costs were /.,"'',''' Total direct labor hours for the department for the year were budgeted for
.'',''', but actual labor hours were <','''

1equired!
AA (hat is the transfer price from Engineering to the Eastern Bivision?

:A (hat is the transfer price from the Eastern Bivision to the (estern Bivision?

CA (hat is the transfer price from the (estern Bivision to the 3entral Bivision?

DA (hat is the transfer price from the 3entral Bivision to the &outhern Bivision

=A (hat is the transfer price paid by the European Bivision for the widget?

&'2(! The Clala Luice 3ompany makes and sells apple +uice Clala operates as two divisions2 the New Xork Bivision under the
name 6Xo, Luicea8K and the 3alifornia Bivision under the name 6(ow, Luice?8 Each division has a sales department and a
production department Each production department makes the same product2 organic, wholesome, pasteuri>ed apple +uice
?sually, each division sells the +uice that it makes However, sometimes the New Xork sales force sells +uice to a customer on the
(est 3oast, in which case the most sensible thing to do is to ship the +uice out of the 3alifornia division-s plant, and for purposes
of calculating divisional income, transfer the product on paper from the 3alifornia Bivision to the New Xork Bivision &imilarly,
sometimes the 3alifornia Bivision sells +uice to an East 3oast customer !ollowing is cost and volume information for each
division for "''5 No marketing costs are incurred on internal sales

5e$ For7 Division Cali#ornia Division
)The 6Xo, Luicea8 3o* )The 6(ow, Luice?8 3o*
External sales 4'' cases at /"# per case .,A'' cases at /"# per case
1anufacturing 3osts2
Jariable costs /.# per case /." per case
!ixed costs /#,''' /.A,"''
1arketing 3osts2
Jariable 3osts /.'' per case /'#' per case
!ixed 3osts /#'' /.,'''
9roduction .,''' cases .,"'' cases
Transfers
to the other division "'' cases .'' cases
from the other division .'' cases "'' cases

1equired!
AA %f transfers are made at variable manufacturing cost of the division that produced and transfers the product, calculate the
divisional income of each division, using Jariable 3osting

162
:A %f transfers are made at full manufacturing cost of the division that produced and transfers the product, calculate the
divisional income of each division, using ,bsorption 3osting

&'2) CContinuation o# &'2(A! (hich of the following will maximi>e the sum of divisional operating income for the two
divisions?

),* , dual transfer price in which the selling division receives the full )variable plus fixed* manufacturing cost and
the buying division pays the market price

)E* , dual transfer price in which the selling division receives the market price and the buying division pays the
full )variable plus fixed* manufacturing cost

)3* , transfer price calculated as the variable manufacturing cost of the selling division

)B* Every transfer price will result in the same total for the sum of the two division-s operating income The transfer
price only affects how this total is allocated between the two divisions


&'2* CContinuation o# &'2(A2 ,ssume each division is producing at capacity, and that each division can sell as much product as it
produces to external customers at the market price )unlimited demand* Each manager is allowed to decide whether to
transfer product to the other division (hich transfer price ensures that each manager is willing to transfer product to the
other division?

),* , dual transfer price in which the selling division receives the full )variable plus fixed* manufacturing cost and
the buying division pays the market price

)E* , dual transfer price in which the selling division receives the market price and the buying division pays the full
)variable plus fixed* manufacturing cost

)3* , transfer price calculated as the variable manufacturing cost of the selling division

)B* None of the above

&'2+ CContinuation o# &'2(A2 ,ssume all of the +uice transferred from NX to 3alifornia is sold before year-end However, some
of the +uice transferred from 3alifornia to NX has not been sold, and is in ending inventory (hich transfer pricing
scheme will result in the lowest value for ending inventory for financial reporting of the consolidated company under
G,,9?

),* Jariable manufacturing cost plus a "'$ mark-up

)E* !ull )variable plus fixed* manufacturing cost with no mark-up

)3* 1arket transfer price

)B* Each of the above transfer prices results in the same value for ending inventory

&'2,! Iobinson !arms has two divisions, the Crchard Bivision, and the Hitchen Bivision The Crchard Bivision grows apples for
a variable cost of /@ per bushel %ts "''# sales were .#',''' bushels to outsiders at /.' per bushel and 5',''' bushels to the
Hitchen Bivision at .5'$ of variable costs ?nder a dual transfer pricing system, The Hitchen Bivision pays only the variable
cost per bushel The fixed manufacturing costs of the Crchard Bivision were /"#',''' per year

The Hitchen Bivision bakes pies with the apples, and sells the pies to outside customers for /"'' per pie %t takes one bushel of
apples to make a do>en pies The Hitchen Bivision has variable manufacturing costs of /'5' per pie in addition to the costs from
the Crchard Bivision The annual fixed manufacturing costs of the Hitchen Bivision were /.F',''' There were no beginning
inventories or ending inventories during the year

1equired!
AA (hat is the operating income of the Crchard Bivision?

:A (hat is the operating income of the Hitchen Bivision?

CA (hat is the operating income of Iobinson !arms as a whole?

163
DA Explain why the company operating income is less than the sum of the two divisionsW total income

=A Now assume that there is no beginning or ending inventory of apples, but that out of the 5<',''' pies manufactured,
&unnybrook Hitchen has @',''' pies unsold at the end of "''# %gnoring the issue of spoilage )the pies can be fro>en*,
how would this ending inventory be valued for financial reporting purposes )ie, for G,,9*? That is, what is the dollar
value of this inventory on IobinsonWs consolidated financial statements?

&'2-! The ?pstream Bivision of 3onsolidated %nc makes a widget that is transferred to the Bownstream Bivision for further
processing and eventual sale to outside customers %n 1ay, the ?pstream Bivision started with >ero inventory, made .,'''
widgets, and transferred <'' widgets to the Bownstream Bivision The total cost to produce these .,''' widgets was /#',''' in
variable manufacturing costs and /.'',''' in fixed manufacturing costs &ince the ?pstream Bivision is strictly a manufacturing
division, there were no non-manufacturing costs ,lthough the ?pstream Bivision did not sell any widgets on the open market in
1ay, there is a market for these widgets, and the market price in 1ay was /.<' per widget The Bownstream Bivision processed
F#' of the <'' widgets received in 1ay, at a total cost of /."',''' )/<',''' in variable manufacturing costs, and /5',''' in fixed
manufacturing costs*, and sold @@# of these widgets in 1ay for /5'' each The Bownstream Bivision incurred variable non-
manufacturing costs of /.' per unit sold, and fixed non-manufacturing costs of /A','''

AA (hat is the market-based transfer price? 3alculate divisional income for the ?pstream Bivision using ,bsorption 3osting
and the market-based transfer price

:A (hat is the transfer price if product is transferred at variable cost of production? 3alculate divisional income for the
?pstream Bivision using Jariable 3osting and a variable cost-based transfer price

CA (hat is the transfer price if the company transfers product at the full )variable plus fixed* cost of production? 3alculate
divisional income for the ?pstream Bivision using ,bsorption 3osting and a full cost-based transfer price

DA 3alculate divisional income for the Bownstream Bivision using ,bsorption 3osting and a market-based transfer price

=A 3alculate divisional income for the Bownstream Bivision using ,bsorption 3osting and a full cost-based transfer price

&'2%.! The Chio Bivision of the 3hocolate 3ompany makes chocolate, sells some chocolate to candy manufacturers, and transfers
the rest of the chocolate to the %ce 3ream Bivision of the 3hocolate 3ompany %n Lanuary the Chio Bivision made .',''' pounds
of chocolate, incurred variable manufacturing costs of /.#,''', and fixed manufacturing costs of /.',''' !or internal reporting
purposes, the company uses a full cost transfer price )ie, variable plus fixed manufacturing costs* for transfers of product from
one division to another Cf the .',''' pounds of chocolate made in Lanuary, <,''' pounds were sold to other companies at an
average sales price of /# per pound, and ",''' pounds were transferred to the %ce 3ream Bivision The %ce 3ream division used
.,''' pounds of chocolate to make .',''' gallons of chocolate ice cream ,dditional costs incurred to make the ice cream were
/..,''' in variable manufacturing costs and /"',''' in fixed manufacturing costs ,ll of the ice cream was sold by the end of the
month for /# per gallon, but .,''' pounds of the chocolate received from the Chio Bivision was still on hand at the end of
Lanuary

AA (hat is the transfer price for Lanuary? 3alculate divisional Gross 1argin using ,bsorption 3osting for the Chio Bivision
for Lanuary

:A 3alculate divisional Gross 1argin using ,bsorption 3osting for the %ce 3ream Bivision for Lanuary

CA Now assume the same facts as above, except that instead of using a full cost transfer price, the company uses a market-
based transfer price (hat is the market-based transfer price? 3alculate divisional Gross 1argins for both the Chio
Bivision and the %ce 3ream Bivision using ,bsorption 3osting and the market-based transfer price

DA ,ssume the company uses a market-based transfer price for internal reporting purposes (hat would the company show
for external financial reporting purposes )G,,9* at the end of Lanuary for the cost of ending inventory for the chocolate
held by the %ce 3ream Bivision?

&'2%%! The Transylvania &alad Bressing 3ompany operates in two countries2 Iumania and Eulgaria The Iumanian Bivision has
a processing facility that produces olive oil, and also a factory that mixes and bottles salad dressing for the local market The
Eulgarian Bivision has a processing facility that produces wine vinegar, and also a factory, similar to the Iumanian factory, that
mixes and bottles dressing for the local market Historically, the oil and vinegar processing plants have produced enough oil and
vinegar to meet the demand for both the Iumanian and Eulgarian bottling plants, and each processing facility has sold excess
product )oil or vinegar* in its local market !ollowing are relevant data for "''# ,ll amounts have been translated into ?&
currency


164
Iumanian
bottling plant
Iumanian oil
processing facility
Eulgarian
bottling plant
Eulgarian vinegar
processing facility

production )in gallons*2
outside sales )in gallons*2

ending inventory )gallons*2
dressing
oil
vinegar

variable mfg costs2
fixed mfg costs2

"#','''
"#','''


'
'
'

/'A@Tgal
/.'','''

5'','''
@','''


'
'
'

/.''Tgal
/A'','''

.#','''
."','''


A','''
"','''
'

/'""Tgal
/ A','''

.'','''
"','''


'
'
'

/'<'Tgal
/ #','''

Jariable costs of the bottling plants shown above do not include the costs of the vinegar and oil, and are stated as per gallon of
finished product )ie, dressing* ,ll outside sales are made at the prevailing market prices in that country, as shown below

1arket 9rices, per gallon2



%n Eulgaria

%n Iumania

salad dressing2

/A''

/A''
vinegar2 /."' /.5'
oil2 /"A' /"''

Additional in#ormation! %t takes '" gallons vinegar and '< gallons oil to make . gallon of salad dressing The company is based
in Eulgaria The company pays Iumanian taxes on Iumanian income and Eulgarian taxes on consolidated income in excess of
Iumanian income Iumanian income is equivalent to income of the Iumanian division )bottling plant and oil processing plant*
The tax rate for the company in Iumania is #'$, and the tax rate for the company in Eulgaria is 5'$

1equired!
AA (hat is the transfer price of oil using variable cost? (hat is the transfer price of oil using full cost? (hat is the
transfer price of oil using the selling division-s market price?

:A (hat is the transfer price of vinegar using variable cost? (hat is the transfer price of vinegar using full cost? (hat is
the transfer price of vinegar using the selling division-s market price?

CA ,ssume each division buys and sells intermediate product )oil and vinegar* from the other division (hat transfer
pricing policy )variable cost, full cost, or market price of the selling division* maximi>es the company-s after tax profits
for the year? The same type of transfer price )variable cost, full cost, or market price* must be used for both vinegar and
oil Xou may assume that under any transfer pricing method, taxable income in both countries will be positive

DA ,ssume the company uses a market-based transfer price for calculating its tax expense 3ompute the company-s
ending inventory for financial reporting purposes under ?& Generally ,ccepted ,ccounting 9rinciples

&'2%&! The dairy in Das 9lacitas, New 1exico, sells milk, and makes various products from the milk, such as cheese, powdered
mild, and 1ilk Buds The dairy operates as two divisions2 the 3ow U 1ilk Bivision, and the ,dvanced 9roducts ),9* Bivision
The manager of the 3ow U 1ilk Bivision, Eeatta Eovine, can choose either to package and sell milk directly to independent
customers, or she can sell milk to the manager of the ,9 Bivision The manager of the ,9 Bivision can either buy milk from the
3ow U 1ilk Bivision, or buy milk on the open market, for use in the production of cheese, butter, etc 3urrently, the dairy uses a
market-based transfer price for internal sales of milk from one division to the other Each manager is evaluated based on meeting
)or exceeding* divisional profit targets for his or her division

The manager of the ,9 Bivision, Hank Holstein, suggests changing to a full cost transfer price with a mark-up The mark-up
would be computed such that if all sales of the 3ow U 1ilk Bivision were at this price, the Bivision would +ust meet its targeted
profit amount !urthermore, Hank suggests allowing his division to buy milk on the open market, but requiring the 3ow U 1ilk
Bivision to sell internally whenever the ,9 Bivision wants to buy internally Hank argues that under this new transfer pricing
scheme, his division will be no worse off than before )since if the transfer price is above market, he can buy milk on the open
market instead of internally*, and that the 3ow U 1ilk Bivision should be satisfied with this transfer price, since internal sales
will not pull that Bivision-s profits below what would be necessary for the Bivision to meet its targeted profits ob+ective

?nder Hank-s scheme, indicate whether each of the following statements is true or false
165

CAA %f the market demand for milk exceeds the capacity of the 3ow U 1ilk Bivision, Eeatta will never prefer to sell milk
to Hank )instead of selling to the open market* when Hank prefers to buy milk from Eeatta )instead of buying on the
open market*

C:A %f the 3ow U 1ilk Bivision has excess capacity relative to market demand, Eeatta will always want to supply milk to
the ,dvanced 9roducts Bivision

CCA This new transfer pricing scheme will ensure that the two divisions will only transfer product when the transfer is in
the best interests of the Bairy as a whole

CDA %f the 3ow U 1ilk Bivision can sell all of its production to the ,dvanced 9roducts division, the new transfer pricing
scheme may induce Eeatta to relax cost control pertaining to certain divisional costs
C<A/T=1 &(! Corporate Social 1esponsibility

(But you "ere al"ays a good man of $usiness) Jaco$)* faultered &croogeP

(Business+* cried the Ghost, wringing its hands again (Mankind "as my $usiness, The common "elfare "as
my $usiness- charity) mercy) for$earance) and $eneolence) "ere) all) my $usiness, The dealings of my trade
"ere $ut a drop of "ater in the comprehensie ocean of my $usiness+*
- 3harles Bickens, A #hristmas #arol

Chapter Contents!
- %ntroduction
- The ob+ectives of business organi>ations
- &ustainability
- 3orporate social responsibility and negative externalities
- &ocial responsibility as a means to an end
- &ocial responsibility as an end in itself
- Non-economic goals and management accounting
- The Ealanced &corecard
- The Triple-Eottom-Dine
- 3onclusion
- Biscussion questions

0ntroduction!
1ost of us balance multiple ob+ectives 9robably, you are attempting to balance your efforts across two or more classes this term,
in order to earn good grades in all of them Xou are probably also balancing your accomplishments in school with other
obligations and goals related to work, hobbies, your involvement with charities, and your relationships with friends and family
There is no 6summary measure8 or 6overall grade8 of your success in balancing these multiple ob+ectives and goals, all of which
compete for your time and effort

&imilarly, most government programs and organi>ations balance multiple ob+ectives 3ity governments allocate scarce resources
across diverse activities such as public safety, street maintenance, and public libraries How does the citi>enry choose between two
more police officers or a new children-s wing for the library? How does one develop a single measure to evaluate the city-s overall
success in meeting its goals?

9ublic schools have a goal not to leave any student behind &chools also have goals to provide challenging opportunities for the
very brightest students, and to provide extracurricular activities for all students &chools must allocate limited resources across
these sometimes-competing ob+ectives

The National !orest &ervice attempts to balance the economic needs of local communities and timber-dependent industries with
the goal of conservation and with the goal of providing outdoor-enthusiasts recreational opportunities on public lands These goals
are so disparate that almost nobody thinks the !orest &ervice does a good +ob The National 9ark &ervice has a comparatively
easier time2 it only balances the two competing ob+ectives of conservation and recreational opportunities Even so, the 9ark
&ervice faces controversial decisions such as closing roads to private vehicles in some of the most popular and congested parks,
and balancing different types of recreational activities

The Ob9ectives o# :usiness OrganiDations!
Given that all individuals, and most not-for-profit and governmental organi>ations must balance competing ob+ectives, it is
interesting to observe that both in practice and in theory, businesses have often focused on a single ob+ective That ob+ective is to
maximi>e economic returns to owners
166

!or example, a popular microeconomics textbook tells students2

. &hen "e model the $ehaior of firms) "e "ill "ant to descri$e the o$/ectie as profit ma0imi1ation and the
constraints as technological constraints and market constraints,

2 !al 3arian)
1icroeconomic ,nalysis 456789

,nd a widely-used textbook in corporate finance states2

%uccess is usually /udged $y alue: %hareholders are made $etter off $y any decision "hich increases the alue
of their stake in the firm,*

2 Brealey and Myers)
9rinciples of 3orporate !inance 456779

Examples from practice can be drawn from corporate mission statements available on company websites !or example, the
athletic footwear company Nike has established the following mission2

;ike<s corporate responsi$ility 4#R9 mission is simple and straightfor"ard, It is clear ackno"ledgement that #R
"ork should not $e separate from the $usiness = $ut should instead $e fully integrated into it, >ur #R mission:

2 &e must help the company achiee profita$le and sustaina$le gro"th,
2 &e must protect and enhance the $rand and company,

2 ;ike 4?@@A9

,lthough generously-worded, and sprinkled with friendly words like 6corporate responsibility8 and 6sustainable growth,8 there is
really nothing in this mission statement that implies the company has any other ob+ective than to maximi>e long-run profits to
shareholders

The mission statement for pharmaceutical company 9fi>er states2

&e "ill $ecome the "orldBs most alued company to patients) customers) colleagues) inestors) $usiness
partners) and the communities "here "e "ork and lie,

2 Pfi1er 4?@@A9

Boes 9fi>er have a business philosophy that would ever place the interests of the community above the interests of investors? %f
the 3EC is meeting with local community leaders, he or she can point to this mission statement and imply so, but if the 3EC is
meeting with stock analysts and investment bankers, there is no need to interpret this mission statement that way

%f you work forty or more hours a week for an organi>ation that does not have, as one of its ultimate goals, the ob+ective of
providing its employees with a challenging, rewarding, safe, and fair work environment, but only attempts to satisfy these
ob+ectives as an intermediate step in its efforts to maximi>e shareholder wealth )while complying with labor laws and maintaining
acceptably-low levels of employee turnover*, then your own ability to achieve your personal goals will be all that more difficult
9erhaps this fact helps explain the popularity of small, entrepreneurial forms of businessK a proprietor or partner in a small
company can strive to achieve non-economic goals as well as economic goals within the framework of his or her business

&imilarly, if companies do not have, as a goal, the ob+ective of minimi>ing pollution, but only minimi>e pollution to the extent
necessary to comply with environmental laws and maintain a favorable public image, then a society committed to achieving and
preserving a clean environment will find attaining that ob+ective more difficult !or example, it is possible that the costs incurred
by society from ma+or oil spills7the cleanup costs and the costs of long-term damage to the environment7are greater, in total,
than the costs of additional steps to prevent oil spills in the first place Even if double-hull oil tankers are not cost-effective from
the oil company-s perspective, they may be cost-effective from a societal point of view

Given that we as a society, and all of us as individuals, have non-economic ob+ectives as well as economic ob+ectives, and given
the enormous volume of activity that occurs within for-profit businesses7the human capital, energy, creativity, and material
resources invested in business7one might ask whether businesses should focus only on the goal of maximi>ing shareholder
wealth ,re we as a society better off operating in an economy in which the sole ob+ective of corporate ,merica is to maximi>e the
economic resources of owners, and owners then use those resources to achieve their economic and non-economic goalsK or would
we be better off in an economy in which companies, as well as governments, not-for-profit organi>ations, and individuals,
167
contribute directly and deliberately to the non-economic ob+ectives of our society? To choose the second scenario is to ask
companies to assume multiple ob+ectives, and to ask management to balance resources across those ob+ectives in a manner, and to
an extent, that goes beyond the traditional role that owners have assigned to corporate managers

The question of whether companies have a single ob+ective to maximi>e economic returns to shareholders, or multiple economic
and non-economic ob+ectives, significantly affects the standards of corporate social responsibility by which managers should be
+udged ,t a minimum, if managers are ultimately responsible only for maximi>ing shareholder wealth, society nevertheless
requires managers to comply with laws and regulations, and to meet standards of business ethics related to honesty, integrity, and
fair-play Cn the other hand, if companies have, as ultimate goals, social and environmental goals, then standards of corporate
social responsibility might include the conduct of managers towards achieving these goals

Sustainability!
There is increasing concern by government leaders, policymakers and the public over the accelerated rate at which natural
resources are being depleted, and the associated environmental degradation ,s a result, many businesses and business leaders
have recogni>ed 6sustainability8 as a worthwhile goal2 companies should strive to conduct business in a sustainable manner
However, there is no widely-accepted definition of sustainability %n .4<F, the (orld 3ommission on Environment and
Bevelopment )commonly called the Erundtland 3ommission* defined sustainability as follows2

%ustaina$le deelopment (meets the needs of the present "ithout compromising the a$ility of future generations
to meet their o"n needs,*

This definition has been adopted by many organi>ations, but does not provide guidance on how to make these intergenerational
trade-offs , slightly different view was recently expressed by former &oviet leader 1ikhail Gorbachev2

&e desperately need to . adopt a ne" paradigm for deelopment) $ased on the costs and $enefits to all people)
and $ound $y the limits of nature herself rather than the limits of technology and consumerism,

3an we expect the profit motive to induce companies to adopt sustainable business practices? Boes economic theory, and do
observed business practices, suggest that the goal of maximi>ing long-run profits is consistent with the goal of sustainability? %f
timber companies harvest all of the forests under their control, without replanting, their subsequent profits from timber sales
presumably will be >ero, so the companies would appear to have economic incentives to harvest forests responsibly, and to
replant 3ompanies, unlike individuals, have indefinite lives, so they might be more motivated than individuals to make long-term
investments in the environment, if those investments also offer long-term economic returns

?nfortunately, neither observed business practices nor theory provide strong support for this line of reasoning 1any industries in
both renewable and nonrenewable resources, such as oil and timber, are depleting these resources at alarming rates

!inance theory postulates that companies should maximi>e the present value of future free cash flows (ith appropriate
assumptions, free cash flows over the life of the company equal the sum of earnings over the life of the company, so that
accounting theory postulates that companies should maximi>e current and future profits Boes this theory predict that companies
will use resources in a sustainable manner?

3onsider an oil company with oil reserves that can last .'' years at a given level of production ,ssume a discount rate of <$ )see
3hapter .4 for an explanation of discount rates* ,ssume, for simplicity, that the company anticipates >ero inflation and a constant
sales price for oil How important are the resources available to the company during the last #' years of this .''-year period, to
the value )and the stock price* of the company today? The answer is2 not very important 3onsider an even more extreme
question How important are the resources available to the company during the last <' years of this .''-year period? The answer
is that because of the <$ discount rate, approximately <'$ of the value of the company today derives from oil sales over the first
twenty years Cnly "'$ of the value of the company derives from the last <' years 3an we expect wise stewardship of the
resources controlled by this company, when the company-s actions to ensure the availability of these resources more than twenty
years into the future have such a minimal impact on the company-s stock price today?

Corporate Social 1esponsibility and 5egative =4ternalities!
,nother reason that market mechanisms are unable to consistently induce companies to engage in sustainable business practices
arises from what economists call negative externalities (hen the actions of a company impose costs on third parties, the
economic terminology is that a negative e4ternality exists !or example, if a company discharges pollution into a river, then there
is a negative externality that constitutes a cost to people who live downstream %f the company can pollute the river without
violating environmental laws or incurring negative publicity that ultimately affects sales, then this negative externality can be
difficult to remedy

Bespite numerous laws and regulations designed to limit the costs imposed by negative externalities, they are pervasive Examples
today include cruise ships that dump sewage into coastal waters, and the economically-motivated introduction of invasive foreign
168
plants and animals that then displace or destroy native species, harming the people and industries that appreciated or depended on
them

Cne type of externality is called the tragedy of the commons The term literally refers to overgra>ing of common lands that can
occur in an agricultural community, because each family reali>es that if they limit the opportunity for their animals to gra>e on the
commons7which would be the socially-responsible behavior7they would make themselves worse off in the short-run without
improving their situation in the long-run, because acting alone, one family does not materially affect the health of the pasture
&imilarly, companies in many industries today take advantage of public goods that are sub+ect to the tragedy of the commons The
most poignant examples relate to resources that cannot be owned by one company or country, such as the oceans and atmosphere
!or example, ocean fish populations for some species no longer support commercial fishing2 depletion of these fish populations
constitute both an environmental tragedy and an economic tragedy for small fishing communities

Dimited attempts have been made to use the efficiency of the marketplace to limit the costs imposed by negative externalities !or
example, governments have experimented with pollution credits for certain types of emissions Eecause companies can buy and
sell these credits, they have incentives to reduce emissions without being sub+ect to blanket emission-caps that might not make
sense for a particular company and community &uch attempts do not represent a move away from the single-ob+ective, profit-
maximi>ing framework of our economy, but rather constitute efforts to use regulation to induce for-profit companies to internali>e
part of the cost of negative externalities

Social 1esponsibility as a Means to an =nd!
&ome argue that when companies fail to operate in a sustainable manner, when they impose negative externalities on society, and
when they otherwise fail to act in socially-responsible ways, the resulting negative publicity will eventually translate into
decreased sales and profits Hence, the profit motive is all that is needed to align corporate ob+ectives with society-s non-economic
goals Historically, there are a few instances in which this chain of events has perhaps occurred ,rguably, the divestiture by some
pension funds and other investors in the stock of companies that conducted business in &outh ,frica helped end apartheid 1ost
people agree that the grape boycott led by 3esar 3have> led to long-term improvements in the lives of Hispanic and 1exican
migrant workers

However, such examples are rare and usually involve particularly emotional issues and charismatic leaders ,ccording to Harvard
Eusiness &chool management professor Dynn &harp 9aine2

It strains credulity to suggest that ;ike "ould hae $enefited financially from reCuiring its suppliers to meet
higher standards at the inception of its then2noel oerseas manufacturing program in the 56D@s, Insistence on
adult "orkers 4no children9) safe "orking conditions) and reasona$le hours and pay "ould hae cost ;ike real
dollars and cents, Prior to the 566@<s) "hen "orkers and consumers in industriali1ed countries a"akened to the
conditions of "orkers oerseas) it "ould hae $een difficult to cite een minimal reputational $enefits from such
a stance,

Neither an overview of business history, nor current events, seems to support the idea that the free-market mechanism is a general
remedy for all of the ills that the conduct of business, in its pursuit of profits, imposes on society, even if we could agree on what
those ills are 1ost of us would like to see locally-owned, 61ain &treet8 businesses thrive, yet we shop at the mall and at (al-
1art for price and selection (hen we travel, we eat at 1cBonalds- instead of the local diner, because we know what to expect
from the fast-food chain restaurants in terms of quality and cleanliness 1any of us would prefer to buy eggs laid by free-range
chickens, if we gave the matter any thought, but we won-t pay an extra fifty cents a do>en 1ost of us oppose child-labor, and no
doubt, we all oppose child slave labor, but many of us won-t pay an extra dollar for a candy bar made with fair-trade chocolate,
which is the only way today to ensure that the chocolate was not harvested by children under forced-labor conditions

Cn the other hand, there are alternative views, and in any case, the future might not resemble the past !or example, Cekom, a
German company that grades companies based on environmental and social performance, conducted a +oint study with the
investment banking firm of 1organ &tanley The study found a positive correlation between financial performance and sustainable
business practices ,ccording to 1arkus Hnisel, director of 1organ &tanley 9rivate (ealth 1anagement, 6The positive
correlation between sustainability and financial performance will provide an enormous boost to the sustainable investment sector8
Hence, it is possible that market mechanisms do encourage sustainable business practices, and will be more effective in doing so
in the future

Social 1esponsibility as an =nd in 0tsel#!
&ome argue that a more effective and efficient framework for our economy and society would be for corporate management to
internali>e the non-economic ob+ectives that the owners themselves share !inding the common denominator of values and non-
economic ob+ectives across hundreds or even tens-of-thousands of owners is difficult However, it is not impossible, as
demonstrated by the success over the past two decades of such diverse products as mutual funds, credit cards, and long-distance
telephone companies that target financial support for particular social or environmental goals

169
&uch a philosophy of business involves the expectation by shareholders that corporate managers will consider environmental and
social factors in their decisions, as well as economic factors, and will consider these factors above and beyond what is required by
law or would result in negative publicity that ultimately hurts profits %n fact, shareholders might accept lower economic returns in
exchange for corporate behavior that aligns with their personal values How much lower? 9robably not muchK but if it is any
amount at all, then management must abandon the appealing simplicity of a single-minded focus on economic profits, and address
multiple ob+ectives in a meaningful way

5on2=conomic ;oals and Management Accounting!
Iegardless of whether one believes that companies should adopt non-economic goals as well as profit maximi>ation as ultimate
goals, or whether one believes that the profit motive is sufficient to encourage companies to act in socially and environmentally
responsible ways, there is an important role for management accounting &pecifically, shareholders, potential shareholders, and
customers must have access to the information that enables them to make investment and purchase decisions consistent with their
values

Traditional accounting and financial reporting systems were not designed to collect and report information about social and
environmental performance, in part because many of these measures are non-monetary, and accounting systems traditionally
relied on the monetary-unit as the common denominator in which to measure economic activities and transactions Two relatively
recent innovations in management accounting and corporate reporting that provide a framework for companies to formally
incorporate nonfinancial ob+ectives into management decision-making and corporate reporting are the balanced scorecard and
the triple2bottom2line

The :alanced Scorecard!
The balanced scorecard is a performance measurement tool and a performance management system created in the early .44's by
Iobert Haplan and Bavid Norton The balanced scorecard emphasi>es traditional financial measures, but also adds nonfinancial
measures ,n important motivation for adding these nonfinancial measures is the observation that many financial measures are
backward-looking, while many important forward-looking measures of performance are nonfinancial %n part, the balanced
scorecard seems to have been a response to what was perceived as an inordinate preoccupation by analysts and shareholders on
quarterly earnings announcements, which reflect very short-term past performance, and are not necessarily a strong predictor of
long-term future performance

The four original components of the balanced scorecard were

. The learning and growth perspective
" The internal business process perspective
A The customer perspective
5 The financial perspective

&ometimes, sustainability is added as an additional perspective Each of these perspectives has performance measures associated
with it, and these performance measures are tailored for the specific circumstances of the company implementing the scorecard
,n important advantage of the balanced scorecard is that it explicitly acknowledges the fact that companies have multiple
stakeholders2 investors, creditors, customers, and employees

The popularity of the balanced scorecard is illustrated by the results of a recent survey of .'' large ?& companies The survey
found that @'$ of these companies use some variation of the balanced scorecard ,mong companies using the balanced scorecard,
<'$ of the companies are either using the scorecard or planning to use it for incentive compensation purposes

The use of the balanced scorecard does not imply that the company is compromising its focus on economic profits, or that the
company has identified multiple ob+ectives as ultimate goals %n fact, another survey found that among companies using the
balanced scorecard, on average, financial measures are given ##$ of the total weight in the scorecard, and the remaining 5#$ is
shared by all of the other elements of the scorecard combined Hence, financial measures still predominate 1any companies
adopt the balanced scorecard because management believes that superior performance along the nonfinancial components of the
scorecard will improve long-run financial performance

The Triple2:ottom2Gine!
The balanced scorecard is a management tool Ey contrast, the triple-bottom-line is an external reporting tool designed for
shareholders and other financial statement users The triple-bottom-line reports periodic )quarterly or annual* information about
the company-s performance along environmental and social dimensions, as well as the usual information about the company-s
economic performance Ieporting under the triple-bottom-line is divided into three components2

. =conomic per#ormance reports traditional measures of financial performance, and possibly additional statistics related to
economic performance such as product market share or information about new product development

170
" Social per#ormance reports measures of performance related to employee welfare, such as employee in+ury rates, training
programs, and hiring and retention statistics This category also reports other social performance measures such as
charitable contributions, and the company-s activities in shaping local, national and international public policy

A =nvironmental per#ormance reports the impact of the company-s products, services and processes on the environment
This component of the triple-bottom-line might report on the release of pollutants into the air and public waters, the
utili>ation of renewable and nonrenewable natural resources, and the company-s stewardship of natural resources on
company-owned or company-controlled lands

There are no 6Generally ,ccepted ,ccounting 9rinciples8 for reporting under the triple-bottom-line However, the Global
Ieporting %nitiative )GI%*, sponsored by the ?nited Nations Environment 9rogram, has emerged as a prominent source of
guidance for triple-bottom-line reporting ,ccording to GI%, over #'' organi>ations worldwide follow its reporting guidelines ,n
alternative framework that is widely used for reporting on environmental performance is %&C .5''', established by the
Crgani>ation de &tandards %nternational This organi>ation is a management practice standard-setting body founded in ,msterdam
in .45F %&C establishes standards for a variety of products and production processes, and compliance with %&C is a contractual
requirement by some corporate customers

The triple-bottom-line is gaining momentum in some other nations more quickly than in the ?nited &tates

Conclusion!
Ieporting on sustainability is no more synonymous with engaging in activities that promote sustainability than reporting on
economic profitability is synonymous with being profitable However, in the current ?& regulatory environment, companies are
required to report on economic performance in accordance with Generally ,ccepted ,ccounting 9rinciples, whether they have
good news to tell or bad Ey contrast, reporting to shareholders and to the public on environmental and social performance is
generally voluntary in the ?& and in most other nations Hence, we would expect that company managers that choose to report
this information believe it will be viewed favorably by financial statement users 3ompanies that engage in activities that promote
environmental and social performance goals are the companies most likely to report these activities using the triple-bottom-line or
some similar reporting framework 3ompanies that do not engage in these activities, or engage in them minimally, probably will
not report under the triple-bottom-line

3onsequently, investors and consumers that wish to make investment and purchase decisions based, in part, on companies-
environmental and social performance are hampered by the lack of universal reporting )not all public companies report this
information* and by the lack of uniform reporting )among companies that report this information, they do not report the
information using the same criteria in the same way* ,nother component in the reporting framework that is present for financial
data, but generally absent for environmental and social reporting, is third-party attestation !inancial statements are audited by
public accountants, and financial statement users can place more reliance on the accuracy of that information because of the
independent auditor-s third-party verification role No such audit requirement exists for information that ?& companies report
voluntarily about environmental and social performance

Hence, whether one believes that the profit-motive and reputational effects are sufficient to induce companies to engage in
responsible environmental and social behavior, or one believes that companies should include environmental and social goals as
ultimate ob+ectives along with traditional economic ob+ectives, it would seem that the following elements are essential7but
currently absent7for either mechanism to work effectively2 !irst, the regulatory reporting regime should require that
environmental and social performance information be reported to investors and consumers using commonly-accepted criteria
&econd, the information should be audited, to enhance the credibility of this information with financial statement users

Discussion questions!

"5-. Bo you agree with the Erundtland 3ommission definition of sustainability? 3an you offer an alternative definition that
you prefer?

"5-" %s the goal of achieving sustainable business practices compatible with the goal of maximi>ing long-run financial
performance?

"5-A 3an corporate strategies accommodate multiple long-run ob+ectives? 3an you cite examples of companies that seem to
have established multiple ob+ectives?
"5-5 %f you believe that companies can only effectively accommodate one long-run ob+ective, do you think that shareholders
have the same goals for the company as creditors? %f not, how should the company balance the ob+ectives of creditors
with the ob+ectives of shareholders? &imilarly, do you think that current shareholders have the same ob+ectives for
corporate financial reporting as potential shareholders?
"5-# Boes the balanced scorecard accommodate multiple long-run ob+ectives, or only multiple ob+ectives in the short run?
"5-@ (hat is the relationship between reporting on environmental and social performance, and investing in environmental
and social goals?
171
)ive*Pae $u##ary o" =ey Concepts:

Cost Classi!cations:
Cost obBect: somethng we want to know the cost of.
A costs can be cassed aong each of the foowng three dmensons.
direct costs versus overhead costs (aso caed indirect costs)
variable costs versus !&ed costs (many costs are #i&ed; aso caed se#i*variable)
#anu"acturin costs versus non*#anu"acturin costs

$teps in Cost Allocation:
$tep 1: Identfy the cost obBect (usuay a product or servce of the organzaton).
$tep +: Identfy the direct costs. These costs can be traced drecty to the cost ob|ect.
$tep ,: Identfy the overhead cost pools assocated wth the cost ob|ect.
$tep ;: Seect the cost allocation base for assgnng each overhead poo to the cost ob|ect.
$tep 5: Deveop the overhead rate per unit o" the allocation base:


Overhead Rate =
Tota Costs n the Overhead Cost Poo
Tota Ouantty of the Cost Aocaton Base

This rate is used to allocate overhead to the cost ob+ect based on the quantity of the allocation base incurred by the cost ob+ect !or
example, to allocate utility expense at a factory using direct labor hours as the allocation base, the ratio in &tep # is total utility
expense incurred by the factory during the period divided by total hours of direct labor incurred for all products made at the
factory ?tility expense is then allocated to each product using this ratio multiplied by the total direct labor hours incurred in the
production of each product
If overhead s aocated usng budgeted rates (as n %or#al Costin and $tandard Costin), Step 5
becomes:

$tep 5a: For the budget perod, estmate the tota quantty of the cost aocaton base that w be
ncurred.
$tep 5b: For the budget perod, estmate the cost of tems dented n Step 3 above.
$tep 5c: Compute the budgeted overhead rate as: Step 5b Step 5a

Activity*/ased Costin 8A/C.: A costng system characterzed by the use of #ultiple overhead
pools, each wth ts own aocaton base, and characterzed by the choce of cost drivers for the
aocaton bases.

Misapplied 3verhead 837H.
When overhead s aocated usng budgeted rates, a dherence can arse between actua overhead
ncurred, and overhead aocated to product. Ths dherence s caed Cnderapplied or 3verapplied
3verhead.

Msapped overhead = actua overhead ncurred - overhead apped
If actua overhead ncurred s greater than overhead apped, overhead s underapped.
If actua overhead ncurred s ess than overhead apped, overhead s overapped

Cost*Volu#e*Pro!t Analysis:
P ? 8$P D VC. & 4 )C
Where: P = prots,
$P = saes prce per unt,
VC = varabe cost per unt (manufacturng and non-manufacturng),
4 = number of unts made and sod
)C = tota xed costs (manufacturng and non-manufacturng).
$P D VC s the unit contribution #arin (CCM)
4 & 8$P D VC. s the total contribution #arin. (TCM)
172
TCM E sales s the contribution #arin ratioF (CMR)
/reaGeven Point: n unts ? )C E CCM; n saes doars ? )C E CMR

)le&ible /udetin:
$tatic budet variance = actua resuts - statc budget (.e., the orgna budget)
)le&ible budet "or costs = (statc budget VC x actua unts produced or sod) + statc budget )C.
)le&ible budet "or revenues = statc budget $P x actua unts sod.
)le&ible budet variance = actua resuts - exbe budget

Variable Cost Variances:
The materas prce (or abor rate) varance = 8AP * $P. & A4 ? 8A4 & AP. D 8A4 & $P.

The materas quantty or usage (or abor emcency) varance = 8A4 * $4. & $P ? 8A4 & $P. D 8$4 &
$P.

Where AP = actua prce per unt of nput, $P = budgeted (.e., standard) prce per unt of nput, A4 ?
actua quantty of nputs used (or purchased), and $4 = quantty of nputs that shoud have been used
for the actual output acheved (actua unts produced x standard quantty aowed per unt; a exbe
budget concept)

)i&ed Manu"acturin 3verhead 8)M3H. Cost Variances
There are mportant ssues reated to how the denomnator n the overhead rate (step 5) s cacuated
for the purpose of aocatng xed overhead. Two choces are:
1. Practical Capacity: The eve of the aocaton base that woud be ncurred f xed assets run fu-
tme, but aowng for routne mantenance and unavodabe nterruptons.
2. /udeted CtiliHation: The eve of the aocaton base that woud be expected for budgeted
producton.

/udet variance 8aso caed the xed overhead spendin variance. = actua tota FMOH
budgeted tota FMOH

Volu#e variance = budgeted tota FMOH FMOH aocated to output usng a standard costng system
(.e., budgeted FMOH per unt x actua unts produced).

/udeted )M3H per unit ? FMOH the denomnator concept n step 5 above.

The voume varance s favorabe f actua producton exceeds the denomnator n the FMOH rate.

Absorption Costin and Variable Costin:
Under Absorption Costin (aso caed )ull Costin), product costs (aso caed inventoriable
costs) ncude a manufacturng costs: abor, materas, and manufacturng overhead (xed and
varabe). Absorpton Costng s requred for externa reportng under GAAP.

Variable Costin (aso caed 1irect Costin) s an aternatve method that treats drect
manufacturng costs and varabe manufacturng overhead as product costs, but treats xed
manufacturng overhead as a perod expense (appears on the ncome statement when ncurred).
Varabe costng assumes xed costs are unreated to producton, snce these costs are ncurred n the
short-run even f nothng s produced.

Absorpton Costng and Varabe Costng treat drect abor, drect materas, and varabe manufacturng
overhead n the same way (and they both honor the matchng prncpe for these costs). Both methods
aso treat non-manufacturng costs n the same way (as a perod expense). Only fxed
manufacturing overhead is treated diferently.

173
Each method s assocated wth ts own ncome statement format:

(ross Marin Inco#e $tate#ent under Absorption Costin

I
?
I
?
Saes
COGS (cost of goods sod)
Gross margin
Fxed and varabe non-manufacturng costs
Income

Where COGS = (manufacturng VC + FMOH per unt) x unts sod; and FMOH per unt = FMOH unts
produced (or other denomnator-eve concept).

Contribution Marin Inco#e $tate#ent under Variable Costin

I
I
?
I
I
?
Saes
Varabe manufacturng costs
Varabe non-manufacturng costs
Contribution margin
Fxed manufacturng costs
Fxed non-manufacturng costs
Income

Where varabe manufacturng costs = manufacturng VC x unts sod (honorng the matchng prncpe);
and varabe non-manufacturng costs = a varabe non-manufacturng costs ncurred durng the perod
(not honorng the matching principle).

Calculation o" Endin Inventory:
Absorption Costin: (manufacturng VC + FMOH per unt) x unts n endng nventory
Variable Costin: manufacturng VC x unts n endng nventory

3perational /udetin:
Production budet 8in units.: Begnnng unts + unts produced = unts sod + endng unts

Cash budet 8in dollars.: Begnnng cash + recepts = endng cash + dsbursements

Capital /udetin:
%et Present Value 8%PV. = the present vaue of current and future cash nows mnus the present
vaue of current and future cash outows.
Internal Rate o" Return 8IRR. = the nterest rate computed such that the %PV of the pro|ect s zero.
PaybacG Period = net nvestment average annua cash ow
Accountin Rate o" Return (ARR), aso caed the /ooG Rate o" Return:

ARR

= Average annua ncome
average book nvestment

Where, for exampe, average annua ncome equas cash ow ess deprecaton expense, and average book
nvestment s net of accumuated deprecaton.

1ivisional Per"or#ance Evaluation Tools:
Return on Invest#ent 8R3I. = dvsona operatng prot dvsona nvestment.
Aso, ROI ? nvestment turnover x prot margn;
Where: prot margn = operatng prots revenues;
And: nvestment turnover = revenues nvestment.
Residual Inco#e ? operatng prot - (hurde rate x dvsona nvestment) where operatng prot does
not reect a deducton for nterest expense.
174
Trans"er pricin:
Trans"er prices are used to vaue goods or servces exchanged between dvsons of a decentrazed
rm. The transfer prce s the prce one dvson charges another dvson for an ntermedate product.
The seng dvson s the upstrea# division and the buyng dvson s the do6nstrea# division.
Three methods for settng transfer prces are a #arGet*based transfer prce; a neotiated transfer
prce; and a cost*based transfer prce.

Three Co##on Costin $yste#s:



Actual Costin $yste#

%or#al Costin $yste#

$tandard Costin $yste#

1irect
Costs:

(Actual prces or rates x
actual quantty of nputs per
output) x actual outputs

(Actual prces or rates x
actual quantty of nputs per
output) x actual outputs

(/udeted prces or rates x
standard inputs allo6ed for
each output) x actual outputs

3verhe
ad
Costs:

Actual overhead rates x
actual quantty of the
aocaton base ncurred.

/udeted overhead rates x
actual quantty of the
aocaton base ncurred.

/udeted overhead rates x
(standard inputs allo6ed for
actua outputs acheved)
;lossary!

Absorption costing! , calculation of product costs that includes all manufacturing costs2 labor, materials, variable overhead and
fixed overhead ,bsorption costing is required under G,,9 ,lternatives are variable costing and throughput costing

Accounting rate o# return CA11A! , capital budgeting performance measure that divides the average income from the pro+ect by
the average book investment in the pro+ect, where these averages are over the life of the pro+ect

Activity2based costing CA:CA! , costing system characteri>ed by the use of multiple overhead pools, each with its own
allocation base, and by the choice of cost drivers for the allocation bases

Actual costing system! , costing system that determines costs by using actual prices and quantities of inputs The term is used to
distinguish actual costing from costing systems that rely on budgeted numbers, such as a normal costing system or a standard
costing system The implicit assumption throughout financial accounting is that the accounting information reported is not
materially different from what would be reported under an actual costing system

Asset turnover ratio! , divisional or company-wide performance measure ,t the divisional level, it is calculated as divisional
revenues divided by divisional investment

:alanced scorecard! , performance measurement tool and performance management system that includes nonfinancial measures
as well as traditional financial measures

:asic pro#it equation! The statement that2

profits ; )sales price variable cost* x units sold fixed costs

This equation forms the basis for cost-volume-profit analysis The term )but not the formula* is specific to this book

:atch2level costs! 3osts for which the number of batches run is a key cost driver These costs change in a more-or-less linear
fashion with the number of batches run Eatch-level costs are a typical part of the cost hierarchy in a batch manufacturing
environment

:ilateral ta4 treaties! ,n agreement between two nations that determines how each nation will tax multinational companies that
conduct business in both countries

:oo7 rate o# return! &ynonymous with accounting rate of return

:rea7even analysis! 3ost-volume-profit analysis under the assumption of >ero profits ?sually, it is the determination of the
volume of unit sales required to earn >ero profits

:udget! , plan for the future, expressed in quantitative terms
175

Committed costs! 3osts that will occur in the future, and that cannot be avoided

Common costs! 3ost of resources that benefit multiple parts of the organi>ation The term also refers to costs incurred up to the
split-off point, in a +oint product manufacturing process

Contribution margin! &ales minus variable costs The contribution margin can be calculated either for an individual unit )in
which case it is sometimes called the unit contribution margin* or for all sales activity for a given period &ee also the following
entry

Contribution margin income statement! ,n income statement that subtracts variable costs )variable cost-of-goods-sold plus
variable period costs* to derive contribution margin, and then subtracts fixed costs to derive operating income ,n alternative
income statement format is a gross margin income statement

Conversion costs! ,ll manufacturing costs other than direct materials

Cost! Iesources sacrificed to achieve a specific ob+ective

Cost accounting! This term is sometimes used synonymously with management accounting, and sometimes used to refer to the
accounting system and methods used to determine and track the cost of inventory in manufacturing and merchandising firms

Cost allocation! The assignment of overhead costs to the cost ob+ect The term also refers to the assignment of common costs to
+oint products, and the assignment of service department costs to user departments

Cost allocation base! , quantitative characteristic shared by multiple cost ob+ects that is used to allocate overhead costs among
the cost ob+ects , cost allocation base can be a financial measure or a nonfinancial measure 3ommon cost allocation bases in a
manufacturing setting are direct labor hours, machine hours, and direct labor dollars

Cost center! , responsibility center of the organi>ation that is held responsible for the costs that it incurs, but not for revenues or
capital investments , factory is a likely cost center, as is the human resources department

Cost driver! , cost driver is an economic concept %t is something that increases costs2 if the organi>ation incurs more of the
driver, the organi>ation incurs more costs 1ost cost ob+ects have multiple cost drivers Typical cost drivers for the production of
blue +eans include the price of fabric, sewing operator time, and electric rates

Cost hierarchy! , grouping of costs according to functional or operational levels within the organi>ation that serve as key cost
drivers %n a manufacturing environment, the hierarchy often consists of the overall facility, then products made in that facility,
then batches of product, and then individual units

Cost ob9ect! ,nything that management of the organi>ation wants to know the cost of !or manufacturing firms, typical cost
ob+ects are products and facilities !or service sector companies, typical cost ob+ects are the delivery of services to specific clients

Cost pool! , grouping of overhead cost items for the purpose of allocating those costs to cost ob+ects Cften, an attempt is made
to ensure that the costs in each cost pool are homogenous

Cost2plus contract! , sales contract in which the sales price is a function of the cost of making the product or providing the
customer the service

Depreciation ta4 shield! The reduction in tax expense in any given year due to the reduction in income that arises from the
recognition of depreciation expense on capital assets

Di##erential costs! &ynonymous with relevant costs

Direct cost! 3osts that can be traced to the cost ob+ect in an economically feasible way Birect costs are distinguished from
overhead costs

Direct costing! &ynonymous with variable costing The term is seldom used anymore

Direct method! , method of allocating service department costs to user departments that, for simplicity, ignores services
provided by service departments to other service departments

Discount rate! , finance term that represents a measure of the time value of money

176
Do$nstream division! The buying division in a transfer pricing scenario

Do$n$ard demand spiral! The decline in sales that occurs when sales prices are raised to cover the higher fixed-cost-per-unit
that occurs from either an increase in fixed overhead or an earlier decline in sales The process repeats itself, as the subsequent
decline in sales may prompt another price increase

=##iciency variance! The difference between actual costs and budgeted costs that is due solely to the difference between the
quantity of inputs actually used for the output achieved, and the quantity of inputs that should have been used for the output
achieved

=quivalent units! , concept used to facilitate the valuation of work-in-process by costing partially finished units as a percentage
of the cost of finished units, where the percentage is determined by the stage of completion of the units in (%9 ,n equivalent unit
represents the resources necessary to complete one unit, even though those resources might have been incurred to bring two units
halfway to completion, or four units one-quarter of the way to completion, etc

=4penses! 3osts charged against revenue in a particular accounting period

3acility2level costs! 3osts that are fixed with respect to the facility, and are not associated with a particular product or production
line in the facility !acility-level costs are typically identified as part of the cost hierarchy

303O C3irst2in, 3irst2outA! ,n inventory flow assumption that the first units made are the first units sold )ie, the oldest units in
inventory are the units sold* ,lternative inventory flow assumptions are D%!C and the weighted average method

3inancial accounting! ,ccounting information and financial reports prepared for users external to the organi>ation, such as
investors, creditors, regulators and stock analysts !inancial accounting is distinguished from management accounting

3i4ed cost! , cost that is not expected to change, in total, due to changes in the level of activity )eg, production or sales* within
the relevant range

3le4ible budget! , 6budget8 prepared after the end of the period that multiplies the originally-budgeted cost )or revenue* per unit
by the actual units made )or sold* , flexible budget answers the question2 what would % have budgeted, if % had known how many
units % would have made or sold

3le4ible budget variance! , performance measurement tool that compares actual costs )revenues or profits* to the costs
)revenues or profits* in the flexible budget

3ull costing! %n this textbook, full costing is synonymous with absorption costing 1ore generally, full costing can also refer to
the inclusion of nonmanufacturing as well as manufacturing costs in the determination of product costs

;enerally Accepted Accounting /rinciples C;AA/A! !inancial accounting and reporting standards promulgated by a regulatory
or self-regulatory body that are mandatory for external reporting purposes for companies that meet certain criteria G,,9 for ?&
public companies is promulgated by the !inancial ,ccounting &tandards Eoard, with oversight from the &E3

;oal congruence! The alignment of the incentives of managers with the incentives of shareholders 1ore generally, the term
refers to aligning incentives of any two parties in a principal-agent relationship, which includes any setting in which authority and
responsibility have been delegated

;ross margin income statement! ,n income statement that subtracts cost-of-goods-sold from revenue to derive gross margin,
and then subtracts period costs to derive operating income Jirtually all income statements prepared for financial accounting
purposes are gross margin income statements ,n alternative income statement format is a contribution margin income statement

<urdle rate! , targeted rate of return set by senior management to communicate to managers in the company the criterion by
which to accept or re+ect a capital pro+ect proposal

0dle capacity variance! , term used synonymously with the volume variance when capacity is the denominator-level concept in
the fixed overhead rate

0ndirect costs! &ynonymous with overhead costs

0nstitute o# Management Accountants C0MAA! The most important professional association of management accountants in the
?nited &tates The %1, is headquartered in 1ontvale, NL, and has local chapters throughout the ?&

177
0ntermediate product! , product made by one part of a company and used by another part of the same company in its production
process Transfer prices are often used to 6price8 internal sales of intermediate products

0nternal rate o# return C011A! , capital budgeting performance measure that represents the discount rate required to achieve a
net present value of >ero for the pro+ect

0nventoriable costs! 3osts that are debited to inventory for either external or internal reporting purposes !or manufacturing
firms, inventoriable costs are either the complete set, or a subset of manufacturing costs

0nvestment center! , responsibility center of the organi>ation that is held responsible for revenues, costs and capital investments
%nvestment centers are highly-autonomous units of the organi>ation, with substantial decision-making authority , division is a
likely investment center

0nvestment turnover ratio! &ynonymous with asset turnover ratio

8oint costs! &ynonymous with common costs in the context of +oint products

8ust2in2time C80TA! , manufacturing practice characteri>ed by maintaining inventories at their lowest possible levels

G03O CGast2in, 3irst2outA! ,n inventory flow assumption that the last units made are the first units sold ,lternative inventory
flow assumptions are !%!C and the weighted average method

Management accounting! ,ccounting information prepared for individuals in the organi>ation, particularly managers, to assist
them in planning, performance evaluation, and coordination of business processes 1anagement accounting is distinguished from
financial accounting

Managerial accounting! &ee management accounting

Master budget! , comprehensive set of budgets for a given period that usually consists of a pro forma income statement and
balance sheet and supporting schedules such as a cash budget and production budget

Misapplied overhead! The difference between actual overhead incurred in a given period and overhead applied to cost ob+ects
during that period

Mi4ed cost! , cost that is neither variable )in a linear fashion* nor fixed within the relevant range Cften, mixed costs are
comprised of a variable component and a fixed component

5ational Association o# Accountants C5AAA! The former name of the %nstitute of 1anagement ,ccountants )%1,*

5egative e4ternality! 3osts imposed by companies on the public or specific third parties that do not arise from a contractual
relationship , classic example of a negative externality is pollution generated by a factory

5et present value! , capital budgeting performance measure that discounts all future cash inflows and outflows associated with
the capital pro+ect to the present, and then sums the present values of all inflows and outflows associated with the pro+ect

5ormal capacity! the level of facility activity that satisfies average customer demand over an intermediate period of time %t
frequently averages over seasonal or cyclical fluctuations in demand

5ormal costing system! , costing system that tracks costs by using actual direct costs of the cost ob+ect, and applying overhead
using a budgeted overhead rate and actual quantities of the allocation base incurred The only difference between an actual costing
system and a normal costing system is the use of budgeted overhead rates

Operating pro#it percentage! &ynonymous with return on sales )IC&*

Opportunity cost! The profit foregone by selecting one alternative over another

Overhead costs! 3osts that are associated with the cost ob+ect, but cannot be traced to the cost ob+ect in an economically feasible
way Cverhead costs are distinguished from direct costs

Overhead rate! The ratio of overhead costs to the total quantity of the cost allocation base This ratio is used to allocate overhead
costs to cost ob+ects

178
/aybac7 period! , capital budgeting performance measure that estimates the period of time required to recoup the initial
investment in the asset

/eriod costs! 3osts that are expensed when incurred )sub+ect to the principles of accrual accounting*, because they cannot be
associated with the manufacture of products

/ractical capacity! , measure of factory capacity )or other types of facility output* that allows for anticipated unavoidable
operating interruptions and maintenance

/rice variance! %n the context of variable costs, the price variance is the difference between actual costs and budgeted costs that is
due solely to the difference between the actual price per unit of input and the budgeted price per unit of input %n the context of
fixed overhead, the price variance is synonymous with the spending variance

/rime costs! &ynonymous with direct costs

/roduct costs! ,ny cost that is associated with units of product for a particular purpose

/roduction volume variance! &ee volume variance

/roduct2level costs! 3osts that are direct and fixed with respect to a particular product 9roduct-level costs are a typical part of
the cost hierarchy

/ro#it center! , responsibility center of the organi>ation that is held responsible for the revenues and costs that it incurs, but not
for capital investments , product line is a likely profit center

/ro #orma #inancial statements! !inancial statements pro+ected for a future period based on budgeted or hypothetical levels of
activity

>uantity variance! The efficiency variance for direct materials This variance is also called the usage variance

1eciprocal method! , method of allocating service department costs to user departments that solves a set of simultaneous
equations in order to fully account for services provided by service departments to other service departments

1elevant costs! 3osts that are relevant with respect to a particular decision , relevant cost for a particular decision is one that
changes if an alternative course of action is taken

1elevant range! The range of activity )eg, production or sales* over which fixed costs are fixed and variable costs are variable
%n other words, a fixed cost is called fixed if it behaves as a fixed cost within the relevant range, even if it behaves as a semi-
variable cost over a wider range of activity than specified by the relevant range &imilarly, a variable cost is called variable if it is
linear in output over the relevant range, even if linearity no longer holds outside of the relevant range

1esidual income! , divisional or company-wide performance measure that subtracts a charge for the cost of capital from after-
tax operating income Iesidual income represents an attempt to use accounting information to approximate economic profits

1esponsibility center! , department, division, or any area of activity that is tracked separately by the accounting system, and that
is under the control of a manager who is responsible for the performance of the center

1eturn o# investment C1O0A! , divisional or company-wide performance measure ,t the divisional level, it is calculated as
divisional income divided by divisional investment

1eturn on assets C1OAA! , company-wide performance measure that is calculated as income divided by total assets (hen
applied to a division within a company, the same calculation is sometimes called return on investment )IC%*

1eturn on equity C1O=A! , company-wide performance measure that is calculated as income divided by equity

1eturn on sales C1OSA! , divisional or company-wide performance measure %t is calculated as income divided by revenue

Semi2variable costs! &ynonymous with mixed costs

Separable costs! 3osts incurred by +oint products after the split-off point

Sequential method! &ynonymous with the step-down method

179
Spending variance! (ith respect to variable overhead, the spending variance is analogous to the price variance for variable direct
costs (ith respect to fixed overhead, the spending variance is the difference between actual fixed costs and budgeted fixed costs

Split2o## point! The point in a +oint manufacturing process at which +oint products take on separate identities 3osts incurred prior
to this point are common costs 3osts incurred on +oint products after the split-off point are separable costs

Standard cost! , budgeted cost, usually stated on a per-unit basis, and usually based on a rigorous determination of the quantities
of inputs required to produce the output, and the prices of those inputs

Standard costing system! , costing system that tracks product costs using standard costs during the period, and makes
appropriate ad+ustments for the differences between actual costs and standard costs at the end of the period 1ost manufacturing
firms use standard costing systems

Standard quantity! Eudgeted inputs to produce one unit of output ,lternatively, the budgeted inputs to produce any specified
level of output, particularly the level of output actually achieved during the period

Static budget! , budget that is based on pro+ected levels of activity, prior to the start of the period %t is the 6original8 budget for
the period, not updated as information about the period becomes known

Static budget variance! The difference between actual revenues or costs for a period, and revenues or costs as originally
budgeted for the period and as reported in the static budget

Step2do$n method! , method of allocating service department costs to user departments that accounts for some of the services
provided by service departments to other service departments &ervice department costs are allocated one at a time, and each
service department-s costs are allocated to user departments and to any service departments the costs of which have not yet been
allocated

Sun7 cost! 3osts that were incurred in the past

Super2variable costing! &ynonymous with throughput costing

Target costing! The determination of the per-unit variable cost necessary to achieve desired profits, followed by efforts by those
responsible for product design and manufacturing to achieve the desired per-unit cost

Theoretical capacity! , measure of factory capacity )or other types of facility output* that assumes .''$ efficiency all of the
time %t is a performance benchmark, but generally not an attainable standard

Theory o# constraints! , relatively new operations management tool that increases production throughput and decreases
inventory levels by identifying bottleneck operations and increasing throughput at those operations

Throughput costing! , calculation of product costs that includes only direct materials ,ll conversion costs are treated as period
expenses 1ore traditional alternatives are absorption costing and variable costing

Throughout margin! ,n income statement subtotal that arises when throughput costing is used )see previous entry* The subtotal
is revenues minus cost-of-goods-sold, where cost-of-goods-sold consists of only direct materials associated with units sold

Total quality management CT>MA! The practice of eliminating defects in raw materials and the production process 1ore
generally, the practice of eliminating defects in all aspects of the organi>ation-s value chain T`1 is synonymous with >ero defect
programs

Trans#er price! The amount that one part of a company charges another part of the same company for goods or services Cften,
the term is used in connection with intermediate products that are manufactured by one division, and used by another division in
its manufacturing process

Triple2bottom2line! ,n external reporting method and format that reports the firm-s performance separately along each of three
dimensions2 financial, environmental and social

Unit contribution margin! The per-unit sales price minus per-unit variable costs

Unit2level costs! 3osts for which the number of units produced is a key cost driver These costs change in a more-or-less linear
fashion with the number of units produced ?nit-level costs are a typical part of the cost hierarchy in a manufacturing
environment

180
Upstream division! The selling division in a transfer pricing scenario

Usage variance! The efficiency variance for direct materials This variance is also called the quantity variance

Ealue chain! The sequence of activities that creates value in an organi>ation

Eariable cost! , cost that varies in a linear fashion with the level of activity )eg, production or sales* within the relevant range

Eariable costing! , calculation of product costs that includes all direct manufacturing costs and variable manufacturing overhead,
but not fixed manufacturing overhead ?nder variable costing, fixed manufacturing overhead is treated as a period cost
,lternatives are absorption costing and throughput costing

Eolume variance! %n this book, this term refers only to the fixed overhead volume variance This variance is the difference
between budgeted fixed overhead and the amount of fixed overhead allocated to production using a standard costing system ,s
such, it is a function of actual production volume relative to the denominator used in the fixed overhead rate Eeyond this book,
the term volume variance sometimes refers to the sales volume variance, which is the difference between budgeted revenue and
actual revenue that is due solely to sales volume differing from budgeted volume

6age rate variance! The price variance in the context of direct labor costs %t is the difference between actual costs and budgeted
costs that is due solely to the difference between the actual average wage rate and the budgeted average wage rate
Copyright &..* These materials are available under the terms o# a Creative Commons /ublic Gicense CCC/GA The
CC/G is an attribution, non2commercial, share2ali7e license 3or details, visit! http!""creativecommonsorg"licenses"by2nc2
sa"'."
181