Management Accounting by Cabrera 291 315

MANAGEMENT ACCOUNTING - Solutions Manual
TABLE OF CONTENTS
Chapter 1 1-1 – 1-19

MANAGEMENT ACCOUNTING: AN OVERVIEW
2 Management Accounting and the Business Environment 2-1 – 2-5

3 Understanding of Financial Statements 3-1 – 3-10
4 Financial Statements Analysis – I 4-1 – 4-9

5 Financial Statements Analysis – II 5-1 – 5-38
6 Cash Flow Analysis 6-1 – 6-18
7 Gross Profit Valuation Analysis and Earnings Per Share
Determination 7-1 – 7-7
8 Cost Concepts and Classifications 8-1 – 8-17
9 Cost Behavior: Analysis and Use 9-1 – 9-30
1 Systems Design: Job-Order Costing and Process Costing 10-1– 10-16
0
11 Systems Design: Activity-Based Costing and 11-1 – 11-15
Management
1 Variable Costing 12-1– 12-21
2
1 Cost-Volume-Profit Relationships 13-1– 13-37
3
1 Responsibility Accounting and Transfer Pricing 14-1– 14-26
4
1 Functional and Activity-Based Budgeting 15-1– 15-22
5
1 Standard Costs and Operating Performance Measures 16-1– 16-17
6
1 Application of Quantitative Techniques in Planning,
7 Control and Decision Making - I 17-1– 17-2
1 Application of Quantitative Techniques in Planning,
8 Control and Decision Making – II 18-1– 18-7
1 Relevant Costs for Decision Making 19-1– 19-33
9
1-1
Chapter 1 Management Accounting: An Overview
2 Capital Budgeting Decisions 20-1– 20-16

0
2 Decentralized Operations and Segment Reporting 21-1– 21-4
1
2 Business Planning 22-1– 22-6
2
2 Strategic Cost Management; Balanced Scorecard 23-1– 23-4
3
2 Advanced Analysis and Appraisal of Performance:
4 Financial and Nonfinancial 24-1– 24-12
2 Managing Productivity and Marketing Effectiveness 25-1– 25-19
5
2 Executive Performance Measures and Compensation 26-1– 26-3
6
2 Managing Accounting in a Changing Environment 27-1– 27-22
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CHAPTER 1
MANAGEMENT ACCOUNTING: AN OVERVIEW
I. Questions
1. Use of the word “need” in the quoted passage is pejorative. It implies an

unlimited level of demand for information. However, rational managers apply
a cost-benefit criterion to information and will only want accounting
information if its benefits exceed its costs. Accounting information provides
benefits by improving decision making and controlling behavior in
organizations. In most organizations, accounting information is very prevalent
which implies that its benefits exceed its costs. Hence, successful managers
will find it in their self-interest to learn how to use accounting information in
these organizations.
Clearly, this statement is incurred in those firms where accounting information
has very limited usefulness (e.g., if the accounting information is often wrong
or is not produced in a timely fashion). In these organizations, managers do
not find the accounting information to have benefits in excess of its costs, will
not use it, do not need to know how to use it, and definitely do not need it.
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Management Accounting: An Overview Chapter 1
2. a. Historical costs are of limited use in making planning decisions in a

rapidly changing environment. With changing products, processes and
prices, the historical costs are inadequate approximations of the
opportunity costs of using resources.
Historical costs may, however, be useful for control purposes, as they
provide information about the activities of managers and can be used as
performance measures to evaluate managers.
b. The purpose of accounting systems is to provide information for planning
purposes and control. Although historical costs are not generally
appropriate for planning purposes, additional measures are costly to make.
An accounting system should include additional measures if the benefits of
improved decision making are greater than the costs of the additional
information.
3. Finance and economics textbooks traditionally state that the goal of a profit
organization is to maximize shareholder wealth. Managers are frequently
presumed to act in the best interest of the shareholder, although recent finance
literature recognizes that appropriate incentives are necessary to align manager
interests with shareholder interests. The goal, however, are not very clear as to
how this is achieved. Most finance textbooks focus on financing decisions and
not on the use of assets and dealing with customers.
Marketing’s goal of satisfying customers recognizes that customers are the
source of revenues for the organization, and therefore the means through which
shareholder value is increased. However, customer satisfaction is only valuable
insofar as it creates shareholder wealth. The further goal of marketing is to
ensure that customer satisfaction is maximized without compromising the
organization’s profitability.
4. Yes. Planning is really much more vital than control; that is, superior control is
fruitless if faulty plans are being implemented. However, planning and control
are so intertwined that it seems artificial to draw rigid lines of separation
between them.
5. Yes. The controller has line authority over the personnel in his own department
but is a staff executive with respect to the other departments.
6. Line authority is exerted downward over subordinates. Staff authority is the

authority to advise but not command others; it is exercised laterally or upward.
Functional authority is the right to command action laterally and downward
with regard to a specific function or specialty.
7. Cost accounting is the controller’s primary means of implementing the 7-point

concept of modern controllership. Cost accounting is intertwined with all
seven duties to some extent, but its major focus is on the first three.
8. Bettina Company
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President
VP, VP, Finance VP, Sales

Production
Controller Treasurer
Assistant Assistant
Controller Treasurer
Special Cost Tax Internal General System

Studies Accounti Manag Audit Accounti &
Manage ng er Manage ng EDP
r Manager r Manager Manage
r
Cost Budget & Performa

Systems Standard nce
Analyst Cost Analyst
Analyst
Cost Payroll Account Accoun Billing General

Clerk Clerk s ts Clerk Ledger
Receiva Payable Bookkeepe
ble Clerk r
Clerk
9. Management accountants contribute to strategic decisions by providing

information about the sources of competitive advantage and by helping
managers identify and build a company’s resources and capabilities.
10. In most organizations, management accountants perform multiple roles:

problem solving (comparative analyses for decision making), scorekeeping
(accumulating data and reporting reliable results), and attention directing
(helping managers properly focus their attention).
11. Three guidelines that help management accountants increase their value to
managers are (a) employ a cost-benefit approach, (b) recognize behavioral as
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well as technical considerations, and (c) identify different costs for different
purposes.
12. Management accounting is an integral part of the controller’s function in an

organization. In most organizations, the controller reports to the chief financial
officer, who is a key member of the top management team.
13. Management accountants have ethical responsibilities that are related to

competence, confidentiality, integrity, and objectivity.
14. By reporting and interpreting relevant data, the controller exerts a force or
influence that impels management toward making better-informed decisions.
The controller of one company described the job as “a business advisor to…
help the team develop strategy and focus the team all the way through
recommendations and implementation.”
15.
Financial Accounting
Audience: External: shareholders, creditors, tax authorities
Purpose: Report on past performance to external parties;
basis of contracts with owners and lenders
Timeliness: Delayed; historical
Restrictions: Regulated; rules driven by generally accepted
accounting principles and government authorities
Type of Information: Financial measurements only
Nature of Information: Objective, auditable, reliable, consistent, precise
Scope: Highly aggregate; report on entire organization
Managerial Accounting
Audience: Internal: Workers, managers, executives
Purpose: Inform internal decisions made by employees and
managers; feedback and control on operating
performance
Timeliness: Current, future oriented
Restrictions: No regulations; systems and information
determined by management to meet strategic and
operational needs
Type of Information: Financial, plus operational and physical
measurements on processes, technologies,
suppliers customers, and competitors
Nature of Information: More subjective and judgmental; valid, relevant,
accurate
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Scope: Disaggregate; inform local decisions and actions
16. The competitive environment has changed dramatically. Companies

encountered severe competition from overseas companies that offered high-
quality products at low prices. Activity-based costing systems are introduced in
many manufacturing and service organizations to overcome the inability of
traditional cost systems to accurately assign overhead costs. Activity-based
management is a viable approach for managers to make decisions based on
ABC information. There has been improvement of operational control systems
such that information is more current and provided more frequently. The
nature of work has changed from controlling to informing. Firms are
concerned about continuous improvement, employee empowerment and total
quality. Nonfinancial information has become a critical feedback measure.
Finally, the focus of many firms is on measuring and managing activities.
17. As measurements are made on operations and, especially, on individuals and

groups, the behavior of the individuals and groups are affected. People will
react to the measurements being made by focusing on the variables or behavior
being measured. In addition, if managers attempt to introduce or redesign cost
and performance measurement systems, people familiar with the previous
system will resist. Management accountants must understand and anticipate
the reactions of individuals to information and measurements. The design and
introduction of new measurements and systems must be accompanied with an
analysis of the likely reactions to the innovations.
II. Exercises
Exercise 1
a. (1) Problem solving

b. (3) Attention-directing
c. (1) Problem solving
d. (2) Scorekeeping
Exercise 2
a. (4) Marketing
b. (3) Production
c. (6) Customer service
d. (5) Distribution
Exercise 3
a. (4) Marketing
b. (3) Production
c. (5) Distribution
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d. (4) Marketing
e. (5) Distribution
f. (3) Production
g. (1) Research and development
h. (2) Design
III. Problems
Problem 1 (Problem Solving, Scorekeeping, and Attention Directing)
Because the accountant’s duties are often not sharply defined, some of these answers
might be challenged:
1. Scorekeeping
2. Attention directing
3. Scorekeeping
4. Problem solving
7. Problem solving
8. Scorekeeping (depending on the extent of the report) or attention getting
9. This question is intentionally vague. The give-and-take of the budgetary
process usually encompasses all three functions, but it emphasizes
scorekeeping the least. The main function is attention directing, but
problem solving is also involved.
10. Problem solving
Problem 2 (Management Accounting Information System)
1. Inputs: b, g, i, m
2. Processes: a, d, f, j
3. Outputs: e, k, n
4. System objectives: c, h, l
Problem 3 (Role of Management Accountants)
Planning. The management accountant gains an understanding of the impact on

the organization of planned transactions (i.e., analyzing strengths and weaknesses)
and economic events, both strategic and tactical, and sets obtainable goals for the
organization. The development of budgets is an example of planning.
Controlling. The management accountant ensures the integrity of financial

information, monitors performance against budgets and goals, and provides
information internally for decision making. Comparing actual performance against
budgeted performance and taking corrective action where necessary is an example
of controlling. Internal auditing is another example.
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Evaluating Performance. The management accountant judges and analyzes the

implication of various past and expected events, and then chooses the optimum
course of action. The management accountant also translates data and
communicates the conclusions. Graphical analysis (such as trend, bar charts, or
regression) and reports comparing actual costs with budgeted costs are examples of
evaluating performance.
Ensuring Accountability of Resources. The management accountant implements a

reporting system closely aligned to organizational goals that contribute to the
measurement of the effective use of resources and safeguarding of assets. Internal
reporting such as comparison of actual to budget is an example of accountability.
External Reporting. The management accountant prepares reports in accordance

with generally accepted accounting principles and then disseminates this
information to shareholders, creditors, and regulatory tax agencies. An annual
report or a credit application are examples of external reporting.
Problem 4 (Line Versus Staff)
Jamie Reyes is staff. She is in a support role – she prepares reports and helps
explain and interpret them. Her role is to help the line managers more effectively
carry out their responsibilities.
Stephen Santos is a line manager. He has direct responsibility for producing a

garden hose. Clearly, one of the basic objectives for the existence of a
manufacturing firm is to make a product. Thus, Stephen has direct responsibility
for a basic objective and therefore holds a line position.
Problem 5 (Professional Ethics and End-of-Year Games)
Requirement 1
The possible motivations for the snack foods division wanting to play end-of-year
games include:
(a) Management incentives. Yummy Foods may have a division bonus scheme
based on one-year reported division earnings. Efforts to front-end revenue into
the current year or transfer costs into the next year can increase this bonus.
(b) Promotion opportunities and job security. Top management of Yummy Foods
likely will view those division managers that deliver high reported earnings
growth rates as being the best prospects for promotion. Division managers who
deliver “unwelcome surprises” may be viewed as less capable.
(c) Retain division autonomy. If top management of Yummy Foods adopts a
“management by exception” approach, divisions that report sharp reductions in
their earnings growth rates may attract a sizable increase in top management
supervision.
Requirement 2
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The “Standards of Ethical Conduct…” require management accountants to:

 Refrain from either actively or passively subverting the attainment of the
organization’s legitimate and ethical objectives, and
 Communicate unfavorable as well as favorable information and
professional judgment or opinions.
Several of the “end-of-year games” clearly are in conflict with these requirements
and should be viewed as unacceptable by Tan:
(a) The fiscal year-end should be closed on midnight of December 31.
“Extending” the close falsely reports next year’s sales as this year’s sales.
(b) Altering shipping dates is falsification of the accounting reports.
(c) Advertisements run in December should be charged to the current year. The
advertising agency is facilitating falsification of the accounting records.
The other “end-of-year games” occur in many organizations and may fall into the
“gray” to “acceptable” area. However, much depends on the circumstances
surrounding each one:
(a) If the independent contractor does not do maintenance work in December, there
is no transaction regarding maintenance to record. The responsibility for
ensuring that packaging equipment is well maintained is that of the plant
manager. The division controller probably can do little more than observe the
absence of a December maintenance charge.
(d) In many organizations, sales are heavily concentrated in the final weeks of the
fiscal year-end. If the double bonus is approved by the division marketing
manager, the division controller can do little more than observe the extra bonus
paid in December.
(e) If TV spots are reduced in December, the advertising cost in December will be
reduced. There is no record falsification here.
(g) Much depends on the means of “persuading” carriers to accept the
merchandise. For example, if an under-the-table payment is involved, it is
clearly unethical. If, however, the carrier receives no extra consideration and
willingly agrees to accept the assignment, the transaction appears ethical.
Each of the (a), (d), (e) and (g) “end-of-year games” may well disadvantage Yummy
Foods in the long run. For example, lack of routine maintenance may lead to
subsequent equipment failure. The divisional controller is well advised to raise
such issues in meetings with the division president. However, if Yummy Foods has
a rigid set of line/staff distinctions, the division president is the one who bears
primary responsibility for justifying division actions to senior corporate officers.
Requirement 3
If Tan believes that Ryan wants her to engage in unethical behavior, she should first
directly raise her concerns with Ryan. If Ryan is unwilling to change his
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request, Tan should discuss her concerns with the Corporate Controller of Yummy
Foods. Tan also may well ask for a transfer from the snack foods division if she
perceives Ryan is unwilling to listen to pressure brought by the Corporate
Controller, CFO, or even President of Yummy Foods. In the extreme, she may want
to resign if the corporate culture of Yummy Foods is to reward division managers
who play “end-of-year games” that Tan views as unethical and possibly illegal.
Problem 6
James Torres has come up with a scheme that involves a combination of data
falsification and smoothing! Not only has he made up the revenue numbers, but
also he has had the gall to defer some of them to the next period. Making up such
numbers is clearly illegal. Smoothing, in this example is also illegal because the
numbers are fictitious.
Problem 7
Clearly the vice-president will lose his or her job if you turn him or her in. Given
that this is a major violation of the code of ethics and a violation patent law, the
vice-president could go to jail. Your best course of action is to check your
information and if the vice-president is definitely involved, go immediately to the
VP’s superior (who is probably a senior VP or the company president). The
organization’s attorneys will take over from there.
Problem 8
One option is to do nothing and ignore what you saw, however, this may violate
your own code of ethics and your ethical responsibilities under the organization’s
code of ethics. Given that you want to do something, it is probably best to start by
talking to employees in your organization whose job it is to deal with ethical issues.
If no such employees exist or are available, you might start by using a decision
model. This model incorporated the following steps:
1. Determine the Facts – What, Who, Where, How
2. Define the Ethical Issue
3. Identify Major Principles, Rule, Values
4. Specify the Alternatives.
5. Compare Values and Alternatives, See if Clear Decision
6. Assess the Consequences.
7. Make Your Decision.
IV. Cases
Case 1 (Financial vs. Managerial Accounting)
Requirement (a)
Other forward looking information desired in addition to the income statement
information are
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1. Disclosure of the components of financial performance, i.e., nature and

source of revenues, various activities, transactions, and other relevant
events affecting the company.
2. Nature and function of the components of income and expenses
Requirement (b)
No. GAAP does not allow capitalization of employee training and advertising costs
even if management feels that they increase the value of the company’s brand name.
The reasons are uncertainty of the future benefits that may be derived therefrom and
difficulty and reliability of their measurement.
Requirement (c)
Detailed information that managers would likely request are analysis of the
significant increases in
1. Sales
2. Cost of sales
3. Payroll
4. Stock and option based compensation
5. Advertising and promotion.
Requirement (d)
Nonmonetary measures:
1. Change in number and profile of customers
2. Share in the market
3. Who, what and how many are the competitors
4. Product lines offered by the entity vs. Product lines of competitors
5. Sales promotion and advertising activities
Requirement (e)
1. Competitors
2. Employees
3. Prospective creditors
Case 2 (You get what you measure!)
Requirement (a)
Increase in sales to new customers to sales
Too much emphasis on this ratio may lead the sales manager to spend more time
developing business with new customers and disregard the needs of existing
customers. It is therefore possible to lose the business of several key accounts.
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Requirement (b)
Decrease in cost of goods sold to sales
This performance measure could create the following problems:
1. Purchasing goods with poor quality at lower cost and selling them for the
same price.
2. Indiscriminately increasing selling price to widen the profit margin
without regard to competitor’s current prices.
3. If the entity is manufacturing its own goods, managers could try to
economize on costs, i.e., buying poorer quality of materials, employing
unskilled workers, etc. thereby causing deterioration of the quality of the
finished products.
In all of the above situations, customer patronage could eventually be adversely

affected.
Requirement (c)
Decrease in selling and administrative expense to sales
Cost-cutting is generally advisable for as long as the quality of goods and services
are not compromised. Likewise, certain cost-saving measures could demotivate
sales people and other employees and could lead to counter-productive activities.
Case 3 (The Roles of Managers and Management Accountants)
1. Managerial accounting, Financial accounting

2. Planning
3. Directing and motivating
4. Feedback
5. Decentralization
6. Line
7. Staff
8. Controller
9. Budgets
10. Performance report
11. Chief Financial Officer
12. Precision; Nonmonetary data
Case 4 (Ethics in Business)
If cashiers routinely short-changed customers whenever the opportunity presented

itself, most of us would be careful to count our change before leaving the counter.
Imagine what effect this would have on the line at your favorite fast-food restaurant.
How would you like to wait in line while each and every customer laboriously
counts out his or her change? Additionally, if you can’t trust the cashiers to give
honest change, can you trust the cooks to take the time to follow health precautions
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such as washing their hands? If you can’t trust anyone at the restaurant would you
even want to eat out?
Generally, when we buy goods and services in the free market, we assume we are
buying from people who have a certain level of ethical standards. If we could not
trust people to maintain those standards, we would be reluctant to buy. The net
result of widespread dishonesty would be a shrunken economy with a lower growth
rate and fewer goods and services for sale at a lower overall level of quality.
Case 5 (Ethics and the Manager)
Requirement 1
Failure to report the obsolete nature of the inventory would violate the Standards of
Ethical Conduct as follows:
Competence
 Perform duties in accordance with relevant technical standards.
 Prepare complete reports using reliable information.
By failing to write down the value of the obsolete inventory, Perez would not be
preparing a complete report using reliable information. In addition, generally
accepted accounting principles (GAAP) require the write-down of obsolete
inventory.
Integrity
 Avoid conflicts of interest.
 Refrain from activities that prejudice the ability to perform duties ethically.
 Refrain from subverting the legitimate goals of the organization.
 Refrain from discrediting the profession.
Members of the management team, of which Perez is a part, are responsible for both
operations and recording the results of operations. Since the team will benefit from
a bonus, increasing earnings by ignoring the obsolete inventory is clearly a conflict
of interest. Perez would also be concealing unfavorable information and subverting
the goals of the organization. Furthermore, such behavior is a discredit to the
profession.
Objectivity
 Communicate information fairly and objectively.
 Disclose all relevant information.
Hiding the obsolete inventory impairs the objectivity and relevance of financial
statements.
Requirement 2
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As discussed above, the ethical course of action would be for Perez to insist on
writing down the obsolete inventory. This would not, however, be an easy thing to
do. Apart from adversely affecting her own compensation, the ethical action may
anger her colleagues and make her very unpopular. Taking the ethical action would
require considerable courage and self-assurance.
Case 6 (Preparing an Organization Chart)
Requirement 1
See the organization chart on page 17.
Requirement 2
Line positions would include the university president, academic vice-president, the
deans of the four colleges, and the dean of the law school. In addition, the
department heads (as well as the faculty) would be in line positions. The reason is
that their positions are directly related to the basic purpose of the university, which
is education. (Line positions are shaded on the organization chart.)
All other positions on the organization chart are staff positions. The reason is that
these positions are indirectly related to the educational process, and exist only to
provide service or support to the line positions.
Requirement 3
All positions would have need for accounting information of some type. For
example, the manager of central purchasing would need to know the level of current
inventories and budgeted allowances in various areas before doing any purchasing;
the vice president for admissions and records would need to know the status of
scholarship funds as students are admitted to the university; the dean of the business
college would need to know his/her budget allowances in various areas, as well as
information on cost per student credit hour; and so forth.
Requirement 1
No, Santos did not act in an ethical manner. In complying with the president’s
instructions to omit liabilities from the company’s financial statements he was in
direct violation of the IMA’s Standards of Ethical Conduct for Management
Accountants. He violated both the “Integrity” and “Objectivity” guidelines on this
code of ethical conduct. The fact that the president ordered the omission of the
liabilities is immaterial.
Requirement 2
No, Santos’ actions can’t be justified. In dealing with similar situations, the
Securities and Exchange Commission (SEC) has consistently ruled that “…
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corporate officers…cannot escape culpability by asserting that they acted as ‘good

soldiers’ and cannot rely upon the fact that the violative conduct may have been
condoned or ordered by their corporate superiors.” (Quoted from: Gerald H. Lander,
Michael T. Cronin, and Alan Reinstein, “In Defense of the Management
Accountant,” Management Accounting, May, 1990, p. 55) Thus, Santos not only
acted unethically, but he could be held legally liable if insolvency occurs and
litigation is brought against the company by creditors or others. It is important that
students understand this point early in the course, since it is widely assumed that
“good soldiers” are justified by the fact that they are just following orders. In the
case at hand, Santos should have resigned rather than become a party to the
fraudulent misrepresentation of the company’s financial statements.
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Case 6
Requirement 1
President
Vice
Vice Vice Academic Vice
Vice
President, President, President,
President President,
Auxiliary Admissions & Physical
Financial Plant
Services Records Services
(Controller)
Manager, Manager, Manager,

Manager, Manager, Manager, Manager, Plant
Central University Grounds &
University Computer Accounting &
Purchasing Bookstore Custodial
Press Services & Finance Maintenance
Services
Dean,
Dean, Business Dean, Dean, Dean,
Engineering &
Humanities Fine Arts Law School
Quantitative
(Departments) (Departments) (Departments) (Departments)
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Requirement 1
Andres Romero has an ethical responsibility to take some action in the matter of
PhilChem, Inc. and the dumping of toxic wastes. The Standards of Ethical
Conduct for Management Accountants specifies that management accountants
should not condone the commission of acts by their organization that violate the
standards of ethical conduct. The specific standards that apply are as follows.
• Competence. Management accountants have a responsibility to perform
their professional duties in accordance with relevant laws and regulations.
• Confidentiality. Management accountants must refrain from disclosing
confidential information unless legally obligated to do so. However, Andres
Romero may have a legal responsibility to take some action.
• Integrity. Management accountants have a responsibility to:
- refrain from either actively or passively subverting the attainment of
the organization’s legitimate and ethical objectives.
- communicate favorable as well as unfavorable information and
professional judgments or opinions.
• Objectivity. Management accountants must fully disclose all relevant
information that could reasonably be expected to influence an intended
user’s understanding of the reports, comments, and recommendations.
Requirement 2
The Standards of Ethical Conduct for Management Accountants indicates that the
first alternative being considered by Andres Romero, seeking the advice of his boss,
is appropriate. To resolve an ethical conflict, the first step is to discuss the problem
with the immediate superior, unless it appears that this individual is involved in the
conflict. In this case, it does not appear that Romero’s boss is involved.
Communication of confidential information to anyone outside the company is

inappropriate unless there is a legal obligation to do so, in which case Romero
should contact the proper authorities.
Contacting a member of the Board of Directors would be an inappropriate action at
this time. Romero should report the conflict to successively higher levels within the
organization and turn only to the Board of Directors if the problem is not resolved
at lower levels.
Requirement 3
Andres Romero should follow the established policies of the organization bearing
on the resolution of such conflict. If these policies do not resolve the ethical
conflict, Romero should report the problem to successively higher levels of
management up to the Board of Directors until it is satisfactorily resolved. There is
no requirement for Romero to inform his immediate superior of this action because
the superior is involved in the conflict. If the conflict is not resolved after
exhausting all courses of internal review, Romero may have no other recourse than
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Chapter 8 Cost Concepts and Classifications
to resign from the organization and submit an informative memorandum to an

appropriate member of the organization.
(CMA Unofficial Solution, adapted)
V. Multiple Choice Questions
1. D 11. D 21. B 31. D 41. A 51. B

2. D 12. D 22. B 32. C 42. C 52. B
3. D 13. D 23. A 33. D 43. D 53. A
4. B 14. A 24. A 34. B 44. B 54. C
5. D 15. A 25. B 35. D 45. C 55. D
6. A 16. A 26. C 36. B 46. B 56. C
7. B 17. D 27. B 37. C 47. A 57. C
8. D 18. A 28. D 38. B 48. B 58. C
9. D 19. D 29. B 39. A 49. C 59. A
10. A 20. D 30. C 40. A 50. D 60. B
CHAPTER 2
MANAGEMENT ACCOUNTING
AND THE BUSINESS ENVIRONMENT
I. Questions
1. Managerial accounting information often brings to the attention of managers

important issues that need their managerial experience and skills. In many
cases, managerial-accounting information will not answer the question or solve
the problem, but rather make management aware that the issue or problem
exists. In this sense, managerial accounting sometimes is said to serve an
attention-directing role.
2. Non-value-added costs are the costs of activities that can be eliminated with no
deterioration of product quality, performance, or perceived value.
3. Managers rely on many information systems in addition to managerial-

accounting information. Examples of other information systems include
economic analysis and forecasting, marketing research, legal research and
analysis, and technical information provided by engineers and production
specialists.
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Cost Concepts and Classifications Chapter 8
4. Becoming the low-cost producer in an industry requires a clear understanding

by management of the costs incurred in its production process. Reports and
analysis of these costs are a primary function of managerial accounting.
5. Some activities in the value chain of a manufacturer of cotton shirts are as

follows:
(a) Growing and harvesting cotton
(b) Transporting raw materials
(c) Designing shirts
(d) Weaving cotton material
(e) Manufacturing shirts
(f) Transporting shirts to retailers
(g) Advertising cotton shirts
Some activities in the value chain of an airline are as follows:
(a) Making reservations and ticketing
(b) Designing the route network
(c) Scheduling
(d) Purchasing aircraft
(e) Maintaining aircraft
(f) Running airport operations, including handling baggage
(g) Serving food and beverages in flight
(h) Flying passengers and cargo
6. Strategic cost management is the process of understanding and managing, to

the organization’s advantage, the cost relationships among the activities in an
organization’s value chain.
7. If customers who provide a company with the most profits are attracted,
satisfied, and retained, profits will increase as a result.
8. A value chain is a sequence of business functions whose objective is to provide

a product to a customer or provide an intermediate good or service in a larger
value chain. These business functions include R&D, design, production,
marketing, distribution, and customer service.
An organization can become more effective by focusing on whether each link in

the chain adds value from the customer’s perspective and furthers the
organization’s objectives.
9. Cost: Organizations are under continuous pressure to reduce the cost of

the products or services they sell to their customers.
Quality: Customers are expecting higher levels of quality and are less
tolerant of low quality than in the past.
8-19
Time: Time has many components: the time taken to develop and bring
new products to market; the speed at which an organization
responds to customer requests; and the reliability with which
promised delivery dates are met. Organizations are under
pressure to complete activities faster and to meet promised
delivery dates more reliably than in the past in order to increase
customer satisfaction.
Innovation: There is now heightened recognition that a continuing flow of
innovative products or services is a prerequisite for the ongoing
success of most organizations.
10. Managers make planning decisions and control decisions. Planning decisions
include deciding on organization goals, predicting results under various
alternative ways of achieving those goals, and then deciding how to attain the
desired goals. Control decisions include taking actions to implement the
planning decisions and deciding on performance evaluation and feedback that
will help future decision making.
11. Four themes for managers to attain success are customer focus, value-chain and
supply-chain analysis, key success factors, and continuous improvement and
benchmarking.
12. Companies add value through R&D; design of products, services, or processes;
production; marketing; distribution; and customer service. Managers in all
business functions of the value chain are customers of management accounting
information.
13. This phrase means that people will direct their attention to work primarily on
those tasks that management monitors and measures. Employees may not pay
as much attention (or no attention) to tasks that are not measured. Often
management will reward people based on how well they perform relative to a
specific measure. As an example, in a manufacturing organization, if people
are measured and rewarded based on the number of outputs per hour, regardless
of quality, employees will focus their attention on producing as many units of
output as possible. A negative consequence is that the quality of output may
suffer.
14. Some of these new measures are quality, speed to market, cycle time, flexibility,
complexity and productivity.
15. Customer satisfaction is often thought to be a qualitative measure of

performance as one cannot directly observe “satisfaction.” However, using
attitude surveys and psychological measurements, customer satisfaction can be
measured in quantitative terms. For instance, people who design surveys often
employ attitude scales that ask questions in which customers respond on a 1 to
5 scale. These values can be summed and averaged to determine satisfaction
scores.
8-20
16.
Stakeholders Contribution Requirements
Employees Effort, skills, Rewards, interesting
information jobs, economic security,
proper treatment
Partners Goods, services, Financial rewards
information commensurate with the
risk taken
Owners Capital Financial rewards
Community Allows the organization Conformance to laws,
to operate and does not good corporate
oppose its operation citizenship and,
perhaps, leadership
17. Competitive benchmarking is an organization’s search for, and implementation

of, the best way to do something as practiced in other organizations.
Continuous improvement is the relentless search to (1) document, understand,

and improve the activities that the organization undertakes to meet its
customers’ requirement, (2) eliminate processing activities that do not add
product features that customers value, and (3) improve the performance of
activities that increase customer value or satisfaction.
18. A value-added activity is an activity that, if eliminated, would reduce the

product’s service to the customer in the long run.
An activity that cannot be classified as value-added is a nonvalue-added

activity:
a. Value-added
b. Nonvalue-added
c. Nonvalue-added
d. Value-added
e. Nonvalue-added
f. Nonvalue-added
g. Value-added
h. Value-added
i. Nonvalue-added
j. Value-added
19. Just-in-time means making a good or service only when the customer, internal
or external, requires it. Just-in-time requires a product layout with a
8-21
continuous flow (no delays) once production starts. It means that setup costs
must be reduced substantially to eliminate the need to produce in batches, and it
means that processing systems must be reliable. Just-in-time production is
based on the elimination of all nonvalue-added activities to reduce cost and
time. It is an approach to improvement that is continuous and involves
employee empowerment and involvement.
20. Managerial accounting is concerned with providing information to managers

for use within the organization. Financial accounting is concerned with
providing information to stockholders, creditors, and others outside of the
organization.
21. A strategy is a game plan that enables a company to attract customers by

distinguishing itself from competitors. The focal point of a company’s strategy
should be its target customers.
II. Multiple Choice Questions
11. B 21. A 31. B

12. A 22. B 32. C
13. D 23. C 33. C
14. A 24. D
15. D 25. A
16. A 26. A
17. C 27. B
18. B 28. C
19. D 29. B
20. B 30. A
CHAPTER 3
UNDERSTANDING FINANCIAL STATEMENTS
I. Questions
1. A financial statement is a means of communicating information about an

enterprise in financial (i.e., peso) terms. It represents information that the
accountant believes is a true and fair representation of the financial activity of
the enterprise.
2. Every financial statement relates to time in one way or another. A statement of

financial position, or balance sheet, represent a “picture” of the enterprise at a
point in time (e.g., the end of a month or year). An income statement and a
statement of cash flows, on the other hand, cover activity that took place over a
period of time (e.g., a month or year).
8-22
3. a. Creditors are interested in financial statements to assist them in evaluating

the ability of a business to repay its debts. No one wants to extend credit to
a company that is unable to meet its obligations as they come due.
b. Potential investors use financial statements in selecting among alternative
investment opportunities. They are interested in investing in companies in
which the value of their investment will increase as a result of future
profitable operations.
c. Labor unions are interested in financial statements because the financial
position of a company and its profits are important factors in the
company’s ability to pay higher wages and to employ more people.
4. Business transactions affect a company’s financial position, and as a result they

change the statement of financial position or balance sheet. The other financial
statements – the income statement and the statement of cash flows – are
detailed expansions of certain aspects of the statement of financial position and
help explain how the company’s position changed over time.
5. The cost principle indicates that many assets are included in the financial
records, and therefore, in the statement of financial position, at their original
cost to the reporting enterprise. This principle affects accounting for assets in
several ways, one of which is that the amount of most assets is not adjusted
periodically for changes in the market value of the assets. Instead, cost is
retained as the basic method of accounting, regardless of changes in the market
value of those assets.
6. The going concern assumption states that in the absence of evidence to the
contrary (i.e., bankruptcy proceedings), an enterprise is expected to continue to
operate in the foreseeable future. This means, for example, that it will continue
to use the assets it has in its financial statements for the purpose for which they
were acquired.
7. The three categories and the information included in each are:

Operating activities – Cash provided by and used in revenue and expense
transactions.
Investing activities – Cash provided by and used as a result of investments in
assets, such as machinery, equipment, land, and buildings.
Financial activities – Cash provided by and used in debt and equity financing,
such as borrowing and repaying loans, and investments from and dividends
paid to the enterprise’s owners.
8. Adequate disclosure refers to the requirement that financial statements,

including accompanying notes, must include information necessary for
reasonably informed users of financial statements to understand the company’s
financial activities. This requirement is often met, in part, by the addition of
8-23
notes to the financial statements. Financial statement notes include both

quantitative and qualitative information that is not included in the body of the
financial statements.
9. A strong income statement is one that has significantly more pesos of revenue
than expenses, resulting in net income that is a relatively high percentage of the
revenue figure. A trend of relatively high income numbers over time signals a
particularly strong income situation.
10. A strong statement of cash flows is one that shows significant amounts of cash
generated from operating activities. This means that the enterprise is
generating cash from its ongoing activities and is not required to rely on
continuous debt and equity financing, or the sale of its major assets.
11. The purpose of classifications in financial statements is to develop useful

subtotals, which help users analyze the statements. The most commonly used
classifications are:
In a balance sheet: current assets, plant and equipment, other assets, current
liabilities, long-term liabilities and equity.
In a multiple-step income statement: revenue, cost of goods sold, operating
expenses, and nonoperating items. The operating expense section often
includes subclassifications for selling expenses and for general and
administrative expenses.
In a statement of cash flows: operating activities, investing activities, and
financing activities.
12. In classified financial statements, similar items are grouped together to

produce subtotals which may assist users in their analyses. Comparative
financial statements show financial statements for two or more time periods in
side-by-side columns. Consolidated statements include not only the financial
statement amounts for the company itself but also for any subsidiary companies
that it owns. The financial statements of large corporations often possess all
three of these characteristics.
13. In a multiple-step income statement, different categories of expenses are

deducted from revenue in a series of steps, thus resulting in various subtotals,
such as gross profit and operating income. In a single-step income statement,
all expenses are combined and deducted from total revenue in a single step.
Both formats result in the same amount of net income.
II. Matching Type
1.
1. d 3. a 5. e 7. f 9. c
2. g 4. j 6. h 8. b 10. i
8-24
2.
1. d 3. i 5. m 7. h 9. f 11. b 13. e
2. a 4. g 6. c 8. n 10. k 12. j 14. l
3.
a. F c. F e. I g. F I. I k. F
b. I d. I f. F h. F j. F l. I
III. Problems
Problem 1 (Preparing a Balance Sheet – A Second Problem)
Requirement (a)
SM Farms
Balance Sheet
September 30, 2005
Assets Liabilities and Equity

Cash Liabilities:
P 16,710
Accounts receivable 22,365 Notes payable
P530,000
Land Accountspayable
550,000 77,095
Barns and sheds 78,300 Property taxes payable
9,135
Citrus trees 76,650 Wages payable
1,820
Livestock 120,780
Total liabilities
P618,050
Irrigation system 20,125 Equity:
Farm machinery 42,970 Share capital
250,000
Fences & gates 33,570 Retained earnings*
93,420
Total Total
P961,470 P961,470
* Total assets, P961,470, minus total liabilities, P618,050, less share capital,
P250,000.
Requirement (b)
The loss of an asset, Barns and Sheds, from a typhoon would cause a decrease in
total assets. When total assets are decreased, the balance sheet total of liabilities
8-25
and equity must also decrease. Since there is no change in liabilities as a result of
the destruction of an asset, the decrease on the right-hand side of the balance sheet
must be in the retained earnings account. The amount of the decrease in Barns and
Sheds, in the equity, and in both balance sheet totals, is P23,800.
Problem 2 (Preparing a Balance Sheet and Cash Flow Statement; Effects of
Business Transactions)
Requirement (a)
The Tasty Bakery
Balance Sheet
August 1, 2005

Cash Liabilities:
P 6,940
P 74,900
Supplies 7,000 Accounts payable

16,200
Land Salaries payable
67,000 8,900
Building 84,000
Total liabilities
P100,000
Equipment and fixtures 44,500 Equity:
Share capital
80,000
Retained earnings
40,700
Total Total
P220,700 P220,700
Requirement (b)
The Tasty Bakery
Balance Sheet
August 3, 2005

Cash Liabilities:
P 14,490
P 74,900

7,200
8-26
Land Salaries payable

67,000 8,900
Building 84,000
Total liabilities
P 91,000
Equipment and fixtures 51,700 Equity:
Share capital
105,000
Retained earnings
40,700
Total Total
P236,700 P236,700
The Tasty Bakery

Statement of Cash Flows
For the Period August 1 - 3, 2005
Cash flows from operating

activities:
Cash payment of accounts P(16,200)
payable
Cash purchase of supplies (1,250)
Cash used in operating P(17,450)
activities
Cash flows from investing

activities:
None
Cash flows from financing

activities:
Sale of share capital P25,000
Increase in cash P 7,550

Cash balance, August 1, 2005 6,940
Cash balance, August 3, 2005 P14,490
Requirement (c)
The Tasty Bakery is in a stronger financial position on August 3 than it was on
August 1.
8-27
On August 1, the highly liquid assets (cash and accounts receivable) total only
P18,200, but the company has P25,100 in debts due in the near future (accounts
payable plus salaries payable).
On August 3, after additional infusion of cash from the sale of stock, the liquid
assets total P25,750, and debts due in the near future amount to P16,100.
Note to Instructor: The analysis of financial position strength in requirement (c) is

based solely upon the balance sheets at August 1 and August 3. Hopefully, students
will raise many legitimate issues regarding necessity of information about
operations, rate at which cash flows into the business, etc. In this problem, the
improvement in financial position results solely from the sale of share capital.
Problem 3 (Preparing Financial Statements; Effects of Business Transactions)
Requirement (a)
The First Malt Shop
Balance Sheet
September 30, 2005

Cash Liabilities:
P 7,400
Accounts receivable 1,250 Notes payable*
P 70,000

8,500
Land
55,000 Total liabilities
P 78,500
Building 45,500 Equity:
Share capital
50,000
Furniture & fixtures 20,000 Retained earnings
4,090
Total Total
P132,590 P132,590
* Total assets, P132,590, less equity, P54,090, less accounts payable, P8,500, equals
notes payable.
Requirement (b)
The First Malt Shop
Balance Sheet
8-28
October 6, 2005

Cash Liabilities:
P 29,400
P 70,000

18,000
Land
P 88,000
Share capital
80,000
Furniture & fixtures 38,000 Retained earnings
5,590
Total Total
P173,590 P173,590
The First Malt Shop

Income Statement
For the Period October 1-6, 2005
Revenues P 5,500
Expenses (4,000)
Net income P 1,500
The First Malt Shop

For the Period October 1-6, 2005

activities:
Cash received from revenues P5,500
Cash paid for expenses (4,000
)
Cash paid for accounts (8,500
payable )
8-29
Cash paid for supplies (1,0

00)
Cash used in operating P(8,000)
activities
Cash flows from investing
activities:
None
Cash flows from financing
activities:
Cash received from sale of P30,000
share capital
Increase in cash P 22,000
Cash balance, October 1, 2005 7,400
Cash balance, October 6, 2005 P29,400
Requirement (c)
The First Malt Shop is in a stronger financial position on October 6 than on
September 30. On September 30, the company had highly liquid assets (cash and
accounts receivable) of P8,650, which barely exceeded the P8,500 in liabilities
(accounts payable) due in the near future. On October 6, after the additional
investment of cash by shareholders, the company’s cash alone exceeded its short-
term obligations.
Problem 4 (Preparing a Balance Sheet; Discussion of Accounting Principles)
Requirement (1)
Fil-Cinema Scripts
Balance Sheet
November 30, 2005

Cash Liabilities:
P 3,940
Notes receivable 2,200 Notes payable
P 73,500
Accounts receivable 2,450 Accounts payable

32,700
Land
8-30

P106,200
Share capital
5,000
Office furniture* 12,825 Retained earnings
3,535
Total Total
P114,735 P114,735
* P8,850 + P6,500 – P2,525.
Requirement (2)
(1) The cash in Cruz’s personal savings account is not an asset of the business
entity Fil-Cinema Scripts and should not appear in the balance sheet of the
business. The money on deposit in the business bank account (P3,400) and in
the company safe (P540) constitute cash owned by the business. Thus, the cash
owned by the business at November 30 totals P3,940.
(2) The years-old IOU does not qualify as a business asset for two reasons. First, it
does not belong to the business entity. Second, it appears to be uncollectible. A
receivable that cannot be collected is not viewed as an asset, as it represents no
future economic benefit.
(3) The total amount to be included in “Office furniture” for the rug is P9,400, the
total cost, regardless of whether this amount was paid in cash. Consequently,
“Office furniture” should be increased by P6,500. The P6,500 liability arising
from the purchase of the rug came into existence prior to the balance sheet date
and must be added to the “Notes payable” amount.
(4) The computer is no longer owned by Hollywood Scripts and therefore cannot be
included in the assets. To do so would cause an overstatement of both assets
and equity. The “Office furniture” amount must be reduced by P2,525.
(5) The P22,400 described as “Other assets” is not an asset, because there is no
valid legal claim or any reasonable expectation of recovering the income taxes
paid. Also, the payment of income taxes by Cruz was not a business transaction
by Fil-Cinema Scripts. If a refund were obtained from the government, it
would come to Cruz personally, not to the business entity.
(6) The proper valuation for the land is its historical cost of P39,000, the amount
established by the transaction in which the land was purchased. Although the
land may have a current fair value in excess of its cost, the offer by the friend to
buy the land if Cruz would move the building appears to be mere conversation
rather than solid, verifiable evidence of the fair value of the land. The “cost
principle,” although less than perfect, produces far more reliable financial
statements than would result if owners could “pull figures out of the air” in
recording asset values.
8-31
(7) The accounts payable should be limited to the debts of the business, P32,700,
and should not include Cruz’s personal liabilities.
IV. Multiple Choice Questions
21. D 31. B 21. B 31. B

22. D 32. C 22. C 32. D
23. D 33. D 23. A 33. D
24. B 34. A 24. B 34. D
25. A 35. D 25. A 35. C
26. B a. 26. D 36. A
A
27. D 17. A 27. B 37. A
28. C 18. B 28. B 38. C
29. B 19. C 29. D
30. C 20. C 30. C
CHAPTER 4
FINANCIAL STATEMENTS ANALYSIS - I
I. Questions
1. The objective of financial statements analysis is to determine the extent of a

firm’s success in attaining its financial goals, namely:
a. To earn maximum profit
b. To maintain solvency
c. To attain stability
2. Some of the indications of satisfactory short-term solvency or working capital

position of a business firm are:
1. Favorable credit position
2. Satisfactory proportion of cash to the requirements of the current
volume
3. Ability to pay current debts in the regular course of business
4. Ability to extend more credit to customers
5. Ability to replenish inventory promptly
3. These tests are:

1. Improvement in the financial position
2. Well-balanced financial structure between borrowed funds and equity
3. Effective employment of borrowed funds and equity
4. Ability to declare satisfactory amount of dividends to shareholders
8-32
5. Ability to withstand adverse business conditions

6. Ability to engage in research and development in an attempt to
provide new products or improve old products, methods or processes
4. Some indicators of managerial efficiency are:

1. Ability to earn a reasonable return on its investment of borrowed funds
and equity
2. Ability to control operating costs within reasonable limits
3. No overinvestment in fixed assets, receivables and inventories
5. The techniques used in Financial Statement Analysis are:

I. Vertical analysis which shows the relationships of the items in the
same year: also referred to as “static measure.”
a. Financial ratios
b. Common-size statements
II. Horizontal analysis which shows the changes or tendencies of an item

for 2 or more years; also referred to as “dynamic measure.”
a. Comparative statements - showing changes in absolute
amount and percentages
b. Trend percentages
III. Use of special reports or statements

a. Statements of Changes in Financial Position
b. Gross Profit / Net Income Variation Analysis
6. Refer to page 133 of the textbook.
7. Horizontal analysis involves the comparison of items on financial statements

between years. Analysis of comparative financial statements or the
increase/decrease method of analysis and trend percentages are the two
techniques that may be applied under horizontal analysis.
Vertical analysis involves the study of items on a single statement for a single
year, such as the analysis of an income statement for some given year.
Common-size statement and financial ratios are techniques used in vertical
analysis.
8. Trends can indicate whether a situation is improving, remaining the same or

deteriorating. They can also give insight to the probable future course of events
in a firm.
8-33
9. Trend percentages represent the expression of several years’ financial data in

percentage form in terms of a base year.
11. Observation of trends is useful primarily in determining whether a situation is

improving, worsening, or remaining constant. By comparing current data with
similar data of prior periods we gain insight into the direction in which future
results are likely to move.
Some other standards of comparison include comparison with other similar

companies, comparison with industry standards, and comparison with previous
years’ information. By comparing analytical data for one company with some
independent yardstick, the analyst hopes to determine how the position of the
company in question compares with some standard of performance.
12. Trend percentages are used to show the increase or decrease in a financial
statement amount over a period of years by comparing the amount in each year
with the base-year amount. A component percentage is the percentage
relationship between some financial amount and a total of which it is a part.
Measuring the change in sales over a period of several years would call for use
of trend percentages. The sales in the base year are assigned a weight of 100%.
The percentage for each later year is computed by dividing that year’s sales by
the sales in the base year.
13. Expenses (including the cost of goods sold) have been increasing at an even
faster rate than net sales. Thus Premiere is apparently having difficulty in
effectively controlling its expenses.
14. A corporate net income of P1 million would be unreasonably low for a large
corporation, with, say, P100 million in sales, P50 million in assets, and P40
million in equity. A return of only P1 million for a company of this size would
suggest that the owners could do much better by investing in insured bank
savings accounts or in government bonds which would be virtually risk-free
and would pay a higher return.
On the other hand, a profit of P1 million would be unreasonably high for a

corporation which had sales of only P5 million, assets of, say, P3 million, and
equity of perhaps one-half million pesos. In other words, the net income of a
corporation must be judged in relation to the scale of operations and the amount
invested.
II. True or False
1. True 3. True 5. False 7. True 9. True

2. False 4. True 6. False 8. False 10. True
8-34
III. Problems
Problem 1 (Percentage Changes)
a. Accounts receivable decreased 16% (P24,000 decrease  P150,000 = 16%

decrease).
b. Marketable securities decreased 100% (P250,000 decrease  P250,000 = 100%
decrease).
c. A percentage change cannot be calculated because retained earnings showed a
negative amount (a deficit) in the base year and a positive amount in the
following year.
d. A percentage change cannot be calculated because of the zero amount of notes
receivable in 2005, the base year.
e. Notes payable increased 7 ½% (P60,000 increase  P800,000 = 7 ½%
increase).
f. Cash increased 3% (P2,400 increase  P80,000 = 3% increase).
g. Sales increased 10% (P90,000 increase  P900,000 = 10% increase).
Problem 2 (Computing and Interpreting Rates of Change)
Requirement (a)
Computation of percentage changes:
1. Net sales increased 10% (P200,000 increase  P2,000,000 = 10% increase).
2. Total expenses increased 11% (P198,000 increase  P1,800,000 = 11%
increase).
Requirement (b)
1. Total expenses grew faster than net sales. Net income cannot also have grown
faster than net sales, or the sum of the parts would exceed the size of the whole.
2. Net income must represent a smaller percentage of net sales in 2006 than it did
in 2005. Again, the reason is that the expenses have grown at a faster rate than
net sales. Thus, total expenses represent a larger percentage of total sales in
2006 than in 2005, and net income must represent a smaller percentage.
Problem 3 (Financial Statement Analysis using Comparative Statements or

Increase-Decrease Method)
Requirement 1
XYZ Corporation
Balance Sheet
As of December 31
Change
8-35
Peso %
2005 2006
Assets
Cash and equivalents 14,000 16,000 2,000 14.29%
Receivables 28,800 55,600 26,800 93.06%
Inventories 54,000 85,600 31,600 58.52%
Prepayments and others 4,800 7,400 2,600 54.17%
Total current assets 101,600 164,600 63,000 62.01%
Property, plant & equipment - net
of dep. 30,200 73,400 43,200 143.05%
Total assets 131,800 238,000 106,200 80.58%
Liabilities and Equity

Notes payable to banks 10,000 54,000 44,000 440.00%
Accounts payable 31,600 55,400 23,800 73.32%
Accrued liabilities 4,200 6,800 2,600 61.90%
Income taxes payable 5,800 7,000 1,200 20.69%
Total current liabilities 51,600 123,200 71,600 138.76%
Share capital 44,600 44,600 0 0.00%
Retained earnings 35,600 70,200 34,600 97.19%
Total equity 80,200 114,800 34,600 43.14%
Total liabilities and equity 131,800 238,000 106,200 80.58%
XYZ Corporation
Income Statement
Years ended December 31
(P thousands)
Change
Peso %
2005 2006
Net sales 266,400 424,000 157,600 59.16%
Cost of goods sold 191,400 314,600 123,200 64.37%
Gross profit 75,000 109,400 34,400 45.87%
Selling, general and administrative
expenses 35,500 58,400 22,900 64.51%
Income before income taxes 39,500 51,000 11,500 29.11%
Income taxes 12,300 16,400 4,100 33.33%
Net income 27,200 34,600 7,400 27.21%
Requirement 2
Short-term financial position

1. Current increased by Current increased by
while
Assets 62.01% Liabilities 138.76%
 Unfavorable
2. Quick increased by Current increased by
while
8-36
 Unfavorable
3. Net Accounts
increased by
Sales while Receivabl increased by 93.06%
59.16%
e
 Unfavorable
4. Cost of increased by Inventorie
while increased by 58.52%
Goods Sold 64.37% s
 Favorable
Leverage
5. Total increased by Total increased by
while
 Unfavorable
6. Total Total
increased by 138.76% while increased by 43.14%
Liabilities Equity
 Unfavorable
Profitability
7. Net increased by Cost of
Sales 59.16% Goods Sold
 Unfavorable
8. Net Selling,
Sales increased by while General & increased by 64.51%
59.16% Administrati
ve
Expenses
 Unfavorable
9. Net increased by Net
Sales 59.16% Income
 Unfavorable
10. Net increased by Total
Income 27.21% Assets
 Unfavorable
Problem 4 (Trend Percentages)
Requirement (1)
The trend percentages are:

Year 5 Year 4 Year 3 Year 2 Year 1
Sales 125.0 120.0 110.0 105.0 100.0
Cash 80.0 90.0 105.0 110.0 100.0

Accounts receivable 140.0 124.0 108.0 104.0 100.0
Inventory 112.0 110.0 102.0 108.0 100.0
8-37
Total current assets 118.8 113.1 104.1 106.9 100.0
Current liabilities 130.0 106.0 108.0 110.0 100.0
Requirement (2)
Sales: The sales are increasing at a steady rate, with a particularly strong
gain in Year 4.
Assets: Cash declined from Year 3 through Year 5. This may have been due
to the growth in both inventories and accounts receivable. In
particular, the accounts receivable grew far faster than sales in Year
5. The decline in cash may reflect delays in collecting receivables.
This is a matter for management to investigate further.
Liabilities: The current liabilities jumped up in Year 5. This was probably due
to the buildup in accounts receivable in that the company doesn’t
have the cash needed to pay bills as they come due.
Problem 5 (Use of Trend Percentages)
a. 1. An unfavorable tendency could be observed in Receivables in relation to

Net Sales from 2003 – 2005 because receivables had been increasing at a
much faster rate than Net Sales. This could indicate inefficiency in the
collection of receivables or simply poor company credit policy. The
situation however, improved in 2006 and 2007 when sales started to move
up at a faster rate than accounts receivable. This would indicate
improvement in the credit and collection policy or more cash sales were
being generated.
2. Unfavorable tendency in inventory persisted from 2003 to 2007 because it
had been going up at a much faster rate than Net Sales. If this continues,
the company will end up with over-investment in inventory because the
buying rate is faster than the selling price.
3. Favorable tendencies could be noted in Fixed Assets in relation to Net
Sales because inspite of the minimal additions to fixed assets made by the
company from 2003 through 2007, sales had been increasing at a very
encouraging rate.
4. Net Income had likewise been increasing at a much faster rate than net
sales. This is favorable because this would indicate that the company had
been successfully controlling the increases in Cost of Sales and Operating
Expenses.
8-38
b. Review computations of the Trend Percentages. It will be noted that the Trend
Percentages in Total Noncurrent Liabilities and Equity from 2005 to 2007 were
interchanged. Correction should be made first before interpretation is done.
1. The upward tendency in current assets had been accompanied by an
upward trend in current liabilities. It could be noted that current assets had
been moving up at a much faster rate than current liabilities. This is
favorable because the margin of safety of the short-term creditors is
widened.
2. Favorable tendencies could also be observed in noncurrent assets which
had been increasing and which increases had been accompanied by
downward trend in noncurrent liabilities. This would mean better security
on the part of creditors and stronger financial position.
3. There is an unfavorable tendency in Net Sales in relation to non-current
assets. Sales had not been increasing at the same rate as the increases in
fixed assets. This could indicate that more investments are made in
noncurrent assets without considering whether or not they could sell the
additional units of product they are producing.
c. The unfavorable trend in net income could be attributed to the following
tendencies:
1. Higher rates of increases in cost of sales as compared to sales.
2. Higher rates of increases in selling, general and administrative expenses in
relation to net sales.
3. Higher rates of increases in other financial expenses than the rates of
increases in net sales
31. D 36. A, C, D
32. A 37. B*
33. A 38. D
34. B
35. D
36. C
37. C
38. A
39. D
40. C
* (P400,000 – P160,000)  P160,000 = 150%
8-39
CHAPTER 5
FINANCIAL STATEMENTS ANALYSIS - II
I. Questions
1. By looking at trends, an analyst hopes to get some idea of whether a situation is

improving, remaining the same, or deteriorating. Such analyses can provide
insight into what is likely to happen in the future. Rather than looking at
trends, an analyst may compare one company to another or to industry averages
using common-size financial statements.
2. Ratios highlight relationships, movements, and trends that are very difficult to
perceive looking at the raw underlying data standing alone. Also, ratios make
financial data easier to grasp by putting the data into perspective. As to the
limitation in the use of ratios, refer to page 129.
3. Price-earnings ratios are determined by how investors see a firm’s future

prospects. Current reported earnings are generally considered to be useful only
so far as they can assist investors in judging what will happen in the future.
For this reason, two firms might have the same current earnings, but one might
have a much higher price-earnings ratio if investors view it to have superior
future prospects. In some cases, firms with very small current earnings enjoy
very high price-earnings ratios. This is simply because investors view these
firms as having very favorable prospects for earnings in future years. By
definition, a stock with current earnings of P4 and a price-earnings ratio of 20
would be selling for P80 per share.
4. A manager’s financing responsibilities relate to the acquisition of assets for use

in his or her company. The acquisition of assets can be financed in a number of
ways, including through issue of ordinary shares, through issue of preference
shares, through issue of long-term debt, through leasing, etc. A manager’s
operating responsibilities relate to how these assets are used once they have
been acquired. The return on total assets ratio is designed to measure how well
a manager is discharging his or her operating responsibilities. It does this by
looking at a company’s income before any consideration is given as to how the
income will be distributed among capital resources, i.e., before interest
deductions.
5. Financial leverage, as the term is used in business practice, means obtaining

funds from investment sources that require a fixed annual rate of return, in the
hope of enhancing the well-being of the ordinary shareholders. If the assets in
which these funds are invested earn at a rate greater that the return required by
8-40
the suppliers of the funds, then leverage is positive in the sense that the excess
accrues to the benefit of the ordinary shareholders. If the return on assets is
less than the return required by the suppliers of the funds, then leverage is
negative in the sense that part of the earnings from the assets provided by the
ordinary shareholders will have to go to make up the deficiency.
6. How a shareholder would feel would depend in large part on the stability of the
firm and its industry. If the firm is in an industry that experiences wide
fluctuations in earnings, then shareholders might be very pleased that no
interest-paying debt exists in the firm’s capital structure. In hard times, interest
payments might be very difficult to meet, or earnings might be so poor that
negative leverage would result.
7. No, the stock is not necessarily overpriced. Book value represents the
cumulative effects on the balance sheet of past activities evaluated using
historical prices. The market value of the stock reflects investors’ beliefs about
the company’s future earning prospects. For most companies market value
exceeds book value because investors anticipate future growth in earnings.
8. A company in a rapidly growing technological industry probably would have

many opportunities to invest its earnings at a high rate of return; thus, one
would expect it to have a low dividend payout ratio.
9. It is more difficult to obtain positive financial leverage from preference shares

than from long-term debt due to the fact that interest on long-term debt is tax
deductible, whereas dividends paid on preference shares are not tax deductible.
10. The current ratio would probably be highest during January, when both current
assets and current liabilities are at a minimum. During peak operating periods,
current liabilities generally include short-term borrowings that are used to
temporarily finance inventories and receivables. As the peak periods end, these
short-term borrowings are paid off, thereby enhancing the current ratio.
11. A 2-to-1 current ratio might not be adequate for several reasons. First, the
composition of the current assets may be heavily weighted toward slow-turning
inventory, or the inventory may consist of large amounts of obsolete goods.
Second, the receivables may be large and of doubtful collectibility, or the
receivables may be turning very slowly due to poor collection procedures.
12. Expenses (including the cost of goods sold) have been increasing at an even
faster rate than net sales. Thus Sunday is apparently having difficulty in
effectively controlling its expenses.
13. If the company’s earnings are very low, they may become almost insignificant
in relation to stock price. While this means that the p/e ratio becomes very
high, it does not necessarily mean that investors are optimistic. In fact, they
8-41
may be valuing the company at its liquidation value rather than a value based
upon expected future earnings.
14. From the viewpoint of the company’s shareholders, this situation represents a
favorable use of leverage. It is probable that little interest, if any, is paid for the
use of funds supplied by current creditors, and only 11% interest is being paid
to long-term bondholders. Together these two sources supply 40% of the total
assets. Since the firm earns an average return of 16% on all assets, the amount
by which the return on 40% of the assets exceeds the fixed-interest
requirements on liabilities will accrue to the residual equity holders – the
ordinary shareholders – raising the return on equity.
15. The length of operating cycle of the two companies cannot be determined from
the fact the one company’s current ratio is higher. The operating cycle depends
on the relationships between receivables and sales, and between inventories and
cost of goods sold. The company with the higher current ratio might have
either small amounts of receivables and inventories, or large sales and cost of
sales, either of which would tend to produce a relatively short operating cycle.
16. The investor is calculating the rate of return by dividing the dividend by the
purchase price of the investment (P5  P50 = 10%). A more meaningful figure
for rate of return on investment is determined by relating dividends to current
market price, since the investor at the present time is faced with the alternative
of selling the stock for P100 and investing the proceeds elsewhere or keeping
the investment. A decision to retain the stock constitutes, in effect, a decision to
continue to invest P100 in it, at a return of 5%. It is true that in a historical
sense the investor is earning 10% on the original investment, but this is
interesting history rather than useful decision-making information.
17. A corporate net income of P1 million would be unreasonably low for a large
corporation, with, say, P100 million in sales, P50 million in assets, and P40
million in equity. A return of only P1 million for a company of this size would
suggest that the owners could do much better by investing in insured bank
savings accounts or in government bonds which would be virtually risk-free
and would pay a higher return.
On the other hand, a profit of P1 million would be unreasonably high for a
corporation which had sales of only P5 million, assets of, say, P3 million, and
equity of perhaps one-half million pesos. In other words, the net income of a
corporation must be judged in relation to the scale of operations and the amount
invested.
II. True or False
1. True 3. True 5. True 7. True 9. False

2. True 4. False 6. True 8. True 10. False
III. Problems
8-42
Problem 1 (Common Size Income Statements)
Common size income statements for 2005 and 2006:

2006 2005
Sales........................................................ 100% 100%
Cost of goods sold................................... 66 67
Gross profit............................................. 34% 33%
Operating expenses................................. 28 29
Net income.............................................. 6% 4%
The changes from 2005 to 2006 are all favorable. Sales increased and the gross
profit per peso of sales also increased. These two factors led to a substantial
increase in gross profit. Although operating expenses increased in peso amount, the
operating expenses per peso of sales decreased from 29 cents to 28 cents. The
combination of these three favorable factors caused net income to rise from 4 cents
to 6 cents out of each peso of sales.
Problem 2 (Measures of Liquidity)
Requirement (a)
Current assets:
Cash P 47,600
Marketable securities 175,040
Accounts receivable 230,540
Inventory 179,600
Unexpired insurance 4,500
Total current assets P637,280
Current liabilities:
Notes payable P 70,000
Accounts payable 125,430
Salaries payable 7,570
Income taxes payable 14,600
Unearned revenue 10,000
Total current liabilities P227,600
Requirement (b)
The current ratio is 2.8 to 1. It is computed by dividing the current assets of

P637,280 by the current liabilities of P227,600. The amount of working capital is
P409,680, computed by subtracting the current liabilities of P227,600 from the
current assets of P637,280.
The company appears to be in a strong position as to short-run debt-paying ability.

It has almost three pesos of current assets for each peso of current liabilities. Even
if some losses should be sustained in the sale of the merchandise on hand or in the
8-43
collection of the accounts receivable, it appears probable that the company would
still be able to pay its debts as they fall due in the near future. Of course, additional
information, such as the credit terms on the accounts receivable, would be helpful in
a careful evaluation of the company’s current position.
Problem 3 (Common-Size Income Statement)
Requirement 1
2006 2005
Sales 100.0 % 100.0 %
Less cost of goods sold...........................................................................................................
63.2 60.0
Gross margin..........................................................................................................................
36.8 40.0
Selling expenses.....................................................................................................................
18.0 17.5
Administrative expenses........................................................................................................
13.6 14.6
Total expenses........................................................................................................................
31.6 32.1
Net operating income............................................................................................................
5.2 7.9
Interest expense.....................................................................................................................
1.4 1.0
Net income before taxes.........................................................................................................
3.8 % 6.9 %
Requirement 2
The company’s major problem seems to be the increase in cost of goods sold, which
increased from 60.0% of sales in 2005 to 63.2% of sales in 2006. This suggests that
the company is not passing the increases in costs of its products on to its customers.
As a result, cost of goods sold as a percentage of sales has increased and gross
margin has decreased. Selling expenses and interest expense have both increased
slightly during the year, which suggests that costs generally are going up in the
company. The only exception is the administrative expenses, which have decreased
from 14.6% of sales in 2005 to 13.6% of sales in 2006. This probably is a result of
the company’s efforts to reduce administrative expenses during the year.
Problem 4 (Comparing Operating Results with Average Performance in the

Industry)
Requirement (a)
Ms. Freeze,Inc. Industry Average
Sales (net) 100% 100%
Cost of goods sold 49 57
Gross profit on sales 51% 43%
Operating expenses:
Selling 21% 16%
General and administrative 17 20
Total operating expenses 38% 36%
Operating income 13% 7%
Income taxes 6 3
Net income 7% 4%
Requirement (b)
8-44
Ms. Freeze’s operating results are significantly better than the average performance
within the industry. As a percentage of sales revenue, Ms. Freeze’s operating
income and net income after nearly twice the average for the industry. As a
percentage of total assets, Ms. Freeze’s profits amount to an impressive 23% as
compared to 14% for the industry.
The key to Ms. Freeze’s success seems to be its ability to earn a relatively high rate
of gross profit. Ms. Freeze’s exceptional gross profit rate (51%) probably results
from a combination of factors, such as an ability to command a premium price for
the company’s products and production efficiencies which lead to lower
manufacturing costs.
As a percentage of sales, Ms. Freeze’s selling expenses are five points higher than
the industry average (21% compared to 16%). However, these higher expenses may
explain Ms. Freeze’s ability to command a premium price for its products. Since
the company’s gross profit rate exceeds the industry average by 8 percentage points,
the higher-than-average selling costs may be part of a successful marketing strategy.
The company’s general and administrative expenses are significantly lower than the
industry average, which indicates that Ms. Freeze’s management is able to control
expenses effectively.
Problem 5 (Common-Size Statements)
Requirement 1
The income statement in common-size form would be:

2006 2005
Sales................................................................. 100.0% 100.0%
Less cost of goods sold.................................... 65.0 60.0
Gross margin................................................... 35.0 40.0
Less operating expenses.................................. 26.3 30.4
Net operating income...................................... 8.7 9.6
Less interest expense....................................... 1.2 1.6
Net income before taxes.................................. 7.5 8.0
Less income taxes (30%)................................ 2.3 2.4
Net income...................................................... 5.3% 5.6%
The balance sheet in common-size form would be:
2006 2005
Current assets:
Cash 2.0% 5.1%
.................................................................
Accounts receivable, net 15.0 10.1
.................................................................
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Inventory 30.1 15.2

.................................................................
Prepaid expenses 1.0 1.3
.................................................................
Total current assets 48.1 31.6
Plant and equipment....................................... 51.9 68.4

Total assets...................................................... 100.0% 100.0%
Liabilities:
Current liabilities..................................... 25.1% 12.7%
Bonds payable, 12%................................. 20.1 25.3
Total liabilities.................................. 45.1 38.0
Equity:
Preference shares, 8%, P10 par 15.0 19.0
Ordinary shares, P5 par 10.0 12.7
Retained earnings 29.8 30.4
Total equity 54.9 62.0
Total liabilities and equity............................... 100.0% 100.0%
Note: Columns do not total down in all cases due to rounding differences.
Requirement 2
The company’s cost of goods sold has increased from 60 percent of sales in 2005 to
65 percent of sales in 2006. This appears to be the major reason the company’s
profits showed so little increase between the two years. Some benefits were realized
from the company’s cost-cutting efforts, as evidenced by the fact that operating
expenses were only 26.3 percent of sales in 2006 as compared to 30.4 percent in
2005. Unfortunately, this reduction in operating expenses was not enough to offset
the increase in cost of goods sold. As a result, the company’s net income declined
from 5.6 percent of sales in 2005 to 5.3 percent of sales in 2006.
Problem 6 (Solvency of Alabang Supermarket)
Requirement (a)
(Pesos in
Millions)
Current assets:
Cash P 74.8
Receivables 152.7
Merchandise inventories 1,191.8
Prepaid expenses 95.5
8-46
Total current assets P1,514.8
Quick assets:
Cash P 74.8
Receivables 152.7
Total quick assets P 227.5
Requirement (b)
(1) Current ratio:

Current assets (Req. a) P1,514.8
Current liabilities P1,939.0
Current ratio (P1,514.8  P1,939.0) 0.8 to 1
(2) Quick ratio:

Quick assets (Req. a) P 227.5
Current liabilities P1,939.0
Quick ratio (P227.5  P1,939.0) 0.1 to 1
(3) Working capital:

Current assets (Req. a) P1,514.8
Less: Current liabilities P1,939.0
Working capital P(424.2)
Requirement (c)
No. It is difficult to draw conclusions from the above ratios. Alabang

Supermarket’s current ratio and quick ratio are well below “safe” levels, according
to traditional rules of thumb. On the other hand, some large companies with steady
ash flows are able to operate successfully with current ratios lower than Alabang
Supermarket’s.
Requirement (d)
Due to characteristics of the industry, supermarkets tend to have smaller amounts of

current assets and quick assets than other types of merchandising companies. An
inventory of food has a short shelf life. Therefore, the inventory of a supermarket
usually represents only a few weeks’ sales. Other merchandising companies may
stock inventories representing several months’ sales. Also, supermarkets sell
primarily for cash. Thus, they have relatively few receivables. Although
supermarkets may generate large amounts of cash, it is not profitable for them to
hold assets in this form. Therefore, they are likely to reinvest their cash flows in
business operations as quickly as possible.
Requirement (e)
In evaluating Alabang Supermarket’s liquidity, it would be useful to review the

company’s financial position in prior years, statements of cash flows, and the
8-47
financial ratios of other supermarket chains. One might also ascertain the
company’s credit rating from an agency such as Dun & Bradstreet.
Note to Instructor: Prior to the year in which the data for this problem was
collected, Alabang Supermarket had reported a negative retained earnings balance
in its balance sheet for several consecutive periods. The fact that Alabang
Supermarket has only recently removed the deficit from its financial statements is
also worrisome.
Problem 7 (Balance Sheet Measures of Liquidity and Credit Risk)
Requirement (a)
(1) Quick assets:

Cash P 47,524
Marketable securities (short-term) 55,926
Total quick assets P127,003
(2) Current assets:

Cash P 47,524
Marketable securities (short-term) 55,926
Inventories 32,210
Prepaid expenses 5,736
Total current assets P164,949
(3) Current liabilities:

Notes payable to banks (due within one year) P 20,000
Accounts payable 5,912
Dividends payable 1,424
Accrued liabilities (short-term) 21,532
Income taxes payable 6,438
Total current liabilities P 55,306
Requirement (b)
(1) Quick ratio:

Quick assets (Req. a) P127,003
Current liabilities (Req. a) P 55,306
Quick ratio (P127,003  P55,306) 2.3 to 1
(2) Current ratio:
8-48
Current assets (Req. a) P164,949

Current liabilities (Req. a) P 55,306
Current ratio (P164,949  P55,306) 3.0 to 1
(3) Working capital:

Current assets (Req. a) P164,949
Less: Current liabilities (Req. a) 55,306
Working capital P109,643
(4) Debt ratio:

Total liabilities (given) P 81,630
Total assets (given) P353,816
Debt ratio (P81,630  P353,816) 23.1%
Requirement (c)
(1) From the viewpoint of short-term creditors, Bonbon Sweets’ appear highly
liquid. Its quick and current ratios are well above normal rules of thumb, and
the company’s cash and marketable securities alone are almost twice its current
liabilities.
(2) Long-term creditors also have little to worry about. Not only is the company
highly liquid, but creditors’ claims amount to only 23.1% of total assets. If
Bonbon Sweets’ were to go out of business and liquidate its assets, it would
have to raise only 23 cents from every peso of assets for creditors to emerge
intact.
(3) From the viewpoint of shareholders, Bonbon Sweets’ appears overly liquid.
Current assets generally do not generate high rates of return. Thus, the
company’s relatively large holdings of current assets dilutes its return on total
assets. This should be of concern to shareholders. If Bonbon Sweets is unable
to invest its highly liquid assets more productively in its business, shareholders
probably would like to see the money distributed as dividends.
Problem 8 (Selected Financial Measures for Short-term Creditors)
Requirement 1
Current assets (P80,000 + P460,000 + P750,000 + P10,000).............................................. P1,300,000

Current liabilities (P1,300,000 ÷ 2.5)...................................................................................
520,000
Working capital......................................................................................................................
P 780,000
Requirement 2
Cash + Marketable securities + Accounts receivable
Acid-test ratio = Current liabilities
P80,000 + P0 + P460,000
Acid-test ratio = P520,000 = 1.04 to 1 (rounded)
8-49
Requirement 3
a. Working capital would not be affected:
Current assets (P1,300,000 – P100,000)...............................................................................

P1,200,000
Current liabilities (P520,000 – P100,000)............................................................................
420,000
Working capital......................................................................................................................
P 780,000
b. The current ratio would rise:

Current assets
Current ratio = Current liabilities
P1,200,000
Current rate = P420,000 = 2.9 to 1 (rounded)
Problem 9 (Selected Financial Ratios)
1. Gross margin percentage:

Gross margin P840,000
Sales = P2,100,000 = 40%
2. Current ratio:
Current assets P490,000
= P200,000 = 2.45 to 1
Current liabilities
3. Acid-test ratio:
Quick assets P181,000

Current liabilities = P200,000 = 0.91 to 1 (rounded)
4. Accounts receivable turnover:
Sales P2,100,000
Average accounts receivables = P150,000 = 14 times
365 days
14 times = 26.1 days (rounded)
5. Inventory turnover:
Cost of goods sold P1,260,000

Average inventory = P280,000 = 4.5 times
365 days
4.5 times = 81.1 days to turn (rounded)
8-50
6. Debt-to-equity ratio:
Total liabilities P500,000

Total equity = P800,000 = 0.63 to 1 (rounded)
7. Times interest earned:
Earnings before interest

and income taxes P180,000
Interest expense = P30,000 = 6.0 times
8. Book value per share:

Equity P800,000
Ordinary shares outstanding = 20,000 shares* = P40 per share
* P100,000 total par value ÷ P5 par value per share = 20,000 shares
Problem 10 (Selected Financial Ratios for Ordinary Shareholders)
1. Earnings per share:
Net income to ordinary shares P105,000

Average ordinary shares = 20,000 shares = P5.25 per share
outstanding
2. Dividend payout ratio:
Dividends paid per share P3.15
= = 60%
Earnings per share P5.25
3. Dividend yield ratio:

Dividends paid per share P3.15
= = 5%
Market price per share P63.00
4. Price-earnings ratio:
Market price per share P63.00
= = 12.0
Earnings per share P5.25
Problem 11 (Selected Financial Ratios for Ordinary Shareholders)
1. Return on total assets:
Return on Net income + [Interest expense x (1 – Tax rate)]

=
total assets Average total assets
P105,000 + [P30,000 x (1 – 0.30)]

=
½ (P1,100,000 + P1,300,000)
8-51
P126,000
= P1,200,000 = 10.5%
2. Return on ordinary shareholders’ equity:

Return on ordinary
shareholders’ equity = Net income – preference dividends
Average ordinary shareholders’ equity
= P105,000
½ (P725,000 + P800,000)
P105,000
= = 13.8% (rounded)
P762,500
3. Financial leverage was positive, since the rate of return to the ordinary
shareholders (13.8%) was greater than the rate of return on total assets
(10.5%). This positive leverage is traceable in part to the company’s current
liabilities, which may carry no interest cost, and to the bonds payable, which
have an after-tax interest cost of only 7%.
10% interest rate × (1 – 0.30) = 7% after-tax cost.
Problem 12 (Selected Financial Measures for Short-Term Creditors)
Requirement (1)
Current assets
(P80,000 + P460,000 + P750,000 + P10,000)............................................... P1,300,000
Current liabilities (P1,300,000 ÷ 2.5)................................................................. 520,000
Working capital...................................................................................................
P 780,000
Requirement (2)
Cash + Marketable securities

Acid-test ratio + Accounts receivable + Short-term notes
=
Current liabilities
P80,000 + P0 + P460,000 + P0
= = 1.04 (rounded)
P520,000
Requirement (3)
a. Working capital would not be affected by a P100,000 payment on accounts

payable:
8-52
Current assets (P1,300,000 – P100,000)..........................................P1,200,000

Current liabilities (P520,000 – P100,000)....................................... 420,000
Working capital.................................................................................P 780,000
b. The current ratio would increase if the company makes a P100,000 payment on
accounts payable:
Current ratio Current assets

=
Current liabilities
P1,200,000
= = 2.9 (rounded)
P420,000
Problem 13 (Effects of Transactions on Various Financial Ratios)
1. Decrease Sale of inventory at a profit will be reflected in an increase in

retained earnings, which is part of shareholders’ equity. An
increase in shareholders’ equity will result in a decrease in the
ratio of assets provided by creditors as compared to assets
provided by owners.
2. No effect Purchasing land for cash has no effect on earnings or on the

number of ordinary shares outstanding. One asset is exchanged
for another.
3. Increase A sale of inventory on account will increase the quick assets

(cash, accounts receivable, marketable securities) but have no
effect on the current liabilities. For this reason, the acid-test
ratio will increase.
4. No effect Payments on account reduce cash and accounts payable by equal

amounts; thus, the net amount of working capital is not affected.
5. Decrease When a customer pays a bill, the accounts receivable balance is

reduced. This increases the accounts receivable turnover, which
in turn decreases the average collection period.
6. Decrease Declaring a cash dividend will increase current liabilities, but

have no effect on current assets. Therefore, the current ratio will
decrease.
7. Increase Payment of a previously declared cash dividend will reduce both
8-53
current assets and current liabilities by the same amount. An

equal reduction in both current assets and current liabilities will
always result in an increase in the current ratio, so long as the
current assets exceed the current liabilities.
8. No effect Book value per share is not affected by the current market price
of the company’s stock.
9. Decrease The dividend yield ratio is obtained by dividing the dividend

per share by the market price per share. If the dividend per
share remains unchanged and the market price goes up, then
the yield will decrease.
10. Increase Selling property for a profit would increase net income and
therefore the return on total assets would increase.
11. Increase A write-off of inventory will reduce the inventory balance,

thereby increasing the turnover in relation to a given level of
cost of goods sold.
12. Increase Since the company’s assets earn at a rate that is higher than the
rate paid on the bonds, leverage is positive, increasing the
return to the ordinary shareholders.
13. No effect Changes in the market price of a stock have no direct effect on
the dividends paid or on the earnings per share and therefore
have no effect on this ratio.
14. Decrease A decrease in net income would mean less income available to
cover interest payments. Therefore, the times-interest-earned
ratio would decrease.
15. No effect Write-off of an uncollectible account against the Allowance for

Bad Debts will have no effect on total current assets. For this
reason, the current ratio will remain unchanged.
16. Decrease A purchase of inventory on account will increase current

liabilities, but will not increase the quick assets (cash, accounts
receivable, marketable securities). Therefore, the ratio of quick
assets to current liabilities will decrease.
17. Increase The price-earnings ratio is obtained by dividing the market

price per share by the earnings per share. If the earnings per
share remains unchanged, and the market price goes up, then
8-54
the price-earnings ratio will increase.
18. Decrease Payments to creditors will reduce the total liabilities of a

company, thereby decreasing the ratio of total debt to total
equity.
Problem 14 (Interpretation of Financial Ratios)
a. The market price is going down. The dividends paid per share over the three-
year period are unchanged, but the dividend yield is going up. Therefore, the
market price per share of stock must be decreasing.
b. The earnings per share is increasing. Again, the dividends paid per share have
remained constant. However, the dividend payout ratio is decreasing. In order
for the dividend payout ratio to be decreasing, the earnings per share must be
increasing.
c. The price-earnings ratio is going down. If the market price of the stock is going
down [see part (a) above], and the earnings per share are going up [see part (b)
above], then the price-earnings ratio must be decreasing.
d. In Year 1, leverage was negative because in that year the return on total assets
exceeded the return on ordinary equity. In Year 2 and in Year 3, leverage was
positive because in those years the return on ordinary equity exceeded the
return on total assets employed.
e. It is becoming more difficult for the company to pay its bills as they come due.
Although the current ratio has improved over the three years, the acid-test ratio
is down. Also note that the accounts receivable and inventory are both turning
more slowly, indicating that an increasing portion of the current assets is being
made up of those items, from which bills cannot be paid.
f. Customers are paying their bills more slowly in Year 3 than in Year 1. This is
evidenced by the decline in accounts receivable turnover.
g. Accounts receivable is increasing. This is evidenced both by a slowdown in

turnover and in an increase in total sales.
h. The level of inventory undoubtedly is increasing. Notice that the inventory

turnover is decreasing. Even if sales (and cost of goods sold) just remained
constant, this would be evidence of a larger average inventory on hand.
However, sales are not constant but rather are increasing. With sales increasing
(and undoubtedly cost of goods sold also increasing), the average level of
inventory must be increasing as well in order to service the larger volume of
sales.
IV. Cases
8-55
Case 1 (Common-Size Statements and Financial Ratios for Creditors)
Requirement 1
This Year Last Year

a. Current assets P2,060,000 P1,470,000
Current liabilities 1,100,000 600,000
Working capital P 960,000 P 870,000
b. Current assets (a) P2,060,000 P1,470,000

Current liabilities (b) P1,100,000 P600,000
Current ratio (a) ÷ (b) 1.87 to 1 2.45 to 1
c. Quick assets (a) P740,000 P650,000

Acid-test ratio (a) ÷ (b) 0.67 to 1 1.08 to 1
d. Sales on account (a) P7,000,000 P6,000,000

Average receivables (b) P525,000 P375,000
Turnover of receivables (a) ÷ (b) 13.3 times 16.0 times
Average age of receivables:

365 ÷ turnover 27.4 days 22.8 days
e. Cost of goods sold (a) P5,400,000 P4,800,000

Average inventory (b) P1,050,000 P760,000
Inventory turnover (a) ÷ (b) 5.1 times 6.3 times
Turnover in days: 365 ÷ turnover 71.6 days 57.9 days

f. Total liabilities (a) P1,850,000 P1,350,000
Equity (b) P2,150,000 P1,950,000
Debt-to-equity ratio (a) ÷ (b) 0.86 to 1 0.69 to 1
g. Net income before interest and taxes (a) P630,000 P490,000

Interest expense (b) P90,000 P90,000
Times interest earned (a) ÷ (b) 7.0 times 5.4 times
Requirement 2
a. METRO BUILDING SUPPLY

Common-Size Balance Sheets
This Year Last Year

Current assets:
Cash 2.3 % 6.1 %
Marketable securities 0.0 1.5
Accounts receivable, net 16.3 12.1
8-56
Inventory 32.5 24.2

Prepaid expenses 0.5 0.6
Total current assets 51.5 44.5
Plant and equipment, net 48.5 55.5
Total assets 100.0 % 100.0 %
Liabilities:
Current liabilities 27.5 % 18.2 %
Bonds payable, 12% 18.8 22.7
Total liabilities 46.3 40.9
Equity:
Preference shares, P50 par, 8% 5.0 6.1
Ordinary shares, P10 par 12.5 15.2
Retained earnings 36.3 37.9
Total equity 53.8 59.1
Total liabilities and equity 100.0 % 100.0 %
Note: Columns do not total down in all cases due to rounding.
b. METRO BUILDING SUPPLY

Common-Size Income Statements
This Year Last Year

Sales 100.0 % 100.0 %
Less cost of goods sold 77.1 80.0
Gross margin 22.9 20.0
Less operating expenses 13.9 11.8
Net operating income 9.0 8.2
Less interest expense 1.3 1.5
Net income before taxes 7.7 6.7
Less income taxes 3.1 2.7
Net income 4.6 % 4.0 %
Requirement 3
The following points can be made from the analytical work in parts (1) and (2)
above:
The company has improved its profit margin from last year. This is attributable to
an increase in gross margin, which is offset somewhat by an increase in operating
expenses. In both years the company’s net income as a percentage of sales equals or
exceeds the industry average of 4%.
Although the company’s working capital has increased, its current position actually
has deteriorated significantly since last year. Both the current ratio and the acid-test
ratio are well below the industry average, and both are trending downward. (This
8-57
shows the importance of not just looking at the working capital in assessing the
financial strength of a company.) Given the present trend, it soon will be
impossible for the company to pay its bills as they come due.
The drain on the cash account seems to be a result mostly of a large buildup in
accounts receivable and inventory. This is evident both from the common-size
balance sheet and from the financial ratios. Notice that the average age of the
receivables has increased by 5 days since last year, and that it is now 9 days over the
industry average. Many of the company’s customers are not taking their discounts,
since the average collection period is 27 days and collection terms are 2/10, n/30.
This suggests financial weakness on the part of these customers, or sales to
customers who are poor credit risks. Perhaps the company has been too aggressive
in expanding its sales.
The inventory turned only 5 times this year as compared to over 6 times last year. It
takes three weeks longer for the company to turn its inventory than the average for
the industry (71 days as compared to 50 days for the industry). This suggests that
inventory stocks are higher than they need to be.
In the authors’ opinion, the loan should be approved on the condition that the
company take immediate steps to get its accounts receivable and inventory back
under control. This would mean more rigorous checks of creditworthiness before
sales are made and perhaps paring out of slow paying customers. It would also
mean a sharp reduction of inventory levels to a more manageable size. If these
steps are taken, it appears that sufficient funds could be generated to repay the loan
in a reasonable period of time.
Case 2 (Financial Ratios for Ordinary Shareholders)
Requirement 1
a. This Year Last Year

Net income P324,000 P240,000
Less preference dividends 16,000 16,000
Net income remaining for ordinary (a) P308,000 P224,000
Average number of ordinary shares (b) 50,000 50,000
Earnings per share (a) ÷ (b) P6.16 P4.48
b. Ordinary dividend per share (a)* P2.16 P1.20

Market price per share (b) P45.00 P36.00
Dividend yield ratio (a) ÷ (b) 4.8% 3.33%
*P108,000 ÷ 50,000 shares = P2.16;
P60,000 ÷ 50,000 shares = P1.20
c. Ordinary dividend per share (a)............................................................................................

P2.16 P1.20
Earnings per share (b)...........................................................................................................
P6.16 P4.48
8-58
Dividend payout ratio (a) ÷ (b)..............................................................................................

35.1% 26.8%
d. Market price per share (a).....................................................................................................

P45.00 P36.00
Earnings per share (b)...........................................................................................................
P6.16 P4.48
Price-earnings ratio (a) ÷ (b).................................................................................................
7.3 8.0
Investors regard Metro Building Supply less

favorably than other firms in the industry. This is
evidenced by the fact that they are willing to pay
only 7.3 times current earnings for a share of the
company’s stock, as compared to 9 times current
earnings for the average of all stocks in the industry.
If investors were willing to pay 9 times current
earnings for Metro Building Supply’s stock, then it
would be selling for about P55 per share (9 ×
P6.16), rather than for only P45 per share.
e. This Year Last Year
Equity.....................................................................................................................................
P2,150,000 P1,950,000
Less preference shares...........................................................................................................
200,000 200,000
Ordinary equity (a)................................................................................................................
P1,950,000 P1,750,000
Number of ordinary shares (b)..............................................................................................

50,000 50,000
Book value per share (a) ÷ (b)...............................................................................................
P39.00 P35.00
A market price in excess of book value does not mean that the price of a stock is
too high. Market value is an indication of investors’ perceptions of future
earnings and/or dividends, whereas book value is a result of already completed
transactions and is geared to the past.
Requirement 2
a. This Year Last Year

Net income.............................................................................................................................
P 324,000 P 240,000
Add after-tax cost of interest paid:
[P90,000 × (1 – 0.40)].......................................................................................................
54,000 54,000
Total (a)..................................................................................................................................
P 378,000 P 294,000
Average total assets (b)..........................................................................................................

P3,650,000 P3,000,000
Return on total assets (a) ÷ (b)..............................................................................................
10.4% 9.8%
b. This Year Last Year

Net income.............................................................................................................................
P 324,000 P 240,000
8-59
Less preference dividends......................................................................................................

16,000 16,000
Net income remaining for ordinary
shareholders (a).................................................................................................................
P 308,000 P 224,000
Average total equity*.............................................................................................................

P2,050,000 P1,868,000
Less average preference shares..............................................................................................
200,000 200,000
Average ordinary equity (b)...................................................................................................
P1,850,000 P1,668,000
*1/2(P2,150,000 + P1,950,000); 1/2(P1,950,000 + P1,786,000).
Return on ordinary equity (a) ÷ (b) 16.6% 13.4%
c. Financial leverage is positive in both years, since the return on ordinary equity
is greater than the return on total assets. This positive financial leverage is due
to three factors: the preference shares, which has a dividend of only 8%; the
bonds, which have an after-tax interest cost of only 7.2% [12% interest rate ×
(1 – 0.40) = 7.2%]; and the accounts payable, which may bear no interest cost.
Requirement 3
We would recommend keeping the stock. The stock’s downside risk seems small,
since it is selling for only 7.3 times current earnings as compared to 9 times
earnings for the average firm in the industry. In addition, its earnings are strong
and trending upward, and its return on ordinary equity (16.6%) is extremely good.
Its return on total assets (10.4%) compares favorably with that of the industry.
The risk, of course, is whether the company can get its cash problem under control.
Conceivably, the cash problem could worsen, leading to an eventual reduction in
profits through inability to operate, a reduction in dividends, and a precipitous drop
in the market price of the company’s stock. This does not seem likely, however,
since the company can easily control its cash problem through more careful
management of accounts receivable and inventory. If this problem is brought under
control, the price of the stock could rise sharply over the next few years, making it
an excellent investment.
Case 3 (Comprehensive Ratio Analysis)
Requirement 1
This Year Last Year
a. Net income.............................................................................................................................
P 280,000 P 168,000
Add after-tax cost of interest:
P120,000 × (1 – 0.30).......................................................................................................
84,000
P100,000 × (1 – 0.30).......................................................................................................
70,000
Total (a)..................................................................................................................................
P 364,000 P 238,000
Average total assets (b)..........................................................................................................

P5,330,000 P4,640,000
8-60
Return on total assets (a) ÷ (b)..............................................................................................

6.8% 5.1%
b. Net income.............................................................................................................................
P 280,000 P 168,000
Less preference dividends......................................................................................................
48,000 48,000
Net income remaining for ordinary (a).................................................................................
P 232,000 P 120,000
Average total equity...............................................................................................................

P3,120,000 P3,028,000
Less average preference shares..............................................................................................
600,000 600,000
Average ordinary equity (b)...................................................................................................
P2,520,000 P2,428,000
Return on ordinary equity (a) ÷ (b).......................................................................................

9.2% 4.9%
c. Leverage is positive for this year, since the return on ordinary equity (9.2%) is
greater than the return on total assets (6.8%). For last year, leverage is negative
since the return on the ordinary equity (4.9%) is less than the return on total
assets (5.1%).
Requirement 2
This Year Last Year

a. Net income remaining for ordinary (a) P 232,000 P 120,000
Average number of ordinary shares (b) 50,000 50,000
Earnings per share (a) ÷ (b) P4.64 P2.40
b. Ordinary dividend per share (a) P1.44 P0.72

Market price per share (b) P36.00 P20.00
Dividend yield ratio (a) ÷ (b) 4.0% 3.6%
c. Ordinary dividend per share (a) P1.44 P0.72

Earnings per share (b) P4.64 P2.40
Dividend payout ratio (a) ÷ (b) 31.0% 30.0%
d. Market price per share (a) P36.00 P20.00

Earnings per share (b) P4.64 P2.40
Price-earnings ratio (a) ÷ (b) 7.8 8.3
Notice from the data given in the problem that the average P/E ratio for
companies in Helix’s industry is 10. Since Helix Company presently has a P/E
ratio of only 7.8, investors appear to regard it less well than they do other
companies in the industry. That is, investors are willing to pay only 7.8 times
current earnings for a share of Helix Company’s stock, as compared to 10 times
current earnings for a share of stock for the average company in the industry.
e. Equity P3,200,000 P3,040,000

Less preference shares 600,000 600,000
Ordinary equity (a) P2,600,000 P2,440,000
8-61
Number of ordinary shares (b) 50,000 50,000

Book value per share (a) ÷ (b) P52.00 P48.80
Note that the book value of Helix Company’s stock is greater than the market
value for both years. This does not necessarily indicate that the stock is selling
at a bargain price. Market value is an indication of investors’ perceptions of
future earnings and/or dividends, whereas book value is a result of already
completed transactions and is geared to the past.
f. Gross margin (a) P1,050,000 P860,000

Sales (b) P5,250,000 P4,160,000
Gross margin percentage (a) ÷ (b) 20.0% 20.7%
Requirement 3
This Year Last Year
a. Current assets P2,600,000 P1,980,000
Current liabilities 1,300,000 920,000
Working capital P1,300,000 P1,060,000
b. Current assets (a) P2,600,000 P1,980,000

Current ratio (a) ÷ (b) 2.0 to 1 2.15 to 1
c. Quick assets (a) P1,220,000 P1,120,000

Acid-test ratio (a) ÷ (b) 0.94 to 1 1.22 to 1
d. Sales on account (a) P5,250,000 P4,160,000

Average receivables (b) P750,000 P560,000
Accounts receivable turnover (a) ÷ (b) 7.0 times 7.4 times
Average age of receivables,
365 ÷ turnover 52 days 49 days
e. Cost of goods sold (a) P4,200,000 P3,300,000
Average inventory (b) P1,050,000 P720,000
Inventory turnover (a) ÷ (b) 4.0 times 4.6 times
Number of days to turn inventory,
365 days ÷ turnover (rounded) 91 days 79 days
f. Total liabilities (a) P2,500,000 P1,920,000

Equity (b) P3,200,000 P3,040,000
Debt-to-equity ratio (a) ÷ (b) 0.78 to 1 0.63 to 1
g. Net income before interest and taxes (a) P520,000 P340,000

Interest expense (b) P120,000 P100,000
Times interest earned (a) ÷ (b) 4.3 times 3.4 times
8-62
Requirement 4
As stated by Meri Ramos, both net income and sales are up from last year. The
return on total assets has improved from 5.1% last year to 6.8% this year, and the
return on ordinary equity is up to 9.2% from 4.9% the year before. But this appears
to be the only bright spot in the company’s operating picture. Virtually all other
ratios are below the industry average, and, more important, they are trending
downward. The deterioration in the gross margin percentage, while not large, is
worrisome. Sales and inventories have increased substantially, which should
ordinarily result in an improvement in the gross margin percentage as fixed costs
are spread over more units. However, the gross margin percentage has declined.
Notice particularly that the average age of receivables has lengthened to 52 days—
about three weeks over the industry average—and that the inventory turnover is
50% longer than the industry average. One wonders if the increase in sales was
obtained at least in part by extending credit to high-risk customers. Also notice that
the debt-to-equity ratio is rising rapidly. If the P1,000,000 loan is granted, the ratio
will rise further to 1.09 to 1.
In the author’s opinion, what the company needs is more equity—not more debt.
Therefore, the loan should not be approved. The company should be encouraged to
make another issue of ordinary stock in order to provide a broader equity base on
which to operate.
Case 4 (Statement Reconstruction Using Ratios)
Bulacan Company
Income Statement
For the Year Ended December 31, 2005
Sales P140,800
Less: Cost of Sales (4) 84,480
Gross Profit P 56,320
Less: Expenses 46,320
Net Income (1) P 10,000
Bulacan Company
Balance Sheet
December 31, 2005
As s e t s
Current Assets:
Cash P 27,720
Accounts Receivable (5) 28,160
Merchandise Inventory (3) 21,120
Total Current Assets (2) P 77,000
8-63
Fixed Assets (8) 55,000

Total Assets P132,000
Current Liabilities:
Accounts Payable (2) P 44,000
Equity:
Share Capital (issued 20,000 shares) (6) P40,000
Retained Earnings 48,000 88,000
Total Liabilities and Equity P132,000
Supporting Computations:
(1) Earnings Per Share = Net Income

Ordinary Shares Outstanding
P0.50 = X
20,000
X (Net Income) = P10,000
(2) Current Assets Pxx 1.75

Current Liabilities xx 1
Working Capital P33,000 0.75
Current Liabilities = P33,000  0.75
= P44,000
Current Assets
(3) Current Ratio =
Current Liabilities
1.27 = X
44,000
X (Current Assets) = P77,000
Quick Ratio = Quick Assets

Current Liabilities
1.27 =
X
44,000
X (Current Assets) = P55,880
8-64
Current Assets P77,000

Quick Assets 55,800
Inventory P21,120
Cost of Sales
(4) Inventory turnover =
Ave. Inventory
4 = X
P21,120
X (Cost of Sales) = P84,480
(5) Average age of outstanding = Quick Assets

Accounts Receivable Current Liabilities
365 = 73 days (Average age of
5 receivables)
Net Sales
Average Receivables = 5
P140,800
= 5
X
X (Receivables) = P28,160
Another Method:
P140,800
= 73 days = P28,160 Accounts receivable
365
(6) Earnings for the year as a percentage of Share Capital
P10,000
Share Capital = 25%
Share Capital = P40,000
(7) Current Fixed Current Liabilities +

Assets + Assets = Equity
P77,000 + 0.625X = P44,000 + X
0.375X = P33,000
X = P88,000 Equity
8-65
(8) Fixed Assets to Equity

Fixed Assets = 0.625
Equity
X
= 0.625
P140,800
X (Fixed Assets) = P55,000
Case 5 (Ethics and the Manager)
Requirement 1
The loan officer stipulated that the current ratio prior to obtaining the loan must be
higher than 2.0, the acid-test ratio must be higher than 1.0, and the interest on the
loan must be no more than four times net operating income. These ratios are
computed below:
Current assets
P290,000
Current rate = P164,000 = 1.8 (rounded)
Cash + Marketable securities + Accounts receivable
P70,000 + P0 + P50,000
Acid-test ratio = P164,000 = 0.70 (rounded)
Net operating income P20,000
= P80,000 x 0.10 x (6/12) = 5.0
Interest on the loan
The company would fail to qualify for the loan because both its current ratio and its
acid-test ratio are too low.
Requirement 2
By reclassifying the P45 thousand net book value of the old machine as inventory,
the current ratio would improve, but there would be no effect on the acid-test ratio.
This happens because inventory is considered to be a current asset but is not
included in the numerator when computing the acid-test ratio.
Current assets
P290,000 + P45,000
Current rate = P164,000 = 2.0 (rounded)
Cash + Marketable securities + Current receivables

P70,000 + P0 + P50,000
Acid-test ratio = 8-66
P164,000 = 0.70 (rounded)
Even if this tactic had succeeded in qualifying the company for the loan, we
strongly advise against it. Inventories are assets the company has acquired for the
sole purpose of selling them to outsiders in the normal course of business. Used
production equipment is not considered to be inventory—even if there is a clear
intention to sell it in the near future. Since the loan officer would not expect used
equipment to be included in inventories, doing so would be intentionally
misleading.
Nevertheless, the old equipment is an asset that could be turned into cash. If this
were done, the company would immediately qualify for the loan since the P45
thousand in cash would be included in the numerator in both the current ratio and
in the acid-test ratio.
Current ratio = Current assets

Current liabilities
P290,000 + P45,000
Current rate = = 2.0 (rounded)
P164,000
Cash + Marketable securities + Current receivables
P70,000 + P0 + P50,000 + P45,000
Acid-test ratio = P164,000 = 1.00 (rounded)
However, other options may be available. After all, the old machine is being used to
relieve bottlenecks in the plastic injection molding process and it would be desirable
to keep this standby capacity. We would advise Rome to fully and honestly explain
the situation to the loan officer. The loan officer might insist that the machine be
sold before any loan is approved, but he might instead grant a waiver of the current
ratio and acid-test ratio requirements on the basis that they could be satisfied by
selling the old machine. Or he may approve the loan on the condition that the
equipment is pledged as collateral. In that case, Rome would only have to sell the
machine if he would otherwise be unable to pay back the loan.
Case 6 (Financial Ratios for Ordinary Shareholders)

[pesos in thousands]
Requirement (1)
Calculation of the gross margin percentage:

Gross margin percentage Gross margin
=
Sales
P23,000
= = 34.8%
P66,000
Requirement (2)
8-67
Calculation of the earnings per share:

Earnings per share Net income – Preference dividends
=
Average number of ordinary shares outstanding
P1,980 – P60
= = P3.20 per share
600 shares
Requirement (3)
Calculation of the price-earnings ratio:

Price-earnings ratio Market price per share
=
Earnings per share
P26
= = 8.1
P3.20
Requirement (4)
Calculation of the dividend payout ratio:

Dividend payout ratio Dividends per share
=
Earnings per share
P0.75
= = 23.4%
P3.20
Requirement (5)
Calculation of the dividend yield ratio:
Dividend yield ratio Dividends per share

=
Market price per share
P0.75
= = 2.9%
P26.00
Requirement (6)
Calculation of the return on total assets:
Return on total assets Net income + [Interest expense x (1 – Tax rate)]

=
Average total assets
P1,980 + [P800 x (1 – 0.40)]
= = 3.7%
(P65,810 + P68,480) / 2
Requirement (7)
Calculation of the return on ordinary shareholders’ equity:
Beginning balance, shareholders’ equity (a) P39,610
8-68
Ending balance, shareholders’ equity (b) 41,080

Average shareholders’ equity [(a) + (b)]/2 40,345
Average preference shares 1,000
Average ordinary shareholders’ equity P39,345
Return on ordinary Net income – Preference dividends
=
shareholders’ equity Average ordinary shareholders’ equity
P1,980 – P60
= = 4.9%
P39,345
Requirement (8)
Calculation of the book value per share:

Book value Total shareholders’ equity – Preference shares
=
per share Number of ordinary shares outstanding
P41,080 – P1,000
Case 7 (Financial Ratios= for Short-Term Creditors)
600 shares = P66.80 per share
Requirement (1)
Calculation of working capital:
Working capital = Current assets – Current liabilities

= P22,680 – P19,400 = P3,280
Requirement (2)
Calculation of the current ratio:

Current assets
Current ratio =
Current liabilities
P22,680
= = 1.17
P19,400
Requirement (3)
Calculation of the acid-test ratio:

Cash + Marketable securities
+ Accounts receivable + Short-term notes
P1,080 + P0 + P9,000 + P0
Acid-test ratio = P19,400 = 0.52
Requirement (4)
Calculation of accounts receivable turnover:
8-69
Accounts receivable Sales on account

= Average accounts receivable balance
turnover
P66,000 = 8.5
Acid-test ratio = (P6,500 + P9,000) / 2
Requirement (5)
Calculation of the average collection period:
Average collection 365 days

= Accounts receivable turnover
period
365 days = 42.9 days
Acid-test ratio = 8.5
Requirement (6)
Calculation of inventory turnover:
Inventory Cost of goods sold

= Average inventory balance
turnover
P43,000
Acid-test ratio = = 3.8
(P10,600 + P12,000) / 2
Requirement (7)
Calculation of the average sale period:
Average sale 365 days

= Inventory turnover
period
365 days
Acid-test ratio = 3.8 = 96.1 days
Case 8 (Financial Ratios for Long-Term Creditors)
Requirement (1)
Calculation of the times interest earned ratio:

Times interest earned Earnings before interest expense
= and income taxes
ratio
Inventory expense
P800
8-70
Requirement (2)
Calculation of the debt-to-equity ratio:
Debt-to-equity Total liabilities

= Shareholders’ equity
ratio
P27,400
41. A 39. C 34. B 41. C 41. C

42. C 40. A 35. D 42. D
43. D 41. C 36. A 43. C
44. B 42. B 37. C 44. A
45. A 43. D 38. A 45. A
46. D 44. B 39. C 46. C
47. C 45. A 40. D 47. A
48. D 46. C 41. A 48. A
49. A 47. A 42. D 49. C
50. B 48. C 43. A 50. C
CHAPTER 6
CASH FLOW ANALYSIS
I. Questions
1. Purposes of the Statement of Cash Flows

a. To predict future cash flows
b. To evaluate management decisions
c. To determine the ability to pay dividends to shareholders and interest
and principal to creditors
d. To show the relationship of net income to changes in the business’s
cash.
2. Comparative balance sheets present the financial position of the enterprise at

two points in time. The income statement for the period between the two
balance sheets describes how the income-producing activities affected the
financial position. Because cash flows from operating activities may differ
8-71
substantially from net income, and because numerous other financing and
investing activities have an impact on financial position, the statement of cash
flows is necessary. The statement emphasizes changes in the cash balances that
result from changes in assets, liabilities and equity accounts caused by
operating, investing and financing activities.
3. The most important source of cash for many successful companies is from
operating activities. A large positive operating cash flow is a good sign because
it means funds have been internally generated with no fixed obligations or
commitment to return such to anybody.
4. It is possible for cash to decrease during a year when income is high because
cash may be used not only for operating activities but also for investing and
financing activities.
5. Transactions involving accounts payable are not considered to be financing

activities because such transactions are used to obtain goods and services rather
than to obtain cash. Furthermore, purchases of goods and services relate to a
company’s day-to-day operating activities.
6. The loss is added back to net income to avoid double counting since the entire
proceeds from the sale (net book value minus loss on sale) will appear as a cash
inflow from investing activities.
7. Three categories of transactions that may result in increases in cash are

a. Operating activities
b. Investing activities (e.g., sale of investments or other assets).
c. Financing activities (e.g., borrowing or sale of shares).
These activities are sources of cash when cash is increased as a result of the
particular activity.
8. Three categories of transactions that may result in decreases in cash are

a. Operating activities
b. Investing activities (e.g., purchase of investments or other assets).
c. Financing activities (e.g., repayment of debt or retirement of shares).
These activities are uses of cash when cash is decreased as a result of the
particular activity.
9. Noncash transactions do not provide or consume cash even though they may
result in significant changes in financial position. Examples are the issuance of
share capital for plant assets and the conversion of debt or preference shares
into ordinary shares. Such transactions are not presented in the body of the
8-72
statement of cash flows but rather disclosed in a separate schedule as financing

or investing activities.
10. While net loss is usually associated with a decrease in cash, it may be a source
of cash if noncash expenses are greater than the amount of the net loss. For
example, if a net loss of P100,000 included amortization and depreciation of
P125,000 and no noncash revenues existed, cash provided by operating
activities would be P25,000, computed as follows:
Net loss P(100,000)

Add: Expenses not requiring cash – depreciation
and amortization 125,000
Net cash provided by operating activities P 25,000
11. The change in cash is the difference between cash at the beginning and end of
the accounting period. The net amount of cash provided by or used in
operating, investing and financing activities must equal this change in cash.
For example, if cash increased by P150,000 during the year, total sources from
operating, investing, and financing activities must exceed total uses by
P150,000. Also, if cash decreased by P25,000 during the year, total uses of
cash must exceed total sources by P25,000.
12. (a) The use of cash does not occur until the cash dividend is actually paid in
the next period. The declaration of the dividend does affect financial
position, however, and should be disclosed as a noncash financing activity
in a separate schedule accompanying the statement of cash flows.
(b) Because the dividend was declared and paid in the same accounting period,
it appears in the statement of cash flows as a cash decrease in the financing
activities category.
13. Disagree. The refunding of 10% debt by the 8% debt represents a significant
financing activity, even though the net impact of the exchange on the balance
sheet or on the amount of cash is not material. The issuance of 8% bonds and
the retirement of 10% bonds should be reported as noncash financing
transactions in a schedule accompanying the statement of cash flows.
14. The net income figure includes P150,000 as an expense. Only P112,500 of this
amount resulted in a decrease in cash, because P37,500 represents an increase
in the deferred income tax liability account. In determining cash provided by
operating activities, the amount of income tax paid is P112,500 (direct method).
Alternatively, under the indirect method, P37,500 must be added to net income
to determine cash flows from operating activities.
8-73
15. The loss is omitted when listing expenses requiring cash payment (direct
approach) or added back to net income (indirect approach) in determining cash
provided by operating activities. This eliminates the impact of the transaction
from cash provided by operating activities. Then, the proceeds from the sale
are included as a source of cash in the investing activities category of the
statement of cash flows. Any tax effects of the transaction are included in the
tax expense figure and remain a part of cash flows from operating activities.
16. (1) Operating activities: Transactions that affect current assets, current
liabilities, or net income.
(2) Investing activities: Transactions that involve the acquisition or disposition
of noncurrent assets.
(3) Financing activities: Transactions (other than the payment of interest)
involving borrowing from creditors, and any transactions (involving the
owners of a company.
17. Interest is included as an operating activity since it is part of net income.

Financing activities are narrowly defined to include only the principal amount
borrowed or repaid.
18. Since the entire proceeds from a sale of an asset (including any gain) appear as
a cash inflow from investing activities, the gain must be deducted from net
income to avoid double counting.
19. The direct method reconstructs the income statement on a cash basis by
restating revenues and expenses in terms of cash inflows and outflows. The
indirect method starts with net income and adjusts it to a cash basis to
determine the cash provided by operating activities.
20. An increase in the Accounts Receivable account must be deducted from net
income under the indirect method because this is an increase in a noncash
asset.
21. A decrease in the Accounts Payable account must be added to cost of goods sold
under the direct method. The cost of goods sold is increased by the amount of
the decrease in accounts payable. Because the cost of goods sold is increased,
the net cash flow provided by operating activities is decreased. The effect of a
decrease in a liability is a decrease in cash.
22. A sale of equipment for cash would be classified as an investing activity. Any
transaction involving the acquisition or disposition of noncurrent assets is
classified as an investing activity.
II. Exercises
Exercise 1
8-74
Net income......................................................................................................................
P84,000
Adjustments to convert net income to a cash basis:
Depreciation charges for the year..............................................................................
P50,000
Increase in accounts receivable..................................................................................
(60,000)
Increase in inventory..................................................................................................
(77,000)
Decrease in prepaid expenses....................................................................................
2,000
Increase in accounts payable......................................................................................
30,000
Decrease in accrued liabilities...................................................................................
(4,000)
Increase in deferred income taxes.............................................................................
6,000 (53,000)
Net cash provided by operating activities...................................................................... P31,000
Exercise 2
Sales P1,000,000
Adjustments to a cash basis:
Less increase in accounts receivable...................................................
– 60,000 P940,000
Cost of goods sold........................................................................................

580,000
Plus increase in inventory....................................................................
+ 77,000
Less increase in accounts payable.......................................................
– 30,000 627,000
Selling and administrative expenses............................................................

300,000
Less decrease in prepaid expenses.......................................................
– 2,000
Plus decrease in accrued liabilities......................................................
+ 4,000
Less depreciation charges....................................................................
– 50,000 252,000
Income taxes.................................................................................................
36,000
Less increase in deferred income taxes...............................................
– 6,000 30,000
Net cash provided by operating activities.................................................... P 31,000
Note that the P31,000 agrees with the cash provided by operating activities figure
under the indirect method in the previous exercise.
Exercise 3
Item Amount Add Deduct

Accounts Receivable.................................................
P70,000 decrease X
Accrued Interest Receivable..................................... P6,000 increase X
Inventory...................................................................
P110,000 increase X
Prepaid Expenses......................................................
P3,000 decrease X
Accounts Payable......................................................
P40,000 decrease X
Accrued Liabilities...................................................
P9,000 increase X
8-75
Deferred Income Taxes Liability..............................P15,000 increase X

Sale of equipment.....................................................
P8,000 gain X
Sale of long-term investments..................................
P12,000 loss X
Exercise 4
Requirement (1)
Net income.............................................................................................................. P75

Adjustments to convert net income to a cash basis:
Depreciation charges..........................................................................................
P40
Decrease in accounts receivable......................................................................... 10
Increase in inventory..........................................................................................
(30)
Decrease in prepaid expenses............................................................................. 5
Increase in accounts payable.............................................................................. 20
Decrease in accrued liabilities............................................................................ (10)
Increase in taxes payable.................................................................................... 10
Increase in deferred taxes................................................................................... 5
Loss on sale of long-term investments............................................................... 5
Gain on sale of land............................................................................................
(40) 15
Net cash provided by operating activities............................................................... P90
Requirement (2)
Swan Company
Operating activities:
Net cash provided by operating activities (see above)......................................................
P 90
Investing activities:
Proceeds from sale of long-term investments...................................................................
P 45
Proceeds from sale of land.................................................................................................
70
Additions to long-term investments..................................................................................
(20)
Additions to plant & equipment........................................................................................
(150)
Net cash used for investing activities................................................................................
(55)
Financing activities:
Decrease in bonds payable.................................................................................................
(20)
Increase in ordinary shares................................................................................................
40
Cash dividends...................................................................................................................
(35)
Net cash used by financing activities................................................................................ (15)
Net increase in cash (net cash flow).................................................................................. 20

Cash balance, beginning....................................................................................................
100
Cash balance, ending.........................................................................................................
P120
8-76
While not a requirement, a worksheet may be helpful.
Cash
Sourc Flow
Chang e or Effec Adjust Adjuste Classificatio
e Use? t -ments d Effect n
Assets (except cash and cash equivalents)
Current assets:
Accounts receivable................................... –10 Source +10 +10 Operating
Inventory................................................... +30 Use –30 –30 Operating
Prepaid expenses....................................... –5 Source +5 +5 Operating
Noncurrent assets:
Long-term investments............................. –30 Source +30 –50 –20 Investing
–
Plant and equipment.................................+150 Use 150 –150 Investing
Land........................................................... –30 Source +30 –30 0 Investing
Liabilities, Contra assets, and Shareholders’ Equity

Contra assets:
Accumulated depreciation......................... +40 Source +40 +40 Operating
Accounts payable....................................... +20 Source +20 +20 Operating
Accrued liabilities..................................... –10 Use –10 –10 Operating
Taxes payable............................................ +10 Source +10 +10 Operating
Noncurrent liabilities:
Bonds payable............................................ –20 Use –20 –20 Financing
Deferred income taxes............................... +5 Source +5 +5 Operating
Shareholders’ equity:
Ordinary shares......................................... +40 Source +40 +40 Financing
Retained earnings:
Net income............................................ +75 Source +75 +75 Operating
Dividends.............................................. –35 Use –35 –35 Financing
Additional entries
Proceeds from sale of investments................ +45 +45 Investing
Loss on sale of investments........................... +5 +5 Operating
Proceeds from sale of land............................. +70 +70 Investing
Gain on sale of land....................................... –40 –40 Operating
Total +20 0 +20
Exercise 5
Sales P600
Decrease in accounts receivable...................................................+10 P610
8-77
Cost of goods sold.................................................................................250

Increase in inventory....................................................................+30
Increase in accounts payable........................................................–20 260
Selling and administrative expenses.....................................................280
Decrease in prepaid expenses....................................................... –5
Decrease in accrued liabilities......................................................+10
Depreciation charges....................................................................–40 245
Income taxes.......................................................................................... 30
Increase in taxes payable..............................................................–10
Increase in deferred taxes............................................................. –5 15
Net cash provided by operating activities............................................. P 90
Exercise 6
Requirements (1) and (2)
Stephenie Company
Operating activities:
Net income...........................................................................................................P 56
Adjustments to convert net income to cash basis:
Depreciation charges..................................................................................
25
Increase in accounts receivable.................................................................. (80)
Decrease in inventory.................................................................................
35
Increase in prepaid expenses...................................................................... (2)
Increase in accounts payable...................................................................... 75
Decrease in accrued liabilities....................................................................(10)
Gain on sale of investments........................................................................ (5)
Loss on sale of equipment.......................................................................... 2
Increase in deferred income taxes.............................................................. 8 48
Net cash provided by operating activities........................................................... 104
Investing activities:
Proceeds from sale of long-term investments.....................................................
12
Proceeds from sale of equipment........................................................................
18
Additions to plant and equipment.......................................................................
(110)
Net cash used for investing activities.................................................................. (80)
Financing activities:
Increase in bonds payable....................................................................................
25
Decrease in ordinary shares................................................................................
(40)
Cash dividends....................................................................................................
(16)
Net cash used for financing activities................................................................. (31)
8-78
Net decrease in cash............................................................................................ (7)

Cash balance, January 1, 2008............................................................................ 11
Cash balance, December 31, 2008......................................................................P 4
While not a requirement, a worksheet may be helpful.

Cash
Sourc Flow
Chang e or Effec Adjust Adjuste Classi-
e Use? t -ments d Effect fication
Assets (except cash and cash equivalents)
Current assets:
Accounts receivable................................... +80 Use –80 –80 Operating
Inventory................................................... –35 Source +35 +35 Operating
Prepaid expenses....................................... +2 Use –2 –2 Operating
Noncurrent assets:
Plant and equipment................................. +80 Use –80 –30 –110 Investing
Long-term investments............................. –7 Source +7 –7 0 Investing
Liabilities, Contra assets, and Shareholders’ Equity

Contra assets:
Accumulated depreciation......................... +15 Source +15 +10 +25 Operating
Accounts payable....................................... +75 Source +75 +75 Operating
Accrued liabilities..................................... –10 Use –10 –10 Operating
Noncurrent liabilities:
Financin
Bonds payable............................................ +25 Source +25 +25 g
Deferred income taxes............................... +8 Source +8 +8 Operating
Shareholders’ equity:
Financin
Ordinary shares......................................... –40 Use –40 –40 g
Retained earnings:
Net income............................................ +56 Source +56 +56 Operating
Financin
Dividends.............................................. –16 Use –16 –16 g
Additional entries
Proceeds from sale of equipment................... +18 +18 Investing
Loss on sale of equipment............................. +2 +2 Operating
Proceeds from sale of long-term
investments................................................ +12 +12 Investing
Gain on sale of long-term investments......... –5 –5 Operating
Total –7 0 –7
8-79
II. Problems
Problem 1
Transaction Operating Investing Financing Source Use

1. Short-term investment
securities were
purchased X X
.....................................
2. Equipment was
purchased X X
.....................................
3. Accounts payable
increased X X
.....................................
4. Deferred taxes
decreased X X
.....................................
5. Long-term bonds were
issued X X
.....................................
6. Ordinary shares were
sold X X
.....................................
7. Interest was paid to
long-term creditors X X
.....................................
8. A long-term mortgage
was entirely paid off X X
.....................................
9. A cash dividend was
declared and paid X X
.....................................
10. Inventories decreased. . . X X
11. Accounts receivable
increased X X
......................................
12. Depreciation charges
totaled P200,000 for
the year X X
......................................
Problem 2 (Analysis of Cash Flow Transactions)
Requirement (a)
8-80
The eight items should be presented in the statement of cash flows as follows:
1. Net income is the basis for the calculation of cash flows from operating
activities by starting with that number and adjusting for noncash revenue and
expense transactions (indirect method) or by computing by the direct method
the positive cash flows from revenues, less the negative cash flows from
expenses. The cash flows from the transaction giving rise to the extraordinary
loss is reclassified as an investing activity.
2. The acquisition of intangibles is a negative cash flow from investing activities.
The amortization is a noncash expense in determining cash flows from
operating activities.
3. The payment of a cash dividend is a negative cash flow that is presented in the
financing activities section of the statement.
4. The purchase of treasury share is a negative cash flow in the financing
activities section of the statement.
5. The depreciation expense recognized during the year is a noncash expense in
determining cash flows from operating activities.
6. The conversion of convertible bonds into ordinary shares is a noncash
financing activity that requires disclosure in a separate schedule.
7. The changes in plant asset accounts – land, equipment, and building –
represent activities whose cash flow effects are presented in the investing
activities section of the statement.
8. The increase in working capital also represents the change in cash because all
other current assets and current liabilities remained constant. The net of all
cash flows from operating, investing and financing activities must reconcile
with the change in cash in the statement of cash flows.
Requirement (b)
1. Net cash provided by operating activities

Net income P145,000
Noncash expense adjustments:
Depreciation expense 46,250
Amortization expense 6,000
Reclassification of extraordinary loss 15,000
P212,250
2. Net cash used in investing activities
Purchase of intangible assets P (34,000)
Purchase of land (130,000)
Purchase of equipment (60,000)
Purchase of building (100,000)
Sale of land 165,000
P(159,000)
3. Net cash used in financing activities
8-81
Purchase of treasury shares P(31,000)

Payment of dividends (12,500)
P(43,500)
Computations:
Depreciation expense
Change in accumulated depreciation account P35,000
Accumulated depreciation on fully depreciated
assets disposed 11,250
P46,250
Purchase of land
Change in land account P (50,000)
Cost of land sold in condemnation proceedings 180,000
P130,000
Problem 3 (Cash Flow from Operating Activities)
Cash received from customers:

Total revenues P185,000
Less: Note receivable (15,000) P170,000
Cash disbursed for expenses:
Total expenses (P173,000 + P4,200) P177,200
Less: Income taxes deferred (1,260)
Depreciation (25,000)
Amortization (7,000) (143,940)
Net cash provided by operating activities P 26,060
Problem 4 (Cash Flow from Operating Activities)
Cash received from customers (1) P5,237,000

Cash paid for expenses:
Cost of goods sold P3,150,000
Selling 246,000
Salaries and wages (2) 394,400
Interest (3) 65,200
Miscellaneous operating 5,000
Incomes taxes (4) 335,000 4,195,600
Net cash provided by operating activities P1,041,400
Computations:
1. Revenue from sales P5,432,000
Less: Note receivable (120,000)
Land (75,000)
P5,237,000
2. Salaries and wages expense P 400,000
8-82
Less: Increase in accrued salaries and wages

(P45,600 – P40,000) (5,600)
P 394,400
3. Interest expense P 72,000

Less: Discount amortization (6,800)
P 65,200
4. Income tax expense P 445,000

Less: Deferred portion (110,000)
P 335,000
Problem 5 (Statement of Cash Flows Preparation – Indirect)
Green Tea Company

Cash flows from operating activities

Net income* P8,500
Adjustments to reconcile net income to
net cash flows provided by operating
activities:
Depreciation 1,000
Amortization of intangibles 1,000
Increase in current assets (6,000
)
Increase in current liabilities 3,000
Net cash provided by operating P7,500
activities
Cash flows from financing activities

Dividends paid (1,500
)
Retirement of long-term liabilities (1,000
)
Net cash used in financing activities (2,500)
Net increase in cash P
5,000
Cash, January 1, 2005 10,00
0
Cash, December 31, 2005 P15,00
0
*
Increase in retained earnings (P20,000 – P13,000) P7,000
Dividends declared 1,500
Net income P8,500
8-83
Problem 6 (Cash Flow Statement Preparation – Direct)
Requirement (a)
Hundred Acre Company


activities
Cash received from customers P74,00
0
Cash paid for expense 67,00
0
Net cash provided by operating P7,000
activities
Cash flow from investing activities
Sale of equipment 9,500
Sale of investments 15,000
Acquisition of equipment (53,000
)
Net cash used in investing (28,500)
activities
Cash flows from financing activities
Sale of ordinary shares 40,000
Payment of cash dividends (8,500
)
Net cash used in financing 31,50
activities 0
Net increase in cash P10,00
0
Cash, January 1, 2005 20,00
0
Cash, December 31, 2005 P30,00
0
Reconciliation of net income to net cash provided

by operating activities:
Net income P15,00
0
Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation expense 24,500*
Amortization expense 1,000
*
Net increase during 2005 (P33,600 – P27,100) P 6,500
Accumulated depreciation on assets sold 18,000
Depreciation expense for 2005 P24,500
8-84
Increase in accounts receivable (33,000)

Decrease in accrued expenses (500)
Net cash provided by operating activities P
7,000
Computations:
Cash received from customers:
Revenues P107,000
Deduct: Increase in accounts receivable
(P78,000 – P45,000) 33,000
P 74,000
Cash paid for expenses:
Expenses P 92,000
Add: Decrease in accrued expenses
(P7,500 – P7,000) 500
Deduct: Depreciation expense
(P33,600 – P27,100 + P18,000) (24,500)
Amortization (1,000)
P 67,000
Cash from sale of equipment:
Cost P 27,500
Deduct: Accumulated depreciation (18,000)
Cash received on sale at book value P 9,500
Cash paid to acquire equipment:
Increase in property, plant and equipment
(P118,100 – P92,600) P 25,500
Cost of machinery sold 27,500
P 53,000
Cash received on sale of shares:
Increase in ordinary shares amount
(P100,000 – P75,000) P 25,000
Increase in additional paid-in capital account
(P55,000 – P40,000) 15,000
P 40,000
Cash dividends:
Increase in retained earnings (P21,000 – P14,500) P 6,500
Net income (P107,000 – P92,000) (15,000)
P 8,500
Requirement (b)
The reconciliation of net income to net cash provided by or used in operating

activities is required to be disclosed in order to show more clearly the relationship
and emphasize the differences between the two. Users of financial statements are
often not as aware of the accrual concepts, which determine net income, as are
preparers of those statements. The reconciliation of net income to net cash flows
8-85
from operating activities clearly demonstrates that the two are different and details
those events and transactions that account for the difference.
Problem 7 (Interpretation of Cash Flow Statement)
Requirement (a)
The two companies are similar in the following respects:

1. Overall size.
2. Industry in which they operate.
3. Current ratio (2.4 to 1).
4. Overall peso amounts of cash provided and used:
Range, 2002-2005
Cash Cash Used
Provided
Ebony P125,000 – P115,000 –
Company P168,000 P170,000
Ivory P135,000 – P125,000 –
Company P160,000 P165,000
5. Net increase in working capital is identical for each year, 2002 – 2005.
Requirement (b)
The two companies are dissimilar in the makeup of the sources of cash, as indicated
in the following analysis:
Sources of Cash in Percentages

2002 2003 2004
Ebony Ivory Ebony Ivory Ebony
Cash
provided
:
Operations 80 37 77 21 70
Long-term debt 8 56 -- 10 --
Share capital -- -- 16 52 --
Asset 12 7 7 17 30
disposition
100 100 100 100 100
Ebony Company has relied much more heavily on operations to provide cash and to
a very limited extent on debt and equity financing and asset disposition. On the
other hand, Ivory Company has not been able to provide cash from operations and
8-86
has been required to rely on the alternatives of debt and equity financing and asset
disposition.
Requirement (c)
Ebony Company is in a considerably stronger position (as determined by the data

given) and thus should be considered the better investment and credit risk. The
following points are significant:
1. Ebony Company has provided 70%-80% of its cash via operating activities,
supplementing with other means to maintain a current ratio at the industry
average. Ebony has not had to rely consistently on any alternative source
of funding.
2. Ivory Company has apparently been forced to rely continuously on debt
financing except in 2005, perhaps because of the inability to obtain such
financing. The year 2004 is particularly weak for Ivory, with operations
resulting in a P60,000 reduction in cash. The ability of Ivory to sustain its
present financial position (i.e., current ratio, etc.) is questionable in light of
its history.
III. Multiple Choice Questions
1. D 4. D 7. C 10. B
2. C 5. B 8. B 11. A
3. D 6. D 9. A 12. D
CHAPTER 7
GROSS PROFIT VARIATION ANALYSIS AND EARNINGS PER SHARE

DETERMINATION
I. Problems
Problem I
The Dawn Mining Company

Gross Profit Variation Analysis
For 2006
Increase in Sales:
Quantity Factor [(24,000) x P8] P(192,000)
Price Factor (105,000 x P3) 315,000
Quantity/Price Factor [(24,000) x P3] (72,000)P 51,000
Less: Increase (decrease) in Cost of Sales:
Quantity Factor [(24,000) x P9] P(216,000)
8-87
Cost Factor [105,000 x (P.50)] (52,500)

Quantity/Cost Factor [(24,000) x (P.50)] 12,000 (256,500)
Increase in Gross Profit P 307,500
Problem II
1. Selling Price Factor

Sales in 2006 P210,000
Less: Sales in 2006 at 2005 prices
(P210,000  105%) 200,000
Favorable P 10,000
2. Cost Factor
Cost of Sales in 2006 P164,000
Less: Cost of Sales in 2006 at 2005 costs 176,000
Favorable P(12,000)
3. Quantity Factor
Increase in Sales
Sales in 2006 at 2005 prices P200,000
Less: Sales in 2005 150,000
Favorable P 50,000
Less: Increase in Cost of Sales
Cost of Sales in 2006 at 2005 costs
(P132,000 x 133-1/3%) P176,000
Less: Cost of Sales in 2005 132,000
Unfavorable P 44,000
Net favorable quantity factor 6,000*
Increase in Gross Profit P 28,000
* This may also be obtained using the following presentation:

Quantity Factor:
Sales in 2006 at 2005 prices P200,000
Less: Sales in 2005 150,000
Increase in Sales P 50,000
Multiplied by: Ave. Gross Profit rate in 2005 12%
Net favorable variance P 6,000
Problem III
Requirement A:
Tony Corporation
Statement Accounting for Gross Profit Variation
For 2006
8-88
Increase (Decrease) in Sales accounted for as follows:

Price Factor
Sales this year P210,210
Less: Sales this year at last year’s prices 269,500
Favorable (Unfavorable) P(59,290)
Quantity Factor
Sales this year at last year’s
prices (P210,210  78%) P269,500
Less: Sales last year 192,500
Favorable (Unfavorable) P 77,000
Net Increase (decrease) in sales P 17,710
Increase (decrease) in Cost of Sales accounted for as follows:
Cost Factor
Cost of Sales this year P 165,400
Less: Cost of Sales this year at last
year’s costs 161,700
(Favorable) Unfavorable P 3,700
Quantity Factor
Cost of Sales this year at last year’s
costs (115,500 x 140%) P 161,700
Less: Cost of Sales last year 115,500
(Favorable) Unfavorable P 46,200
Net increase (decrease) in Cost of Sales P 49,900

Net increase (decrease) in Gross Profit P (32,190)
Gross Profit, this year P 44,810

Gross Profit, last year 77,000
Increase (Decrease) in Gross Profit P(32,190)
Requirement B:
(1) Change in Quantity = P 77,000 = 40% increase

P192,500
(2) Change in Unit Costs = P 3,700 = 2.38% increase

P161,700
Problem IV
Quantity Factor
1. Decrease in Sales due to decrease in the number
8-89
of customers [(1,000) x 18 MCF x P2.50)] P(45,000)
2. Increase in Sales due to increase in consumption

rate per customer (26,000 x 2 MCF x P2.50) 130,000
Net Increase P 85,000
Price Factor
3. Decrease in Sales due to the decrease in rate per
MCF [P(.05) x 520,000] (26,000)
Increase in operating revenues P 59,000
Average Consumption:
(a) 2006 = 520,000  26,000 = 20 MCF/customer
2005 = 486,000  27,000 = 18 MCF/customer
Increase in Consumption
per customer 2 MCF/customer
(b) 27,000 - 26,000 = 1,000 decrease in number of customers
(c) Price 2006 P2.45

2005 2.50
Decrease in rate or
price per MCF sold P(.05)
Problem V
XYZ Corporation
Gross Profit Variation Analysis
For 2006
Price Factor
Sales in 2006 P 1,750
Less: Sales in 2006 at 2005 prices
A (25 x P10) P 250
B (75 x P20) 1,500 1,750
Increase (decrease) in gross profit P -
Cost Factor:
Cost of sales in 2006 P 875
Less: Cost of sales in 2006 at 2005 costs:
A (25 X P5) P 125
B (75 x P10) 750 875
8-90
Quantity Factor:
Increase (decrease) in total quantity
Multiplied by: Average gross profit
per unit in 2005 (P750  100) P 7.50
Sales Mix Factor:

Average gross profit per unit in 2006 at
2005 prices P8.75 *
Less: Average gross profit per unit in 2005 7.50
Increase (decrease) P1.25
Multiplied by: Total quantity in 2006 100

Increase (decrease) in gross profit P125.00
Increase in Gross Profit P125.00
* Sales in 2006 at 2005 prices P1,750

Less: Cost of sales in 2006 at 2005 prices 875
Gross profit in 2006 at 2005 prices P 875
Average Gross Profit on 2006 at 2005 prices:
P875 = P8.75
100 (volume in 2006)
Problem VI (Computation of Weighted Average Number of Ordinary Shares)
Number of Shares
Adjustment
for 25% stock
dividend As Weighted
Date Unadjusted Adjusted Multiplier Shares
1/1/2006 16,000 4,000 20,000 12/12 20,000
2/15/2006 3,200 800 4,000 10.5/12 3,500
4/1/2006 (3,000) (750) (3,750) 9/12 (2,812)
6/1/2006 1,400 350 1,750 7/12 1,020
9/1/2006 6,400 1,600 8,000 4/12 2,667
12/1/2006 6,000 (6,000) - - -
Total 30,000 - 30,000 24,375
Problem VII (Computation of Basic EPS and Diluted EPS)
1. Basic EPS = P 90,000

100,000
8-91
= P0.90
2. Diluted EPS = P90,000 + (10% x P500,000 x 65%)

P500,000
100,000 +
P1,000
x 100
P90,000 + P32,500
= 150,000
= P0.82 (rounded off)
Problem VIII
Requirements (1) and (2)
Explanation Earnings  Shares = Per Share

Basic earnings and shares P122,000 a
 33,333 = P3.66 Basic
b
Stock option share increment 293c

Tentative DEPS1 amounts P122,000  33,626 = P3.63 DEPS1
10% bond interest expense savings e 13,300d
Increment in shares 4,400d
Tentative DEPS2 amounts P135,300  38,026 = P3.56 DEPS2
7.5% preference dividend savingse 28,500d
Increment in shares 9,310d
P163,800  47,336 = P3.46 DEPS3
5.8% bonds 21,924 6,264
Diluted earnings and shares P185,724  53,600 = P3.465 Diluted
a
P122,000 = P150,500 (net income) - P28,500 (preference dividends)
b
Weighted average shares: 25,000 x 1.20 = 30,000 x 7/12 = 17,500
32,000 x 1.20 = 38,400 x 4/12 = 12,800
38,400 - 2,000 = 36,400 x 1/12 = 3,033
Weighted average shares 33,333
c
Increment due to stock options:
Issued 4,000
4,000 x ( P33 + P5 )
Reacquired P41 = (3,707)
Increment in shares 293

d
Impact on diluted earnings per share and ranking:
8-92
Impact
Ranking
[(0.10 x P200,000) – P1,000] x 0.7 P13,300
10% bonds: 200 x 22 = 4,400 P3.02 5
(0.058 x P540,000) x 0.7 P21,924

5.8% bonds: 540 x 11.6 = 6,264 P3.50 3
(0.075 x P380,000) P28,500

7.5% preference: 3,800 x 2.45 = 9,310 P3.06 2
e
Dilutive effect on diluted earnings per share:
10% bonds: P3.02 impact < P3.63 (DEPS 1), therefore dilutive
7.5% preference: P3.06 impact < P3.56 (DEPS2), therefore dilutive
5.8% bonds: P3.50 impact > P3.46 (DEPS3), therefore exclude from EPS
Requirement 3
Fuego Company would report basic earnings per share of P3.66 and diluted
earnings per share of P3.46 on its 2005 income statement.
1. B 5. A 9. A 13. A 17. A 21. C

2. B 6. B 10. A 14. D 18. B 22. A
3. C 7. B 11. D * 15. C 19. C 23. B
4. D 8. B 12. C 16. A 20. D
* Supporting computation for no. 11:

P3,500,000 + (P800,000 x 65%)
Diluted EPS for 12/31/2006 =
400,000 + 25,000 + 225,000
P4,020,000
= or P6.18
650,000
CHAPTER 8
COST CONCEPTS AND CLASSIFICATIONS
I. Questions
1. The phrase “different costs for different purposes” refers to the fact that the
word “cost” can have different meanings depending on the context in which it
is used. Cost data that are classified and recorded in a particular way for one
purpose may be inappropriate for another use.
8-93
2. Fixed costs remain constant in total across changes in activity, whereas variable
costs change in proportion to the level of activity.
3. Examples of direct costs of the food and beverage department in a hotel include
the money spent on the food and beverages served, the wages of table service
personnel, and the costs of entertainment in the dining room and lounge.
Examples of indirect costs of the food and beverage department include
allocations of the costs of advertising for the entire hotel, of the costs of the
grounds and maintenance department, and of the hotel general manager’s
salary.
4. The cost of idle time is treated as manufacturing overhead because it is a

normal cost of the manufacturing operation that should be spread out among all
of the manufactured products. The alternative to this treatment would be to
charge the cost of idle time to a particular job that happens to be in process
when the idle time occurs. Idle time often results from a random event, such as
a power outage. Charging the cost of the idle time resulting from such a
random event to only the job that happened to be in process at the time would
overstate the cost of that job.
5. a. Uncontrollable cost
b. Controllable cost
c. Uncontrollable cost
6. Product costs are costs that are associated with manufactured goods until the
time period during which the products are sold, when the product costs become
expenses. Period costs are expensed during the time period in which they are
incurred.
7. The most important difference between a manufacturing firm and a service

industry firm, with regard to the classification of costs, is that the goods
produced by a manufacturing firm are inventoried, whereas the services
produced by a service industry firm are consumed as they are produced. Thus,
the costs incurred in manufacturing products are treated as product costs until
the period during which the goods are sold. Most of the costs incurred in a
service industry firm to produce services are operating expenses that are treated
as period costs.
8. Product costs are also called inventoriable costs because they are assigned to
manufactured goods that are inventoried until a later period, when the products
are sold. The product costs remain in the finished goods inventory account
until the time period when the goods are sold.
9. A sunk cost is a cost that was incurred in the past and cannot be altered by any
current or future decision. A differential cost is the difference in a cost item
under two decision alternatives.
8-94
10. a. Direct cost

b. Direct cost
c. Indirect cost
d. Indirect cost
11. The two properties of a relevant cost are:

1. it differs between the decision options
2. it will be incurred in the future
12. The three types of product costs are:

1. direct materials – the materials used in manufacturing the product, which
become a physical part of the finished product.
2. direct labor – the labor used in manufacturing the product.
3. factory overhead – the indirect costs for materials, labor, and facilities used
to support the manufacturing process, but not used directly in
manufacturing the product.
13. The three types of manufacturing inventories are:

1. materials inventory – the store of materials used in the manufacturing
process or in providing the service.
2. work in process inventory – accounts for all costs put into the
manufacturing of products that are started but not complete at the financial
statement date.
3. finished goods inventory – the cost of goods that are ready for sale.
14. Direct materials include the materials in the product and a reasonable
allowance for scrap and defective units, while indirect materials are materials
used in manufacturing that are not physically part of the finished product.
15. The income statement of a manufacturing company differs from the income
statement of a merchandising company in the cost of goods sold section. A
merchandising company sells finished goods that it has purchased from a
supplier. These goods are listed as “purchases” in the cost of goods sold section.
Since a manufacturing company produces its goods rather than buying them
from a supplier, it lists “cost of goods manufactured” in place of “purchases.”
Also, the manufacturing company identifies its inventory in this section as
Finished Goods inventory, rather than as Merchandise Inventory.
16. Yes, costs such as salaries and depreciation can end up as part of assets on the
balance sheet if these are manufacturing costs. Manufacturing costs are
inventoried until the associated finished goods are sold. Thus, if some units are
still in inventory, such costs may be part of either Work in Process inventory or
Finished Goods inventory at the end of a period.
8-95
17. No. A variable cost is a cost that varies, in total, in direct proportion to changes
in the level of activity. A variable cost is constant per unit of product. A fixed
cost is fixed in total, but the average cost per unit changes with the level of
activity.
18. Manufacturing overhead is an indirect cost since these costs cannot be easily
and conveniently traced to particular units of products.
19.
Direct labor cost (34 hours  P15 per hour).................................... P510
Manufacturing overhead cost (6 hours  P15 per hour)................. 90
Total wages earned........................................................................... P600
20.
Direct labor cost (45 hours  P14 per hour).................................. P630
Manufacturing overhead cost (5 hours  P7 per hour)................. 35
Total wages earned..................................... P665
II. Exercises
Exercise 1 (Schedule of Cost of Goods Manufactured and Sold; Income

Statement)
Requirement 1
Amazing Aluminum Company

Schedule of Cost of Goods Manufactured
Direct material:
Raw-material inventory, January 1.......................... P
60,000
Add: Purchases of raw material.............................. 250,00
0
Raw material available for use................................. P310,00
0
Deduct: Raw-material inventory, December 70,00
31 0
Raw material used P240,00
0
Direct labor..................................................................... 400,000
Manufacturing overhead:
Indirect material P
10,000
Indirect labor 25,000
Depreciation on plant and equipment 100,000
8-96
Utilities 25,000
....................................................................
....................................................................
Other 30,00
.................................................................... 0
....................................................................
Total manufacturing overhead 190,00
0
Total manufacturing costs............................................... P830,00
0
Add: Work-in-process inventory, January 1.................. 120,00
0
Subtotal........................................................................... P950,00
0
Deduct: Work-in-process inventory, December 1.......... 115,000
Cost of goods manufactured........................................... P835,00
0
Requirement 2

Schedule of Cost of Goods Sold
Finished goods inventory, January 1................................................... P150,00

0
Add: Cost of goods manufactured..................................................... 835,00
0
Cost of goods available for sale.......................................................... P985,00
0
Deduct: Finished goods inventory, December 31.............................. 165,00
0
Cost of goods sold............................................................................... P820,00
0
Requirement 3

Income Statement
Sales revenue....................................................................................... P1,105,00

0
Less: Cost of goods sold..................................................................... 820,00
0
8-97
Gross margin....................................................................................... P
285,000
Selling and administrative expenses................................................... 110,000
Income before taxes............................................................................. P
175,000
Income tax expense............................................................................. 70,00
0
Net income ........................................................................................ P
105,000
Exercise 2
Fixed (F) Period (P)

Cost Item Variable (V) Product (R)
a. Transportation-in costs on materials
purchased V R
b. Assembly-line workers’ wages V R
c. Property taxes on work in process
inventories V R
d. Salaries of top executives in the company F P
e. Overtime premium for assembly workers V R
f. Sales commissions V P
g. Sales personnel office rental F P
h. Production supervisory salaries F R
i. Controller’s office supplies F P
Fixed (F) Period (P)
Cost Item Variable (V) Product (R)
j. Executive office heat and air conditioning F P
k. Executive office security personnel F P
l. Supplies used in assembly work V R
m. Factory heat and air conditioning F R
n. Power to operate factory equipment V R
o. Depreciation on furniture for sales staff F P
p. Varnish used for finishing product V R
q. Marketing personnel health insurance F P
r. Packaging materials for finished product V R
s. Salary of the quality control manager who
checks work on the assembly line F R
t. Assembly-line workers’ dental insurance F R
Exercise 3 (Cost Classifications; Manufacturer)
1. a, d, g, i
2. a, d, g, j
3. b, f
4. b, d, g, k
8-98
5. a, d, g, k
6. a, d, g, j
7. b, c, f
8. b, d, g, k
9. b, c and d*, e and f and g*, k*
* The building is used for several purposes.
10. b, c, f
11. b, c, h
12. b, c, f
13. b, c, e
14. b, c and d†, e and f and g†, k†
†
The building that the furnace heats is used for several purposes.
15. b, d, g, k
Exercise 4 (Economic Characteristics of Costs)
1. marginal cost
2. sunk cost
3. average cost
4. opportunity cost
5. differential cost
6. out-of-pocket cost
Exercise 5 (Cost Classifications; Hotel)
1. a, c, e, k
2. b, d, e, k
3. d, e, i
4. d, e, i
5. a, d, e, k
6. a, d, e, k
7. d, e, k
8. b, d†, e, k
†
Unless the dishwasher has been used improperly.
9. h
10. a, d, e*, j
* The hotel general manager may have some control over the total space
allocated to the kitchen.
8-99
11. i
12. j
13. a, c, e
14. e, k
Exercise 6
Pickup Truck Output
3,000 trucks 6,000 trucks 9,000 trucks

Variable production costs P 29,640,000 P 59,280,000 P 88,920,000
Fixed production costs 39,200,000 39,200,000 39,200,000
Variable selling costs 4,500,000 9,000,000 13,500,000
Fixed selling costs 13,660,000 13,660,000 13,660,000
Total costs P 87,000,000 P121,140,000 P155,280,000
Selling price per truck 46,000 40,100 35,900
Unit cost 29,000 20,190 17,253
Profit per truck 17,000 19,910 18,647
Exercise 7
(see next page)
Exercise 8
1. The wages of employees who build the sailboats: direct labor cost.
2. The cost of advertising in the local newspapers: marketing and selling cost.
3. The cost of an aluminum mast installed in a sailboat: direct materials cost.
4. The wages of the assembly shop’s supervisor: manufacturing overhead cost.
5. Rent on the boathouse: a combination of manufacturing overhead,
administrative, and marketing and selling cost. The rent would most likely be
prorated on the basis of the amount of space occupied by manufacturing,
administrative, and marketing operations.
6. The wages of the company’s bookkeeper: administrative cost.
7. Sales commissions paid to the company’s salespeople: marketing and selling
cost.
8. Depreciation on power tools: manufacturing overhead cost.
8-100
Exercise 7
Period Product Cost

Variable Fixed (Selling and Direct Direc Manufacturin Sunk
Cost Cost Administrative) Material t g Overhead Cost
Cost s Labor
1. Wood used
in a table
X X
(P200 per
table)
2. Labor cost
to assemble
a table X X
(P80 per
table)
3. Salary of
the factory
supervisor X X
(P76,000
per year)
4. Cost of
electricity
to produce
tables (P4 X X
per
machine-
hour)
5. X X X*
Depreciatio
n of
8-101
machines
used to
produce
tables
(P20,000
per year)
6. Salary of
the
company
X X
president
(P200,000
per year)
7.
Advertisin
X X
g expense
(P500,000
per year)
8.
Commissio
ns paid to X X
salesperson
s (P60 per
table sold)
9. Rental
income
forgone on
factory
space
*
This is a sunk cost because the outlay for the equipment was made in a previous period.
8-102
1
This is an opportunity cost because it represents the potential benefit that is lost or sacrificed as a result of using the factory
space to produce tables. Opportunity cost is a special category of cost that is not ordinarily recorded in an organization’s
accounting books. To avoid possible confusion with other costs, we will not attempt to classify this cost in any other way except
as an opportunity cost.
8-103
Exercise 9
Direc Indirec
t t
Cost Cost Object Cost Cost
1. The salary of the head chef The hotel’s restaurant X
2. The salary of the head chef A particular restaurant X
customer
3. Room cleaning supplies A particular hotel guest X
4. Flowers for the reception desk A particular hotel guest X
5. The wages of the doorman A particular hotel guest X
6. Room cleaning supplies The housecleaning X
department
7. Fire insurance on the hotel The hotel’s gym X
building
8. Towels used in the gym The hotel’s gym X
Note: The room cleaning supplies would most likely be considered an indirect cost
of a particular hotel guest because it would not be practical to keep track of exactly
how much of each cleaning supply was used in the guest’s room.
III. Problems
Problem 1
The relevant costs for this decision are the differential costs. These are:
Opportunity cost or lost wages (take home)

[P1,500 x 70% x 12 months]............. P12,600
Tuition............................................................ 2,200
Books and supplies........................................ 300
Total differential costs............................ P15,100
Room and board, clothing, car, and incidentals are not relevant because these are
presumed to be the same whether or not Francis goes to school. The possibility of
part-time work, summer jobs, or scholarship assistance could be considered as
reductions to the cost of school. If students are familiar with the time value of
money, then they should recognize that the analysis calls for a comparison of the
present value of the differential after-tax cash inflows with the present value of
differential costs of getting the education (including the opportunity costs of lost
income).
Problem 2
Requirement (a)
8-104
Only the differential outlay costs need be considered. The travel and other variable
expenses of P22 per hour would be the relevant costs. Any amount received in
excess would be a differential, positive return to Pat.
Requirement (b)
The opportunity cost of the hours given up would be considered in this situation.
Unless Pat receives more than the P100 normal consulting rate, the contract would
not be beneficial.
Requirement (c)
In this situation Pat would have to consider the present value of the contract and
compare that to the present value of the existing consulting business. The final rate
may be more or less than the normal P100 rate depending on the outcome of Pat’s
analysis.
Problem 3
Utilities for the bakery 2,100

Paper used in packaging product 90
Salaries and wages in the bakery 19,500
Cookie ingredients 35,000
Bakery labor and fringe benefits 1,300
Bakery equipment maintenance 800
Depreciation of bakery plant and equipment 2,000
Uniforms 400
Insurance for the bakery 900
Boxes, bags, and cups used in the bakery 1,100
Bakery overtime premiums 2,600
Bakery idle time 500
Total product costs in pesos 66,290
Problem 4
Administrative costs 1,000

Rent for administration offices 17,200
Advertising 1,900
Office manager’s salary 13,000
Total period costs in pesos 33,100
Problem 5
Requirement (a)
8-105
Sunk costs not shown could include lost book value on traded assets, depreciation
estimates for new investment, and interest costs on capital needed during facilities
construction.
Requirement (b)
The client might be used to differential cost as a decision tool, and believes
(correctly) that use of differential analyses has several advantages --- it is quicker,
requires less data, and tends to give a better focus to the decision. The banker might
suspect the client of hiding some material data in order to make the proposal more
acceptable to the financing agency.
Problem 6
Requirement (1)
EH Corporation
Schedule of Cost of Goods Manufactured
For the Year Ended December 31
Direct materials:
Raw materials, inventory, January 1 P
45,000
Add: Purchases of raw materials 375,0
00
Raw materials available for use 420,00
0
Deduct: Raw materials inventory, 30,0
December 31 00
Raw materials used in production P
390,000
Direct labor 75,000
Utilities, factory 18,000
Depreciation, factory 81,000
Insurance, factory 20,000
Supplies, factory 7,500
Indirect labor 150,00
0
Maintenance, factory 43,5
00
Total manufacturing overhead cost 320,0
00
Total manufacturing cost 785,000
Add: Work in process inventory, January 1 90,00
0
875,000
8-106
Deduct: Work in process inventory, 50,00

December 31 0
Cost of goods manufactured P825,00
0
Requirement (2)
The cost of goods sold would be computed as follows:
Finished goods inventory, January 1 P130,00

0
Add: Cost of goods manufactured 825,00
0
Goods available for sale 955,000
Deduct: Finished goods inventory, December 31 105,00
0
Cost of goods sold P850,00
0
Requirement (3)
EH Corporation
Income Statement
For the Year Ended December 31
Sales P1,250,00
0
Cost of goods sold (above) 850,00
0
Gross margin 400,000
Selling and administrative expenses:
Selling expenses P
70,000
Administrative expenses 135,0 205,00
00 0
Net operating income P
195,000
8-107
Problem 7
Note to the Instructor: Some of the answers below are debatable.
Manufacturing
Variable or Selling Adminis- (Product) Cost
Cost Item Fixed Cost trative Cost Direct Indirect
1. Depreciation, executive jet......................................................................................... F X
2. Costs of shipping finished goods to customers......................................................... V X
3. Wood used in manufacturing furniture..................................................................... V X
4. Sales manager’s salary............................................................................................... F X
5. Electricity used in manufacturing furniture.............................................................. V X
6. Secretary to the company president........................................................................... F X
7. Aerosol attachment placed on a spray can produced by the company...................... V X
8. Billing costs............................................................................................................... V X*
9. Packing supplies for shipping products overseas...................................................... V X
10. Sand used in manufacturing concrete....................................................................... V X
11. Supervisor’s salary, factory........................................................................................ F X
12. Executive life insurance............................................................................................. F X
13. Sales commissions..................................................................................................... V X
14. Fringe benefits, assembly line workers..................................................................... V X**
15. Advertising costs........................................................................................................ F X
16. Property taxes on finished goods warehouses........................................................... F X
17. Lubricants for production equipment........................................................................ V X
*Could be an administrative cost.
**Could be an indirect cost.
Problem 8
Requirement (1)
Period
(Selling
Product Cost and
Variable Fixe Direct Direc Mfg. Admin.) Opportunity Sunk
d t
Name of the Cost Cost Cost Materials Labor Overhead Cost Cost Cost
Ling’s present salary of P400,000 per
month................................................................... X
Rent on the garage, P15,000 per month.................. X X
Rent of production equipment, P50,000
per month............................................................. X X
Materials for producing flyswatters, at
P30.00 each..........................................................
X X
Labor cost of producing flyswatters, at
P50.00 each..........................................................
X X
Rent of room for a sales office, P7,500
per month............................................................. X X
Answering device attachment, P2,000
per month............................................................. X X
Interest lost on savings account,
P100,000 per year................................................ X
Advertising cost, P40,000 per month...................... X X
Sales commission, at P10.00 per
flyswatter..............................................................
X X
Legal and filing fees, P60,000................................. X
8-109
Requirement (2)
The P60,000 legal and filing fees are not a differential cost. These legal and filing
fees have already been paid and are a sunk cost. Thus, the cost will not differ
depending on whether Ling decides to produce flyswatters or to stay with the
consulting firm. All other costs listed above are differential costs since they will be
incurred only if Ling leaves the consulting firm and produces the flyswatters.
Problem 9
Requirement (1)
Ms. Rio’s first action was to direct that discretionary expenditures be delayed until
the first of the new year. Providing that these “discretionary expenditures” can be
delayed without hampering operations, this is a good business decision. By delaying
expenditures, the company can keep its cash a bit longer and thereby earn a bit
more interest. There is nothing unethical about such an action. The second action
was to ask that the order for the parts be cancelled. Since the clerk’s order was a
mistake, there is nothing unethical about this action either.
The third action was to ask the accounting department to delay recognition of the
delivery until the bill is paid in January. This action is dubious. Asking the
accounting department to ignore transactions strikes at the heart of the integrity of
the accounting system. If the accounting system cannot be trusted, it is very difficult
to run a business or obtain funds from outsiders. However, in Ms. Rio’s defense, the
purchase of the raw materials really shouldn’t be recorded as an expense. He has
been placed in an extremely awkward position because the company’s accounting
policy is flawed.
Requirement (2)
The company’s accounting policy with respect to raw materials is incorrect. Raw
materials should be recorded as an asset when delivered rather than as an expense.
If the correct accounting policy were followed, there would be no reason for Ms. Rio
to ask the accounting department to delay recognition of the delivery of the raw
materials. This flawed accounting policy creates incentives for managers to delay
deliveries of raw materials until after the end of the fiscal year. This could lead to
raw materials shortages and poor relations with suppliers who would like to record
their sales before the end of the year.
The company’s “manage-by-the-numbers” approach does not foster ethical behavior

—particularly when managers are told to “do anything so long as you hit the target
profits for the year.” Such “no excuses” pressure from the top too often leads to
unethical behavior when managers have difficulty meeting target profits.
13-110
Cost-Volume-Profit Relationships Chapter 13
1. B 7. C 13. D 19. A 25. C

2. D 8. D 14. D† 20. A* 26. B
3. B 9. C 15. B† 21. B 27. B
4. A 10. C 16. A† 22. B 28. A **
5. C 11. A 17. C† 23. C 29. A
6. D 12. C 18. C 24. C 30. B
* Controllable costs are those costs that can be influenced by a specified manager
within a given time period.
** The answer assumes absorption costing method is used.
†
Supporting Computations
14. P60 + P10 + P18 + P4 = P92 16. P60 + P10 + P18 + P32 = P120
15. P32 + P16 = P48 17. P4 + P16 = P20
CHAPTER 9
COST BEHAVIOR: ANALYSIS AND USE
I. Questions
1. a. Variable cost: A variable cost is one that remains constant on a per unit
basis, but which changes in total in direct relationship to changes in
volume.
b. Fixed cost: A fixed cost is one that remains constant in total amount, but
which changes, if expressed on a per unit basis, inversely with changes in
volume.
c. Mixed cost: A mixed cost is a cost that contains both variable and fixed
cost elements.
2. a. Unit fixed costs will decrease as volume increases.

b. Unit variable costs will remain constant as volume increases.
c. Total fixed costs will remain constant as volume increases.
d. Total variable costs will increase as volume increases.
3. a. Cost behavior: Cost behavior can be defined as the way in which costs
change or respond to changes in some underlying activity, such as sales
volume, production volume, or orders processed.
b. Relevant range: The relevant range can be defined as that range of
activity within which assumptions relative to variable and fixed cost
behavior are valid.
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Chapter 13 Cost-Volume-Profit Relationships
4. Although the accountant recognizes that many costs are not linear in
relationship to volume at some points, he concentrates on their behavior within
narrow bands of activity known as the relevant range. The relevant range can
be defined as that range of activity within which assumptions as relative to
variable and fixed cost behavior are valid. Generally, within this range an
assumption of strict linearity can be used with insignificant loss of accuracy.
5. The high-low method, the scattergraph method, and the least-squares
regression method are used to analyze mixed costs. The least-squares
regression method is generally considered to be most accurate, since it derives
the fixed and variable elements of a mixed cost by means of statistical analysis.
The scattergraph method derives these elements by visual inspection only, and
the high-low method utilizes only two points in doing a cost analysis, making it
the least accurate of the three methods.
6. The fixed cost element is represented by the point where the regression line
intersects the vertical axis on the graph. The variable cost per unit is
represented by the slope of the line.
7. The two assumptions are:

1. A linear cost function usually approximates cost behavior within the
relevant range of the cost driver.
2. Changes in the total costs of a cost object are traceable to variations or
changes in a single cost driver.
8. No. High correlation merely implies that the two variables move together in
the data examined. Without economic plausibility for a relationship, it is less
likely that a high level of correlation observed in one set of data will be found
similarly in another set of data.
10. The relevant range is the range of the cost driver in which a specific
relationship between cost and cost driver is valid. This concept enables the use
of linear cost functions when examining CVP relationships as long as the
volume levels are within that relevant range.
11. A unit cost is computed by dividing some amount of total costs (the numerator)
by the related number of units (the denominator). In many cases, the
numerator will include a fixed cost that will not change despite changes in the
denominator. It is erroneous in those cases to multiply the unit cost by activity
or volume change to predict changes in total costs at different activity or
volume levels.
12. Cost estimation is the process of developing a well-defined relationship

between a cost object and its cost driver for the purpose of predicting the cost.
The cost predictions are used in each of the management functions:
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Strategic Management: Cost estimation is used to predict costs of alternative

activities, predict financial impacts of alternative strategic choices, and to
predict the costs of alternative implementation strategies.
Planning and Decision Making: Cost estimation is used to predict costs so that
management can determine the desirability of alternative options and to budget
expenditures, profits, and cash flows.
Management and Operational Control: Cost estimation is used to develop cost
standards, as a basis for evaluating performance.
Product and Service Costing: Cost estimation is used to allocate costs to
products and services or to charge users for jointly incurred costs.
13. The five methods of cost estimation are:

a. Account Classification. Advantages: simplicity and ease of use.
Disadvantages: subjectivity of method and some costs are a mix of both
variable and fixed.
b. Visual fit. The visual fit method is easy to use, and requires only that the
data is graphed. Disadvantages are that the scale of the graph may limit
ability to estimate costs accurately and in both graphical and tabular form,
significant perceptual errors are common.
c. High-Low. Because of the precision in the development of the equation, it
provides a more consistent estimate than the visual fit and is not difficult to
use. Disadvantages: uses only two selected data points and is, therefore,
subjective.
d. Work Measurement. The advantage is accurate estimates through detailed
study of the different operations in the product process, but like regression,
it is more complex.
e. Regression. Quantitative, objective measures of the precision and accuracy
and reliability of the model are the advantages of this model; disadvantages
are its complexity: the effort, expense, and expertise necessary to utilize
this method.
14. Implementation problems with cost estimation include:

a. cost estimates outside of the relevant range may not be reliable.
b. sufficient and reliable data may not be available.
c. cost drivers may not be matched to dependent variables properly in each
observation.
d. the length of the time period for each observation may be too long, so that
the underlying relationship between the cost driver and the variable to be
estimated is difficult to isolate from the numerous variables and events
occurring in that period of time; alternatively the period may be too short,
so that the data is likely to be affected by accounting errors in which
transactions are not properly posted in the period in which they occurred.
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e. dependent variables and cost drivers may be affected by trend or

seasonality.
f. when extreme observations (outliers) are used the reliability of the results
will be diminished.
g. when there is a shift in the data, as, for example, a new product is
introduced or when there is a work stoppage, the data will be unreliable for
future estimates.
15. The dependent variable is the cost object of interest in the cost estimation. An
important issue in selecting a dependent variable is the level of aggregation in
the variable. For example, the company, plant, or department may all be
possible levels of data for the cost object. The choice of aggregation level
depends on the objectives for the cost estimation, data availability, reliability,
and cost/benefit considerations. If a key objective is accuracy, then a detailed
level of analysis is often preferred. The detail cost estimates can then be
aggregated if desired.
16. Nonlinear cost relationships are cost relationships that are not adequately
explained by a single linear relationship for the cost driver(s). In accounting
data, a common type of nonlinear relationship is trend and seasonality. For a
trend example, if sales increase by 8% each year, the plot of the data for sales
with not be linear with the driver, the number of years. Similarly, sales which
fluctuate according to a seasonal pattern will have a nonlinear behavior. A
different type of nonlinearity is where the cost driver and the dependent
variable have an inherently nonlinear relationship. For example, payroll costs
as a dependent variable estimated by hours worked and wage rates is nonlinear,
since the relationship is multiplicative and therefore not the additive linear
model assumed in regression analysis.
17. The advantages of using regression analysis include that it:

a. provides an estimation model with best fit (least squared error) to the data
b. provides measures of goodness of fit and of the reliability of the model
which can be used to assess the usefulness of the specific model, in contrast
to the other estimation methods which provide no means of self-evaluation
c. can incorporate multiple independent variables
d. can be adapted to handle non-linear relationships in the data, including
trends, shifts and other discontinuities, seasonality, etc.
e. results in a model that is unique for a given set of data
18. High correlation exists when the changes in two variables occur together. It is
a measure of the degree of association between the two variables. Because
correlation is determined from a sample of values, there is no assurance that it
measures or describes a cause and effect relationship between the variables.
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19. An activity base is a measure of whatever causes the incurrence of a variable

cost. Examples of activity bases include units produced, units sold, letters
typed, beds in a hospital, meals served in a cafe, service calls made, etc.
20. (a) Variable cost: A variable cost remains constant on a per unit basis, but
increases or decreases in total in direct relation to changes in activity.
(b) Mixed cost: A mixed cost is a cost that contains both variable and fixed
cost elements.
(c) Step-variable cost: A step-variable cost is a cost that is incurred in large
chunks, and which increases or decreases only in response to fairly wide
changes in activity.
Mixed Cost
Variable Cost
Cost
Step-Variable Cost
Activity
21. The linear assumption is reasonably valid providing that the cost formula is
used only within the relevant range.
22. A discretionary fixed cost has a fairly short planning horizon—usually a year.
Such costs arise from annual decisions by management to spend on certain
fixed cost items, such as advertising, research, and management development.
A committed fixed cost has a long planning horizon—generally many years.
Such costs relate to a company’s investment in facilities, equipment, and basic
organization. Once such costs have been incurred, they are “locked in” for
many years.
23. a. Committed d. Committed

b. Discretionary e. Committed
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c. Discretionary f. Discretionary
24. The high-low method uses only two points to determine a cost formula. These
two points are likely to be less than typical since they represent extremes of
activity.
25. The term “least-squares regression” means that the sum of the squares of the
deviations from the plotted points on a graph to the regression line is smaller
than could be obtained from any other line that could be fitted to the data.
26. Ordinary single least-squares regression analysis is used when a variable cost is
a function of only a single factor. If a cost is a function of more than one factor,
multiple regression analysis should be used to analyze the behavior of the cost.
II. Exercises
Exercise 1 (Cost Classification)
1. b
2. f
3. e
4. i
5. e
6. h
7. l
8. a
9. j
10. k
11. c or d
12. g
Exercise 2 (Cost Estimation; High-Low Method)
Requirement (1)
Cost equation using square fee as the cost driver:
Variable costs:
P4,700 – P2,800
4,050 – 2,375 = P1.134
Fixed costs:
P4,700 = Fixed Cost + P1.134 x 4,050

Fixed Cost = P107
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Equation One: Total Cost = P107 + P1.134 x square feet

There are two choices for the High-Low points when using openings for the cost
driver. At 11 openings there is a cost of P2,800 and at 10 openings there is a cost of
P2,875.
Cost equation using 11 openings as the cost driver:
Variable costs:
P4,700 – P2,800
19 – 11 = P237.50
Fixed costs:
P4,700 = Fixed Cost + P237.50 x 19

Fixed Cost = P187.50
Equation Two: Total Cost = P187.50 + P237.50 x openings
Cost equation using 10 openings as the cost driver:
Variable costs:
P4,700 – P2,875
19 – 10 = P202.78
Fixed costs:
P4,700 = Fixed Cost + P202.78 x 19

Fixed Cost = P847.18
Equation Three: Total Cost = P847.18 + P202.78 x openings
Predicted total cost for a 3,200 square foot house with 14 openings using equation
one:
P107 + P1.134 x 3,200 = P3,735.80
two:
P187.50 + P237.50 x 14 = P3,512.50
three:
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P847.18 + P202.78 x 14 = P3,686.10
There is no simple method to determine which prediction is best when using the
High-Low method. In contrast, regression provides quantitative measures (R-
squared, standard error, t-values,…) to help asses which regression equation is best.
Predicted cost for a 2,400 square foot house with 8 openings, using equation one:
P107 + P1.134 x 2,400 = P2,828.60
We cannot predict with equation 2 or equation 3 since 8 openings are outside the
relevant range, the range for which the high-low equation was developed.
Requirement 2
Figure 9-A shows that the relationship between costs and square feet is relatively
linear without outliers, while Figure 9-B shows a similar result for the relationship
between costs and number of openings. From this perspective, both variables are
good cost drivers.
Figure 9-A
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Figure 9-B
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Exercise 3 (Cost Estimation; Account Classification)
Requirement 1
Fixed Costs:
Rent P10,250
Depreciation 400
Insurance 750
Advertising 650
Utilities 1,250
Mr. Black’s salary 18,500
Total P31,800
Variable Costs:
Wages P17,800
CD Expense 66,750
Shopping Bags 180
Total P84,730
Variable Costs Per Unit = P84,730 / 8,900

= P95.20
Cost Function Equation: y = P31,800 + P95.20 x (CD’s sold)
Requirement 2
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New Sales = 8,900 x 1.25

= 11,125 units
= round to 11,130
Total Costs = P31,800 + P95.20 x (11,130)

= P137,760
Per Unit Total Costs = P137,760 / 11,130

= P123.80
Add P1 profit per disc: P123.80 + P10 = P133.80
Requirement 3
Adjusted New Sales = 8,900 x 11.50

= 10,240 units
Revenue = P133.80 x (10,240)

= P137,010
Total Cost = P31,800 + P95.20 x (10,240)

= P129,280
Cost Per Disc = P129,280 / 10,240 = P126.30
Profit Per Disk = P133.80 – P126.30

= P7.50
Exercise 4 (Cost Estimation Using Graphs; Service)
Requirement 1
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Requirement 2
There seems to be a positive linear relationship for the data between P2,500 and
P4,000 of advertising expense. Llanes’ analysis is correct within this relevant range
but not outside of it. Notice that the relationship between advertising expense and
sales changes at P4,000 of expense.
Exercise 5 (Fixed and Variable Cost Behavior)
Requirement (1)
Cups of Coffee Served
in a Week
1,800 1,900 2,000
Fixed cost P11,000 P11,000 P11,000
Variable cost 4,680 4,940 5,200
Total cost P15,680 P15,940 P16,200
Cost per cup of coffee served * P8.71 P8.39 P8.10
* Total cost ÷ cups of coffee served in a week
Requirement (2)
The average cost of a cup of coffee declines as the number of cups of coffee served
increases because the fixed cost is spread over more cups of coffee.
Exercise 6 (Scattergraph Analysis)
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Requirement (1)
The completed scattergraph is presented below:
16,000
14,000
12,000
10,000
Total Cost
8,000
6,000
4,000
2,000
0
0 2,000 4,000 6,000 8,000 10,000
Units Processed
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Requirement (2)
(Students’ answers will vary considerably due to the inherent imprecision and
subjectivity of the quick-and-dirty scattergraph method of estimating variable and
fixed costs.)
The approximate monthly fixed cost is P6,000—the point where the straight line
intersects the cost axis.
The variable cost per unit processed can be estimated as follows using the 8,000-
unit level of activity, which falls on the straight line:
Total cost at the 8,000-unit level of activity........................................................ P14,000

Less fixed costs....................................................................................................6,000
Variable costs at the 8,000-unit level of activity.................................................. P 8,000
P8,000 ÷ 8,000 units = P1 per unit.
Observe from the scattergraph that if the company used the high-low method to
determine the slope of the line, the line would be too steep. This would result in
underestimating the fixed cost and overestimating the variable cost per unit.
Exercise 7 (High-Low Method)
Requirement (1)
Month Occupancy-Days Electrical Costs

High activity level (August).......................... 3,608 P8,111
Low activity level (October).......................... 186 1,712
Change........................................................... 3,422 P6,399
Variable cost = Change in cost ÷ Change in activity

= P6,399 ÷ 3,422 occupancy-days
= P1.87 per occupancy-day
Total cost (August).........................................................................................................

P8,111
Variable cost element
(P1.87 per occupancy-day × 3,608 occupancy-days)................................................ 6,747
Fixed cost element..........................................................................................................
P1,364
Requirement (2)
Electrical costs may reflect seasonal factors other than just the variation in
occupancy days. For example, common areas such as the reception area must be
lighted for longer periods during the winter. This will result in seasonal effects on
the fixed electrical costs.
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Additionally, fixed costs will be affected by how many days are in a month. In other
words, costs like the costs of lighting common areas are variable with respect to the
number of days in the month, but are fixed with respect to how many rooms are
occupied during the month.
Other, less systematic, factors may also affect electrical costs such as the frugality of
individual guests. Some guests will turn off lights when they leave a room. Others
will not.
Exercise 8 (Least-Squares Regression)
The least-squares regression estimates of fixed and variable costs can be computed
using any of a variety of statistical and mathematical software packages or even by
hand.
Month Rental Car Wash

Returns Costs
January............................. 2,310 P10,113
February............................ 2,453 P12,691
March............................... 2,641 P10,905
April................................. 2,874 P12,949
May................................... 3,540 P15,334
June................................... 4,861 P21,455
July................................... 5,432 P21,270
August.............................. 5,268 P19,930
September......................... 4,628 P21,860
October............................. 3,720 P18,383
November......................... 2,106 P 9,830
December.......................... 2,495 P11,081
Intercept P2,29
6
Slope P3.74
RSQ 0.92
The intercept provides the estimate of the fixed cost element, P2,296 per month,
and the slope provides the estimate of the variable cost element, P3.74 per rental
return. Expressed as an equation, the relation between car wash costs and rental
returns is
Y = P2,296 + P3.74X
where X is the number of rental returns.
Note that the R2 is 0.92, which is quite high, and indicates a strong linear
relationship between car wash costs and rental returns.
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While not a requirement of the exercise, it is always a good to plot the data on a
scattergraph. The scattergraph can help spot nonlinearities or other problems with
the data. In this case, the regression line (shown below) is a reasonably good
approximation to the relationship between car wash costs and rental returns.
III. Problems
Problem 1
Requirement (a) Miles Total Annual

Driven Cost*
High level of activity................................ 120,000 P13,920
Low level of activity................................. 80,000 10,880
Difference............................................ 40,000 P 3,040
* 120,000 miles x P0.116 = P13,920.

80,000 miles x P0.136 = P10,880.
Variable cost per mile:
Change in cost, P3,040
Change in activity, 40,000 = P0.076 per mile.
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Fixed cost per year:

Total cost at 120,000 miles............................................ P13,920
Less variable cost element: 120,000 x P0.076............. 9,120
Fixed cost per year..................................................... P 4,800
Requirement (b)
Y = P4,800 + P0.076X
Requirement (c)
Fixed cost.............................................................................. P 4,800

Variable cost: 100,000 miles x P0.076................................ 7,600
Total annual cost............................................................ P12,400
Problem 2
Requirement 1
Cost of goods sold............................................................... Variable

Shipping expense................................................................ Mixed
Advertising expense............................................................ Fixed
Salaries and commissions................................................... Mixed
Insurance expense............................................................... Fixed
Depreciation expense.......................................................... Fixed
Requirement 2
Analysis of the mixed expenses:

Salaries and
Shipping Comm.
Units Expense Expense
High level of activity..................... 4,500 P56,000 P143,000
Low level of activity...................... 3,000 44,000 107,000
Difference............................... 1,500 P12,000 P 36,000
Variable cost element:

Change in cost
Change in activity = Variable rate
Shipping expense: P12,000

1,500 units = P8 per unit.
P36,000
Salaries and comm. expense:
1,500 units = P24 per unit.
Fixed cost element:
Shipping Salaries and
Expense Comm. Expense
Cost at high level of activity...................... P56,000 P143,000
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Less variable cost element:

4,500 units x P8.................................. 36,000
4,500 units x P24................................ 108,000
Fixed cost element..................................... P20,000 P 35,000
The cost elements are:

Shipping expense: P20,000 per month plus P8 per unit or Y = P20,000 +
P8X.
Salaries and comm. expense: P35,000 per month plus P24 per unit or Y =
P35,000 + P24X.
Requirement 3
LILY COMPANY
Income Statement
For the Month Ended June 30
Sales in units........................................................... 4,500

Sales revenues......................................................... P630,000
Less variable expenses:
Cost of goods sold (@P56)................................ P252,000
Shipping expense (@P8)................................... 36,000
Salaries and commission expense
(@P24)........................................................... 108,000 396,000
Contribution margin............................................... 234,000
Less fixed expense:
Shipping expense.............................................. 20,000
Advertising........................................................ 70,000
Salaries and commissions................................. 35,000
Insurance........................................................... 9,000
Depreciation...................................................... 42,000 176,000
Net income.............................................................. P 58,000
Problem 3
Requirement 1
Number of Total Cost (Y)

Year Leagues (X) XY X2
2004 5 P13,000 P 65,000 25
2005 2 7,000 14,000 4
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2006 4 10,500 42,000 16

2007 6 14,000 84,000 36
2008 3 10,000 30,000 9
20 P54,500 P235,000 90
n (XY) - (X) (Y)

b = n (X2) - (X)2
5 (235,000) - (20) (54,500)
= 5 (90) - (20) 2
= 1,700
a = (Y) - b(X)
n
(54,500) - 1,700 (20)
= 5
= P4,100
Therefore, the variable cost per league is P1,700 and the fixed cost is
P4,100 per year.
Requirement 2
Y = P4,100 + P1,700X
Requirement 3
The expected value total would be:

Fixed cost....................................................................... P 4,100
Variable cost (7 leagues x P1,700)................................. 11,900
Total cost................................................................... P16,000
The problem with using the cost formula from (2) to derive this total cost figure is
that an activity level of 7 sections lies outside the relevant range from which the
cost formula was derived. [The relevant range is represented by a solid line on the
graph in requirement 4 below.]
Although an activity figure may lie outside the relevant range, managers will often
use the cost formula anyway to compute expected total cost as we have done above.
The reason is that the cost formula frequently is the only basis that the manager has
to go on. Using the cost formula as the starting point should not present a problem
so long as the manager is alert for any unusual problems that the higher activity
level might bring about.
Requirement 4
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P16,000 Y
P14,000
P12,000
P10,000
P8,000
P6,000
P4,000
P2,000
X
P-
Problem 4 (Regression
0 Analysis,
1 2 Service
3 Company)
4 5 6 7 8
Requirement 1
Figure 9-C plots the relationship between labor-hours and overhead costs and
shows the regression line.
y = P48,271 + P3.93 X
Economic plausibility. Labor-hours appears to be an economically plausible driver

of overhead cost for a catering company. Overhead costs such as scheduling, hiring
and training of workers, and managing the workforce are largely incurred to
support labor.
Goodness of fit. The vertical differences between actual and predicted costs are
extremely small, indicating a very good fit. The good fit indicates a strong
relationship between the labor-hour cost driver and overhead costs.
Slope of regression line. The regression line has a reasonably steep slope from left
to right. The positive slope indicates that, on average, overhead costs increase as
labor-hours increase.
Requirement 2
The regression analysis indicates that, within the relevant range of 2,500 to 7,500
labor-hours, the variable cost per person for a cocktail party equals:
Food and beverages P15.00
Labor (0.5 hrs. x P10 per hour) 5.00
Variable overhead (0.5 hrs. x P3.93 per labor-hour) 1.97
Total variable cost per person P21.97
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Requirement 3
To earn a positive contribution margin, the minimum bid for a 200-person cocktail
party would be any amount greater than P4,394. This amount is calculated by
multiplying the variable cost per person of P21.97 by the 200 people. At a price
above the variable costs of P4,394, Bobby Gonzales will be earning a contribution
margin toward coverage of his fixed costs.
Of course, Bobby Gonzales will consider other factors in developing his bid
including (a) an analysis of the competition – vigorous competition will limit
Gonzales’ ability to obtain a higher price (b) a determination of whether or not his
bid will set a precedent for lower prices – overall, the prices Bobby Gonzales
charges should generate enough contribution to cover fixed costs and earn a
reasonable profit, and (c) a judgment of how representative past historical data
(used in the regression analysis) is about future costs.
Figure 9-C
Regression Line of Labor-Hours on Overhead Costs for Bobby Gonzales’ Catering
Company
Problem 5 (Linear Cost Approximation)
Requirement 1
Difference in cost
Slope coefficient (b) =
Difference in labor-hours
P529,000 – P400,000
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= = P43.00
Constant (a) = P529,000 – P43.00 (7,000)

= P228,000
Cost function = P228,000 + P43.00 (professional labor-hours)
The linear cost function is plotted in Figure 9-D.
No, the constant component of the cost function does not represent the fixed
overhead cost of the ABS Group. The relevant range of professional labor-hours is
from 3,000 to 8,000. The constant component provides the best available starting
point for a straight line that approximates how a cost behaves within the 3,000 to
8,000 relevant range.
Requirement 2
A comparison at various levels of professional labor-hours follows. The linear cost

function is based on formula of P228,000 per month plus P43.00 per professional
labor-hours.
Total overhead cost behavior:
Month 1 Month 2 Month 3 Month 4 Mont

Actual total
overhead P340,000 P400,00 P435,00 P477,00 P529
costs 0 0 0
Linear 357,000 400,00 443,00 486,00 529
approximati 0 0 0
on
Actual minus
linear P(17,000 P 0 P (8,000) P (9,000) P
approximati )
on
Professional 3,000 4,000 5,000 6,000 7,
labor-hours
The data are shown in Figure 9-D. The linear cost function overstates costs by
P8,000 at the 5,000-hour level and understates costs by P15,000 at the 8,000-hour
level.
Requirement 3
Based on Based on
Actual Linear
Cost
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Function
Contribution before deducting
incremental overhead P38,00 P38,00
0 0
Incremental overhead 35,00 43,00
0 0
Contribution after incremental P P
overhead 3,000 (5,000)
The total contribution margin actually forgone is P3,000.
Figure 9-D
Linear Cost Function Plot of Professional Labor-Hours
on Total Overhead Costs for ABS Consulting Group
Problem 6 (Cost Behavior)
The variable cost per hour can be computed as follows:
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P20,000 / 5,000 hours = P4 per hour
Therefore, the missing amounts are as follows:
Hours of Operating Time

5,000 6,000 7,000 8,000
Total costs:
Variable
costs
(@ P4 P
per hour) 20,000 P24,000 P28,000 P32,000
Fixed
costs 168,000 168,000 168,000 168,000
Total costs P188,000 P192,000 P196,000 P200,000
Hours of Operating Time

5,000 6,000 7,000 8,000
Cost per
hour:
Variable
cost P4.00 P4.00 P4.00 P4.00
Fixed
cost 33.60 28.00 24.00 21.00
Total cost
per hour P37.60 P32.00 P28.00 P25.00
Observe that the total variable costs increase in proportion to the number of hours of
operating time, but that these costs remain constant at P4 if expressed on a per hour
basis.
In contrast, the total fixed costs do not change with changes in the level of activity.
They remain constant at P168,000 within the relevant range. With increases in
activity, however, the fixed cost per hour decreases, dropping from P33.60 per hour
when the boats are operated 5,000 hours a period to only P21.00 per hour when the
boats are operated 8,000 hours a period. Because of this troublesome aspect of
fixed costs, they are most easily (and most safely) dealt with on a total basis, rather
than on a unit basis, in cost analysis work.
Problem 7 (High-Low Method)
Requirement (1)
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The first step in the high-low method is to identify the periods of the lowest and
highest activity. Those periods are November (1,100 patients admitted) and June
(1,900 patients admitted).
The second step is to compute the variable cost per unit using those two data points:
Number of Admitting
Month Patients Department
Admitted Costs
High activity level (June) 1,900 P15,20
0
Low activity level 1,100 12,80
(November) 0
Change 800 P
2,400
Change in cost
Variable cost =
Change in activity
= P240,000
800 patients admitted
= P3 per patient admitted
The third step is to compute the fixed cost element by deducting the variable cost
element from the total cost at either the high or low activity. In the computation
below, the high point of activity is used:
Fixed cost element = Total cost – Variable cost element

= P15,200 – (P3 per patient admitted
x 1,900 patients admitted)
= P9,500
Requirement (2)
The cost formula is Y = P9,500 + P3X.
Problem 8 (Scattergraph Analysis; Selection of an Activity Base)
Requirement (1)
The completed scattergraph for the number of units produced as the activity base is
presented below:
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5,000
Requirement (2)
4,500
4,000
The completed scattergraph for the number of workdays as the activity base is
presented below:
3,500
Janitorial Labor Cost
3,000
2,500
2,000
1,500
1,000
500
0
0 20 40 60 80 100 120 140
Units Produced
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Requirement (3)
5,000
4,500
4,000
3,500
Janitorial Labor Cost
3,000
2,500
2,000
1,500
1,000
500
0
0 2 4 6 8 10 12 14 16 18 20 22 24
Number of Janitorial Workdays
The number of workdays should be used as the activity base rather than the number
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of units produced. There are several reasons for this. First, the scattergraphs reveal
that there is a much stronger relationship (i.e., higher correlation) between
janitorial costs and number of workdays than between janitorial costs and number of
units produced. Second, from the description of the janitorial costs, one would
expect that variations in those costs have little to do with the number of units
produced. Two janitors each work an eight-hour shift—apparently irrespective of
the number of units produced or how busy the company is. Variations in the
janitorial labor costs apparently occur because of the number of workdays in the
month and the number of days the janitors call in sick. Third, for planning
purposes, the company is likely to be able to predict the number of working days in
the month with much greater accuracy than the number of units that will be
produced.
Note that the scattergraph in part (1) seems to suggest that the janitorial labor costs
are variable with respect to the number of units produced. This is false. Janitorial
labor costs do vary, but the number of units produced isn’t the cause of the
variation. However, since the number of units produced tends to go up and down
with the number of workdays and since the janitorial labor costs are driven by the
number of workdays, it appears on the scattergraph that the number of units drives
the janitorial labor costs to some extent. Analysts must be careful not to fall into this
trap of using the wrong measure of activity as the activity base just because it
appears there is some relationship between cost and the measure of activity. Careful
thought and analysis should go into the selection of the activity base.
1. A 11. C* 21. C 31. D 41. B

2. D 11. C* 22. D 32. B 42. D
3. B 12. C 23. C 33. A 43. C
4. A 13. A 24. A 34. B
5. B 14. D 25. D 35. A
6. B 15. C 26. B 36. D
7. C 16. D 27. D 37. B
8. D 17. B 28. B 38. C
9. C 18. C 29. A 39. B
10. A 19. C 30. D 40. D
* Supporting Computations:
11. (10,000 x 2) – (P3,000 x 2) – P5,000 = P9,000
12. [(P20 + P3 + P6) x 2,000 units] + (P10 x 1,000 units) = P68,000
CHAPTER 10
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SYSTEMS DESIGN: JOB-ORDER COSTING AND PROCESS COSTING
I. Questions
1. Job-order costing is used in those manufacturing situations where there are
many different products produced each period. Each product or job is different
from all others and requires separate costing. Process costing is used in those
manufacturing situations where a single, homogeneous product, such as
cement, bricks, or gasoline, is produced for long periods at a time.
2. The job cost sheet is used in accumulating all costs assignable to a particular
job. These costs would include direct materials cost traceable to the job, and
manufacturing overhead cost allocable to the job. When a job is completed, the
job cost sheet is used to compute the cost per completed unit. The job cost sheet
is then used as a control document for: (1) determining how many units have
been sold and determining the cost of these units; and (2) determining how
many units are still in inventory at the end of a period and determining the cost
of these units on the balance sheet.
3. Many production costs cannot be traced directly to a particular product or job,
but rather are incurred as a result of overall production activities. Therefore, in
order to be assigned to products, such costs must be allocated to the products in
some manner. Examples of such costs would include utilities, maintenance on
machines, and depreciation of the factory building. These costs are indirect
production costs.
4. A firm will not know its actual manufacturing overhead costs until after a
period is over. Thus, if actual costs were used to cost products, it would be
necessary either (1) to wait until the period was over to add overhead costs to
jobs, or (2) to simply add overhead cost to jobs as the overhead cost was
incurred day by day. If the manager waits until after the period is over to add
overhead cost to jobs, then cost data will not be available during the period. If
the manager simply adds overhead cost to jobs as the overhead cost is incurred,
then unit costs may fluctuate from month to month. This is because overhead
cost tends to be incurred somewhat evenly from month to month (due to the
presence of fixed costs), whereas production activity often fluctuates. For these
reasons, most firms use predetermined overhead rates, based on estimates of
overhead cost and production activity, to apply overhead cost to jobs.
5. An allocation base should act as a cost driver in the incurrence of the overhead
cost; that is, the base should cause the overhead cost. If the allocation base
does not really cause the overhead, then costs will be incorrectly attributed to
products and jobs and their costs will be distorted.
6. A process costing system is appropriate in those situations where a
homogeneous product is produced on a continuous basis.
7. In a process costing system, costs are accumulated by department.
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8. First, the activity performed in a department must be performed uniformly on

all units moving through it. Second, the output of the department must be
homogeneous.
9. The reason cost accumulation is simpler is that costs only need to be identified
by department - not by separate job. Usually there will be only a few
departments in a company, whereas there can be hundreds or even thousands of
jobs in a job-order costing system.
10. A quantity schedule shows the physical flow of units through a department
during a period. It serves several purposes. First, it provides the manager with
information relative to activity in his or her department and also shows the
manager the stage of completion of any in-process units. Second, it serves as
an essential guide in computing the equivalent units and in preparing the other
parts of the production report.
11. By definition, manufacturing overhead consists of costs that cannot be
practically traced to products or jobs. Therefore, if these costs are to be assigned
to products or jobs, they must be allocated rather than traced.
12. Assigning manufacturing overhead costs to jobs does not ensure a profit. The
units produced may not be sold and if they are sold, they may not be sold at
prices sufficient to cover all costs. It is a myth that assigning costs to products
or jobs ensures that those costs will be recovered. Costs are recovered only by
selling to customers—not by allocating costs.
13. (a) Job-order costing and process costing have the same basic purposes—to
assign materials, labor, and overhead cost to products and to provide a
mechanism for computing unit product costs.
(b) Both systems use the same basic manufacturing accounts.
(c) Costs flow through the accounts in basically the same way in both systems.
14. The company will want to distinguish between the costs of the metals used to
make the medallions, but the medals are otherwise identical and go through the
same production processes. Thus, operation costing is ideally suited for the
company’s needs.
II. Exercises
Exercise 1 (Process Costing and Job Order Costing)
a. Job-order costing f. Process costing

b. Process costing g. Process costing
c. Process costing * h. Job-order costing
d. Job-order costing i. Job-order costing
e. Job-order costing j. Job-order costing
* Some of the listed companies might use either a process costing or a job-order
costing system, depending on how operations are carried out and how
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homogeneous the final product is. For example, a plywood manufacturer might
use job-order costing if plywoods are constructed of different woods or come in
markedly different sizes.
Exercise 2 (Applying Overhead with Various Bases)
Requirement 1
Predetermined overhead rates:
Company X:
Predetermined Estimated total manufacturing overhead cost

= Estimated total amount of the allocation base
overhead rate
P432,000
= 60,000 DLHs = P7.20 per DLH
Company Y:

overhead rate
P270,000
= 90,000 DLHs = P3.00 per MH
Company Z:

overhead rate
P384,000
= P240,000 materials cost = 160% of materials cost
Requirement 2
Actual overhead costs incurred.................................................. P420,000

Overhead cost applied to Work in Process:................................
58,000* actual hours × P7.20 per hour............................... 417,600
Underapplied overhead cost....................................................... P 2,400
* 7,000 hours + 30,000 hours + 21,000 hours = 58,000 hours
Exercise 3 (Departmental Overhead Rates)
Requirement 1
Milling Department:

overhead rate
P510,000
= 60,000 machine-hours = P8.50 per machine-hour
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Assembly Department:

overhead rate
P800,000
= P640,000 direct labor cost = 125% of direct labor cost
Requirement 2
Overhead Applied
Milling Department: 90 MHs × P8.50 per MH P765
Assembly Department: P160 × 125% 200
Total overhead cost applied P965
Requirement 3
Yes; if some jobs required a large amount of machine time and little labor cost, they
would be charged substantially less overhead cost if a plantwide rate based on direct
labor cost were being used. It appears, for example, that this would be true of job
123 which required considerable machine time to complete, but required only a
small amount of labor cost.
Exercise 4 (Process Costing Journal Entries)
Work in Process—Mixing.....................................................................................................
330,000
Raw Materials Inventory...............................................................................................
330,000
260,000
Work in Process—Baking......................................................................................................
120,000
Wages Payable...............................................................................................................
380,000
190,000
90,000
Manufacturing Overhead..............................................................................................
280,000
760,000
Work in Process—Mixing.............................................................................................
760,000
Finished Goods......................................................................................................................
980,000
Work in Process—Baking.............................................................................................
980,000
Exercise 5 (Quantity Schedule, Equivalent Units, and Cost per Equivalent Unit
– Weighted Average Method)
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Requirement 1
Weighted-Average Method
Quantit
y
Schedul
e
Gallons to be accounted for:
Work in process, May 1 (materials
80% complete, labor and overhead
75% complete) 80,000
Started into production 760,000
Total gallons accounted for 840,000
Equivalent Units
Material
s Labor Overhead
Gallons accounted for as follows:
Transferred to the next department....... 790,000 790,000 790,000 790,000
20% complete)................................... 50,000 30,000 10,000 10,000
Total gallons accounted for........................ 840,000 820,000 800,000 800,000
Requirement 2
Total Whole
Costs Materials Labor Overhead Unit
Cost to be accounted for:
P
Work in process, May 1.............................
146,600 P 68,600 P 30,000 P 48,000
Cost added during the month....................

1,869,200 907,200 370,000 592,000
Total cost to be accounted for P2,015,80
(a) 0 P975,800 P400,000 P640,000
Equivalent units (b).......................................
— 820,000 800,000 800,000
Cost per equivalent unit (a) ÷ + +
(b) P1.19 P0.50 P0.80= P2.49
Exercise 6 (Quantity Schedule, Equivalent Units, and Cost per Equivalent Unit
– FIFO Method)
Requirement 1
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FIFO Method
Quantit
y
Schedul
e
Gallons to be accounted for:
75% complete) 80,000
Started into production 760,000
Total gallons accounted for 840,000
Equivalent Units
Material
s Labor Overhead
Gallons accounted for as follows:
Transferred to the next department:
From the beginning inventory.......... 80,000 16,000* 20,000* 20,000*
Started and completed this
month**........................................... 710,000 710,000 710,000 710,000
20% complete)................................... 50,000 30,000 10,000 10,000
Total gallons accounted for........................ 840,000 756,000 740,000 740,000
* Work required to complete the beginning inventory.

** 760,000 gallons started – 50,000 gallons in ending work in process = 710,000
gallons started and completed.
Requirement 2
Total Whole
Costs Materials Labor Overhead Unit
P
Work in process, May 31...........................
146,600
Cost added during the month
(a) 1,869,200 P907,200 P370,000 P592,000
P2,015,80
Total cost to be accounted for........................0
Equivalent units (b)....................................... 756,000 740,000 740,000
Cost per equivalent unit (a) ÷ + +
(b) P1.20 P0.50 P0.80= P2.50
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Exercise 7
Requirement (1)
The direct materials and direct labor costs listed in the exercise would have been
recorded on four different documents: the materials requisition form for Job KC123,
the time ticket for Kristine, the time ticket for Clarisse, and the job cost sheet for
Job KC123.
Requirement (2)
The costs for Job KC123 would have been recorded as follows:
Materials requisition form:

Quantity Unit Cost Total Cost
Blanks 40 P80.00 P3,200
Nibs 960 P6.00 5,760
P8,960
Time ticket for Kristine

Time Job
Started Ended Completed Rate Amount Number
9:00 AM 12:15 PM 3.25 P120.00 P390.00 KC123
Time ticket for Clarisse

Time Job
Started Ended Completed Rate Amount Number
2:15 PM 4:30 PM 2.25 P140.00 P315.00 KC123
Job Cost Sheet for Job KC123

Direct materials.................. P8,960.00
Direct labor:
Kristine........................ 390.00
Clarisse........................ 315.00
P9,665.00
Exercise 8
The predetermined overhead rate is computed as follows:
Estimated total manufacturing overhead............................................... P586,000

÷ Estimated total direct labor hours (DLHs).......................................... 40,000 DLHs
= Predetermined overhead rate............................................................... P14.65 per DLH
Exercise 9
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Materials Labor Overhead Total
Work in process, May 1................................. P 14,550 P23,620 P118,100
Cost added during May.................................88,350 14,330 71,650
Total cost (a)..................................................
P102,900 P37,950 P189,750
Equivalent units of
production (b)............................................ 1,200 1,100 1,100
Cost per equivalent unit
(a) ÷ (b).....................................................P85.75 P34.50 P172.50 P292.75
Exercise 10
FIFO Method
Materials Conversion
To complete beginning work in process:
Materials: 400 units x (100% – 75%).............................................................
100
Conversion: 400 units x (100% – 25%).......................................................... 300
Units started and completed during the period
(42,600 units started – 500 units in ending
inventory).........................................................................................................
42,100 42,100
Ending work in process
Materials: 500 units x 80% complete..............................................................
400
Conversion: 500 units x 30% complete........................................................... 150
Equivalent units of production...............................................................................
42,600 42,550
III. Problems
Problem 1
Requirement 1
a. Raw Materials Inventory....................................................... 210,000

Accounts Payable.............................................................. 210,000
b. Work in Process..................................................................... 178,000

Manufacturing Overhead...................................................... 12,000
Raw Materials Inventory.................................................. 190,000
c. Work in Process..................................................................... 90,000

Manufacturing Overhead...................................................... 110,000
Salaries and Wages Payable.............................................. 200,000
d. Manufacturing Overhead...................................................... 40,000

Accumulated Depreciation............................................... 40,000
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e. Manufacturing Overhead...................................................... 70,000

Accounts Payable.............................................................. 70,000
f. Work in Process..................................................................... 240,000

Manufacturing Overhead.................................................. 240,000
30,000 MH x P8 per MH = P240,000.
g. Finished Goods..................................................................... 520,000

Work in Process................................................................ 520,000
h. Cost of Goods Sold................................................................ 480,000

Finished Goods................................................................. 480,000
Accounts Receivable............................................................. 600,000

Sales.................................................................................. 600,000
P480,000 × 1.25 = P600,000
Requirement 2
Manufacturing Overhead Work in Process

(b) 12,000 240,000 (f) Bal. 42,000 510,000 (g)
(c) 110,000 (b) 178,000
(d) 40,000 (c) 90,000
(e) 70,000 (f) 240,000
8,000 Bal. 30,000

(Overapplied
overhead)
Problem 2
Requirement 1
The costing problem does, indeed, lie with manufacturing overhead cost, as
suggested. Since manufacturing overhead is mostly fixed, the cost per unit
increases as the level of production decreases. The problem can be solved by use of
predetermined overhead rates, which should be based on expected activity for the
entire year. Many students will use units of product in computing the
predetermined overhead rate, as follows:
Estimated manufacturing overhead cost, P840,000
= P4.20 per unit.
Estimated units to be produced, 200,000
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The predetermined overhead rate could also be set on the basis of either direct labor cost
or direct materials cost. The computations are:
Estimated manufacturing overhead cost, P840,000 350% of direct
Estimated direct labor cost, P240,000 = labor cost
Estimated manufacturing overhead cost, P840,000 140% of direct

Estimated direct materials cost, P600,000 = materials cost
Requirement 2
Using a predetermined overhead rate, the unit costs would be:

Quarter
First Second Third Fourth
Direct materials....................... P240,000 P120,000 P 60,000 P180,000
Direct labor.............................. 96,000 48,000 24,000 72,000
Applied at P4.20 per units;
350% of direct labor cost, or
140% of direct materials
cost 336,000 168,000 84,000 252,000
Total cost........................... P672,000 P336,000 P168,000 P504,000

Number of units
produced............................... 80,000 40,000 20,000 60,000
Estimated cost per unit............ P8.40 P8.40 P8.40 P8.40
Problem 3
Quantity
Schedule
Pounds to be accounted for:
Work in process, May 1
(all materials, 55% labor and
overhead added last month).......... 30,000
Started into production during
May................................................ 480,000
Total pounds............................. 510,000
Equivalent Units
Labor &
Materials Overhead
Pounds accounted for as follows:
Transferred to Department 2............ 490,000* 490,000 490,000
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(all materials, 90% labor and

overhead added this month).......... 20,000 20,000 18,000
Total pounds............................. 510,000 510,000 508,000
* 30,000 + 480,000 - 20,000 = 490,000.
Problem 4 (Weighted-Average Method; Interpreting a Production Report)
Requirement 1
The equivalent units for the month would be:
Quantity Equivalent Units

Schedule Materials Conversion
Units accounted for as follows:
Transferred to next department........ 190,000 190,000 190,000
Work in process, April 30
(75% materials, 60%
conversion cost added this
month)........................................... 40,000 30,000 24,000
Total units and equivalent units
of production................................. 230,000 220,000 214,000
Requirement 2
Total Cost Materials Conversio Whole

n U
nit
Work in process, April 1. . P 98,000 P 67,800 P 30,200
Cost added during the
month 827,000 579,000 248,000
Total cost (a).................... P925,000 P646,800 P278,200
Equivalent units of
production (b) – 220,000 214,000
Cost per EU (a)  (b)....... – P2.94 + =

P P
1 4
. .
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3 2
0 4
Requirement 3
Total units transferred................................................................ 190,000

Less units in the beginning inventory........................................ 30,000
Units started and completed during April.................................. 160,000
Requirement 4
No, the manager should not be rewarded for good cost control. The reason for the
Mixing Department’s low unit cost for April is traceable to the fact that costs of the
prior month have been averaged in with April’s costs in computing the lower, P2.94
per unit figure. This is a major criticism of the weighted-average method in that the
figures computed for product costing purposes can’t be used to evaluate cost control
or measure performance for the current period.
Problem 5 (Preparation of Production Report from Analysis of Work in Process

T-account – Weighted-Average Method)
Requirement 1
Quantity Schedule and Equivalent Units
Quantity
Schedule
Pounds to be accounted for:
(materials all complete, labor
and overhead 4/5 complete).......... 35,000
Started into production..................... 280,000
Total pounds to be accounted for........... 315,000
Equivalent Units (EU)

Labor &
Materials Overhead
Pounds accounted for as follows:
Transferred to Blending*.................. 270,000 270,000 270,000
(materials all complete, labor
and overhead 2/3 complete).......... 45,000 45,000 30,000
Total pounds accounted for.................... 315,000 315,000 300,000
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* 35,000 + 280,000 – 45,000 = 270,000.
Cost per Equivalent Unit Labor & Whole

Total Materials O Unit
ve
rh
ea
d
Work in process, May 1... P 63,700 P 43,400 P 20,300
Cost added during the
month 587,300 397,600 189,700
Total cost to be accounted
for (a) P651,000 P441,000 P210,000
Equivalent units (b)......... 315,000 300,000

Cost per equivalent unit
(a)  (b) P1.40 + =
P P
0 2
. .
7 1
0 0
Cost Reconciliation
Total Equivalent Units (EU)

Cost Materials Conversion
Cost accounted for as follows:
Transferred to Blending:
270,000 pounds x P2.10
per pound.................................. P567,000 270,000 270,000
Work in process, May 31:
Materials, at P1.40 per EU........... 63,000 45,000
Labor and overhead, at P0.70
per EU........................................ 21,000 30,000
Total work in process, May 31......... 84,000
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Total costs accounted for....................... P651,000
Requirement 2
In computing unit costs, the weighted-average method mixes costs of the prior
period with current period costs. Thus, under the weighted-average method, unit
costs are influenced to some extent by what happened in a prior period. This
problem becomes particularly significant when attempting to measure performance
in the current period. Good (or bad) cost control in the current period might be
concealed to some degree by the costs that have been brought forward in the
beginning inventory.
1. D 6. D 11. A 16. A
2. D 7. A 12. D 17. D
3. D 8. C 13. B 18. A
4. C 9. C 14. D 19. C
5. D 10. B 15. C 20. D
CHAPTER 11
SYSTEMS DESIGN: ACTIVITY-BASED COSTING AND MANAGEMENT
I. Questions
1. The three levels available are: Level 1, in which a company uses a plantwide
overhead rate; Level 2, in which a company uses departmental overhead rates;
and Level 3, in which a company uses activity-based costing.
2. New approaches to costing are needed because events of the last few decades
have made drastic changes in many organizations. Automation has greatly
decreased the amount of direct labor required to manufacture products; product
diversity has increased in that companies are manufacturing a wider range of
products and these products differ substantially in volume, lot size, and
complexity of design; and total overhead cost has increased to the point in some
companies that a correlation no longer exists between it and direct labor.
3. The departmental approach to assigning overhead cost to products relies solely
on volume as an assignment base. Where diversity exists between products
(that is, where products differ in terms of number of units produced, lot size, or
complexity of production), volume alone is not adequate for overhead costing.
Overhead costing based on volume will systematically overcost high-volume
products and undercost low-volume products.
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4. Process value analysis (PVA) is a systematic approach to gaining an

understanding of the steps associated with a product or service. It identifies all
resource-consuming activities involved in the production process and labels
these activities as being either value-added or non-value-added. Thus, it is the
beginning point in designing an activity-based costing system since
management must know what activities are involved with each product before
activity centers can be designated and cost drivers established. Also, PVA helps
management to eliminate any non-value-added activities and thereby
streamline operations and minimize costs.
5. The four general levels of activities are:
1. Unit-level activities, which are performed each time a unit is produced.
2. Batch-level activities, which are performed each time a batch of goods is
handled or processed.
3. Product-level activities, which are performed as needed to support specific
products.
4. Facility-level activities, which simply sustain a facility’s general
manufacturing process.
6. First, activity-based costing increases the number of cost pools used to
accumulate overhead costs. Second, it changes the base used to assign
overhead costs to products. And third, it changes a manager’s perception of
many overhead costs in that costs that were formerly thought to be indirect
(such as depreciation or machine setup) are identified with specific activities
and thereby are recognized as being traceable to individual products.
7. The two chief limitations are: First, the portion of overhead costs that relate to
facility-level activities are still usually allocated to products on some arbitrary
basis, such as machine-hours or direct labor-hours. Critics of activity-based
costing argue that facility-level activities account for the bulk of all overhead
costs in some companies. Second, high measurement costs are involved in
operating an activity-based costing system. That is, the system requires the
tracking of large amounts of detail and the completion of many separate
computations in order to determine the cost of a unit or product.
8. Yes, activity-based costing can be used in service organizations. It has been
successfully implemented, for example, in railroads, hospitals, banks and data
service companies.
9. A resource driver is a measure of the quality of resources consumed by an
activity.
10. An activity driver is a measure of frequency and intensity of demands placed on
activities by cost objects.
11. Two-stage allocation is a procedure that first assigns a firm’s resource costs,
namely factory overhead cost, to cost pools, and then to cost objects.
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12. Two major advantages of ABM are:

a. ABM measures the effectiveness of the key business processes and
activities, and identifies how they can be improved to reduce costs and
improve the customer value.
b. ABM improves the management focus by allocating resources to key value-
added activities, key customers, key products, and continuous improvement
methods to maintain the firm’s competitive advantage.
13. When direct labor is used as an allocation base for overhead, it is implicitly
assumed that overhead cost is directly proportional to direct labor. When cost
systems were originally developed in the 1800s, this assumption may have been
reasonably accurate. However, direct labor has declined in importance over the
years while overhead has been increasing. This suggests that there is no longer
a direct link between the level of direct labor and overhead. Indeed, when a
company automates, direct labor is replaced by machines; a decrease in direct
labor is accompanied by an increase in overhead. This violates the assumption
that overhead cost is directly proportional to direct labor. Overhead cost appears
to be driven by factors such as product diversity and complexity as well as by
volume, for which direct labor has served as a convenient measure.
14. Employees may resist activity-based costing because it changes the “rules of the
game.” ABC changes some of the key measures, such as product costs, used in
making decisions and may affect how individuals are evaluated. Without top
management support, employees may have little interest in making these
changes. In addition, if top managers continue to make decisions based on the
numbers generated by the traditional costing system, subordinates will quickly
conclude that the activity-based costing system can be ignored.
15. Unit-level activities are performed for each unit that is produced. Batch-level
activities are performed for each batch regardless of how many units are in the
batch. Product-level activities must be carried out to support a product
regardless of how many batches are run or units produced. Customer-level
activities must be carried out to support customers regardless of what products
or services they buy. Organization-sustaining activities are carried out
regardless of the company’s precise product mix or mix of customers.
16. Organization-sustaining costs, customer-level costs, and the costs of idle
capacity should not be assigned to products. These costs represent resources
that are not consumed by the products.
II. True or False
1. True 3. False 5. False 7. True

2. True 4. True 6. False 8. True
III. Exercises
Exercise 1
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Examples of Examples of
Activity Traceable Cost
Activity Classification Costs Drivers
a. Materials are moved Batch-level Labor cost; Number of
from the receiving depreciation receipts;
dock to product flow pounds handled
of equipment;
lines by a material-
space cost
handling crew
b. Direct labor workers Unit-level Direct labor Direct labor-
assemble various cost; indirect hours
products labor cost;
labor benefits
c. Ongoing training is Facility-level* Space cost; Hours of
provided to all training costs; training time;
employees in the administration number trained
company costs
d. A product is Product-level Space cost; Hours of design
designed by a supplies used; time; number
specialized design depreciation of of engineering
team design change orders
equipment
e. Equipment setups Batch-level Labor cost; Number of
are performed on a supplies used; setups; hours or
regular basis depreciation of setup time
equipment
f. Numerical control Unit-level Power; supplies Machine-hours;
(NC) machines are used; number of units
used to cut and shape maintenance;
materials depreciation
* Personnel administration and training costs might be traceable in part to the
facility-level and in part to other activity centers at the unit-level, product-
level, and batch-level.
Exercise 2
1. plantwide overhead rate 6. Batch-level

2. volume 7. Product-level
3. two stage, stage, stage 8. Facility-level
4. Process value analysis 9. high-volume, low-volume, low-volume
5. Unit-level 10. activity centers
Exercise 3
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a. Various individuals manage the parts inventories. Product-level

b. A clerk in the factory issues purchase orders for a job. Batch-level
The personnel department trains new production Organization-
workers. sustaining
d. The factory’s general manager meets with other
department heads such as marketing to coordinate Organization-
plans. sustaining
Direct labor workers assemble products. Unit-level
Engineers design new products. Product-level
g. The materials storekeeper issues raw materials to be
used in jobs. Batch-level
h. The maintenance department performs periodic
preventative maintenance on general-use Organization-
equipment. sustaining
Note: Some of these classifications are debatable and may depend on the specific
circumstances found in particular companies.
Exercise 4
Sales (P1,650 per standard model glider × 10 standard

model gliders + P2,300 per custom designed glider × 2
custom designed gliders)......................................................................................
P21,100
Costs:
Direct materials (P462 per standard model glider × 10
standard model gliders + P576 per custom
designed glider × 2 custom designed gliders).................................................
P5,772
Direct labor (P19 per direct labor-hour × 28.5 direct
labor-hours per standard model glider × 10 standard
model gliders + P19 per direct labor-hour × 32 direct
labor-hours per custom designed glider × 2 custom
designed gliders)..............................................................................................
6,631
Supporting manufacturing (P18 per direct labor-hour ×
28.5 direct labor-hours per standard model glider ×
10 standard model gliders + P18 per direct labor-
hour × 32 direct labor-hours per custom designed
glider × 2 custom designed gliders).................................................................
6,282
Order processing (P192 per order × 3 orders)..................................................... 576
Custom designing (P261 per custom design × 2 custom
designs)............................................................................................................
522
Customer service (P426 per customer ×
1 customer).......................................................................................................
426 20,209
Customer margin......................................................................................................
P 891
Exercise 5
13-156
Requirement 1
The predetermined overhead rate is computed as follows:
Predetermined P290,000
= = P5.80 per DLH
overhead rate 50,000 DLHs
The unit product costs under the company’s traditional costing system are computed
as follows:
Special Regular
Direct materials................................................................................................................
P60.00 P45.00
Direct labor......................................................................................................................
9.60 7.20
Manufacturing overhead (0.8 DLH × P5.80 per DLH;
0.6 DLH × P5.80 per DLH)........................................................................................
4.64 3.48
Unit product cost..............................................................................................................
P74.24 P55.68
Requirement 2
The activity rates are computed as follows:
(a)
Estimate (b)
d
Overhea Total (a) ÷ (b)
d
Activities Cost Expected Activity Activity Rate
Supporting direct labor.........................
P150,000 50,000 DLHs P3 per DLH
Batch setups..........................................
P60,000 250 setups P24 per setup
0
Safety testing........................................
P80,000 100 tests P80 per test
0
Manufacturing overhead is assigned to the two products as follows:
Special Product:
(a) × (b)
(a) (b) ABC
Activity Cost Pool Activity Rate Activity Cost
Supporting direct labor..................................... P3 per DLH 8,000 DLHs P24,000
Batch setups......................................................
P240 per setup 200 setups 48,000
Safety testing.....................................................
P800 per test 80 tests 64,000
Total P136,000
Regular Product:
Activity Cost Pool (a) (b) (a) × (b)
Activity Rate Activity ABC
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Cost
Supporting direct labor.....................................
P3 per DLH 42,000 DLHs P126,00
0
Batch setups......................................................
P240 per setup 50 setups 12,000
Safety testing.....................................................
P800 per test 20 tests 16,000
P154,00
Total 0
Activity-based costing unit product costs are computed as follows:
Special Regular
Direct materials...................................................................................................
P60.00 P45.00
Direct labor.........................................................................................................
9.60 7.20
Manufacturing overhead (P136,000 ÷ 10,000 units; P154,000 ÷
70,000 units)..................................................................................................
13.60 2.20
Unit product cost.................................................................................................
P83.20 P54.40
IV. Problems
Problem 1
Cost Pool Cost Driver Cost

Systems Rate Consumption Assignment
Traditional cost system 350% P10,000 P35,000
ABC system
Labor 10% P10,000 P 1,000
Machining P25/hour 800 hours 20,000
Setup P10/hour 100 hours 1,000
Production order P100/order 12 orders 1,200
Material handling P20/requisition 5 requisitions 100
Parts administration P40/part 18 parts 720
P24,020
Problem 2
Requirement 1
(a)
Total overhead = P200,000 + P32,000 + P100,000 + P120,000
= P452,000
Overhead rate = P452,000 / 50,000 direct labor hours

= P9.04 per direct labor hour
Overhead assigned to proposed job = P9.04 x 1,000 direct labor hours

= P9,040
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(b) Total cost of proposed job:

Direct materials P 6,000
Direct labor 10,000
Overhead applied 9,040
Total cost P25,040
(c) Company’s bid = Full manufacturing cost x 120% = P25,040 x 120%

= P30,048
Requirement 2
(a) Maintenance : P200,000 / 20,000 = P10 per machine hour

Materials handling: P32,000 / 1,600 = P20 per move
Setups: P100,000 / 2,500 = P40 per setup
Inspection: P120,000 / 4,000 = P30 per inspection
Overhead assigned to proposed job:

Maintenance (P10 x 500) P5,000
Material handling (P20 x 12) 240
Setups (P40 x 2) 80
Inspection (P30 x 10) 300
Total overhead assigned to job P5,620
(b) Total cost of proposed project:

Direct materials P 6,000
Direct labor 10,000
Overhead applied 5,620
Total cost P21,620
(c) Company’s bid = Full manufacturing cost x 120% = P21,620 x 120%

= P25,944
The bid price of P25,944 was determined as follows:

Direct materials P6,000
Direct labor 10,000
Overhead assigned:
Maintenance (P10 x 500) P5,000
Material handling (P20 x 12) 240
Setups (P40 x 2) 80
Inspections (P30 x 10) 300
Total overhead assigned to job 5,620
Total cost P21,620
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Markup 120%
Bid price P25,944
Problem 3 (Activity-Based Costing)
Requirement 1
The first-stage allocation of costs to the activity cost pools appears below:
Activity Cost Pools

Assemblin Processin Supportin
g Units g Orders g Other Total
Customers
Manufacturing
overhead P250,000 P175,000 P25,000 P50,000 P500,000
Selling and
administrati
ve overhead 30,000 135,000 75,000 60,000 300,000
Total cost P280,000 P310,000 P100,000 P110,000 P800,000
Requirement 2
The activity rates for the cost pools are:
(a) (b) (a)  (b)

Total Cost Total Activity Activity Rate
Assembling units P280,000 1,000 units P280 per unit
Processing orders P310,000 250 orders P1,240 per order
Supporting customers P1,000 per
P100,000 100 customers customer
Requirement 3
The overhead cost attributable to Lucky Sale would be computed as follows:
(a) (b) (a) x (b)

Activity Cost Pools Activity Rate Activity ABC Cost
Assembling units P280 per unit 80 units P22,400
Processing orders P1,240 per order 4 orders P4,960
Supporting customers P1,000 per customer 1 customer P1,000
Requirement 4
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The customer margin can be computed as follows:
Sales (P595 per unit x 80 units) P47,600

Costs:
Direct materials (P180 per unit x 80 units) P14,400
Direct labor (P50 per unit x 80 units) 4,000
Unit-related overhead (above) 22,400
Order-related overhead (above) 4,960
Customer-related overhead (above) 1,000 46,760
Customer margin P 840
Problem 4 (Activity-Based Costing as an Alternative to Traditional Product

Costing)
Requirement 1
a. When direct labor-hours are used to apply overhead cost to products, the
company’s predetermined overhead rate would be:
Predetermined Manufacturing overhead cost
=
overhead rate Direct labor hours
P1,480,000
= = P74 per DLH
20,000 DLHs
b. Model
HY5 AS2
Direct materials................................................................................
P35.00 P25.00
Direct labor:
P20 per hour × 0.2 DLH, 0.4 DLH.............................................. 4.00 8.00
P74 per hour × 0.2 DLH, 0.4 DLH.............................................. 14.80 29.60
Total unit product cost......................................................................
P53.80 P62.60
Requirement 2
a. Predetermined overhead rates for the activity cost pools:
(a) (b)
Estimated Estimated (a) ÷ (b)
Activity Cost Pool Total Cost Total Activity Activity Rate
Machine setups..................... P180,000 250 setups P720 per setup
Special milling..................... P300,000 1,000 MHs P300 per MH
General factory.....................P1,000,000 20,000 DLHs P50 per DLH
The overhead applied to each product can be determined as follows:
Model HY5
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(a) (a) × (b)

Predetermined (b) Overhead
Activity Cost Pool Overhead Rate Activity Applied
Machine setups...........................................................................
P720 per setup 150 setups P108,000
Special milling...........................................................................
P300 per MH 1,000 MHs 300,000
General factory...........................................................................
P50 per DLH 4,000 DLHs 200,000
Total manufacturing overhead cost (a)...................................... P608,000
Number of units produced (b).................................................... 20,000
Overhead cost per unit (a) ÷ (b)................................................. P30.40
Model AS2
(a) (a) × (b)
Predetermined (b) Overhead
Activity Cost Pool Overhead Rate Activity Applied
Machine setups...........................................................................
P720 per setup 100 setups P 72,000
Special milling...........................................................................
P300 per MH 0 MHs 0
General factory...........................................................................
P50 per DLH 16,000 DLHs 800,000
Total manufacturing overhead cost (a)...................................... P872,000
Number of units produced (b).................................................... 40,000
Overhead cost per unit (a) ÷ (b)................................................. P21.80
b. The unit product cost of each model under activity-

based costing would be computed as follows:
Model
HY5 AS2
Direct materials..............................................................................................
P35.00 P25.00
Direct labor (P20 per DLH × 0.2 DLH; P20 per DLH ×
04.DLH).....................................................................................................
4.00 8.00
Manufacturing overhead (above)...................................................................
30.40 21.80
Total unit product cost...................................................................................
P69.40 P54.80
Comparing these unit cost figures with the unit costs in Part 1(b), we find that
the unit product cost for Model HY5 has increased from P53.80 to P69.40, and
the unit product cost for Model AS2 has decreased from P62.60 to P54.80.
Requirement 3
It is especially important to note that, even under activity-based costing, 68% of the
company’s overhead costs continue to be applied to products on the basis of direct
labor-hours:
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Machine setups (number of setups).................................... P 180,000 12%

Special milling (machine-hours)........................................ 300,000 20
General factory (direct labor-hours)................................... 1,000,000 68
Total overhead cost.............................................................. P1,480,000 100%
Thus, the shift in overhead cost from the high-volume product (Model AS2) to the
low-volume product (Model HY5) occurred as a result of reassigning only 32% of
the company’s overhead costs.
The increase in unit product cost for Model HY5 can be explained as follows: First,
where possible, overhead costs have been traced to the products rather than being
lumped together and spread uniformly over production. Therefore, the special
milling costs, which are traceable to Model HY5, have all been assigned to Model
HY5 and none assigned to Model AS2 under the activity-based costing approach. It
is common in industry to have some products that require special handling or
special milling of some type. This is especially true in modern factories that produce
a variety of products. Activity-based costing provides a vehicle for assigning these
costs to the appropriate products.
Second, the costs associated with the batch-level activity (machine setups) have also
been assigned to the specific products to which they relate. These costs have been
assigned according to the number of setups completed for each product. However,
since a batch-level activity is involved, another factor affecting unit costs comes into
play. That factor is batch size. Some products are produced in large batches and
some are produced in small batches. The smaller the batch, the higher the cost per
unit of the batch activity. In the case at hand, the data can be analyzed as shown
below.
Model HY5:
Cost to complete one setup [see 2(a)].................................................. P720 (a)
Number of units processed per setup
(20,000 units ÷ 150 setups)............................................................. 133.33 (b)
Setup cost per unit (a) ÷ (b)................................................................. P5.40
Model AS2:
Cost to complete one setup (above)...................................................... P720 (a)
Number of units processed per setup
(40,000 units ÷ 100 setups)............................................................. 400 (b)
Setup cost per unit (a) ÷ (b)................................................................. P1.80
Thus, the cost per unit for setups is three times as great for Model HY5, the low-
volume product, as it is for Model AS2, the high-volume product. Such differences
in cost are obscured when direct labor-hours (or any other volume measure) is
used as the basis for applying overhead cost to products.
In sum, overhead cost has shifted from the high-volume product to the low-volume
13-163
product as a result of more appropriately assigning some costs to the products on

the basis of the activities involved, rather than on the basis of direct labor-hours.
1. A 11. B 21. D
2. D 12. D 21. A
3. C 13. C 22. B
4. B 14. A 23. A
5. A 15. C 24. B
6. D 16. D 25. D
7. A 17. D 26. B
8. B 18. C 27. C
9. D 19. B 28. A
10. C 20. A 29. C
CHAPTER 12
VARIABLE COSTING
I. Questions
1. The variable costing technique does not consider fixed costs as unimportant or
irrelevant, but it maintains that the distinction between behaviors of different
costs is crucial for certain decisions.
2. The central issue in variable costing is what is the proper timing for release of
fixed manufacturing overhead as expense: at the time of incurrence, or at the
time the finished units to which the fixed overhead relates are sold.
3. Direct costing would be more accurately called variable or marginal costing

because in substance it is the inventory costing method which applies only
variable production costs to product; fixed factory overhead is not assigned to
product.
4. Marketing and administrative costs are treated as period costs under both
variable costing and absorption costing methods of product costing.
5. Under absorption costing, as a company manufactures units of product, the

fixed manufacturing overhead costs of the period are added to the units, along
with direct materials, direct labor, and variable manufacturing overhead. If
some of these units are not sold by the end of the period, then they are carried
into the next period as inventory. The fixed manufacturing overhead cost
attached to the units in ending inventory follow the units into the next period as
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part of their inventory cost. When the units carried over as inventory are
finally sold, the fixed manufacturing overhead cost that has been carried over
with the units is included as part of that period’s cost of goods sold.
6. Many accountants and managers believe absorption costing does a better job of
matching costs with revenues than variable costing. They argue that all
manufacturing costs must be assigned to products to properly match the costs of
producing units of product with the revenues from the units when they are sold.
They believe that the fixed costs of depreciation, taxes, insurance, supervisory
salaries, and so on, are just as essential to manufacturing products as are the
variable costs.
7. If fixed manufacturing overhead cost is released from inventory, then inventory

levels must have decreased and therefore production must have been less than
sales.
8. Under absorption costing it is possible to increase net operating income without

increasing sales by increasing the level of production. If production exceeds
sales, units of product are added to inventory. These units carry a portion of the
current period’s fixed manufacturing overhead costs into the inventory account,
thereby reducing the current period’s reported expenses and causing net
operating income to rise.
9. Generally speaking, variable costing cannot be used externally for financial

reporting purposes nor can it be used for tax purposes.
10. If production exceeds sales, absorption costing will show higher net operating
income than variable costing. The reason is that inventories will increase and
therefore part of the fixed manufacturing overhead cost of the current period
will be deferred in inventory to the next period under absorption costing. By
contrast, all of the fixed manufacturing overhead cost of the current period will
be charged immediately against revenues as a period cost under variable
costing.
11. Absorption and variable costing differ in how they handle fixed manufacturing
overhead. Under absorption costing, fixed manufacturing overhead is treated as
a product cost and hence is an asset until products are sold. Under variable
costing, fixed manufacturing overhead is treated as a period cost and is
expensed on the current period’s income statement.
12. Advocates of variable costing argue that fixed manufacturing costs are not
really the cost of any particular unit of product. If a unit is made or not, the
total fixed manufacturing costs will be exactly the same. Therefore, how can
one say that these costs are part of the costs of the products? These costs are
incurred to have the capacity to make products during a particular period and
should be charged against that period as period costs according to the matching
principle.
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II. Exercises
Exercise 1 (Variable and Absorption Costing Unit Product Costs and Income
Statements)
Requirement 1
a. The unit product cost under absorption costing would be:
Direct materials..................................................................................... P18

Direct labor............................................................................................ 7
Variable manufacturing overhead......................................................... 2
Total variable manufacturing costs....................................................... 27
Fixed manufacturing overhead (P160,000 ÷ 20,000 units).................. 8
Unit product cost................................................................................... P35
b. The absorption costing income statement:
Sales (16,000 units × P50 per unit)............................... P800,000

Less cost of goods sold:
Beginning inventory.................................................. P 0
Add cost of goods manufactured
(20,000 units × P35 per unit)................................ 700,000
Goods available for sale............................................. 700,000
Less ending inventory
(4,000 units × P35 per unit).................................. 140,000 560,000
Gross margin.................................................................. 240,000
Less selling and administrative expenses...................... 190,000*
Net operating income..................................................... P 50,000
*(16,000 units × P5 per unit) + P110,000 = P190,000.
Requirement 2
a. The unit product cost under variable costing would be:
Direct materials........................................................................................... P18

Direct labor................................................................................................. 7
Variable manufacturing overhead............................................................... 2
Unit product cost......................................................................................... P27
b. The variable costing income statement:
Sales (16,000 units × P50 per unit)............................. P800,000

Variable cost of goods sold:
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Beginning inventory............................................ P 0
Add variable manufacturing costs
(20,000 units × P27 per unit).......................... 540,000
Goods available for sale....................................... 540,000
(4,000 units × P27 per unit)............................ 108,000
Variable cost of goods sold....................................... 432,000 *
Variable selling expense
(16,000 units × P5 per unit)................................ 80,000 512,000
Contribution margin..................................................... 288,000
Less fixed expenses:
Fixed manufacturing overhead................................ 160,000
Fixed selling and administrative............................. 110,000 270,000
Net operating income................................................... P 18,000
* The variable cost of goods sold could be computed more simply as: 16,000
units × P27 per unit = P432,000.
Exercise 2 (Variable and Absorption Costing Unit Product Costs)
Requirement 1
Sales (40,000 units × P33.75 per unit).............................................. P1,350,000

Variable cost of goods sold
(40,000 units × P16 per unit*)..................................................
P640,000
Variable selling and administrative expenses
(40,000 units × P3 per unit)......................................................
120,000 760,000
Contribution margin.......................................................................... 590,000
Fixed manufacturing overhead..................................................... 250,000
Fixed selling and administrative expenses................................... 300,000 550,000
Net operating income........................................................................ P 40,000
*Direct materials.....................................................................................................................
P10
Direct labor............................................................................................................................
4
Variable manufacturing overhead.........................................................................................
2
Total variable manufacturing cost.........................................................................................
P16
Requirement 2
The difference in net operating income can be explained by the P50,000 in fixed
manufacturing overhead deferred in inventory under the absorption costing method:
Variable costing net operating income................................................... P40,000

Add: Fixed manufacturing overhead cost 50,000
deferred in inventory under absorption
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costing: 10,000 units × P5 per unit in fixed

manufacturing overhead cost..............................................................
Absorption costing net operating income............................................... P90,000
Exercise 3 (Variable Costing Unit Product Cost and Income Statement; Break-
even)
Requirement 1
Under variable costing, only the variable manufacturing costs are included in
product costs.
Direct materials....................................................................................... P 600

Direct labor.............................................................................................. 300
Variable manufacturing overhead........................................................... 100
Unit product cost..................................................................................... P1,000
Note that selling and administrative expenses are not treated as product costs; that
is, they are not included in the costs that are inventoried. These expenses are
always treated as period costs and are charged against the current period’s revenue.
Requirement 2
The variable costing income statement appears below:
Sales................................................................................. P18,000,000
Beginning inventory............................................. P 0
(10,000 units × P1,000 per unit)....................... 10,000,000
Goods available for sale........................................ 10,000,000
Less ending inventory (1,000 units × P1,000
per unit).......................................................... 1,000,000
Variable cost of goods sold*........................................ 9,000,000
Variable selling and administrative (9,000 units ×
P200 per unit)............................................................. 1,800,000 10,800,000
Contribution margin........................................................ 7,200,000
Fixed manufacturing overhead........................................ 3,000,000
Fixed selling and administrative..................................... 4,500,000 7,500,000
Net operating loss............................................................ P (300,000)
* The variable cost of goods sold could be computed more simply as: 9,000 units
sold × P1,000 per unit = P9,000,000.
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Requirement 3
The break-even point in units s old

can be computed using the
contribution margin per unit as follows:
Selling price per unit.............................................................................................................
P2,000
Variable cost per unit.............................................................................................................
1,200
Contribution margin per unit................................................................................................
P 800
Exercise 4 (Absorption Fixed expenses

Break-even unit Costing
sales Unit
= Product Cost and Income Statement)
Unit contribution margin
P7,500,000
Requirement 1 = P800 per unit
Under absorption costing, all manufacturing
= 9,375costs (variable and fixed) are included
units
in product costs.
Direct materials........................................................................... P 600

Direct labor................................................................................. 300
Variable manufacturing overhead............................................... 100
Fixed manufacturing overhead
(P3,000,000 ÷ 10,000 units)................................................... 300
Unit product cost......................................................................... P1,300
Requirement 2
The absorption costing income statement appears below:
Sales (9,000 units × P2,000 per unit)............................................ P18,000,000

Cost of goods sold:
Beginning inventory.................................................................. P 0
(10,000 units × P1,300 per unit)........................................... 13,000,000
Goods available for sale............................................................. 13,000,000
(1,000 units × P1,300 per unit)............................................. 1,300,000 11,700,000
Gross margin.................................................................................. 6,300,000
Selling and administrative expenses:
Variable selling and administrative (9,000 units ×
P200 per unit)........................................................................
1,800,000
Fixed selling and administrative............................................... 4,500,000 6,300,000
Net operating income..................................................................... P 0
Note: The company apparently has exactly zero net operating income even though
its sales are below the break-even point computed in Exercise 3. This occurs
because P300,000 of fixed manufacturing overhead has been deferred in inventory
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and does not appear on the income statement prepared using absorption costing.
Exercise 5 (Variable Costing Income Statement; Explanation of Difference in Net
Operating Income)
Requirement 1
2,000 units × P60 per unit fixed manufacturing overhead = P120,000
Requirement 2
The variable costing income statement appears below:
Sales P4,000,000
Variable expenses:
Beginning inventory.......................................................
P 0
(10,000 units × P310 per unit)............................... 3,100,000
Goods available for sale.................................................
3,100,000
(2,000 units × P310 per unit).................................... 620,000
Variable cost of goods sold*...............................................
2,480,000
Variable selling and administrative
(8,000 units × P20 per unit)........................................... 160,000 2,640,000
Contribution margin............................................................... 1,360,000
Fixed expenses:
Fixed manufacturing overhead........................................... 600,000
Fixed selling and administrative........................................ 400,000 1,000,000
Net operating income.............................................................. P 360,000
* The variable cost of goods sold could be computed more simply as: 8,000 units sold
× P310 per unit = P2,480,000.
The difference in net operating income between variable and absorption costing can
be explained by the deferral of fixed manufacturing overhead cost in inventory that
has taken place under the absorption costing approach. Note from part (1) that
P120,000 of fixed manufacturing overhead cost has been deferred in inventory to
the next period. Thus, net operating income under the absorption costing approach
is P120,000 higher than it is under variable costing.
Exercise 6 (Evaluating Absorption and Variable Costing as Alternative Costing
Methods)
Requirement 1
a. By assumption, the unit selling price, unit variable costs, and total fixed costs
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are constant from year to year. Consequently, variable costing net operating
income will vary with sales. If sales increase, variable costing net operating
income will increase. If sales decrease, variable costing net operating income
will decrease. If sales are constant, variable costing net operating income will
be constant. Because variable costing net operating income was P16,847 each
year, unit sales must have been the same in each year.
The same is not true of absorption costing net operating income. Sales and
absorption costing net operating income do not necessarily move in the same
direction because changes in inventories also affect absorption costing net
operating income.
b. When variable costing net operating income exceeds absorption costing net
operating income, sales exceeds production. Inventories shrink and fixed
manufacturing overhead costs are released from inventories. In contrast, when
variable costing net operating income is less than absorption costing net
operating income, production exceeds sales. Inventories grow and fixed
manufacturing overhead costs are deferred in inventories. The year-by-year
effects are shown below.
Year 1 Year 2 Year 3

Variable costing NOI = Variable costing NOI < Variable costing NOI >
Absorption costing Absorption costing Absorption costing
NOI NOI NOI
Production = Sales Production > Sales Production < Sales
Inventories remain the
same Inventories grow Inventories shrink
Requirement 2
a. As discussed in part (1 a) above, unit sales and variable costing net operating
income move in the same direction when unit selling prices and the cost
structure are constant. Because variable costing net operating income declined,
unit sales must have also declined. This is true even though the absorption
costing net operating income increased. How can that be? By manipulating
production (and inventories) it may be possible to maintain or increase the level
of absorption costing net operating income even though unit sales decline.
However, eventually inventories will grow to be so large that they cannot be
ignored.
b. As stated in part (1 b) above, when variable costing net operating income is less
than absorption costing net operating income, production exceeds sales.
Inventories grow and fixed manufacturing overhead costs are deferred in
inventories. The year-by-year effects are shown below.

Variable costing NOI = Variable costing NOI < Variable costing NOI
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Absorption costing < Absorption costing

NOI Absorption costing NOI NOI
Production = Sales Production > Sales Production > Sales
Inventories remain the
same Inventories grow Inventories grow
Requirement 3
Variable costing appears to provide a much better picture of economic reality than
absorption costing in the examples above. In the first case, absorption costing net
operating income fluctuates wildly even though unit sales are the same each year
and unit selling prices, unit variable costs, and total fixed costs remain the same. In
the second case, absorption costing net operating income increases from year to year
even though unit sales decline. Absorption costing is much more subject to
manipulation than variable costing. Simply by changing production levels (and
thereby deferring or releasing costs from inventory) absorption costing net operating
income can be manipulated upward or downward.
Note: This exercise is based on the following data:
Common data:
Annual fixed manufacturing costs........................................ P153,153
Contribution margin per unit............................................... P35,000
Annual fixed SGA costs........................................................ P180,000
Part 1:
Beginning inventory............................................................. 1 1 2
Production............................................................................. 10 11 9
Sales...................................................................................... 10 10 10
Ending................................................................................... 1 2 1
Variable costing net operating income.................................P16,84 P16,84 P16,84

7 7 7
Fixed manufacturing overhead in beginning P15,31 P15,31 P27,84

inventory*...................................................................... 5 5 6
Fixed manufacturing overhead in ending inventory............P15,31 P27,84 P17,01
5 6 7
Absorption costing net operating income............................P16,84 P29,37
7 8 P6,018
* Fixed manufacturing overhead in beginning inventory is assumed in both parts 1 and

2 for Year 1. A FIFO inventory flow assumption is used.
13-172
Part 2:
Beginning inventory................................................... 1 1 4
Production.................................................................. 10 12 20
Sales........................................................................... 10 9 8
Ending........................................................................ 1 4 16
Variable costing net operating income (loss)............ (P18,153

P16,847 ) (P53,153)
Fixed manufacturing overhead in beginning

inventory*...........................................................P15,315 P15,315 P51,051
Fixed manufacturing overhead in ending
inventory.............................................................P15,315 P51,051 P122,522
Absorption costing net operating income.................P16,847 P17,583 P18,318
* Fixed manufacturing overhead in beginning inventory is assumed in both parts 1 and

2 for Year 1. A FIFO inventory flow assumption is used.
III. Problems
Problem 1
Requirement 1: Variable Costing Method
Romero Parts, Inc.

Income Statement - Manufacturing
Sales P20,700,000
Less: Variable Cost of Sales
Inventory, Jan. 1 P1,155,000
Current Production 7,700,000
Total Available for Sale P8,855,000
Inventory, Dec. 31 805,000 8,050,000
Contribution Margin P12,650,000
Less Fixed Costs and Expenses 6,000,000
Net Income P 6,650,000
Requirement 2: Absorption Costing Method
Romero Parts, Inc.

For the Year Ending December 31, 2006
Sales P26,100,000
Less Cost of goods sold:
Inventory, Jan. 1 P 1,380,000
13-173
Current Production 16,100,000

Inventory, Dec. 31 747,500
Cost of Sales - Standard P16,732,500
Favorable Capacity Variance 900,000 15,832,500
Income from Manufacturing P10,267,500
Requirement 3: Variable Costing Method
Romero Parts, Inc.

For the Year Ending December 31, 2006
Sales P26,100,000
Less Variable Cost of Sales:
Inventory, Jan. 1 P 805,000
Production 9,800,000
Inventory, Dec. 31 455,000 10,150,000
Contribution Margin - Manufacturing P15,950,000
Less Fixed Cost 5,400,000
Income from Manufacturing P10,550,000
Reconciliation
Net Income, absorption costing P10,267,500

Add Fixed Factory Overhead Inventory, 1/1 575,000
Total P10,842,500
Less Fixed Factory Overhead Inventory, 12/31 292,500
Net Income, direct costing P10,550,000
Problem 2
Requirement 1
Honey Company
Income Statement - Direct Costing
Sales P280,000
Less Variable Cost of Sales:
Finished Goods Inventory, 1/1 P 4,000
Current Production 120,000
13-174
Total Available for Sale P124,000

Finished Goods Inventory, 12/31 12,000
Variable Cost of Sale - Standard P112,000
Unfavorable Variance 5,000 117,000
Contribution Margin - Manufacturing P163,000

Less Variable Marketing Expenses 28,000
Contribution Margin - Final P135,000
Less Fixed Costs and Expenses:
Fixed Factory Overhead P 54,000
Fixed Marketing and
Administrative Expenses 20,000 74,000
Net Income P 61,000
Requirement 2
Honey Company
Income Statement - Absorption Costing
Sales P280,000
Less: Cost of Sales
Finished goods inventory, Jan. 1 (1,000 x P5.50) P 5,500
Current production costs
Variable (30,000 x P4.00) P120,000
Fixed (30,000 x P1.50) 45,000 165,000
P170,500
Less: Finished goods inventory, Dec. 31
(3,000 x P5.50) 16,500
Cost of Sales - at Standard P154,000
Add (Deduct) Variance
Unfavorable variable manufacturing
costs variances 5,000
Underapplied fixed factory overhead
(6,000 x P1.50) 9,000
Cost of Sales - Actual P168,000
Gross Profit P112,000
Less: Selling and administrative expenses
Variable 28,000
Fixed 20,000
P 48,000
Net Income P 64,000
Problem 3 (Variable Costing Income Statement; Reconciliation)
Requirement 1
13-175
The unit product cost under the variable costing

approach would be computed as follows:
Direct materials.....................................................................................................................
P 8
Direct labor............................................................................................................................
10
Variable manufacturing overhead.........................................................................................
2
Unit product cost....................................................................................................................
P20
With this figure, the variable costing income statements can be prepared:
Year 1 Year 2
Sales P1,000,000 P1,500,000
Variable cost of goods sold @ P20 per unit......................................................................
400,000 600,000
Variable selling and administrative
@ P3 per unit................................................................................................................
60,000 90,000
Total variable expenses..........................................................................................................
460,000 690,000
Contribution margin..............................................................................................................
540,000 810,000
Fixed manufacturing overhead.........................................................................................
350,000 350,000
Fixed selling and administrative.......................................................................................
250,000 250,000
Total fixed expenses...............................................................................................................
600,000 600,000
Net operating income (loss)...................................................................................................
P (60,000) P 210,000
Requirement 2
Variable costing net operating income (loss).......................P (60,000) P 210,000

Add: Fixed manufacturing overhead cost deferred in
inventory under absorption costing (5,000 units ×
P14 per unit).................................................................... 70,000
Deduct: Fixed manufacturing overhead cost released
from inventory under absorption costing (5,000
units × P14 per unit)........................................................ (70,000)
Absorption costing net operating income.............................P 10,000 P 140,000
Problem 4 (Prepare and Interpret Statements; Changes in Both Sales and

Production; JIT)
Requirement 1

Sales P1,000,000 P 800,000 P1,000,000
@ P4 per unit 200,000 160,000 200,000
Variable selling and administrative 100,000 80,000 100,000
13-176
@ P2 per unit
Total variable expenses 300,000 240,000 300,000
Contribution margin 700,000 560,000 700,000
Fixed manufacturing overhead 600,000 600,000 600,000
Fixed selling and administrative 70,000 70,000 70,000
Total fixed expenses 670,000 670,000 670,000
Net operating income (loss) P 30,000 P(110,000) P 30,000
Requirement 2
a.
Variable manufacturing cost P 4 P 4 P 4
Fixed manufacturing cost:
P600,000 ÷ 50,000 units 12
P600,000 ÷ 60,000 units 10
P600,000 ÷ 40,000 units 15
Unit product cost P16 P14 P19
b.
Variable costing net operating income
(loss) P30,000 P(110,000) P 30,000
Add (Deduct): Fixed manufacturing
overhead cost deferred in inventory
from Year 2 to Year 3 under absorption
costing (20,000 units × P10 per unit)
200,000 (200,000)
Add: Fixed manufacturing overhead cost
deferred in inventory from Year 3 to the
future under absorption costing (10,000
units × P15 per unit) 150,000
Absorption costing net operating income
(loss) P30,000 P 90,000 P(20,000)
Requirement 3
Production went up sharply in Year 2 thereby reducing the unit product cost, as
shown in (2a). This reduction in cost, combined with the large amount of fixed
manufacturing overhead cost deferred in inventory for the year, more than offset the
loss of revenue. The net result is that the company’s net operating income rose even
though sales were down.
Requirement 4
13-177
The fixed manufacturing overhead cost deferred in inventory from Year 2 was
charged against Year 3 operations, as shown in the reconciliation in (2b). This
added charge against Year 3 operations was offset somewhat by the fact that part of
Year 3’s fixed manufacturing overhead costs was deferred in inventory to future
years [again see (2b)]. Overall, the added costs charged against Year 3 were greater
than the costs deferred to future years, so the company reported less income for the
year even though the same number of units was sold as in Year 1.
Requirement 5
a. Several things would have been different if the company had been using JIT
inventory methods. First, in each year production would have been geared to
sales so that little or no inventory of finished goods would have been built up in
either Year 2 or Year 3. Second, unit product costs probably would have been
the same in all three years, since these costs would have been established on the
basis of expected sales (50,000 units) for each year. Third, since only 40,000
units were sold in Year 2, the company would have produced only that number
of units and therefore would have had some underapplied overhead cost for the
year. (See the discussion on underapplied overhead in the following
paragraph.)
b. If JIT had been in use, the net operating income under absorption costing would
have been the same as under variable costing in all three years. The reason is
that with production geared to sales, there would have been no ending
inventory on hand, and therefore there would have been no fixed
manufacturing overhead costs deferred in inventory to other years. Assuming
to sell 50,000 units in each year
that the company expected
and that unit product costs were set on the basis of
that level of expected activity, the income
statements under absorption costing would have
appeared as follows:
Sales P1,000,000 P 800,000 P1,000,000
Less cost of goods sold:
Cost of goods manufactured @ P16 per unit 800,000 640,000 * 800,000
Add underapplied overhead 120,000 **
Cost of goods sold 800,000 760,000 800,000
Gross margin 200,000 40,000 200,000
Selling and administrative expenses 170,000 150,000 170,000
Net operating income (loss) P 30,000 P(110,000) P 30,000
* 40,000 units × P16 per unit = P640,000.

** 10,000 units not produced × P12 per unit fixed manufacturing overhead cost =
P120,000 fixed manufacturing overhead cost not applied to products.
13-178
Problem 5 (Contrasting Variable and Absorption Costing)
Requirement 1 (a)
Under absorption costing, all manufacturing costs, variable and fixed, are included
in unit product costs:
Year 1 Year 2
Direct materials P11 P11
Direct labor 6 6
Variable manufacturing overhead 3 3
Fixed manufacturing overhead
(P120,000  10,000 units) 12
(P120,000  6,000 units) 20
Unit product cost P32 P40
Requirement 1 (b)
The absorption costing income statements follow:
Year 1 Year 2
Sales (8,000 units x P50 per unit) P400,00 P400,00
0 0
Cost of goods sold:
Beginning inventory P P
0 64,000
(10,000 units x P32 per unit; 320,0 240,00
6,000 units x P40 per unit) 00 0
Goods available for sale 320,00 304,00
0 0
(2,000 units x P32 per unit; 0 64,00 256,00 304,00
units x P40 per unit) 0 0 0 0
Gross margin 144,000 96,000
Selling and administrative
expenses (8,000 units x P4 per 102,00 102,00
unit + P70,000) 0 0
Net operating income P
42,000 P (6,000)
Requirement 2 (a)
Under variable costing, only the variable manufacturing costs are included in unit
product costs:
13-179
Year 1 Year 2
Direct materials P11 P11
Direct labor 6 6
Variable manufacturing overhead 3 3
Unit product cost P20 P20
Requirement 2 (b)
The variable costing income statements follow. Notice that the variable cost of
goods sold is computed in a simpler, more direct manner than in the examples
provided earlier. On a variable costing income statement, this simple approach or
the more complex approach illustrated earlier is acceptable for computing the cost
of goods sold.
Year 1 Year 2
Sales (8,000 units x P50 per P400,00 P400,00
unit) 0 0
Variable expenses:
(8,000 units x P20 per P160,00 P160,00
unit) 0 0
Variable selling and
administrative (8,000 units 32,00 192,00 32,00 192,00
x P4 per unit) 0 0 0 0
Contribution margin 208,000 208,000
Fixed expenses:
Fixed manufacturing
overhead 120,000 120,000
Fixed selling and 70,00 190,00 70,00 190,00
administrative expenses 0 0 0 0
Net operating income P P
18,000 18,000
Requirement 3
The reconciliation of the variable and absorption costing net operating incomes
follows:
Year 1 Year 2
Variable costing net operating income P18,000 P18,000
Add fixed manufacturing overhead costs deferred
in inventory under absorption costing (2,000
units x P12 per unit) 24,000
Deduct fixed manufacturing overhead costs
released from inventory under absorption
costing (2,000 units x P12 per unit) (24,000)
13-180
Absorption costing net operating income P42,000 P(6,000)
Problem 6 (Variable Costing Income Statement; Reconciliation)
Requirement 1
Sales (40,000 units × P33.75 per unit).................................................... P1,350,000

Variable expenses:
(40,000 units × P16 per unit*)........................................................
P640,000
Variable selling and administrative expenses
(40,000 units × P3 per unit)............................................................
120,000 760,000
Contribution margin................................................................................. 590,000
Fixed expenses:
Fixed manufacturing overhead............................................................
250,000
Fixed selling and administrative expenses..........................................
300,000 550,000
Net operating income............................................................................... P 40,000
* Direct materials................................................................. P10

Direct labor....................................................................... 4
Variable manufacturing overhead..................................... 2
Total variable manufacturing cost.................................... P16
Requirement 2
The difference in net operating income can be explained by the P50,000 in fixed
manufacturing overhead deferred in inventory under the absorption costing method:
Variable costing net operating income..............................................................................

P40,000
Add: Fixed manufacturing overhead cost deferred in inventory
under absorption costing: 10,000 units × P5 per unit in fixed
manufacturing overhead cost........................................................................................
50,000
Absorption costing net operating income..........................................................................
P90,000
1. D 11. B
2. B 12. A
3. B 13. C
4. B 14. D
5. B 15. B
6. C 16. A
7. A 17. C
8. B 18. C
9. A 19. B
13-181
10. A 20. C
CHAPTER 13
COST-VOLUME-PROFIT RELATIONSHIPS
I. Questions
1. The total “contribution margin” is the excess of total revenue over total variable
costs. The unit contribution margin is the excess of the unit price over the unit
variable costs.
2. Total contribution margin:
Selling price - manufacturing variable costs expensed - nonmanufacturing
variable costs expensed = Total contribution margin.
Gross margin:
Selling price - variable manufacturing costs expensed - fixed manufacturing
costs expensed = Gross margin.
3. A company operating at “break-even” is probably not covering costs which are
not recorded in the accounting records. An example of such a cost is the
opportunity cost of owner-invested capital. In some small businesses, owner-
managers may not take a salary as large as the opportunity cost of forgone
alternative employment. Hence, the opportunity cost of owner labor may be
excluded.
4. In the short-run, without considering asset replacement, net operating cash
flows would be expected to exceed net income, because the latter includes
depreciation expense, while the former does not. Thus, the cash basis break-
even would be lower than the accrual break-even if asset replacement is
ignored. However, if asset replacement costs are taken into account, (i.e., on a
“cradle to grave” basis), the long-run net cash flows equal long-run accrual net
income, and the long-run break-even points are the same.
5. Both unit price and unit variable costs are expressed on a per product basis, as:
 = (P1 - V1) X1 + (P2 - V2) X2 +  + (Pn - Vn) Xn - F,
for all products 1 to n where:
 = operating profit,
P = average unit selling price,
V = average unit variable cost,
X = quantity of units,
F = total fixed costs for the period.
13-182
6. If the relative proportions of products (i.e., the product “mix”) is not held
constant, products may be substituted for each other. Thus, there may be almost
an infinite number of ways to achieve a target operating profit. As shown from
the multiple product profit equation, there are several unknowns for one
equation:
 = (P1 - V1) X1 + (P2 - V2) X2 +  + (Pn - Vn) Xn - F,
for all products 1 to n.
7. A constant product mix is assumed to simplify the analysis. Otherwise, there
may be no unique solution.
8. Operating leverage measures the impact on net operating income of a given
percentage change in sales. The degree of operating leverage at a given level of
sales is computed by dividing the contribution margin at that level of sales by
the net operating income.
9. Three approaches to break-even analysis are (a) the equation method, (b) the
contribution margin method, and (c) the graphical method. In the equation
method, the equation is: Sales = Variable expenses + Fixed expenses + Profits,
where profits are zero at the break-even point. The equation is solved to
determine the break-even point in units or peso sales.
10. The margin of safety is the excess of budgeted (or actual) sales over the break-
even volume of sales. It states the amount by which sales can drop before
losses begin to be incurred.
11. The sales mix is the relative proportions in which a company’s products are
sold. The usual assumption in cost-volume-profit analysis is that the sales mix
will not change.
12. A higher break-even point and a lower net operating income could result if the
sales mix shifted from high contribution margin products to low contribution
margin products. Such a shift would cause the average contribution margin
ratio in the company to decline, resulting in less total contribution margin for a
given amount of sales. Thus, net operating income would decline. With a
lower contribution margin ratio, the break-even point would be higher since it
would require more sales to cover the same amount of fixed costs.
13. The contribution margin (CM) ratio is the ratio of the total contribution margin
to total sales revenue. It can be used in a variety of ways. For example, the
change in total contribution margin from a given change in total sales revenue
can be estimated by multiplying the change in total sales revenue by the CM
ratio. If fixed costs do not change, then a peso increase in contribution margin
will result in a peso increase in net operating income. The CM ratio can also be
used in break-even analysis. Therefore, knowledge of a product’s CM ratio is
extremely helpful in forecasting contribution margin and net operating income.
14. Incremental analysis focuses on the changes in revenues and costs that will
result from a particular action.
13-183
15. All other things equal, Company B, with its higher fixed costs and lower
variable costs, will have a higher contribution margin ratio than Company A.
Therefore, it will tend to realize a larger increase in contribution margin and in
profits when sales increase.
16. (a) If the selling price decreased, then the total revenue line would rise less
steeply, and the break-even point would occur at a higher unit volume. (b) If the
fixed cost increased, then both the fixed cost line and the total cost line would
shift upward and the break-even point would occur at a higher unit volume. (c)
If the variable cost increased, then the total cost line would rise more steeply
and the break-even point would occur at a higher unit volume.
II. Exercises
Exercise 1 (Using a Contribution Format Income Statement)
Requirement 1
Total Per Unit
Sales (30,000 units × 1.15 = 34,500 units)...........................................................................
P172,500 P5.00
Less variable expenses...........................................................................................................
103,500 3.00
69,000 P2.00
Less fixed expenses................................................................................................................
50,000
P 19,000
Requirement 2

P162,000 P4.50
108,000 3.00
54,000 P1.50
50,000
P 4,000
Requirement 3

P156,750 P5.50
85,500 3.00
71,250 P2.50
Less fixed expenses (P50,000 + P10,000).............................................................................
60,000
P 11,250
Requirement 4

P151,200 P5.60
86,400 3.20
64,800 P2.40
50,000
P 14,800
13-184
Exercise 2 (Break-even Analysis and CVP Graphing)
Requirement 1
The contribution margin per person would be:
Price per ticket.......................................................................................................................

P30
Dinner................................................................................................................................
P7
Favors and program..........................................................................................................
3 10
Contribution margin per person............................................................................................ P20
The fixed expenses of the Extravaganza total P8,000; therefore, the break-even
point would be computed as follows:
Sales = Variable expenses + Fixed expense + Profits
P30Q = P10Q + P8,000 + P0

P20Q = P8,000
Q = P8,000 ÷ P20 per person
Q = 400 persons; or, at P30 per person, P12,000
Alternative solution:
Break-even point Fixed expenses
in unit sales = Unit contribution margin
P8,000
= P20 per person
= 400 persons
or, at P30 per person, P12,000.
Requirement 2
Variable cost per person (P7 + P3)........................................................................................

P10
Fixed cost per person (P8,000 ÷ 250 persons)......................................................................
32
Ticket price per person to break even....................................................................................
P42
Requirement 3
Cost-volume-profit graph:
13-185
Total Sales
Break-even point: 400 persons,

or P12,000 in sales
Total Expenses
Fixed Expenses
Exercise 3 (Break-even and Target Profit Analysis)
Requirement 1
Sales = Variable expenses + Fixed expenses + Profits

P900Q = P630Q + P1,350,000 + P0
P270Q = P1,350,000
Q = P1,350,000 ÷ P270 per lantern
Q = 5,000 lanterns, or at P900 per lantern, P4,500,000 in sales
P1,350,000
= P270 per lantern
= 5,000 lanterns
13-186
or at P900 per lantern, P4,500,000 in sales
Requirement 2
An increase in the variable expenses as a percentage of the selling price would

result in a higher break-even point. The reason is that if variable expenses increase
as a percentage of sales, then the contribution margin will decrease as a percentage
of sales. A lower CM ratio would mean that more lanterns would have to be sold to
generate enough contribution margin to cover the fixed costs.
Requirement 3
Present: Proposed:
8,000 Lanterns 10,000 Lanterns*
Total Per Unit Total Per Unit
Sales P7,200,000 P900 P8,100,000 P810 **
Less variable expenses 5,040,000 630 6,300,000 630
Contribution margin 2,160,000 P270 1,800,000 P180
Less fixed expenses 1,350,000 1,350,000
Net operating income P 810,000 P 450,000
* 8,000 lanterns × 1.25 = 10,000 lanterns

** P900 per lantern × 0.9 = P810 per lantern
As shown above, a 25% increase in volume is not enough to offset a 10% reduction
in the selling price; thus, net operating income decreases.
Requirement 4

P810Q = P630Q + P1,350,000 + P720,000
P180Q = P2,070,000
Q = P2,070,000 ÷ P180 per lantern
Q = 11,500 lanterns
Unit sales to attain Fixed expenses + Target profit
target profit = Unit contribution margin
P1,350,000 + P720,000
= P180 per lantern
= 11,500 lanterns
Exercise 4 (Operating Leverage)
Requirement 1
13-187
Sales (30,000 doors)..............................................................................................................

P18,000,000 P600
12,600,000 420
5,400,000 P180
4,500,000
P 900,000
Degree of Contribution margin
operating leverage = Net operating income
P5,400,000
= P900,000
= 6
Requirement 2
a. Sales of 37,500 doors represents an increase of 7,500 doors, or 25%, over

present sales of 30,000 doors. Since the degree of operating leverage is 6, net
operating income should increase by 6 times as much, or by 150% (6 × 25%).
b. Expected total peso net operating income for the next year is:
Present net operating income................................................................................................

P 900,000
Expected increase in net operating income next year
(150% × P900,000)...........................................................................................................
1,350,000
Total expected net operating income.....................................................................................
P2,250,000
Exercise 5 (Multiproduct Break-even Analysis)
Requirement 1
Model E700 Model J1500 Total Company
Amount % Amount % Amount %
Sales P700,000 100 P300,000 100 P1,000,000 100
Less variable expenses
280,000 40 90,000 30 370,000 37
Contribution margin P420,000 60 P210,000 70 630,000 63 *
Less fixed expenses 598,500
Net operating income P 31,500
* 630,000 ÷ P1,000,000 = 63%.
Requirement 2
The break-even point for the company as a whole would be:

in total peso sales = Overall CM ratio
13-188
P598,500
= 0.63
= P950,000 in sales
Requirement 3
The additional contribution margin from the additional sales can be computed as
follows:
P50,000 × 63% CM ratio = P31,500
Assuming no change in fixed expenses, all of this additional contribution margin

should drop to the bottom line as increased net operating income.
This answer assumes no change in selling prices, variable costs per unit, fixed
expenses, or sales mix.
Exercise 6 (Break-even Analysis; Target Profit; Margin of Safety)
Requirement 1

P40Q = P28Q + P150,000 + P0
P12Q = P150,000
Q = P150,000 ÷ P12 per unit
Q = 12,500 units, or at P40 per unit, P500,000
Alternatively:

P150,000
= P12 per unit
= 12,500 units
or, at P40 per unit, P500,000.
Requirement 2
The contribution margin at the break-even point is P150,000 since at that point it
must equal the fixed expenses.
Requirement 3
P150,000 + P18,000
= P12 per unit
13-189
= 14,000 units
Total Unit
Sales (14,000 units × P40 per unit).......................................................................................
P560,000 P40
(14,000 units × P28 per unit)............................................................................................
392,000 28
Contribution margin
(14,000 units × P12 per unit)............................................................................................
168,000 P12
150,000
P 18,000
Requirement 4
Margin of safety in peso terms:
Margin of safety in pesos = Total sales – Break-even sales
= P600,000 – P500,000 = P100,000
Margin of safety in percentage terms:

Margin of safety Margin of safety in pesos
percentage = Total sales
P100,000
= P600,000
= 16.7% (rounded)
Requirement 5
The CM ratio is 30%.
Expected total contribution margin: P680,000 × 30%.........................................................

P204,000
Present total contribution margin: P600,000 × 30%............................................................
180,000
Increased contribution margin...............................................................................................
P 24,000
P80,000 incremental sales × 30% CM ratio = P24,000
Since in this case the company’s fixed expenses will not change, monthly net
operating income will increase by the amount of the increased contribution margin,
P24,000.
13-190
Exercise 7 (Changes in Variable Costs, Fixed Costs, Selling Price, and Volume)
Requirement (1)
The following table shows the effect of the proposed change in monthly advertising
budget:
Sales With
Additional
Current Advertising
Sales Budget Difference
Sales P225,000 P240,000 P15,000
Variable expenses............................... 135,000 144,000 9,000
Contribution margin........................... 90,000 96,000 6,000
Fixed expenses.................................... 75,000 83,000 8,000
Net operating income......................... P 15,000 P 13,000 P(2,000)
Assuming that there are no other important factors to be considered, the increase in
the advertising budget should not be approved since it would lead to a decrease in
net operating income of P2,000.
Alternative Solution 1
Expected total contribution margin:

P240,000 × 40% CM ratio..................................................... P96,000
Present total contribution margin:
P225,000 × 40% CM ratio..................................................... 90,000
Incremental contribution margin............................................... 6,000
Change in fixed expenses:
Less incremental advertising expense................................... 8,000
Change in net operating income................................................ P(2,000)
Alternative Solution 2
Incremental contribution margin:

P15,000 × 40% CM ratio...................................................... P 6,000
Less incremental advertising expense....................................... 8,000
Change in net operating income................................................ P(2,000)
Requirement (2)
The P3 increase in variable costs will cause the unit contribution margin to decrease
from P30 to P27 with the following impact on net operating income:
Expected total contribution margin with the higher-quality

components:
3,450 units × P27 per unit........................................................................... P93,150
13-191

3,000 units × P30 per unit........................................................................... 90,000
Change in total contribution margin............................................................... P 3,150
Assuming no change in fixed costs and all other factors remain the same, the
higher-quality components should be used.
Exercise 8 (Compute the Margin of Safety)
Requirement (1)
To compute the margin of safety, we must first compute the break-even unit sales.

P25Q = P15Q + P8,500 + P0
P10Q = P8,500
Q = P8,500 ÷ P10 per unit
Q = 850 units
Sales (at the budgeted volume of 1,000 units)............................................. P25,000

Break-even sales (at 850 units).................................................................... 21,250
Margin of safety (in pesos).......................................................................... P 3,750
Requirement (2)
The margin of safety as a percentage of sales is as follows:
Margin of safety (in pesos)................................................................ P3,750

÷ Sales............................................................................................... P25,000
Margin of safety as a percentage of sales.......................................... 15.0%
Exercise 9 (Compute and Use the Degree of Operating Leverage)
Requirement (1)
The company’s degree of operating leverage would be computed as follows:
Contribution margin......................................... P36,000

÷ Net operating income.................................... P12,000
Degree of operating leverage............................ 3.0
Requirement (2)
A 10% increase in sales should result in a 30% increase in net operating income,
computed as follows:
Degree of operating leverage......................................................................................

3.0
× Percent increase in sales.........................................................................................
10%
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Estimated percent increase in net operating income.................................................

30%
Requirement (3)
The new income statement reflecting the change in sales would be:
Percent of
Amount Sales
Sales P132,000 100%
Variable expenses............................... 92,400 70%
Contribution margin........................... 39,600 30%
Fixed expenses.................................... 24,000
Net operating income......................... P 15,600
Net operating income reflecting change in sales................................................... P15,600

Original net operating income................................................................................
P12,000
Percent change in net operating income................................................................30%
Exercise 10 (Compute the Break-Even Point for a Multiproduct Company)
Requirement (1)
The overall contribution margin ratio can be computed as follows:
Overall CM ratio Total contribution margin

= Total sales
P120,000
= P150,000
Requirement (2) = 80%

The overall break-even point in sales pesos can be computed as follows:
Overall break-even Total fixed expenses
= Overall CM ratio
P90,000
= 80%
Requirement (3) = P112,500
To construct the required income statement, we must first determine the relative
sales mix for the two products:
Ping Pong Total
13-193
Original peso sales............................. P100,000 P50,000 P150,000

Percent of total.................................... 67% 33% 100%
Sales at break-even............................. P75,000 P37,500 P112,500
Ping Pong Total

Sales P75,000 P37,500 P112,500
Variable expenses*............................. 18,750 3,750 22,500
Contribution margin........................... P56,250 P33,750 90,000
Fixed expenses.................................... 90,000
Net operating income......................... P 0
*Ping variable expenses: (P75,000/P100,000) × P25,000 = P18,750

Pong variable expenses: (P37,500/P50,000) × P5,000 = P3,750
Exercise 11 (Break-Even and Target Profit Analysis)
Requirement (1)
Variable expenses: P60 × (100% – 40%) = P36.
Requirement (2)
Selling price...................................................... P60 100%

Variable expenses.............................................. 36 60%
Contribution margin......................................... P24 40%
Let Q = Break-even point in units.

P60Q = P36Q + P360,000 + P0
P24Q = P360,000
Q = P360,000 ÷ P24 per unit
Q = 15,000 units
In sales pesos: 15,000 units × P60 per unit = P900,000
Let X = Break-even point in sales pesos.

X = 0.60X + P360,000 + P0
0.40X = P360,000
X = P360,000 ÷ 0.40
X = P900,000
In units: P900,000 ÷ P60 per unit = 15,000 units

P60Q = P36Q + P360,000 + P90,000
P24Q = P450,000
13-194
Q = P450,000 ÷ P24 per unit

Q = 18,750 units
In sales pesos: 18,750 units × P60 per unit = P1,125,000

X = 0.60X + P360,000 + P90,000

0.40X = P450,000
X = P450,000 ÷ 0.40
X = P1,125,000
In units: P1,125,000 ÷ P60 per unit = 18,750 units
c. The company’s new cost/revenue relationships will be:
Selling price........................................................................... P60 100%

Variable expenses (P36 – P3)................................................. 33 55%
Contribution margin.............................................................. P27 45%
P60Q = P33Q + P360,000 + P0

P27Q = P360,000
Q = P360,000 ÷ P27 per unit
Q = 13,333 units (rounded).
In sales pesos: 13,333 units × P60 per unit = P800,000 (rounded)
X = 0.55X + P360,000 + P0
0.45X = P360,000
X = P360,000 ÷ 0.45
X = P800,000
In units: P800,000 ÷ P60 per unit = 13,333 units (rounded)
Requirement (3)
a. =
in unit sales Unit contribution margin
= P360,000  P24 per unit = 15,000 units

In sales pesos: 15,000 units × P60 per unit = P900,000

in sales pesos = CM ratio
13-195
= P360,000  0.40 = P900,000
In units: P900,000 ÷ P60 per unit = 15,000 units
b. Unit sales to attain Fixed expenses + Target profit

= (P360,000 + P90,000)  P24 per unit
= 18,750 units
In sales pesos: 18,750 units × P60 per unit = P1,125,000
Peso sales to Fixed expenses + Target profit
attain target profit = CM ratio
= (P360,000 + P90,000)  0.40
= P1,125,000
In units: P1,125,000 ÷ P60 per unit = 18,750 units
c. Break-even point Fixed expenses

= P360,000  P27 per unit
= ×13,333
In sales pesos: 13,333 units P60 perunits (rounded)
unit = P800,000 (rounded)

= P360,000  0.45
= P800,000
In units: P800,000 ÷ P60 per unit = 13,333 (rounded)
13-196
Exercise 12 (Operating Leverage)
Requirement (1)
Sales (30,000 doors)...................................... P1,800,000 P60

Variable expenses.......................................... 1,260,000 42
Contribution margin...................................... 540,000 P18
Fixed expenses.............................................. 450,000
Net operating income.................................... P 90,000
Degree of operating Contribution margin
leverage = Net operating income
= P540,000  P90,000 = 6
Requirement (2)
a. Sales of 37,500 doors represents an increase of 7,500 doors, or 25%, over

present sales of 30,000 doors. Since the degree of operating leverage is 6, net
operating income should increase by 6 times as much, or by 150% (6 × 25%).
b. Expected total peso net operating income for the next year is:
Present net operating income........................................................................... P 90,000

Expected increase in net operating income next year (150% ×
P90,000).......................................................................................................
135,000
Total expected net operating income............................................................... P225,000
III. Problems
Problem 1 (CVP Relationships)
Requirement 1
Contribution margin P15
CM ratio = Selling price = P60 =
25%
Variable expense P45
Variable expense ratio = Selling price = P60 =
75%
Requirement 2

P60Q = P45Q + P240,000 + P0
P15Q = P240,000
Q = P240,000 ÷ P15 per unit
Q = 16,000 units, or at P60 per unit, P960,000
13-197
X = 0.75X + P240,000 + P0
0.25X = P240,000
X = P240,000 ÷ 0.25
X = P960,000; or at P60 per unit, 16,000 units
Requirement 3
Increase in sales........................................................... P400,000

Multiply by the CM ratio............................................. x 25%
Expected increase in contribution margin................... P100,000
Since the fixed expenses are not expected to change, net operating income will
increase by the entire P100,000 increase in contribution margin computed above.
Requirement 4

P60Q = P45Q + P240,000 + P90,000
P15Q = P330,000
Q = P330,000 ÷ P15 per unit
Q = 22,000 units
Contribution margin method:

Fixed expenses + Target profit P240,000 + P90,000
Contribution margin per unit = P15 per unit = 22,000 units
Requirement 5
Margin of safety in pesos = Total sales – Break-even sales
= P1,200,000 – P960,000 = P240,000
Margin of safety Margin of safety in pesos P240,000

percentage = Total sales = P1,200,000 = 20%
Requirement 6
a. Degree of operating leverage = Contribution margin = P300,000 = 5

b. Expected increase in sales................................................... 8%

Degree of operating leverage.............................................. x 5
Expected increase in net operating income........................ 40%
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c. If sales increase by 8%, then 21,600 units (20,000 x 1.08 = 21,600) will be sold
next year. The new income statement will be as follows:
Percent of
Total Per Unit Sales
Sales (21,600 units)............... P1,296,000 P60 100%
Less variable expenses........... 972,000 45 75%
Contribution margin.............. 324,000 P15 25%
Less fixed expenses................ 240,000
Net operating income............. P 84,000
Thus, the P84,000 expected net operating income for next year represents a
40% increase over the P60,000 net operating income earned during the current
year:
P84,000 – P60,000 P24,000
P60,000 = P60,000 = 40% increase
Note from the income statement above that the increase in sales from 20,000 to
21,600 units has resulted in increases in both total sales and total variable
expenses. It is a common error to overlook the increase in variable expense
when preparing a projected income statement.
Requirement 7
a. A 20% increase in sales would result in 24,000 units being sold next year:
20,000 units x 1.20 = 24,000 units.
Percent of
Total Per Unit Sales
Sales (24,000 units)............... P1,440,000 P60 100%
Less variable expenses........... 1,152,000 48* 80%
Contribution margin.............. 288,000 P12 20%
Less fixed expenses................ 210,000†
Net operating income............. P 78,000
* P45 + P3 = P48; P48  P60 = 80%.

†
P240,000 – P30,000 = P210,000.
Note that the change in per unit variable expenses results in a change in both
the per unit contribution margin and the CM ratio.
b. Break-even point Fixed expenses

in unit sales = Contribution margin per unit
P210,000
= P12 per unit
13-199
= 17,500 units
c. Yes, based on these point

Break-even data the changes
Fixedshould be made. The changes will
expenses
increase the incompany’s =
peso salesnet operating income
CM ratiofrom the present P60,000 to
P78,000 per year. Although the changes will also result in a higher break-even
point (17,500 units as compared to P210,000
the present 16,000 units), the company’s
margin of safety will actually be= wider than
0.20before:
Margin of safety in pesos = =TotalP1,050,000

sales – Break-even sales
= P1,440,000 – P1,050,000 = P390,000
As shown in requirement (5) above, the company’s present margin of safety is

only P240,000. Thus, several benefits will result from the proposed changes.
Problem 2 (Basics of CVP Analysis; Cost Structure)
Requirement 1
The CM ratio is 30%.

Total Per Unit Percentage
Sales (13,500 units) P270,000 P20 100 %
Less variable expenses 189,000 14 70
Contribution margin P 81,000 P 6 30 %
The break-even point is:

P20Q = P14Q + P90,000 + P0
P 6Q = P90,000
Q = P90,000 ÷ P6 per unit
Q = 15,000 units
15,000 units × P20 per unit = P300,000 in sales
P90,000
= P6 per unit
13-200
= 15,000 units

P90,000
= 0.30
Requirement 2 = P300,000 in sales
Incremental contribution margin:

P70,000 increased sales × 30% CM ratio.........................................................................
P21,000
Less increased fixed costs:
Increased advertising cost.................................................................................................
8,000
Increase in monthly net operating income............................................................................
P13,000
Since the company presently has a loss of P9,000 per month, if the changes are
adopted, the loss will turn into a profit of P4,000 per month.
Requirement 3
Sales (27,000 units × P18 per unit*).....................................................................................

P486,000
(27,000 units × P14 per unit)............................................................................................
378,000
108,000
Less fixed expenses (P90,000 + P35,000).............................................................................
125,000
Net operating loss..................................................................................................................
P(17,000)
*P20 – (P20 × 0.10) = P18
Requirement 4

P 20Q = P14.60Q* + P90,000 + P4,500
P5.40Q = P94,500
Q = P94,500 ÷ P5.40 per unit
Q = 17,500 units
* P14.00 + P0.60 = P14.60.

target profit = CM per unit
P90,000 + P4,500
= 13-201
P5.40 per unit**
= 17,500 units
** P6.00 – P0.60 = P5.40.
Requirement 5
a. The new CM ratio would be:

Per Unit Percentage
Sales P20 100 %
Less variable expenses 7 35
Contribution margin P13 65 %
The new break-even point would be:

P208,000
= P13 per unit
= 16,000 units

P208,000
= 0.65
b. = follow:
Comparative income statements P320,000 in sales
Not Automated Automated

Total Per Unit % Total Per Unit %
Sales (20,000 units) P400,000 P20 100 P400,000 P20 100
Less variable expenses 280,000 14 70 140,000 7 35
Contribution margin 120,000 P 6 30 260,000 P13 65
Less fixed expenses 90,000 208,000
c. Whether or not one would recommend that the company automate its
operations depends on how much risk he or she is willing to take, and depends
heavily on prospects for future sales. The proposed changes would increase the
company’s fixed costs and its break-even point. However, the changes would
also increase the company’s CM ratio (from 30% to 65%). The higher CM
13-202
ratio means that once the break-even point is reached, profits will increase
more rapidly than at present. If 20,000 units are sold next month, for example,
the higher CM ratio will generate P22,000 more in profits than if no changes
are made.
The greatest risk of automating is that future sales may drop back down to
present levels (only 13,500 units per month), and as a result, losses will be even
larger than at present due to the company’s greater fixed costs. (Note the
problem states that sales are erratic from month to month.) In sum, the
proposed changes will help the company if sales continue to trend upward in
future months; the changes will hurt the company if sales drop back down to or
near present levels.
Note to the Instructor: Although it is not asked for in the problem, if time
permits you may want to compute the point of indifference between the two
alternatives in terms of units sold; i.e., the point where profits will be the same
under either alternative. At this point, total revenue will be the same; hence,
we include only costs in our equation:
Let Q = Point of indifference in units sold

P14Q + P90,000 = P7Q + P208,000
P7Q = P118,000
Q = P118,000 ÷ P7 per unit
Q = 16,857 units (rounded)
If more than 16,857 units are sold, the proposed plan will yield the greatest profit; if
less than 16,857 units are sold, the present plan will yield the greatest profit (or the
least loss).
Problem 3 (Sales Mix; Multiproduct Break-even Analysis)
Requirement 1
Products
Sinks Mirrors Vanities Total
Percentage of total sales
32% 40% 28% 100%
P160,00 P200,00 P140,00 P500,00
Sales 0 100% 0 100 % 0 100% 0 100%
48,000 30 160,000 80 77,000 55 285,000 57
P112,00
Contribution margin 0 70%P 40,000 20 % P 63,000 45% 215,000 43%*
Less fixed expenses 223,600

Net operating income
(loss) P ( 8,600)
13-203
* P215,000 ÷ P500,000 = 43%.
Requirement 2
Break-even sales:
in total peso sales = CM ratio
P223,600
Requirement 3 = 0.43
Memo to the president:
= P520,000 in sales
Although the company met its sales budget of P500,000 for the month, the mix of
products sold changed substantially from that budgeted. This is the reason the
budgeted net operating income was not met, and the reason the break-even sales
were greater than budgeted. The company’s sales mix was planned at 48% Sinks,
20% Mirrors, and 32% Vanities. The actual sales mix was 32% Sinks, 40%
Mirrors, and 28% Vanities.
As shown by these data, sales shifted away from Sinks, which provides our greatest
contribution per peso of sales, and shifted strongly toward Mirrors, which provides
our least contribution per peso of sales. Consequently, although the company met
its budgeted level of sales, these sales provided considerably less contribution
margin than we had planned, with a resulting decrease in net operating income.
Notice from the attached statements that the company’s overall CM ratio was only
43%, as compared to a planned CM ratio of 52%. This also explains why the
break-even point was higher than planned. With less average contribution margin
per peso of sales, a greater level of sales had to be achieved to provide sufficient
contribution margin to cover fixed costs.
Problem 4 (Basic CVP Analysis)
Requirement 1
The CM ratio is 60%:

Selling price P150 100%
Less variable expenses 60 40
Contribution margin P 90 60%
Requirement 2
13-204

in total sales pesos = CM ratio
P1,800,000
= 0.60
Requirement 3 = P3,000,000 in sales
P450,000 increased sales × 60% CM ratio = P270,000 increased contribution

margin. Since fixed costs will not change, net operating income should also
increase by P270,000.
Requirement 4
a. Degree of operating leverage = Contribution margin = P2,160,000 = 6

b. 6 × 15% = 90% increase in net operating income.
Requirement 5
Last Year: Proposed:
28,000 units 42,000 units*
Total Per Unit Total Per Unit
Sales P4,200,000 P150.00 P5,670,000 P135.00**
1,680,000 60.00 2,520,000 60.00
Contribution margin 2,520,000 P 90.00 3,150,000 P 75.00
Less fixed expenses 1,800,000 2,500,000
* 28,000 units × 1.5 = 42,000 units

** P150 per unit × 0.90 = P135.00 per unit
No, the changes should not be made.
Requirement 6
Expected total contribution margin:

28,000 units × 200% × P70 per unit*...............................................................................
P3,920,000
28,000 units × P90 per unit...............................................................................................
2,520,000
Incremental contribution margin, and the amount by which
advertising can be increased with net operating income
remaining unchanged........................................................................................................
P1,400,000
* P150 – (P60 + P20) = P70
13-205
Problem 5 (Break-Even and Target Profit Analysis)
Requirement 1
The contribution margin per patch would be:
Selling price...........................................................................................................................
P30
Purchase cost of the patches..............................................................................................
P15
Commissions to the student salespersons.........................................................................
6 21
P 9
Since there are no fixed costs, the number of unit sales needed to yield the desired
P7,200 in profits can be obtained by dividing the target profit by the unit
contribution margin:
Target profit P7,200
= = 800 patches
Unit contribution margin P9 per patch
800 patches x P30 per patch = P24,000 in total sales
Requirement 2
Since an order has been placed, there is now a “fixed” cost associated with the
purchase price of the patches (i.e., the patches can’t be returned). For example, an
order of 200 patches requires a “fixed” cost (investment) of P3,000 (200 patches ×
P15 per patch = P3,000). The variable costs drop to only P6 per patch, and the new
contribution margin per patch becomes:
Selling price...........................................................................................................................
P30
Less variable expenses (commissions only).......................................................................... 6
P24
Since the “fixed” cost of P3,000 must be recovered before Ms. Morales shows any
profit, the break-even computation would be:
P3,000
= P24 per patch = 125 patches
125 patches x P30 per patch = P3,750 in total sales
If a quantity other than 200 patches were ordered, the answer would change
accordingly.
Problem 6
13-206
Requirement 1: Break-even chart
TR
600,000
500,000
TC
400,000
(P)
Break-even
300,000 point
200,000
FC
100,000
250,000
P 200,000
R
O 5,000 10,000 15,000 20,000 25,000 30,000
F 150,000 (units)
I
T
Requirement 2: Profit-volume graph
100,000
Break-even
50,000
point
0
5,000 10,000 15,000 20,000 25,000 30,000
50,000
100,000
L
13-207
O
S 150,000
S
200,000
250,000
Problem 7 (Sales Mix; Break-Even Analysis; Margin of Safety)
Requirement (1)
Hun Yun Total
Pesos % P % Euros %
Sales...............................................
P80,000 100 P48,000 100 P128,000 100
Variable expenses.......................... 48,000 60 9,600 20 57,600 45
Contribution margin...................... P32,000 40 P38,400 80 70,400 55
Fixed expenses............................... 66,000
Net operating income.................... P 4,400
b. Break-even sales = Fixed expenses ÷ CM ratio

= P66,000 ÷ 0.55 = P120,000
Margin of safety
= Actual sales – Break-even sales
in pesos
= P128,000 – P120,000
= P8,000
Margin of safety in pesos  Actual sales
Margin of safety
= 13-208
percentage
= P8,000  P128,000
= 6.25%
Requirement (2)
Hun Yun HY143 Total

Pesos % Pesos % Pesos % Pesos %
Sales P80,000 100 P48,000 100 P32,000 100 P160,000 100
Variable
expenses 48,000 60 9,600 20 2,4000 75 81,600 51
Contribution
margin P32,000 40 P38,400 80 P 8,000 25 78,400 49
Fixed expenses 66,000
Net operating
income P 12,400
b. Break-even sales = Fixed expenses ÷ CM ratio

= P66,000 ÷ 0.49 = P134,700 (rounded)
Margin of safety
= Actual sales – Break-even sales
in pesos
= P160,000 – P134,700
= P25,300
Margin of safety in pesos  Actual sales
Margin of safety
percentage =
= P25,300  P160,000
Requirement (3) = 15.81%
The reason for the increase in the break-even point can be traced to the decrease in
the company’s average contribution margin ratio when the third product is added.
Note from the income statements above that this ratio drops from 55% to 49% with
the addition of the third product. This product, called HY143, has a CM ratio of
only 25%, which causes the average contribution margin ratio to fall.
This problem shows the somewhat tenuous nature of break-even analysis when
13-209
more than one product is involved. The manager must be very careful of his or her
assumptions regarding sales mix when making decisions such as adding or deleting
products.
It should be pointed out to the president that even though the break-even point is
higher with the addition of the third product, the company’s margin of safety is also
greater. Notice that the margin of safety increases from P8,000 to P25,300 or from
6.25% to 15.81%. Thus, the addition of the new product shifts the company much
further from its break-even point, even though the break-even point is higher.
13-210
Problem 8 (Break-Even Analysis with Step Fixed Costs)
Requirement (1)
The total annual fixed cost of the Pediatric Ward can be computed as follows:
Annual Supervising Total

Patient-Days Aides Nurses Nurses Personnel Other Fixed Cost Total Fixed Cost
@ P360,000 @ P580,000 @ P760,000
10,000-12,000 P2,520,000 P8,700,000 P2,280,000 P13,500,000 P27,400,000 P40,900,000
12,001-13,750 P2,880,000 P8,700,000 P2,280,000 P13,860,000 P27,400,000 P41,260,000
13,751-16,500 P3,240,000 P9,280,000 P3,040,000 P15,560,000 P27,400,000 P42,960,000
16,501-18,250 P3,600,000 P9,280,000 P3,040,000 P15,920,000 P27,400,000 P43,320,000
18,251-20,750 P3,600,000 P9,860,000 P3,800,000 P17,260,000 P27,400,000 P44,660,000
20,751-23,000 P3,960,000 P10,440,000 P3,800,000 P18,200,000 P27,400,000 P45,600,000
Requirement (2)
The “break-even” can be computed for each range of activity by dividing the total fixed cost for that range of activity by the contribution margin per
patient-day, which is P3,000 (=P4,800 revenue − P1,800 variable cost).
(b)
Annual (a) Contribution “Break-Even” Within Relevant
Patient-Days Total Fixed Cost Margin (a) ÷ (b) Range?
10,000-12,000 P40,900,000 P3,000 13,633 No
12,001-13,750 P41,260,000 P3,000 13,753 No
13,751-16,500 P42,960,000 P3,000 14,320 Yes
16,501-18,250 P43,320,000 P3,000 14,440 No
18,251-20,750 P44,660,000 P3,000 14,887 No
20,751-23,000 P45,600,000 P3,000 15,200 No
While a “break-even” can be computed for each range of activity (i.e., relevant range), all but one of these break-evens is bogus. For example, within the
range of 10,000 to 12,000 patient-days, the computed break-even is 13,633 (rounded) patient-days. However, this level of activity is outside this relevant
range. To serve 13,633 patient-days, the fixed costs would have to be increased from P40,900,000 to P41,260,000 by adding one more aide. The only
“break-even” that occurs within its own relevant range is 14,320. This is the only legitimate break-even.
Requirement (3)
13-211
The level of activity required to earn a profit of P7,200,000 can be computed as follows:
(a) (b) Activity to Attain

Annual Total Fixed Cost + Contribution Target Profit Within Relevant
Patient-Days Total Fixed Cost Target Profit Target Profit Margin (a) ÷ (b) Range?
10,000-12,000 P40,900,000 P7,200,000 P48,100,000 P3,000 16,033 No
12,001-13,750 P41,260,000 P7,200,000 P48,460,000 P3,000 16,153 No
13,751-16,500 P42,960,000 P7,200,000 P50,160,000 P3,000 16,720 No
16,501-18,250 P43,320,000 P7,200,000 P50,520,000 P3,000 16,840 Yes
18,251-20,750 P44,660,000 P7,200,000 P51,860,000 P3,000 17,287 No
20,751-23,000 P45,600,000 P7,200,000 P52,800,000 P3,000 17,600 No
In this case, the only solution that is within the appropriate relevant range is 16,840 patient-days.
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1. B 6. B 11. B 16. D 21. A 26. A

2. B 7. D 12. A 17. D 22. D 27. B
3. B 8. B 13. A 18. D 23. C 28. C
4. C 9. A 14. C 19. C 24. B 29. B
5. C 10. D 15. D 20. D 25. C 30. A
CHAPTER 14
RESPONSIBILITY ACCOUNTING AND

TRANSFER PRICING
I. Questions
1. Cost centers are evaluated by means of performance reports. Profit centers are
evaluated by means of contribution income statements (including cost center
performance reports), in terms of meeting sales and cost objectives. Investment
centers are evaluated by means of the rate of return which they are able to
generate on invested assets.
2. Overall profitability can be improved (1) by increasing sales, (2) by reducing
expenses, or (3) by reducing assets.
3. ROI may lead to dysfunctional decisions in that divisional managers may reject
otherwise profitable investment opportunities simply because they would reduce
the division’s overall ROI figure. The residual income approach overcomes this
problem by establishing a minimum rate of return which the company wants to
earn on its operating assets, thereby motivating the manager to accept all
investment opportunities promising a return in excess of this minimum figure.
4. A cost center manager has control over cost, but not revenue or investment
funds. A profit center manager, by contrast, has control over both cost and
revenue. An investment center manager has control over cost and revenue and
investment funds.
5. The term transfer price means the price charged for a transfer of goods or
services between units of the same organization, such as two departments or
divisions. Transfer prices are needed for performance evaluation purposes.
6. The use of market price for transfer purposes will create the actual conditions
under which the transferring and receiving units would be operating if they
were completely separate, autonomous companies. It is generally felt that the
creation of such conditions provides managerial incentive, and leads to greater
overall efficiency in operations.
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7. Negotiated transfer prices should be used (1) when the volume involved is large
enough to justify quantity discounts, (2) when selling and/or administrative
expenses are less on intracompany sales, (3) when idle capacity exists, and (4)
when no clear-cut market price exists (such as a sister division being the only
supplier of a good or service).
8. Suboptimization can result if transfer prices are set in a way that benefits a
particular division, but works to the disadvantage of the company as a whole.
An example would be a transfer between divisions when no transfers should be
made (e.g., where a better overall contribution margin could be generated by
selling at an intermediate stage, rather than transferring to the next division).
Suboptimization can also result if transfer pricing is so inflexible that one
division buys from the outside when there is substantial idle capacity to produce
the item internally. If divisional managers are given full autonomy in setting,
accepting, and rejecting transfer prices, then either of these situations can be
created, through selfishness, desire to “look good”, pettiness, or bickering.
II. Exercises
Exercise 1 (Evaluation of a Profit Center)
No. Although Department 3 does not cover all of the cost allocated to it. It
contributes P21,000 to the total operations over and above its direct costs. Without
Department 3, the company would earn P21,000 less as compared with the original
over-all income of P47,000.
Department
1 2 4 Total
Revenue P132,000 P168,000 P98,000 P398,000
Direct cost of department 82,000 108,000 61,000 251,000
Contribution of the
department P 50,000 P 60,000 P37,000 P147,000
Allocated cost 121,000
Net income P 26,000
With the discontinuance of Department 3, the revenue and direct cost of the
department are eliminated, but there is no reduction in the total allocated cost.
Exercise 2 (Evaluation of an Investment Center)
Requirement 1
ROI RI
Operating assets P400,000 P400,000
Operating income P100,000 P100,000
ROI (P100,000  P400,000) 25%
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Minimum required income
(16% x P400,000) P64,000
RI (P100,000 - P64,000) P36,000
Requirement 2
The manager of the Cling Division would not accept this project under the ROI
approach since the division is already earning 25%. Accepting this project would
reduce the present divisional performance, as shown below:
Present New Project Overall
Operating assets P400,000 P60,000 P460,000
Operating income P100,000 P12,000* P112,000
ROI 25% 20% 24.35%
* P60,000 x 20% = P12,000
Under the RI approach, on the other hand, the manager would accept this project
since the new project provides a higher return than the minimum required rate of
return (20 percent vs. 16 percent). The new project would increase the overall
divisional residual income, as shown below:
Present New Project Overall
Operating assets P400,000 P60,000 P460,000
Operating income P100,000 P12,000 P112,000
Minimum required
return at 16% 64,000 9,600* 73,600
RI P 36,000 P 2,400 P 38,400
* P60,000 x 16% = P9,600
Exercise 3 (ROI, Comparison of Three Divisions)
Requirement 1
Division X Division Y Division Z

ROI: P10,000 P12,600 P 28,800
P40,000 = 25% P70,000 = 18% P180,000 = 16%
Requirement 2
Division X would reject this investment opportunity since the addition would lower
the present divisional ROI. Divisions Y and Z would accept it because they would
look better in terms of their divisional ROI.
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Exercise 4 (ROI, RI, Comparisons of Two Divisions)
Requirement 1
Net Operating income X Sales = ROI

Sales Average Operating Assets
Division A : P630,000
P9,000,000 X P9,000,000 = ROI
P3,000,000
7% X 3 = 21%
Division B :
P20,000,000
P1,800,000 X P10,000,000 = ROI
P20,000,000
Requirement 2 9% X 2 = 18%
Division A Division B
Average operating assets (a).............. P3,000,000 P10,000,000
Net operating income......................... P 630,000 P 1,800,000
Minimum required return on average
operating assets - 16% x (a).......... 480,000 1,600,000
Residual income................................. P 150,000 P 200,000
Requirement 3
No, Division B is simply larger than Division A and for this reason one would
expect that it would have a greater amount of residual income. As stated in the text,
residual income can’t be used to compare the performance of divisions of different
sizes. Larger divisions will almost always look better, not necessarily because of
better management but because of the larger peso figures involved. In fact, in the
case above, Division B does not appear to be as well managed as Division A. Note
from Part (2) that Division B has only an 18 percent ROI as compared to 21 percent
for Division A.
Exercise 5 (Evaluation of a Cost Center)
(1) Controllable Costs by supervisor of Department 10 are as follows:

a. Supplies, Department 10
b. Repairs and Maintenance, Department 10
c. Labor Cost, Department 10
(2) Direct Costs of Department 10 are

a. Salary, supervisor of Department 10
b. Supplies, Department 10
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c. Repairs and Maintenance, Department 10
d. Labor Cost, Department 10
(3) Costs allocated to Factory Department are:

a. Factory, heat and light
b. Depreciation, factory
c. Factory insurance
d. Salary of factory superintendent
(4) Costs which do not pertain to factory operations are:

a. Sales salaries and commissions
b. General office salaries
Exercise 6 (Evaluating New Investments Using Return on Investment (ROI)

and Residual Income)
Requirement 1
Computation of ROI
Division A:
P300,000 P6,000,000
ROI = x = 5% x 4 = 20%
P6,000,000 P1,500,000
Division B:
P900,000 P10,000,000
ROI = x = 9% x 2 = 18%
P10,000,000 P5,000,000
Division C:
P180,000 P8,000,000
ROI = P8,000,000 x P2,000,000 = 2.25% x 4 = 9%
Requirement 2
Division A Division B Division C

Average operating assets P1,500,000 P5,000,000 P2,000,000
Required rate of return × 15% × 18% × 12%
Required operating income P 225,000 P 900,000 P 240,000
Actual operating income P 300,000 P 900,000 P 180,000
Required operating income (above) 225,000 900,000 240,000
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Residual income P 75,000 P 0 P (60,000)
Requirement 3
a. and b. Division A Division B Division C

Return on investment (ROI) 20% 18% 9%
Therefore, if the division is presented
with an investment opportunity
yielding 17%, it probably would Reject Reject Accept
Minimum required return for
computing residual income 15% 18% 12%
Therefore, if the division is presented
with an investment opportunity
yielding 17%, it probably would Accept Reject Accept
If performance is being measured by ROI, both Division A and Division B probably

would reject the 17% investment opportunity. The reason is that these companies
are presently earning a return greater than 17%; thus, the new investment would
reduce the overall rate of return and place the divisional managers in a less
favorable light. Division C probably would accept the 17% investment opportunity,
since its acceptance would increase the Division’s overall rate of return.
If performance is being measured by residual income, both Division A and Division

C probably would accept the 17% investment opportunity. The 17% rate of return
promised by the new investment is greater than their required rates of return of 15%
and 12%, respectively, and would therefore add to the total amount of their residual
income. Division B would reject the opportunity, since the 17% return on the new
investment is less than B’s 18% required rate of return.
Exercise 7 (Transfer Pricing from Viewpoint of the Entire Company)
Requirement 1
Division A Division B Total Company
Sales P3,500,000 1
P2,400,000 2
P5,200,000 3
Less expenses:
Added by the division 2,600,000 1,200,000 3,800,000
Transfer price paid — 700,000 —
Total expenses 2,600,000 1,900,000 3,800,000
Net operating income P 900,000 P 500,000 P1,400,000
1
20,000 units × P175 per unit = P3,500,000.
2
4,000 units × P600 per unit = P2,400,000.
3
Division A outside sales (16,000 units × P175 per unit).......................................................
P2,800,000
Division B outside sales (4,000 units × P600 per unit)........................................................
2,400,000
Total outside sales..................................................................................................................
P5,200,000
Observe that the P700,000 in intracompany sales has been eliminated.
Requirement 2
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Division A should transfer the 1,000 additional units to Division B. Note that
Division B’s processing adds P425 to each unit’s selling price (B’s P600 selling
price, less A’s P175 selling price = P425 increase), but it adds only P300 in cost.
Therefore, each tube transferred to Division B ultimately yields P125 more in
contribution margin (P425 – P300 = P125) to the company than can be obtained
from selling to outside customers. Thus, the company as a whole will be better off if
Division A transfers the 1,000 additional tubes to Division B.
Exercise 8 (Transfer Pricing Situations)
Requirement 1
The lowest acceptable transfer price from the perspective of the selling division is
given by the following formula:
Total contribution margin
Variable cost on lost sales
Transfer price  per unit + Number of units transferred
.
There is no idle capacity, so each of the 20,000 units transferred from Division X to
Division Y reduces sales to outsiders by one unit. The contribution margin per unit
on outside sales is P20 (= P50 – P30).
P20 x 20,000
Transfer price  (P30 – P2) + 20,000
Transfer price = P28 + P20 = P48
The buying division, Division Y, can purchase a similar unit from an outside
supplier for P47. Therefore, Division Y would be unwilling to pay more than P47
per unit.
Transfer price  Cost of buying from outside supplier = P47
The requirements of the two divisions are incompatible and no transfer will take
place.
Requirement 2
In this case, Division X has enough idle capacity to satisfy Division Y’s demand.
Therefore, there are no lost sales and the lowest acceptable price as far as the selling
division is concerned is the variable cost of P20 per unit.
P0
Transfer price  P20 + 20,000 =
P20
The buying division, Division Y, can purchase a similar unit from an outside
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supplier for P34. Therefore, Division Y would be unwilling to pay more than P34
per unit.
Transfer price  Cost of buying from outside supplier = P34
In this case, the requirements of the two divisions are compatible and a transfer will
hopefully take place at a transfer price within the range:
P20  Transfer price  P34
Exercise 9 (Transfer Pricing: Decision Making)
Requirement 1
Division A’s purchase decision from the overall firm perspective:
Purchase costs from outside 10,000 x P150 = P1,500,000

Less: Savings of Divisions B’s variable costs 10,000 x P140 = 1,400,000
Net Cost (Benefit) for A to buy outside P 100,000
Assuming Division B has no outside sales, Division A should buy inside from
Division B for the benefit of the entire firm.
Requirement 2
As above, but in addition, if Division A buys outside, Division B saves an additional

P200,000.

Less: Savings in variable costs 10,000 x P140 = 1,400,000
Less: Savings of B material assignment 200,000
Net Cost (Benefit) for A to buy outside P (100,000)
The additional savings in Division B means that now Division A should buy outside.
Requirement 3
Assuming the outside price drops from P150 to P130:

Less: Savings in variable costs 10,000 x P140 = 1,400,000
Net Cost (Benefit) for A to buy outside P (100,000)
Division A should buy outside.
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Exercise 10 (Compute the Return on Investment (ROI))
Requirement (1)
Net operating income

Margin = Sales
P5,400,000
= P18,000,000 = 30%
Requirement (2)
Sales
Turnover = Average operating assets
P18,000,000
= P36,000,000 = 0.5
Requirement (3)
ROI = Margin x Turnover

= 30% x 0.5 = 15%
Exercise 11 (Residual Income)
Average operating assets (a)....................................................... P2,200,000

Net operating income................................................................. P400,000
Minimum required return: 16% × (a)........................................ 352,000
Residual income......................................................................... P 48,000
III. Problems
Problem 1 (Evaluation of Profit Centers)
Requirement (a)
Jadlow Manufacturing Corporation

Income Statement
Total Product S Product T

Sales P5,100,000 P2,700,000 P2,400,000
Less: Variable Costs 3,330,000 1,890,000 1,440,000
Contribution Margin P1,770,000 P 810,000 P 960,000
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Less: Controllable fixed
expenses 501,000 66,000 435,000
Contribution to the recovery of
non-controllable fixed
expenses P1,269,000 P 744,000 P 525,000
Requirement (b)
The complaint of the manager of Product T is justified on the ground that his
product line shows a positive contribution margin and therefore, contributes to the
recovery of non-controllable fixed expenses. This observation is, of course, made
under the assumption that the preceding year’s figures (which are not given) were
less favorable than the current year.
Problem 2 (Evaluation of Profit Centers)
Requirement 1
Product
A B C
Incremental sales P71,000 P46,000 P117,000
Less: Incremental costs 42,000 15,000 96,000
Net income P29,000 P31,000 P 21,000
Product B seems to offer the best profit potential.
Requirement 2
The sunk costs are:
Depreciation of equipment P 6,400
Operating cost of the equipment 4,600
Total P11,000
Requirement 3
Opportunity cost of selling Product B is
From Product A P29,000
From Product C 21,000
Total P50,000
Problem 3 (Evaluation of Performance)
Ranjie Tool Company

Performance Report
For the Year 2005
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Budgeted Labor Hours 4,000
Actual Labor Hours 4,200
Budget
Actual Based on
Cost-Volume 4,200 4,200 Variance
Formula Hours Hours U (F)
Variable Overhead Costs:
Utilities P0.80 per hour P 3,600 P 3,360 P240
Supplies 1.80 7,400 7,560 (160)
Indirect labor 1.20 5,300 5,040 260
Total P3.80 P16,300 P15,960 P340
Fixed Overhead Costs:
Utilities P 1,600 P 1,600 -
Supplies 2,200 2,200 -
Depreciation 6,000 6,000 -
Indirect labor 5,400 5,400 -
Insurance 1,200 1,200 -
Total P16,400 P16,400 -
Total Factory Overhead Costs P32,700 P32,360 P340
Problem 4 (Evaluation of Performance)
Requirement 1
Performance Report for the Production Manager

Actual Flexible Variance
Cost Budget Cost (U) or (F)
Controllable costs:
Direct material P24,000 P20,000 P4,000 (U)
Direct labor 48,000 50,000 2,000 (F)
Supplies 4,000 6,000 2,000 (F)
Maintenance 3,000 4,000 1,000 (F)
Total P79,000 P80,000 P1,000 (F)
The cost of raw materials rose significantly, possibly because of (1) deficient
machinery due to the cutback in maintenance expenditures and/or (2) to the lower
labor cost, possibly due to the use of less-skilled workers. Supplies decreased,
indicating possible inadequacies for next period’s production run.
Requirement 2
Performance Report for the Vice President

Actual Flexible Variance
Cost Budget Cost (U) or (F)
Controllable costs:
Marketing division P104,000 P102,000 P2,000 (U)
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Production division 79,000 80,000 1,000 (F)
Personnel division 72,000 76,000 4,000 (F)
Other costs 68,800 70,000 1,200 (F)
Total P323,800 P328,000 P4,200 (F)
The marketing division is behind its cost allotment. The personnel division came
in somewhat under its budgeted costs. Perhaps there has been a cutback in hiring,
indicating possible reduction in future production.
Problem 5 (Target Sales Price; Return on Investment)
Requirement 1
Return on investment = Operating income / Investment

20% = X / P800,000
Target Operating Income = P160,000
Target revenues, calculated as follows:
Fixed overhead P200,000

Variable costs 1,500,000 x P300 450,000
Desired operating income 160,000
Revenues P810,000
The selling price per units is P540 = P810,000 / 1,500
Requirement 2
Data are in thousands.
Units 1,500 2,000 1,000

Revenues P810 P1,080 P540
Variable costs 450 600 300

Fixed costs 200 200 200
Total costs 650 800 500
Operating income P160 P280 P 40

Return on investment 20% 35% 5%
= P160 / = P280 / = P40 / P800
P800 P800
Note how the change in income follows the change in revenues, as predicted by
operating leverage. Operating leverage multiplied times the percentage change in
sales gives the percentage change in income. Thus, the greater the operating
leverage ratio, the larger the effect on income and ROI of a given percentage change
in sales. This exercise provides an opportunity to review the relationship between
volume and profit. See the illustration below:
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Operating leverage = contribution margin / operating income

= (P810 – P450) / P160 = 2.25
% change in income = operating leverage x % change in revenues

= 2.25 x 33.33% = 75%
% change in income
If volume goes to 2,000 units: (P280 – P160) / P160 = 75%
If volume goes to 1,000 units: (P160 – P40) / P160 = 75%
% change in ROI
If volume goes to 2,000 units: (35% - 20%) / 20% = 75%
If volume goes to 1,000 units: (20% - 5%) / 20% = 75%
Problem 6 (Contrasting Return on Investment (ROI) and Residual Income)
Requirement 1
ROI computations:
Net operating income Sales

ROI = x
Sales Average operating assets
Pasig: P630,000 P9,000,000
P9,000,000 x P3,000,000 = 7% x 3 = 21%
Quezon: P1,800,000 P20,000,000

P20,000,000 x P10,000,000 = 9% x 2 = 18%
Requirement 2
Pasig Quezon
Average operating assets (a) P3,000,000 P10,000,000
Net operating income P 630,000 P 1,800,000
Minimum required return on average
operating assets—16% × (a) 480,000 P 1,600,000
Residual income P 150,000 P 200,000
Requirement 3
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No, the Quezon Division is simply larger than the Pasig Division and for this reason
one would expect that it would have a greater amount of residual income. Residual
income can’t be used to compare the performance of divisions of different sizes.
Larger divisions will almost always look better, not necessarily because of better
management but because of the larger peso figures involved. In fact, in the case
above, Quezon does not appear to be as well managed as Pasig. Note from Part (1)
that Quezon has only an 18% ROI as compared to 21% for Pasig.
Problem 7 (Transfer Pricing)
Requirement 1
Since the Valve Division has idle capacity, it does not have to give up any outside
sales to take on the Pump Division’s business. Applying the formula for the lowest
acceptable transfer price from the viewpoint of the selling division, we get:

Transfer price  per unit + Number
P0 of units transferred
Transfer price  P16 + 10,000 =
P16
The Pump Division would be unwilling to pay more than P29, the price it is
currently paying an outside supplier for its valves. Therefore, the transfer price
must fall within the range:
Requirement 2
Since the Valve Division is selling all of the valves that it can produce on the
outside market, it would have to give up some of these outside sales to take on the
Pump Division’s business. Thus, the Valve Division has an opportunity cost, which
is the total contribution margin on lost sales:
(P30 – P16) x 10,000

Transfer price  P16 + 10,000
= P16 + P14 =
Since the Pump Division can purchase valves from an outside supplier at only P29
per unit, no transfers will be madeP30
between the two divisions.
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Requirement 3
Applying the formula for the lowest acceptable price from the viewpoint of the
selling division, we get:

(P30 – P16) x 10,000

Transfer price  (P16 – P3) + 10,000
= P13 + P14 =
In this case, the transfer price must fall within the range:
P27
Problem 8 (Transfer Pricing)
To produce the 20,000 special valves, the Valve Division will have to give up sales
of 30,000 regular valves to outside customers. Applying the formula for the lowest
acceptable price from the viewpoint of the selling division, we get:
(P30 – P16) x 30,000

Transfer price  P20 + 20,000
= P20 + P21 =
Problem 9 (Effects of Changes in Sales, Expenses, and Assets in ROI)
P41
1. Net operating income
Margin = Sales
P800,000
= P8,000,000 = 10%
2. Sales
Turnover = Average operating assets
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P8,000,000
= P3,200,000 = 2.5
II
3.
ROI = Margin x Turnover
= 10% x 2.5 = 25%
Problem 10 (Transfer Pricing Basics)
Requirement (1)
a. The lowest acceptable transfer price from the perspective of the selling division,
the Electrical Division, is given by the following formula:

Transfer price = +
per unit Number of units transferred
Because there is enough idle capacity to fill the entire order from the Motor
Division, there are no lost outside sales. And because the variable cost per unit
is P21, the lowest acceptable transfer price as far as the selling division is
concerned is also P21.

10,000
b. The Motor Division can buy a similar transformer from an outside supplier for
P38. Therefore, the Motor Division would be unwilling to pay more than P38
per transformer.
Transfer price: Cost from buying from outside supplier = P38
c. Combining the requirements of both the selling division and the buying
division, the acceptable range of transfer prices in this situation is:
P21 : Transfer price : P38
Assuming that the managers understand their own businesses and that they are
cooperative, they should be able to agree on a transfer price within this range
and the transfer should take place.
d. From the standpoint of the entire company, the transfer should take place. The
cost of the transformers transferred is only P21 and the company saves the P38
cost of the transformers purchased from the outside supplier.
Requirement (2)
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a. Each of the 10,000 units transferred to the Motor Division must displace a sale
to an outsider at a price of P40. Therefore, the selling division would demand a
transfer price of at least P40. This can also be computed using the formula for
the lowest acceptable transfer price as follows:
Transfer price = P21 + (P40 – P21) x 10,000

10,000
b. As before, the Motor Division= would

P21 +be (P40 – P21)
unwilling = more
to pay P40 than P38 per
transformer.
c. The requirements of the selling and buying divisions in this instance are
incompatible. The selling division must have a price of at least P40 whereas the
buying division will not pay more than P38. An agreement to transfer the
transformers is extremely unlikely.
d. From the standpoint of the entire company, the transfer should not take place.
By transferring a transformer internally, the company gives up revenue of P40
and saves P38, for a loss of P2.
Problem 11 (Transfer Pricing with an Outside Market)
Requirement (1)
The lowest acceptable transfer price from the perspective of the selling division is
given by the following formula:
Variable cost + on lost sales
Transfer price =
The Tuner Division has no idle capacity, so transfers from the Tuner Division to the
Assembly Division would cut directly into normal sales of tuners to outsiders. The
costs are the same whether a tuner is transferred internally or sold to outsiders, so
the only relevant cost is the lost revenue of P200 per tuner that could be sold to
outsiders. This is confirmed below:
Transfer price = P110 + (P200 – P110) x 30,000

30,000
= P110 + (P200 – P110) = P200

Therefore, the Tuner Division will refuse to transfer at a price less than P200 per
tuner.
The Assembly Division can buy tuners from an outside supplier for P200, less a
10% quantity discount of P20, or P180 per tuner. Therefore, the Division would be
unwilling to pay more than P180 per tuner.
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Transfer price : Cost of buying from outside supplier = P180

The requirements of the two divisions are incompatible. The Assembly Division
won’t pay more than P180 and the Tuner Division will not accept less than P200.
Thus, there can be no mutually agreeable transfer price and no transfer will take
place.
Requirement (2)
The price being paid to the outside supplier, net of the quantity discount, is only
P180. If the Tuner Division meets this price, then profits in the Tuner Division and
in the company as a whole will drop by P600,000 per year:
Lost revenue per tuner................................................................ P200

Outside supplier’s price.............................................................. P180
Loss in contribution margin per tuner........................................ P20
Number of tuners per year.......................................................... × 30,000
Total loss in profits..................................................................... P600,000
Profits in the Assembly Division will remain unchanged, since it will be paying the
same price internally as it is now paying externally.
Requirement (3)
The Tuner Division has idle capacity, so transfers from the Tuner Division to the
Assembly Division do not cut into normal sales of tuners to outsiders. In this case,
the minimum price as far as the Assembly Division is concerned is the variable cost
per tuner of P11. This is confirmed in the following calculation:

30,000supplier for P180 each and
The Assembly Division can buy tuners from an outside
would be unwilling to pay more than that in an internal transfer. If the managers
understand their own businesses and are cooperative, they should agree to a transfer
and should settle on a transfer price within the range:
P110 : Transfer price : P180
Requirement (4)
Yes, P160 is a bona fide outside price. Even though P160 is less than the Tuner
Division’s P170 “full cost” per unit, it is within the range given in Part 3 and
therefore will provide some contribution to the Tuner Division.
If the Tuner Division does not meet the P160 price, it will lose P1,500,000 in
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potential profits:
Price per tuner.......................................................... P160

Variable costs............................................................ 110
Contribution margin per tuner................................. P 50
30,000 tuners × P50 per tuner = P1,500,000 potential increased profits
This P1,500,000 in potential profits applies to the Tuner Division and to the
company as a whole.
Requirement (5)
No, the Assembly Division should probably be free to go outside and get the best
price it can. Even though this would result in lower profits for the company as a
whole, the buying division should probably not be forced to purchase inside if better
prices are available outside.
Requirement (6)
The Tuner Division will have an increase in profits:
Selling price............................................................. P200

Variable costs............................................................ 110
Contribution margin per tuner................................. P 90
30,000 tuners × P90 per tuner = P2,700,000 increased profits
The Assembly Division will have a decrease in profits:
Inside purchase price............................................... P200

Outside purchase price............................................. 160
Increased cost per tuner........................................... P 40
30,000 tuners × P40 per tuner = P1,200,000 decreased profits
The company as a whole will have an increase in profits:
Increased contribution margin in the Tuner Division.......................................................

P 90
Decreased contribution margin in the Assembly Division................................................40
Increased contribution margin per tuner...........................................................................
P 50
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30,000 tuners × P50 per tuner = P1,500,000 increased profits
So long as the selling division has idle capacity and the transfer price is greater than
the selling division’s variable costs, profits in the company as a whole will increase
if internal transfers are made. However, there is a question of fairness as to how
these profits should be split between the selling and buying divisions. The
inflexibility of management in this situation damages the profits of the Assembly
Division and greatly enhances the profits of the Tuner Division.
Problem 12 (Transfer Pricing; Divisional Performance)
Requirement (1)
The Electronics Division is presently operating at capacity; therefore, any sales of

the KK8 circuit board to the Clock Division will require that the Electronics
Division give up an equal number of sales to outside customers. Using the transfer
pricing formula, we get a minimum transfer price of:
Variable cost + on lost sales
Transfer price =
Transfer price = P82.50 + (P125.00 – P82.50)

Transfer price = P82.50 + P42.50
Thus, Transfer
the Electronics Division P125.00
price = should not supply the circuit board to the Clock
Division for P90 each. The Electronics Division must give up revenues of P125.00
on each circuit board that it sells internally. Since management performance in the
Electronics Division is measured by ROI and dollar profits, selling the circuit
boards to the Clock Division for P9 would adversely affect these performance
measurements.
Requirement (2)
The key is to realize that the P100 in fixed overhead and administrative costs
contained in the Clock Division’s P697.50 cost per timing device is not relevant.
There is no indication that winning this contract would actually affect any of the
fixed costs. If these costs would be incurred regardless of whether or not the Clock
Division gets the oven timing device contract, they should be ignored when
determining the effects of the contract on the company’s profits. Another key is that
the variable cost of the Electronics Division is not relevant either. Whether the
circuit boards are used in the timing devices or sold to outsiders, the production
costs of the circuit boards would be the same. The only difference between the two
alternatives is the revenue on outside sales that is given up when the circuit boards
are transferred within the company.
Selling price of the timing devices.............................................................................

P700.00
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Less:
The cost of the circuit boards used in the timing devices (i.e.
the lost revenue from sale of circuit boards to outsiders).................................
P125.00
Variable costs of the Clock Division excluding the circuit board
(P300.00 + P207.50)..........................................................................................
507.50 632.50
Net positive effect on the company’s profit................................................................ P 67.50
Therefore, the company as a whole would be better off by P67.50 for each timing
device that is sold to the oven manufacturer.
Requirement (3)
As shown in part (1) above, the Electronics Division would insist on a transfer price
of at least P125.00 for the circuit board. Would the Clock Division make any money
at this price? Again, the fixed costs are not relevant in this decision since they
would not be affected. Once this is realized, it is evident that the Clock Division
would be ahead by P67.50 per timing device if it accepts the P125.00 transfer price.
Selling price of the timing devices........................................................................... P700.00

Less:
Purchased parts (from outside vendors)...............................................................
P300.00
Circuit board KK8 (assumed transfer price)........................................................
125.00
Other variable costs..............................................................................................
207.50 632.50
Clock Division contribution margin......................................................................... P 67.50
In fact, since the contribution margin is P62.50, any transfer price within the range
of P125.00 to P192.50 (= P125.00 + P67.50) will improve the profits of both
divisions. So yes, the managers should be able to agree on a transfer price.
Requirement (4)
It is in the best interests of the company and of the divisions to come to an

agreement concerning the transfer price. As demonstrated in part (3) above, any
transfer price within the range P125.00 to P192.50 would improve the profits of
both divisions. What happens if the two managers do not come to an agreement?
In this case, top management knows that there should be a transfer and could step
in and force a transfer at some price within the acceptable range. However, such an
action, if done on a frequent basis, would undermine the autonomy of the managers
and turn decentralization into a sham.
Our advice to top management would be to ask the two managers to meet to discuss
the transfer pricing decision. Top management should not dictate a course of action
or what is to happen in the meeting, but should carefully observe what happens in
the meeting. If there is no agreement, it is important to know why. There are at least
three possible reasons. First, the managers may have better information than the top
managers and refuse to transfer for very good reasons. Second, the managers may
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be uncooperative and unwilling to deal with each other even if it results in lower
profits for the company and for themselves. Third, the managers may not be able to
correctly analyze the situation and may not understand what is actually in their own
best interests. For example, the manager of the Clock Division may believe that the
fixed overhead and administrative cost of P100 per timing device really does have to
be covered in order to avoid a loss.
If the refusal to come to an agreement is the result of uncooperative attitudes or an
inability to correctly analyze the situation, top management can take some positive
steps that are completely consistent with decentralization. If the problem is
uncooperative attitudes, there are many training companies that would be happy to
put on a short course in team building for the company. If the problem is that the
managers are unable to correctly analyze the alternatives, they can be sent to
executive training courses that emphasize economics and managerial accounting.
1. C 11. E 21. C 31. B

2. D 12. D 22. B 32. D
3. A 13. C 23. A 33. D
4. A 14. C 24. D 34. D
5. C 15. B 25. B 35. C
6. A 16. C 26. A 36. D
7. D 17. B 27. A 37. B
8. A 18. A 28. B 38. D
9. C 19. B 29. D 39. B
10. A 20. A 30. A 40. D
CHAPTER 15
FUNCTIONAL AND ACTIVITY-BASED BUDGETING
I. Questions
1. No. Planning and control are different, although related, concepts. Planning
involves developing objectives and formulating steps to achieve those
objectives. Control, by contrast, involves the means by which management
ensures that the objectives set down at the planning stage are attained.
2. Budgets have a dual purpose, for planning and for following up the
implementation of the plan. The great benefits from budgeting lie in the quick
investigation of deviations and in the subsequent corrective action. Budgets
should not be prepared in the first place if they are ignored, buried in files, or
improperly interpreted.
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3. Two major features of a budgetary program are (1) the accounting techniques
which developed it and (2) the human factors which administer it. The human
factors are far more important. The success of a budgetary system depends
upon its acceptance by the company members who are affected by the budget.
Without a thoroughly educated and cooperative management group at all levels
of responsibility, budgets are a drain on the funds of the business and are a
hindrance instead of help to efficient operations.
4. Manufacturing overhead costs are budgeted at normal operating capacity, and
the costs are applied to the products using a predetermined rate. The
predetermined rate is computed by dividing a factor that can be identified with
both the products and the overhead into the overhead budgeted at the normal
operating capacity. Budgets may also be used in costing products in a standard
cost accounting system.
5. The production division operates to produce the products that are sold.
Production and sales must be coordinated. Products must be manufactured so
that they will be available to meet sales delivery dates. Activity of the
production division will depend upon the sales that can be made. Also, the
sales division is limited by the capabilities of the production department in
manufacturing products. Successful operations depend upon a coordination of
sales and production.
6. Labor hour required for production can be translated into labor pesos by
multiplying the number of hours budgeted by the appropriate labor rates. The
rates to be used will depend upon the rates established for job classifications
and the policy with respect to premium pay for overtime or shift differences.
7. A long-range plan for the acquisition of plant assets is broken down and
entered in the current budget as the plan unfolds. The portion of the plan
which is to be executed in the next year is included in the budget for that year.
8. A budget period is not limited to any particular unit of time. At a minimum, a
budget should cover at least one operating cycle. For example, a budget should
not cover a period when purchasing activity is high and omit the period when
sales volume and cash collection are relatively high. The budget period should
encompass the entire cycle extending from the purchasing operation to the
subsequent sale of the products and the realization of the sales in cash.
Ordinarily, a budget of operations is prepared for a year which in turn is
divided into quarters and months. Long-term budgets, such as budgets for
projects or capital investments, may extend five to ten years or more into the
future.
9. A rolling budget or a progressive budget or sometimes called continuous
budget, is a budget which is prepared throughout the year. As one month
elapses, a budget is prepared for one more month in the future. At any one time
for example, the company will have a budget for one year into the future, when
July of one year is over, a budget for the following July will be added at the
other end of the budget. This process of adding a new month as a month
expires is continuous.
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10. Variances that are revealed by a comparison of actual results with a budget are
investigated if it appears that an investigation is warranted. The investigation
may show that stricter control measures are needed or that some weaknesses in
the operation should be corrected. It may also reveal that the budget plan
should be revised. The comparison is one step in the control and direction of
business operations.
11. A comparison of actual results with a budget can contribute information that
can be applied in the preparation of better budgets in the future. Subsequent
investigation of variances provides management with a better knowledge of
operations. This knowledge can be applied in the preparation of more realistic
budgets for subsequent fiscal periods.
12. A self-imposed budget is one in which persons with responsibility over cost
control prepare their own budgets, i.e., the budget is not imposed from above.
The major advantages are: (1) the views and judgments of persons from all
levels of an organization are represented in the final budget document; (2)
budget estimates generally are more accurate and reliable, since they are
prepared by those who are closest to the problems; (3) managers generally are
more motivated to meet budgets which they have participated in setting; (4)
self-imposed budgets reduce the amount of upward “blaming” resulting from
inability to meet budget goals. One caution must be exercised in the use of self-
imposed budgets. The budgets prepared by lower-level managers should be
carefully reviewed to prevent too much slack.
13. No, although this is clearly one of the purposes of the cash budget. The
principal purpose is to provide information on probable cash needs during the
budget period, so that bank loans and other sources of financing can be
anticipated and arranged well in advance of the actual time of need.
14. Zero-based budgeting requires that managers start at zero levels every year and
justify all costs as if all programs were being proposed for the first time. In
traditional budgeting, by contrast, budget data are usually generated on an
incremental basis, with last year’s budget being the starting point.
15. A budget is a detailed quantitative plan for the acquisition and use of financial
and other resources over a given time period. Budgetary control involves the
use of budgets to control the actual activities of a firm.
16. 1. Budgets communicate management’s plans throughout the organization.
2. Budgets force managers to think about and plan for the future.
3. The budgeting process provides a means of allocating resources to those
parts of the organization where they can be used most effectively.
4. The budgeting process can uncover potential bottlenecks before they occur.
5. Budgets coordinate the activities of the entire organization by integrating
the plans of its various parts. Budgeting helps to ensure that everyone in
the organization is pulling in the same direction.
6. Budgets define goals and objectives that can serve as benchmarks for
evaluating subsequent performance.
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17. A master budget represents a summary of all of management’s plans and goals
for the future, and outlines the way in which these plans are to be
accomplished. The master budget is composed of a number of smaller, specific
budgets encompassing sales, production, raw materials, direct labor,
manufacturing overhead, selling and administrative expenses, and inventories.
The master budget generally also contains a budgeted income statement,
budgeted balance sheet, and cash budget.
18. The flow of budgeting information moves in two directions—upward and
downward. The initial flow should be from the bottom of the organization
upward. Each person having responsibility over revenues or costs should
prepare the budget data against which his or her subsequent performance will
be measured. As the budget data are communicated upward, higher-level
managers should review the budgets for consistency with the overall goals of
the organization and the plans of other units in the organization. Any issues
should be resolved in discussions between the individuals who prepared the
budgets and their managers.
All levels of an organization should participate in the budgeting process—not

just top management or the accounting department. Generally, the lower levels
will be more familiar with detailed, day-to-day operating data, and for this
reason will have primary responsibility for developing the specifics in the
budget. Top levels of management should have a better perspective concerning
the company’s strategy.
19. Budgeting can assist a company forecast its workforce staffing needs through
direct labor and other budgets. By careful planning through the budget process,
a company can often smooth out its activities and avoid erratic hiring and
laying off employees.
II. Matching Type
1. C 6. A
2. H 7. B
3. E 8. J
4. F 9. D
5. I 10. G
III. Exercises
Exercises 1 (Schedule of Expected Cash Collections)
Requirement 1
July August September Total

May sales:
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P430,000 × 10% P 43,000 P 43,000
June sales:
P540,000 × 70%, 10% 378,000 P54,000 432,000
July sales:
P600,000 × 20%,
70%, 10% 120,000 420,000 P 60,000 600,000
August sales:
P900,000 × 20%, 70% 180,000 630,000 810,000
September sales:
P500,000 × 20% 100,000 100,000
Total cash collections P541,000 P654,000 P790,000 P1,985,000
Notice that even though sales peak in August, cash collections peak in September.
This occurs because the bulk of the company’s customers pay in the month
following sale. The lag in collections that this creates is even more pronounced in
some companies. Indeed, it is not unusual for a company to have the least cash
available in the months when sales are greatest.
Requirement 2
Accounts receivable at September 30:
From August sales: P900,000 × 10%....................................................................................

P 90,000
From September sales: P500,000 × (70% + 10%)................................................................
400,000
Total accounts receivable.......................................................................................................
P490,000
Exercise 2 (Production Budget)
Septembe
July August r Quarter
Budgeted sales in units 30,000 45,000 60,000 135,000
Add desired ending inventory* 4,500 6,000 5,000 5,000
Total needs 34,500 51,000 65,000 140,000
Less beginning inventory 3,000 4,500 6,000 3,000
Required production 31,500 46,500 59,000 137,000
* 10% of the following month’s sales
Exercise 3 (Materials Purchase Budget)
Quarter – Year 2 Year 3

First Second Third Fourth First
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Required production of calculators 60,000 90,000 150,000 100,000 80,000
Number of chips per calculator × 3 × 3 × 3 × 3 × 3
Total production needs—chips 180,000 270,000 450,000 300,000 240,000
Year 2
First Second Third Fourth Year
Production needs—chips 180,000 270,000 450,000 300,000 1,200,000
Add desired ending inventory
—chips 54,000 90,000 60,000 48,000 48,000
Total needs—chips 234,000 360,000 510,000 348,000 1,248,000
Less beginning inventory—
chips 36,000 54,000 90,000 60,000 36,000
Required purchases—chips 198,000 306,000 420,000

288,000 1,212,000
Cost of purchases at P2 per P2,424,00
chip P396,000 P612,000 P840,000 P576,000 0
Exercise 4 (Direct Labor Budget)
Requirement 1
Assuming that the direct labor workforce is

adjusted each quarter, the direct labor
budget would be:
1st 2nd 3rd 4th
Quarter Quarter Quarter Quarter Year
Units to be produced 5,000 4,400 4,500 4,900 18,800
Direct labor time per unit (hours)
× 0.40 × 0.40 × 0.40 × 0.40 × 0.40
Total direct labor hours needed 2,000 1,760 1,800 1,960 7,520
Direct labor cost per hour × P11.00 × P11.00 × P11.00 × P11.00 × P11.00
Total direct labor cost P 22,000 P 19,360 P 19,800 P 21,560 P 82,720
Requirement 2
Assuming that the direct labor workforce is not adjusted each quarter and that
overtime wages are paid, the direct labor budget would be:
1st 2nd 3rd 4th

Direct labor time per unit
(hours) × 0.40 × 0.40 × 0.40 × 0.40 × 0.40
Total direct labor hours
needed 2,000 1,760 1,800 1,960 7,520
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Regular hours paid 1,800 1,800 1,800 1,800 7,200
Overtime hours paid 200 - - 160 360
Wages for regular hours
(@ P11.00 per hour) P19,800 P19,800 P19,800 P19,800 P79,200
Overtime wages
(@ P11.00 per hour × 1.5)
3,300 - - 2,640 5,940
Total direct labor cost P23,100 P19,800 P19,800 P22,440 P85,140
Exercise 5 (Manufacturing Overhead Budget)
Requirement 1
Kiko Corporation
Manufacturing Overhead Budget
1st 2nd 3rd 4th

Budgeted direct labor-hours 5,000 4,800 5,200 5,400 20,400
Variable overhead rate x P1.75 x P1.75 x P1.75 x P1.75 x P1.75
Variable manufacturing
overhead P 8,750 P 8,400 P 9,100 P 9,450 P 35,700
Fixed manufacturing overhead 35,000 35,000 35,000 35,000 140,000
Total manufacturing overhead 43,750 43,400 44,100 44,450 175,700
Less depreciation 15,000 15,000 15,000 15,000 60,000
Cash disbursements for
manufacturing overhead P28,750 P28,400 P29,100 P29,450 P115,700
Requirement 2
Total budgeted manufacturing overhead for the year (a) P175,700

Total budgeted direct labor-hours for the year (b) 20,400
Predetermined overhead rate for the year (a) ÷ (b) P 8.61
Exercise 6 (Selling and Administrative Budget)
Helene Company
Selling and Administrative Expense Budget
1st 2nd 3rd 4th

Budgeted unit sales 12,000 14,000 11,000 10,000 47,000
Variable selling and
administrative expense
per unit x P2.75 x P2.75 x P2.75 x P2.75 x P2.75
Variable expense P33,000 P 38,500 P 30,250 P 27,500 P129,250
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Fixed selling and
administrative expenses:
Advertising 12,000 12,000 12,000 12,000 48,000
Executive salaries 40,000 40,000 40,000 40,000 160,000
Insurance 6,000 6,000 12,000
Property taxes 6,000 6,000
Depreciation 16,000 16,000 16,000 16,000 64,000
Total fixed selling and
administrative expenses 68,000 74,000 74,000 74,000 290,000
Total selling and
administrative expenses 101,000 112,500 104,250 101,500 419,250
Less depreciation 16,000 16,000 16,000 16,000 64,000
Cash disbursements for
selling and administrative
expenses P 85,000 P 96,500 P 88,250 P 85,500 P355,250
Exercise 7 (Cash Budget Analysis)
Quarter (000 omitted)

1 2 3 4 Year
Cash balance, beginning P 9 * P 5 P 5 P 5 P 9
Add collections from customers
76 90 125 * 100 391 *
Total cash available 85 * 95 130 105 400
Less disbursements:
Purchase of inventory 40 * 58 * 36 32 * 166
Operating expenses 36 42 * 54 * 48 180 *
Equipment purchases 10 * 8 * 8 * 10 36 *
Dividends 2 * 2 * 2 * 2 * 8
Total disbursements 88 110 * 100 92 390
Excess (deficiency) of cash
available over disbursements
(3)* (15) 30 * 13 10
Financing:
Borrowings 8 20 * — — 28
Repayments (including
interest) 0 0 (25) (7)* (32)
Total financing 8 20 (25) (7) (4)
Cash balance, ending P5 P 5 P 5 P 6 P 6
*Given.
IV. Problems
Problem 1 (Schedule of Expected Cash Collections and Disbursements)
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Requirement 1
September cash sales.............................................................................................................

P 7,400
September collections on account:
July sales: P20,000 × 18%................................................................................................
3,600
August sales: P30,000 × 70%...........................................................................................
21,000
September sales: P40,000 × 10%......................................................................................
4,000
Total cash collections.............................................................................................................
P36,000
Requirement 2
Payments to suppliers:
August purchases (accounts payable)...............................................................................
P16,000
September purchases: P25,000 × 20%..............................................................................
5,000
Total cash payments...............................................................................................................
P21,000
Requirement 3
COOKIE PRODUCTS
Cash Budget
For the Month of September
Cash balance, September 1....................................................................................................

P 9,000
Add cash receipts:
Collections from customers...............................................................................................
36,000
Total cash available before current financing....................................................................... 45,000
Less disbursements:
Payments to suppliers for inventory..................................................................................
P21,000
Selling and administrative expenses.................................................................................
9,000 *
Equipment purchases........................................................................................................
18,000
Dividends paid...................................................................................................................
3,000
Total disbursements...............................................................................................................
51,000
Excess (deficiency) of cash available over
disbursements....................................................................................................................
(6,000)
Financing:
Borrowings........................................................................................................................
11,000
Repayments........................................................................................................................
0
Interest...............................................................................................................................
0
Total financing.......................................................................................................................
11,000
Cash balance, September 30..................................................................................................
P 5,000
* P13,000 – P4,000 = P9,000.
Problem 2 (Production and Purchases Budget)
Requirement 1
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Production budget:
Septembe
July August r October
Budgeted sales (units) 40,000 50,000 70,000 35,000
Add desired ending inventory 20,000 26,000 15,500 11,000
Total needs 60,000 76,000 85,500 46,000
Less beginning inventory 17,000 20,000 26,000 15,500
Required production 43,000 56,000 59,500 30,500
Requirement 2
During July and August the company is building inventories in anticipation of peak
sales in September. Therefore, production exceeds sales during these months. In
September and October inventories are being reduced in anticipation of a decrease
in sales during the last months of the year. Therefore, production is less than sales
during these months to cut back on inventory levels.
Requirement 3
Raw materials purchases budget:

Septembe Third
July August r Quarter
Required production (units) 43,000 56,000 59,500 158,500
Material P214 needed per unit × 3 lbs. × 3 lbs. × 3 lbs. × 3 lbs.
Production needs (lbs.) 129,000 168,000 178,500 475,500
Add desired ending inventory (lbs.) 84,000 89,250 45,750 * 45,750
Total Material P214 needs 213,000 257,250 224,250 521,250
Less beginning inventory (lbs.) 64,500 84,000 89,250 64,500
Material P214 purchases (lbs.) 148,500 173,250 135,000 456,750
* 30,500 units (October production) × 3 lbs. per unit= 91,500 lbs.; 91,500 lbs. ×
0.5 = 45,750 lbs.
As shown in requirement (1), production is greatest in September. However, as

shown in the raw material purchases budget, the purchases of materials is greatest a
month earlier because materials must be on hand to support the heavy production
scheduled for September.
Problem 3 (Cash Budget; Income Statement; Balance Sheet)
Requirement 1
Schedule of cash receipts:
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Cash sales—June...................................................................................................................
P 60,000
Collections on accounts receivable:
May 31 balance..................................................................................................................
72,000
June (50% × 190,000).......................................................................................................
95,000
Total cash receipts.................................................................................................................
P227,000
Schedule of cash payments for purchases:
May 31 accounts payable balance.........................................................................................

P 90,000
June purchases (40% × 200,000)..........................................................................................
80,000
Total cash payments...............................................................................................................
P170,000
PICTURE THIS, INC.

Cash Budget
For the Month of June
Cash balance, beginning........................................................................................................

P 8,000
Add receipts from customers (above)....................................................................................
227,000
Total cash available...............................................................................................................
235,000
Less disbursements:
Purchase of inventory (above)...........................................................................................
170,000
Operating expenses...........................................................................................................
51,000
Purchases of equipment.....................................................................................................
9,000
Total cash disbursements.......................................................................................................
230,000
Excess of receipts over disbursements...................................................................................
5,000
Financing:
Borrowings—note.............................................................................................................
18,000
Repayments—note.............................................................................................................
(15,000)
Interest...............................................................................................................................
(500)
Total financing.......................................................................................................................
2,500
Cash balance, ending.............................................................................................................
P 7,500
Requirement 2
PICTURE THIS, INC.

Budgeted Income Statement
For the Month of June
Sales P250,000
Cost of goods sold:
Beginning inventory..........................................................................................................
P 30,000
Add purchases...................................................................................................................
200,000
Goods available for sale....................................................................................................
230,000
Ending inventory...............................................................................................................
40,000
Cost of goods sold..............................................................................................................
190,000
Gross margin..........................................................................................................................
60,000
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Operating expenses (P51,000 + P2,000)...............................................................................
53,000
7,000
Interest expense.....................................................................................................................
500
Net income.............................................................................................................................
P 6,500
Requirement 3
PICTURE THIS, INC.

Budgeted Balance Sheet
June 30
Assets
Cash P 7,500
Accounts receivable (50% × 190,000).................................................................................. 95,000
Inventory................................................................................................................................
40,000
Buildings and equipment, net of depreciation
(P500,000 + P9,000 – P2,000)..........................................................................................
507,000
Total assets.............................................................................................................................
P649,500

Accounts payable (60% × 200,000)......................................................................................
P120,000
Note payable..........................................................................................................................
18,000
Share capital..........................................................................................................................
420,000
Retained earnings (P85,000 + P6,500).................................................................................
91,500
Total liabilities and equity.....................................................................................................
P649,500
Problem 4 (Sales, Production and Materials Purchases Budget)
Requirement 1
Nikko Manufacturing Company

Sales Budget
For the year ending December 31, 2005
Units Amount
First quarter 16,000 P 480,000
Second quarter 20,000 600,000
Third quarter 22,000 660,000
Fourth quarter 22,000 660,000
Total 80,000 P2,400,000
Requirement 2
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Statement of Production Required
For 2005
Quarter
1st 2nd 3rd 4th Total
Units to be sold 16,000 20,000 22,000 22,000 80,000
Add: Desired ending inventory (20%) 4,000 4,400 4,400 5,000 5,000
Total units required 20,000 24,400 26,400 27,000 85,000
Less: Beginning inventory 3,000 4,000 4,400 4,400 3,000
Requirement 3

Statement of Raw Materials Purchase Requirements
For 2005
Quarter
1st 2nd 3rd 4th Total
Units required for production 51,000 61,200 66,000 67,800 246,000
Add: Desired ending inventory 12,240 13,200 13,560 15,000 15,000
Total units 63,240 74,400 79,560 82,800 261,000
Less: Beginning inventory 12,500 12,240 13,200 13,560 12,500
Raw Materials to be Purchased 50,740 62,160 66,360 69,240 248,500
Problem 5 (Schedule of Expected Cash Collections; Cash Budget)
Requirement 1
Schedule of expected cash collections:
Month
April May June Quarter
From accounts receivable P141,000 P 7,200 P148,200
From April sales:
20% × 200,000 40,000 40,000
75% × 200,000 150,000 150,000
4% × 200,000 P 8,000 8,000
From May sales:

20% × 300,000 60,000 60,000
75% × 300,000 225,000 225,000
From June sales:
20% × 250,000 50,000 50,000
Total cash collections P181,000 P217,200 P283,000 P681,200
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Requirement 2
Cash budget:
Month
April May June Quarter
Cash balance, beginning P 26,000 P 27,000 P 20,200 P 26,000
Add receipts:
Collections from
customers 181,000 217,200 283,000 681,200
Total available 207,000 244,200 303,200 707,200
Less disbursements:
Merchandise purchases 108,000 120,000 180,000 408,000
Payroll 9,000 9,000 8,000 26,000
Lease payments 15,000 15,000 15,000 45,000
Advertising 70,000 80,000 60,000 210,000
Equipment purchases 8,000 — — 8,000
Total disbursements 210,000 224,000 263,000 697,000
Excess (deficiency) of
receipts over
disbursements (3,000) 20,200 40,200 10,200
Financing:
Borrowings 30,000 — — 30,000
Repayments — — (30,000) (30,000)
Interest — — (1,200) (1,200)
Total financing 30,000 — (31,200) (1,200)
Cash balance, ending P 27,000 P 20,200 P 9,000 P 9,000
Requirement 3
If the company needs a minimum cash balance of P20,000 to start each month, the
loan cannot be repaid in full by June 30. If the loan is repaid in full, the cash
balance will drop to only P9,000 on June 30, as shown above. Some portion of the
loan balance will have to be carried over to July, at which time the cash inflow
should be sufficient to complete repayment.
Problem 6 (Flexible Budget)
Summer Machine Company

Flexible Overhead Budget
Department 1
Capacity
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100% 90% 80% 70% 60%
Machine Hours 200,00 180,00 160,00 140,00 120,00
0 0 0 0 0
Variable P1,300,00 P1,170,00 P1,040,00 P P
Overhead 0 0 0 910,000 780,000
Fixed Overhead 300,00 300,00 300,00 300,00 300,00
0 0 0 0 0
Total P1,600,00 P1,470,00 P1,340,00 P1,210,00 P1,080,00
0 0 0 0 0
Manufacturing Overhead rate per machine hour P8.00
Summer Machine Company

Flexible Overhead Budget
Department 2
Capacity
100% 90% 80% 70% 60%
Direct Labor Hours 200,0 180,0 160,0 140,0 120,00
00 00 00 00 0
Machine Hours 400,0 360,0 320,0 280,0 240,00
00 00 00 00 0
Variable Overhead P1,400,0 P1,260,0 P1,120,0 P P
00 00 00 980,000 840,000
Fixed Overhead 500,0 500,0 500,0 500,0 500,0
00 00 00 00 00
Total P1,900,0 P1,760,0 P1,620,0 P1,480,0 P1,340,0
00 00 00 00 00
Manufacturing Overhead rate per machine hour P4.75
Problem 7 (Cash Budget with Supporting Schedules)
1. Collections on sales: July August Sept. Quarter

Cash sales.............................................................
P 8,000 P14,000 P10,000 P 32,000
Credit sales:
May: P30,000 × 80% × 20%............................
4,800 4,800
June: P36,000 × 80% × 70%, 20%..................
20,160 5,760 25,920
July: P40,000 × 80% × 10%, 70%,
20%..............................................................
3,200 22,400 6,400 32,000
Aug.: P70,000 × 80% × 10%, 70%................. 5,600 39,200 44,800
Sept.: P50,000 × 80% × 10%........................... 4,000 4,000
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Total cash collections...........................................
P36,160 P47,760 P59,600 P143,520
2. a. Merchandise purchases budget:

July August Sept. Oct.
Budgeted cost of goods sold.................................
P24,000 P42,000 P30,000 P27,000
Add desired ending inventory*............................
31,500 22,500 20,250
Total needs............................................................
55,500 64,500 50,250
Less beginning inventory.....................................
18,000 31,500 22,500
Required inventory purchases..............................
P37,500 P33,000 P27,750
*75% of the next month’s budgeted cost of goods sold.
b. Schedule of expected cash disbursements for merchandise purchases:
July August Sept. Quarter

Accounts payable, June 30...................................P11,700 P11,700
July purchases....................................................... 18,750 P18,750 37,500
August purchases.................................................. 16,500 P16,500 33,000
September purchases............................................ 13,875 13,875
Total cash disbursements......................................P30,450 P35,250 P30,375 P96,075
3. Ju Products, Inc.
Cash Budget
For the Quarter Ended September 30
July August Sept. Quarter

Cash balance, beginning...................................
P 8,000 P 8,410 P 8,020 P 8,000
Add collections from sales................................36,160 47,760 59,600 143,520
Total cash available......................................44,160 56,170 67,620 151,520
Less disbursements:
For inventory purchases...............................30,450 35,250 30,375 96,075
For selling expenses..................................... 7,200 11,700 8,500 27,400
For administrative expenses......................... 3,600 5,200 4,100 12,900
For land......................................................... 4,500 0 0 4,500
For dividends................................................ 0 0 1,000 1,000
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Total disbursements..........................................45,750 52,150 43,975 141,875
Excess (deficiency) of cash available over
disbursements............................................... (1,590) 4,020 23,645 9,645
Financing:
Borrowings...................................................10,000 4,000 14,000
Repayment.................................................... 0 0 (14,000) (14,000)
Interest.......................................................... 0 0 (380) (380)
Total financing..................................................10,000 4,000 (14,380) (380)
Cash balance, ending........................................
P 8,410 P 8,020 P 9,265 P 9,265
* P10,000 × 1% × 3 = P300
P4,000 × 1% × 2 = 80
P380
1. B 11. C 21. C
2. B 12. B 22. C
3. C 13. C 23. D
4. E 14. B 24. C
5. C 15. D 25. C
6. C 16. C 26. C
7. D 17. A 27. D
8. C 18. B 28. A
9. A 19. E 29. C
10. D 20. B 30. D
Supporting computations:
Questions 16 to 20:
January February
Cost of sales P1,400,000 P1,640,000
Add: Desired Minimum Inventory 492,000 456,000
Total 1,892,000 2,096,000
Less: Beginning Inventory (1,400,000 x 0.3) (17) 420,000 492,000
Gross Purchases (16) 1,472,000 1,604,000
Less: Cash discount 14,720 16,040
Net cost of purchases P1,457,280 P1,587,960
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Payments of Purchases
60% - month of purchase P874,368 P 952,776
40% - following month 582,912
Total (18) P1,535,688
(19)
February
Cash
Gross Discount Net
Current month’s sales (with
discount) 35% P595,000 P11,900 P583,100
Current month’s sales (without
discount) 15% 255,000 0 255,000
Previous month’s sales (with

discount) 4.5% 67,500 1,350 66,150
Previous month’s sales (without
discount) 40.5% 607,500 607,500
P1,525,000 P13,250 P1,511,750
(20)Total Collections in February P1,511,750

Add: Cash sales 350,000
Total P1,861,750
(21)Estimated cash receipts

Collections from customers P1,350,000
Proceeds from issuance of common stock 500,000
Proceeds from short-term borrowing 100,000
Total P1,950,000
Less: Estimated cash disbursements
For cost and expenses P1,200,000
For income taxes 90,000
Purchase of fixed asset 400,000
Payment on short-term borrowings 50,000
Total 1,740,000
Cash balance, Dec. 31 P 210,000
(22)Net income P120,000

Add: Depreciation 65,000
Working capital provided from operations P185,000
Add: Increase in income taxes payable P 80,000
Increase in provision for doubtful
accounts receivable 45,000 125,000
Total P310,000
Less: Increase in accounts receivable P 35,000
Decrease in accounts payable 25,000 60,000
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Increase in cash P250,000
(23)Cash Receipts for February 2005

From February sales (60% x 110,000) P 66,000
From January sales 38,000
Total P104,000
(24)Pro-forma Income Statement, February 2005

Sales P110,000
Cost of sales (75%) 82,500
Gross profit P 27,500
Less: Operating expenses 16,500

Depreciation 5,000
Bad debts 2,200 23,700
Net operating income P 3,800
(25)Accounts Payable on February 28, 2005 will be the unpaid purchases in

February - (75% x P120,000) = P90,000.
Questions 26 to 29:
Net sales P2,000,000

Less: Cost of sales
Finished goods inventory, Jan. 1 P 350,000
Add: Cost of goods manufactured (Sch. I) 1,350,000 *
Total available for sale P1,700,000
Less: Finished goods inventory, Dec. 31 400,000 1,300,000 (26)
Gross Profit P 700,000
Less: Operating and financial expenses
Selling P 300,000
Administrative 180,000
Finance 20,000 500,000
Net income before taxes P 200,000
* Determined by working back from net income to sales.
Schedule I
Raw materials used

Raw materials inventory, Jan. 1 P 250,000
Add: Purchases 491,000 (29)
Total available 741,000
Less: Raw materials inventory, Dec. 31 300,000
Raw materials used P 441,000
Direct labor 588,000
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Manufacturing overhead 441,000 (28)
Total Manufacturing Cost P1,470,000 (27)
Add: Work-in-process inventory, Jan. 1 200,000
Total P1,670,000
Less: Work-in-process inventory, Dec. 31 320,000
Cost of goods manufactured P1,350,000
(30)Variable factory overhead

P150,000
P3.125
48,000
Fixed factory overhead
P240,000
5.000
48,000
Total factory overhead P8.125
CHAPTER 16
STANDARD COSTS AND OPERATING PERFORMANCE MEASURES
I. Questions
1. Standard costs are superior to past data for comparison with actual costs
because they ask the question “Is present performance better than the past?”.
2. No. Cost control and cost reduction are not the same, but cost reduction does
affect the standards which are used as basis for cost control. Cost reduction
means finding ways to achieve a given result through improved design, better
methods, new layouts and so forth. Cost reduction results in setting new
standards. On the other hand, cost control is a process of maintaining
performance at or as new existing standards as is possible.
3. Managerial judgment is the basis for deciding whether a given variance is large
enough to warrant investigation. For some items, a small amount of variance
may spark scrutiny. For some items, 5%, 10% or 25% variances from standard
may call for follow-up. Management may also derive the standard deviation
based on past cost data.
4. The techniques for overhead control differ because
1) The size of individual overhead costs usually does not justify elaborate
individual control systems;
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2) The behavior of individual overhead item is either impossible or difficult to
trace to specific lots or operations; and
3) Various overhead items are the responsibility of different people.
5. In the year-to-year planning of fixed costs, managers must consider:
1) the projected maximum and minimum levels of activity,
2) prices of cost factors, and
3) changes in facilities and organization.
6. Four criteria for selecting a volume base are:

1) Cause of cost variability.
2) Adequacy of control over the base.
3) Independence of activity unit.
4) Ease of understanding.
7. Non-volume factors which cause costs to vary are:
1) Changes in plant and equipment.
2) Changes in products made, materials used, or methods of manufacturing.
3) Changes in prices paid for cost factors.
4) Changes in managerial policy toward costs.
5) Lag between cost incurrence and measurement of volume.
8. A budget is usually expressed in terms of total pesos, whereas a standard is
expressed on a per unit basis. A standard might be viewed as the budgeted cost
for one unit.
9. Under management by exception, managers focus their attention on operating
results that deviate from expectations. It is assumed that results that meet
expectations do not require investigation.
10. Separating an overall variance into a price variance and a quantity variance
provides more information. Moreover, prices and quantities are usually the
responsibilities of different managers.
11. The materials price variance is usually the responsibility of the purchasing
manager. The materials quantity variance is usually the responsibility of the
production managers and supervisors. The labor efficiency variance generally
is also the responsibility of the production managers and supervisors.
12. If used as punitive tools, standards can breed resentment in an organization and
undermine morale. Standards must never be used as an excuse to conduct
witch-hunts, or as a means of finding someone to blame for problems.
13. Several factors other than the contractual rate paid to workers can cause a labor
rate variance. For example, skilled workers with high hourly rates of pay can
be given duties that require little skill and that call for low hourly rates of pay,
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resulting in an unfavorable rate variance. Or unskilled or untrained workers
can be assigned to tasks that should be filled by more skilled workers with
higher rates of pay, resulting in a favorable rate variance. Unfavorable rate
variances can also arise from overtime work at premium rates.
14. Poor quality materials can unfavorably affect the labor efficiency variance. If
the materials create production problems, a result could be excessive labor time
and therefore an unfavorable labor efficiency variance. Poor quality materials
would not ordinarily affect the labor rate variance.
15. If labor is a fixed cost and standards are tight, then the only way to generate
favorable labor efficiency variances is for every workstation to produce at
capacity. However, the output of the entire system is limited by the capacity of
the bottleneck. If workstations before the bottleneck in the production process
produce at capacity, the bottleneck will be unable to process all of the work in
process. In general, if every workstation is attempting to produce at capacity,
then work in process inventory will build up in front of the workstations with
the least capacity.
16. A quantity standard indicates how much of an input should be used to make a
unit of output. A price standard indicates how much the input should cost.
17. Chronic inability to meet a standard is likely to be demoralizing and may result
in decreased productivity.
18. A variance is the difference between what was planned or expected and what
was actually accomplished. A standard cost system has at least two types of
variances. A price variance focuses on the difference between the standard price
and the actual price of an input. A quantity variance is concerned with the
difference between the standard quantity of the input allowed for the actual
output and the actual amount of the input used.
II. Matching Type
1. E 3. C 5. A 7. J 9. I
2. G 4. H 6. D 8. B 10. F
III. Exercises
Exercise 1 (Setting Standards; Preparing a Standard Cost Card)
Requirement 1
Cost per 2 kilogram container...............................................................................................

P6,000.00
Less: 2% cash discount..........................................................................................................
120.00
Net cost..................................................................................................................................
P5,880.00
Add freight cost per 2 kilogram container
(P1,000 ÷ 10 containers)...................................................................................................
100.00
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Total cost per 2 kilogram container (a).................................................................................
P5,980.00
Number of grams per container
(2 kilograms × 1000 grams per kilogram) (b)..................................................................
2,000
Standard cost per gram purchased (a) ÷ (b)..........................................................................
P 2.99
Requirement 2
Beta ML12 required per capsule as per bill of materials......................................................

6.00 grams
Add allowance for material rejected as unsuitable
(6 grams ÷ 0.96 = 6.25 grams;
6.25 grams – 6.00 grams = 0.25 grams)...........................................................................
0.25 grams
Total 6.25 grams
Add allowance for rejected capsules
(6.25 grams ÷ 25 capsules)...............................................................................................
0.25 grams
Standard quantity of Beta ML12 per salable capsule............................................................
6.50 grams
Requirement 3
Standard Quantity per Standard Price per Standard Cost per

Item Capsule Gram Capsule
Beta ML12 6.50 grams P2.99 P19.435
Exercise 2 (Material Variances)
Requirement 1
Number of chopping blocks...................................................................................................

4,000
Number of board feet per chopping block.............................................................................
× 2.5
Standard board feet allowed..................................................................................................
10,000
Standard cost per board foot..................................................................................................
× P1.80
Total standard cost.................................................................................................................
P18,000
Actual cost incurred...............................................................................................................

P18,700
Standard cost above...............................................................................................................
18,000
Total variance—unfavorable.................................................................................................
P 700
Requirement 2
Actual Quantity of Inputs, at Actual Quantity of Inputs, at Standard Quantity Allowed

for Output, at Standard
Actual Price Standard Price Price
(AQ × AP) (AQ × SP) (SQ × SP)
P18,700 11,000 board feet × 10,000 board feet ×
P1.80 per board foot P1.80 per board foot
= P19,800 = P18,000
Price Variance, Quantity Variance,
P1,100 F P1,800 U
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Total Variance, P700 U
18
Alternatively:
Materials Price Variance = AQ (AP – SP)
11,000 board feet (P1.70 per board foot* – P1.80 per board foot) =
P1,100 F
* P18,700 ÷ 11,000 board feet = P1.70 per board foot.
Materials Quantity Variance = SP (AQ – SQ)

P1.80 per board foot (11,000 board feet – 10,000 board feet) = P1,800 U
Exercise 3 (Labor and Variable Overhead Variances)
Requirement 1
Number of units manufactured..............................................................................................

20,000
Standard labor time per unit..................................................................................................
× 0.4*
Total standard hours of labor time allowed...........................................................................
8,000
Standard direct labor rate per hour.......................................................................................
× P6
Total standard direct labor cost.............................................................................................
P48,000
*24 minutes ÷ 60 minutes per hour = 0.4 hour
Actual direct labor cost..........................................................................................................

P49,300
Standard direct labor cost......................................................................................................
48,000
Total variance—unfavorable.................................................................................................
P 1,300
Requirement 2
Actual Hours of Input, at Actual Hour of Input, at Standard Hours Allowed for
the Actual Rate Standard Rate Output, at the Standard Rate
(AH × AR) (AH × SR) (SH × SR)
P49,300 8,500 hours × P6 per hour 8,000 hours* × P6 per hour
= P51,000 = P48,000
Rate Variance, Efficiency Variance,
P1,700 F P3,000 U
Total Variance, P1,300 U

*20,000 units × 0.4 hour per unit = 8,000 hours
Alternative Solution:
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Labor Rate Variance = AH (AR – SR)

8,500 hours (P5.80 per hour* – P6.00 per hour) = P1,700 F
*P49,300 ÷ 8,500 hours = P5.80 per hour
Labor Efficiency Variance = SR (AH – SH)

P6 per hour (8,500 hours – 8,000 hours) = P3,000 U
Requirement 3
Actual Hours of Input, at Actual Hour of Input, at Standard Hours Allowed for
the Actual Rate Standard Rate Output, at the Standard Rate
P39,100 8,500 hours × P4 per hour 8,000 hours × P4 per hour
= P34,000 = P32,000
Spending Variance, Efficiency Variance,
P5,100 U P2,000 U

Variable Overhead Spending Variance = AH (AR – SR)

8,500 hours (P4.60 per hour* – P4.00 per hour) = P5,100 U
*P39,100 ÷ 8,500 hours = P4.60 per hour
Variable Overhead Efficiency Variance = SR (AH – SH)
P4 per hour (8,500 hours – 8,000 hours) = P2,000 U
Exercise 4 (Working Backwards from Labor Variances)
Requirement 1
If the total variance is P330 unfavorable, and if the rate variance is P150 favorable,
then the efficiency variance must be P480 unfavorable, since the rate and efficiency
variances taken together always equal the total variance.
Knowing that the efficiency variance is P480 unfavorable, one approach to the
solution would be:
Efficiency Variance = SR (AH – SH)
P6 per hour (AH – 420 hours*) = P480 U
P6 per hour × AH – P2,520 = P480**
P6 per hour × AH = P3,000
AH = 500 hours
* 168 batches × 2.5 hours per batch = 420 hours
** When used with the formula, unfavorable variances are positive and favorable
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variances are negative.
Requirement 2
Knowing that 500 hours of labor time were used during the week, the actual rate of
pay per hour can be computed as follows:
Rate Variance = AH (AR – SR)
500 hours (AR – P6 per hour) = P150 F
500 hours × AR – P3,000 = –P150*
500 hours × AR = P2,850
AR = P5.70 per hour
* When used with the formula, unfavorable variances are positive and
favorable variances are negative.
Exercise 5 (Direct Labor Variances)
1. Number of meals prepared............................................................ 6,000

Standard direct labor-hours per meal............................................ × 0.20
Total direct labor-hours allowed.................................................... 1,200
Standard direct labor cost per hour............................................... × P9.50
Total standard direct labor cost..................................................... P11,400
Actual cost incurred....................................................................... P11,500

Total standard direct labor cost (above)........................................ 11,400
Total direct labor variance............................................................. P 100 Unfavorable
2. Standard Hours
Actual Hours of Actual Hours of Input, at the Allowed for Output, at the
Input, at the Actual Rate Standard Rate Standard Rate
(AH×AR) (AH×SR) (SH×SR)
1,150 hours × 1,150 hours × 1,200 hours ×
P10.00 per hour P9.50 per hour P9.50 per hour
= P11,500 = P10,925 = P11,400
  
P575 U P475 F
Alternatively, the variances can be computed using the formulas:
Labor rate variance = AH(AR – SR)

= 1,150 hours (P10.00 per hour – P9.50 per hour)
= P575 U
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Labor efficiency variance = SR(AH – SH)

= P9.50 per hour (1,150 hours – 1,200 hours)
= P475 F
Exercise 6 (Variable Overhead Variances)
1. Number of items shipped............................................................................. 140,000

Standard direct labor-hours per item........................................................... × 0.04
Total direct labor-hours allowed.................................................................. 5,600
Standard variable overhead cost per hour................................................... × P2.80
Total standard variable overhead cost......................................................... P15,680
Actual variable overhead cost incurred....................................................... P15,950

Total standard variable overhead cost (above)............................................ 15,680
Total variable overhead variance................................................................. P 270 Unfavorable
2. Standard Hours
Actual Hours of Actual Hours of Input, at the Allowed for Output, at the
Input, at the Actual Rate Standard Rate Standard Rate
(AH×AR) (AH×SR) (SH×SR)
5,800 hours × 5,800 hours × 5,600 hours ×
P2.75 per hour* P2.80 per hour P2.80 per hour
= P15,950 = P16,240 = P15,680
  
Variable overhead spending Variable overhead
variance, P290 F efficiency variance, P560 U
Total variance, P270 U
*P15,950÷ 5,800 hours =P2.75 per hour
Alternatively, the variances can be computed using the formulas:
Variable overhead spending variance:

AH(AR – SR) = 5,800 hours (P2.75 per hour – P2.80 per hour)
= P290 F
Variable overhead efficiency variance:

SR(AH – SH) = P2.80 per hour (5,800 hours – 5,600 hours)
= P560 U
IV. Problems
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Problem 1 (Comprehensive Variance Analysis)
Requirement 1
a.
for Output, at the Standard
the Actual Price Standard Price Price
25,000 pounds x 25,000 pounds x 20,000 pounds* x
P2.95 per pound P2.50 per pound P2.50 per pound
= P73,750 = P62,500 = P50,000
Price Variance,
P11,250 U
19,800 pounds x P2.50 per pound
= P49,500
Quantity Variance,
P500 F
* 5,000 metal molds × 4.0 pounds per metal mold = 20,000 pounds
Alternatively:
25,000 pounds (P2.95 per pound – P2.50 per pound) = P11,250 U
P2.50 per pound (19,800 pounds – 20,000 pounds) = P500 F
b.
Actual Hours of Input, at Actual Hours of Input, at Standard Hours Allowed for
the Actual Rate the Standard Rate Output, at the Standard Rate
3,600 hours x 3,600 hours x 3,000 hours* x
= P31,320 = P32,400 = P27,000
P1,080 F P5,400 U

* 5,000 metal molds × 0.6 hour per metal mold = 3,000 hours
Alternatively:
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3,600 hours (P8.70 per hour – P9.00 per hour) = P1,080 F
P9.00 per hour (3,600 hours – 3,000 hours) = P5,400 U
c.
P4,320 1,800 hours × P2 per hour 1,500 hours* × P2 per hour
= P3,600 = P3,000
P720 U P600 U

*5,000 metal molds × 0.3 hours per metal mold = 1,500 hours
Alternatively:
1,800 hours (P2.40 per hour* – P2.00 per hour) = P720 U
* P4,320 ÷ 1,800 hours = P2.40 per hour
P2.00 per hour (1,800 hours – 1,500 hours) = P600 U
Requirement 2
Summary of variances:
Material price variance..........................................................................................................

P11,250 U
Material quantity variance.....................................................................................................
500 F
Labor rate variance................................................................................................................
1,080 F
Labor efficiency variance.......................................................................................................
5,400 U
Variable overhead spending variance....................................................................................
720 U
Variable overhead efficiency variance...................................................................................
600 U
Net variance...........................................................................................................................
P16,390 U
The net unfavorable variance of P16,390 for the month caused the plant’s variable
cost of goods sold to increase from the budgeted level of P80,000 to P96,390:
Budgeted cost of goods sold at P16 per metal mold..............................................................

P80,000
Add the net unfavorable variance (as above)........................................................................
16,390
Actual cost of goods sold.......................................................................................................
P96,390
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This P16,390 net unfavorable variance also accounts for the difference between the
budgeted net operating income and the actual net loss for the month.
Budgeted net operating income.............................................................................................

P15,000
Deduct the net unfavorable variance added to cost of goods sold for
the month...........................................................................................................................
16,390
Net operating loss..................................................................................................................
P(1,390)
Requirement 3
The two most significant variances are the materials price variance and the labor
efficiency variance. Possible causes of the variances include:
Materials Price Variance: Outdated standards, uneconomical quantity

purchased, higher quality materials, high-cost
method of transport.
Labor Efficiency Variance: Poorly trained workers, poor quality materials,

faulty equipment, work interruptions,
inaccurate standards, insufficient demand.
Problem 2
1. 1,000 units 4. 14,900 lbs.

2. 25,000 lbs. 5. 3,100 hours
3. P2.01 per lb. 6. P3.98 per hour
Problem 3
Material mix variance:

Actual quantity x Standard price
Material A (8,000 x P0.30) P2,400
Material B (2,400 x P0.20) 480
Material C (2,800 x P0.425) 1,190 P4,070
Less: Total actual input x Average
Standard price (13,200 x 0.30*) 3,960
Unfavorable Mix Variance P 110
P 720
* Average Standard price = = P0.30
2,400
Material yield variance:
Total actual input at Average Standard price P3,960
Less: Total actual output at Standard raw material cost
(10,000 x 0.36**) 3,600
Unfavorable yield variance P 360
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** Standard Material Cost = P 720 = P0.36

2,000
Problem 4 (Comprehensive Variance Analysis; Journal Entries)
Requirement 1
a.
for Output, at Standard
Actual Price Standard Price Price
21,120 yards x 21,120 yards x 19,200 yards* x
P3.35 per yard P3.60 per yard P3.60 per yard
= P70,752 = P76,032 = P69,120
Price Variance, Quantity Variance,
P5,280 F P6,912 U

* 4,800 units × 4.0 yards per unit = 19,200 yards
Alternatively:
21,120 yards (P3.35 per yard – P3.60 per yard) = P5,280 F
P3.60 per yard (21,120 yards – 19,200 yards) = P6,912 U
Raw Materials (21,120 yards @ P3.60 per yard)..................................................................

76,032
Materials Price Variance
(21,120 yards @ P0.25 per yard F)..........................................................................
5,280
Accounts Payable
(21,120 yards @ P3.35 per yard).............................................................................
70,752
Work in Process (19,200 yards @ P3.60 per yard)...............................................................

69,120
Materials Quantity Variance
(1,920 yards U @ P3.60 per yard)....................................................................................
6,912
Raw Materials (21,120 yards @ P3.60 per yard).........................................................
76,032
Requirement 2
a.
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18
6,720 hours* x 6,720 hours x 7,680 hours** x
= P32,592 = P30,240 = P34,560
P2,352 U P4,320 F
Total Variance, P1,968 F

* 4,800 units × 1.4 hours per unit = 6,720 hours
** 4,800 units × 1.6 hours per unit = 7,680 hours
Alternatively:
6,720 hours (P4.85 per hour – P4.50 per hour) = P2,352 U
P4.50 per hour (6,720 hours – 7,680 hours) = P4,320 F
Work in Process (7,680 hours @ P4.50 per hour)................................................................

34,560
Labor Rate Variance
(6,720 hours @ P0.35 per hour U)....................................................................................
2,352
Labor Efficiency Variance
(960 hours F @ P4.50 per hour)...............................................................................
4,320
Wages Payable (6,720 hours @ P4.85 per hour)..........................................................
32,592
Requirement 3
6,720 hours x 6,720 hours x 7,680 hours x
P14,448 = P12,096 = P13,824
P2,352 U P1,728 F

Alternatively:
6,720 hours (P2.15 per hour – P1.80 per hour) = P2,352 U
P1.80 per hour (6,720 hours – 7,680 hours) = P1,728 F
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II
Requirement 4
No. This total variance is made up of several quite large individual variances, some
of which may warrant investigation. A summary of variances is shown on the next
page.
Materials:
Price variance P5,280 F
Quantity variance 6,912 U P1,632 U
Labor:
Rate variance 2,352 U
Efficiency variance 4,320 F 1,968 F
Variable overhead:
Spending variance 2,352 U
Efficiency variance 1,728 F 624 U
Net unfavorable variance P 288 U
Requirement 5
The variances have many possible causes. Some of the more likely causes include:
Materials variances:
Favorable price variance: Fortunate buy, inaccurate standards, inferior quality

materials, unusual discount due to quantity purchased, drop in market price.
Unfavorable quantity variance: Carelessness, poorly adjusted machines, unskilled

workers, inferior quality materials, inaccurate standards.
Labor variances:
Unfavorable rate variance: Use of highly skilled workers, change in wage rates,
inaccurate standards, overtime.
Favorable efficiency variance: Use of highly skilled workers, high quality materials,
new equipment, inaccurate standards.
Variable overhead variances:
Unfavorable spending variance: Increase in costs, inaccurate standards, waste, theft,

spillage, purchases in uneconomical lots.
Favorable efficiency variance: Same as for labor efficiency variance.
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18
1. C 11. B 21. A 31. A 41. B
2. C 12. A 22. C 32. B 42. C
3. A 13. B 23. C 33. B 43. D
4. B 14. C 24. C 34. D 44. A
5. A 15. A 25. C 35. B 45. B
6. B 16. D 26. D 36. B
7. C 17. D 27. E 37. C
8. C 18. A 28. B 38. D
9. B 19. D 29. B 39. D
10. B 20. B 30. A 40. A
CHAPTER 17
APPLICATION OF QUANTITATIVE TECHNIQUES IN PLANNING, CONTROL AND

DECISION MAKING - I
I. Questions
1. a. Decision tree analysis provides a systematic framework for analyzing a
sequence of interrelated decisions which may be made over time. Decision
making is formulated in terms of the consequence of acts, events and
consequences because it is believed that present decisions affect future
profitability. The study and understanding of alternative scenarios is
encouraged with the use of decision tree analysis.
b. Advantages of Decision Tree Analysis
1. Clarifies the choices, risks, and monetary gains involved in an
investment problem.
2. Presents the relevant information more clearly.
3. Combines action choices with different possible events or results of
action which are partially affected by chance or other uncontrollable
circumstances.
4. Encourages the focus on the relationship between current and future
decisions.
5. Utilizes such analytical techniques as present value and discounted
cash flow.
6. Considers various alternatives with greater ease.
Weaknesses of Decision Tree Analysis
1. Not all events that can happen can be/are identified.
2. Not all the decisions that must be made on a subject under analysis are
listed because choices are usually not restricted to two or three.
3. If a large number of choices is involved, decision tree analysis by hand
becomes complicated.
4. Uncertain alternatives are generally treated as if they were discrete,
well-defined possibilities.
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II
6. A 6. C 31. B 41. B 46. B

7. A 7. B 32. D 42. C 47. D
8. B 8. D 33. C 43. D 48. B
9. B 9. A 34. B 44. D 49. B
10. B 10. D 35. A 45. A 50. D
CHAPTER 18
APPLICATION OF QUANTITATIVE TECHNIQUES IN PLANNING, CONTROL AND

DECISION MAKING - II
I. Questions
1. PERT is superior to Gantt Charts in complex projects because:
a. PERT charts are flexible and can reflect slippage or changes in plans, but
Gantt charts simply plot a bar chart against a calendar scale.
b. PERT charts reflect interdependencies among activities; Gantt charts do
not.
c. PERT charts reflect uncertainties or tolerances in the time estimates for
various activities; Gantt charts do not.
2. The use of PERT provides a structured foundation for planning complex
projects in sufficient detail to facilitate effective control.
A workable sequence of events that comprise the project are first identified.
Each key event should represent a task; then the interdependent relationships
between the events are structured.
After the network of events is constructed, cost and time parameters are
established for each package. Staffing plans are reviewed and analyzed.
The “critical path” computation identifies sequence of key events with total
time equal to the time allotted for the project’s completion. Jobs which are not
on the critical path can be slowed down and the slack resources available on
these activities reallocated to activities on the critical path.
Use of PERT permits sufficient scheduling of effort by functional areas and by
geographic location. It also allows for restructuring scheduling efforts and
redeployment of workers as necessary to compensate for delays or bottlenecks.
The probability of completing this complex project on time and within the
allotted budget is increased.
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18
3. Time slippage in noncritical activities may not warrant extensive managerial
analysis because of available slack, but activity cost usually increases with time
and should be monitored.
4. The critical path is the network path with the longest cumulative expected
activity time. It is critical because a slowdown along this path delays the entire
project.
5. Crashing the network means finding the minimum cost for completing the
project in minimum time in order to achieve an optimum tradeoff between cost
and time. The differential crash cost of an activity is the additional cost of that
activity for each period of time saved.
6. Slack is the amount of time an event can be delayed without affecting the
project’s completion date. Slack can be utilized by management as a buffer
against bottlenecks that may occur on the critical path.
7. Unit gross margin are typically computed with an allocation of fixed costs.
Total fixed costs generally will not change with a change in volume within the
relevant range. Unitizing the fixed costs results in treating them as though they
are variable costs when, in fact, they are not. Moreover, when multiple
products are manufactured, the relative contribution becomes the criterion for
selecting the optimal product mix. Fixed costs allocations can distort the
relative contributions and result in a suboptimal decision.
8. This approach will maximize profits only if there are no constraints on
production or sales, or if both products use all scarce resources at an equal rate.
Otherwise management would want to maximize the contribution per unit of
scarce resource.
9. The opportunity cost of a constraint is the cost of not having additional
availability of the constrained resources. This is also called a shadow price.
10. The feasible production region is the area which contains all possible
combinations of production outputs. It is bounded by the constraints imposed
on production possibilities. The production schedule which management
chooses must come from the feasible production region.
11. The accountant usually supplies the contribution margin data that is used in
formulating a profit-maximizing objective function. In addition, the accountant
participates in the analysis of linear programming outputs by assessing the
costs of additional capacity or of changes in product mix.
12. a. Hourly fee for inventory audit (C)
b. Salary of purchasing supervisor (N)
c. Costs to audit purchase orders and invoices (P)
d. Taxes on inventory (C)
e. Stockout costs (P)
f. Storage costs charged per unit in inventory (C)
g. Fire insurance on inventory (C)
h. Fire insurance on warehouse (N)
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II
i. Obsolescence costs on inventory (C)
j. Shipping costs per shipment (P)
13. Although the inventory models are developed by operations researchers,
statisticians and computer specialists, their areas of expertise do not extend to
the evaluation of the differential costs for the inventory models. Generally,
discussions of inventory models take the costs as given. It is the role of the
accountant to determine which costs are appropriate for inclusion in an
inventory model.
14. Cost of capital represents the interest expense on funds if they were borrowed
or opportunity cost if funds were provided internally or by owners. It is
included as carrying cost of inventory because funds are tied up in inventory.
15. Costs that vary with the average number of units in inventory:
Inventory insurance P 2.80
Inventory tax 2.05 (P102.25 x 2%)
Total P 4.85
Costs that vary with the number of units purchased:
Purchase price P102.25
Insurance on shipment 1.50
Total P103.75
Total carrying cost = (25% x P103.75) cost of capital + P4.85 = P25.94 + P4.85
= P30.79
Order costs:
Shipping permit P201.65
Costs to arrange for the shipment 21.45
Unloading 80.20
Stockout costs 122.00
Total P425.30
II. Problems
Problem 1 (Solution is found on the next page.)
Problem 2
Requirement (a)
The critical path through each of the three alternative paths calculated as the
longest is 0 - 1 - 6- 7- 8.
0-1-2-5-8 2 + 8 + 10 + 14 = 34
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18
0-1-3-4-7-8 2+8+7+5+3 = 25
0-1-6-7-8 2 + 26 + 9 + 3 = 40*
________
* critical
Requirement (b)
40 - 3 - 5 = 32
Requirement (c)
If path 4 - 7 has an unfavorable time variance of 10, this means it takes a total time
of 15 to finish this activity rather than 5. This gives the path 0 - 1 - 3 - 4 - 7 - 8 a
total time of 35, but since this is less than the critical path of 40, it has no effect.
Requirement (d)
The earliest time for reaching event 5 via 0 - 1 - 2 - 5 is 20, the sum of the expected
times.
Problem 3
No, they didn’t make a right decision, since they included fixed costs which do not
differ in the short run. If they had used contribution margin instead of gross
margin, they would have had P5 for G1 and P6.50 for G2, therefore they would
have decided to produce G2 exclusively.
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Application of Quantitative Techniques in Planning, Control and Decision Making – II Chapter 18
Problem 1
Requirement (a)
TASKS 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28
Order 1 Order 3 Order 4 Order 2
MX X X X Order 1 X X Order 3 X X X Order 4 Order 2

ac
hi
ni
ng
___________
X Dead Time
Requirement (b)
28 days are required for the four orders.
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Problem 4
Order costs = Insurance + Other order costs

P = P860 + P18 = P878
Carrying costs = Out-of-pocket + Cost of capital

costs on inventory
S = P65 + 20% x P222 = P119.40
a. Carrying costs:
QS 250 x P109.40
2 = 2 = P13,675.00
Order costs:
AP 1,500 x P878
= = P 5,268.00
Q 250
Total P18,943.00
b. Economic order quantity:

2 x 1,500 x P878
Q* = =  24,077 = 155 units
P109.40
Carrying costs:
QS 155 x P109.40
2 = 2 = P 8,478.50
Order costs:
AP 1,500 x P878
= = P 8,496.77
Q 155
Total P16,975.27
Problem 5
It is necessary to evaluate the annual carrying costs and expected stockout costs at each safety-stock level. The carrying cost will
be P24.40 for each unit in safety stock. With the given order size, there are 15 orders placed a year (i.e., 39,000/2,600 = 15).
Based on these computations, we prepare the following schedule:
Safety Carrying Costs Expected Stockout Total

Stock of Safety Stock Costs Costs
0 0 0.50 x 15a x P1,650 = P12,375 P12,375
150 150 x P24.40 = P3,660 0.20 x 15a x P1,650 = P 4,950 8,610
175 175 x P24.40 = P4,270 0.05 x 15a x P1,650 = P 1,273.5 5,507.5 (optional)
250 250 x P24.40 = P6,100 b 0.01 x 15a x P1,650 = P 247.5 6,347.5
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Chapter 18 Application of Quantitative Techniques in Planning, Control and Decision Making - II
Additional computations:
a
15 is the number of orders per year.
b
It should be evident that at this level the carrying costs alone exceed the total costs at a safety stock of 175 units. Therefore, it
is not possible for this or any safety-stock level larger than 250 to be less costly than 175 units. Indeed, given a total cost at
175 units of P5,507.5, stockout costs would have to occur with probability zero for any safety stock greater than 225.72 units
(i.e., P5,507.5 / P24.40 = P225.72).
1. C 11. D 21. D 31. C

2. B 12. C 22. C 32. D
3. D 13. A 23. C 33. A
4. B 14. A 24. D 34. C
5. D 15. A 25. D 35. D
6. C 16. C 26. B 36. C
7. A 17. C 27. D 37. D
8. A 18. D 28. E 38. D
9. A 19. C 29. B
10. C 20. D 30. A
CHAPTER 19- Relevant Cost
Exercise 7 (Identification of Relevant Costs)
Requirement 1
18-274
The relevant costs of a fishing trip would be:
Fuel and upkeep on boat per trip..................................... P25

Junk food consumed during trip*.................................... 8
Snagged fishing lures....................................................... 7
Total P40
* The junk food consumed during the trip may not be completely relevant.
Even if Shin were not going on the trip, he would still have to eat. The
amount by which the cost of the junk food exceeds the cost of the food he
would otherwise consume would be the relevant amount.
The other costs are sunk at the point at which the decision is made to go on another fishing trip.
Requirement 2
If he fishes for the same amount of time as he did on his last trip, all of his costs are likely to be about the same as they were on
his last trip. Therefore, it really doesn’t cost him anything to catch the last fish. The costs are really incurred in order to be able
to catch fish and would be the same whether one, two, three, or a dozen fish were actually caught. Fishing, not catching fish,
costs money. All of the costs are basically fixed with respect to how many fish are actually caught during any one fishing trip,
except possibly the cost of snagged lures.
Requirement 3
In a decision of whether to give up fishing altogether, nearly all of the costs listed by Shin’s wife are relevant. If he did not fish,
he would not need to pay for boat moorage, new fishing gear, a fishing license, fuel and upkeep, junk food, or snagged lures. In
addition, he would be able to sell his boat, the proceeds of which would be considered relevant in this decision. The original cost
of the boat, which is a sunk cost, would not be relevant.
These three requirements illustrate the slippery nature of costs. A cost that is relevant in one situation can be irrelevant in the
next. None of the costs are relevant when we compute the cost of catching a particular fish; some of them are relevant when we
compute the cost of a fishing trip; and nearly all of them are relevant when we consider the cost of not giving up fishing. What
is even more confusing is that CG is correct; the average cost of a salmon is P167, even though the cost of actually catching any
one fish is essentially zero. It may not make sense from an economic standpoint to have salmon fishing as a hobby, but as long
as Shin is out in the boat fishing, he might as well catch as many fish as he can.
Exercise 8 (Dropping or Retaining a Segment)
Requirement 1
No, the housekeeping program should not be discontinued. It is actually generating a positive program segment margin and is,
of course, providing a valuable service to seniors. Computations to support this conclusion follow:
Contribution margin lost if the housekeeping program is dropped................... P(80,000)

Fixed costs that can be avoided:
Liability insurance.......................................................................................... P15,000
Program administrator’s salary...................................................................... 37,000 52,000
Decrease in net operating income for the organization as a whole.................... P(28,000)
Depreciation on the van is a sunk cost and the van has no salvage value since it would be donated to another organization. The
general administrative overhead is allocated and none of it would be avoided if the program were dropped; thus it is not relevant
to the decision.
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The same result can be obtained with the alternative analysis below:
Total If House- Difference: Net

keeping Is Operating Income
Current Total Dropped Increase or (Decrease)
Revenues...................................................................... P900,000 P660,000 P(240,000)
Variable expenses......................................................... 490,000 330,000 160,000
Contribution margin.................................................... 410,000 330,000 (80,000)
Fixed expenses:
Depreciation*.......................................................... 68,000 68,000 0
Liability insurance................................................... 42,000 27,000 15,000
Program administrators’ salaries............................ 115,000 78,000 37,000
General administrative overhead............................ 180,000 180,000 0
Total fixed expenses..................................................... 405,000 353,000 52,000
Net operating income (loss)......................................... P 5,000 P(23,000) P (28,000)
*Includes pro-rated loss on disposal of the van if it is donated to a charity.
Requirement 2
To give the administrator of the entire organization a clearer picture of the financial viability of each of the organization’s
programs, the general administrative overhead should not be allocated. It is a common cost that should be deducted from the
total program segment margin. Fol lowing
the format for a segmented income statement, a
better income statement would be:
Meals on
Total Home Nursing Wheels House-keeping
Revenues........................................................ P900,000 P260,000 P400,000 P240,000
Variable expenses.......................................... 490,000 120,000 210,000 160,000
Contribution margin...................................... 410,000 140,000 190,000 80,000
Traceable fixed expenses:
Depreciation.............................................. 68,000 8,000 40,000 20,000
Liability insurance.................................... 42,000 20,000 7,000 15,000
Program administrators’ salaries.............. 115,000 40,000 38,000 37,000
Total traceable fixed expenses....................... 225,000 68,000 85,000 72,000
Program segment margins............................ 185,000 P 72,000 P105,000 P 8,000
General administrative overhead.................. 180,000
Net operating income (loss).......................... P 5,000
Exercise 9 (Special Order)
Requirement 1
Monthly profits would be increased by P9,000:
Per Unit Total for 2,000 Units

Incremental revenue.................................................................................... P12.00 P24,000
Incremental costs:
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Variable costs:
Direct materials.................................................................................. 2.50 5,000
Direct labor......................................................................................... 3.00 6,000
Variable manufacturing overhead...................................................... 0.50 1,000
Variable selling and administrative.................................................... 1.50 3,000
Total variable cost................................................................................... P 7.50 15,000
Fixed costs:
None affected by the special order..................................................... 0
Total incremental cost................................................................................. 15,000
Incremental net operating income.............................................................. P 9,000
Requirement 2
The relevant cost is P1.50 (the variable selling and administrative costs). All other variable costs are sunk, since the units have
already been produced. The fixed costs would not be relevant, since they would not be affected by the sale of leftover units.
Exercise 10 (Make or Buy a Component)
The costs that are relevant in a make-or-buy decision are those costs that can be
avoided as a result of purchasing from the outside. The analysis for this exercise is:
Per Unit
Differential Costs 20,000 Units
Make Buy Make Buy
Cost of purchasing....................................................... P23.50 P470,000
Cost of making:
Direct materials....................................................... P 4.80 P 96,000
Direct labor.............................................................. 7.00 140,000
Variable manufacturing overhead........................... 3.20 64,000
Fixed manufacturing overhead................................ 4.00 * 80,000
Total cost.................................................................. P19.00 P23.50 P380,000 P470,000
* The remaining P6 of fixed manufacturing overhead cost would not be

relevant, since it will continue regardless of whether the company makes or
buys the parts.
The P150,000 rental value of the space being used to produce part R-3 represents
an opportunity cost of continuing to produce the part internally. Thus, the completed
analysis would be:
Make Buy
Total cost, as above.......................................................................................... P380,000 P470,000
Rental value of the space (opportunity cost)................................................... 150,000
Total cost, including opportunity cost............................................................. P530,000 P470,000
Net advantage in favor of buying....................................................................

P60,000
Profits would increase by P60,000 if the outside supplier’s offer is accepted.
Exercise 11 (The Economists’ Approach to Pricing)
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Requirement (1)
Cecile makes more money selling the ice cream cones at the lower price, as shown below:
P17.90 Price P13.90 Price

Unit sales................................................................ 860 1,340
Sales P15,394.00 P18,626.00

Cost of goods sold @ P4.10................................... 3,526.00 5,494.00
Contribution margin............................................... 11,868.00 13,132.00
Fixed expenses....................................................... 425.00 425.00
Net operating income............................................. P11,443.00 P12,707.00
Requirement (2)
The price elasticity of demand is computed as follows:
d =
In(1 + % change in quantity sold)
In(1 + % change in price)
1,340 – 860
In(1 + 860 )
=
13.90 – 17.90
In(1 + 17.90 )
In(1 + 0.55814)
=
In(1 – 0.22346)
In(1.55814)
=
In(0.77654)
0.44349
= = –1.75
–0.25291
Requirement (3)
The profit-maximizing price can be estimated using the following formulas:
Profit-maximizing –1
=
markup on variable cost 1 + d
–1
= = 1.333
1 + (–1.75)
Profit-maximizing Profit-maximizing Variable cost

= 1 + x
price markup on variable cost per unit
= (1 + 1.3333) x P4.10 = P9.60
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This price is much lower than the prices Cecile has been charging in the past. Rather than immediately dropping the price to
P9.60, it would be prudent to drop the price a bit and see what happens to unit sales and to profits. The formula assumes that the
price elasticity is constant, which may not be the case.
Exercise 12 (Target Costing)
Sales (50,000 batteries × P65 per battery)................................................ P3,250,000

Less desired profit (20% × P2,500,000)................................................... 500,000
Target cost for 50,000 batteries................................................................ P2,750,000
Target cost per battery = (P2,750,000 ÷ 50,000 batteries)

= P55 per battery
Exercise 13 (Pricing a New Product)
The selling price of the new amaretto cappuccino product should at least cover its variable cost and its opportunity cost. The
variable cost of the new product is P4.60 and its opportunity cost can be computed by multiplying the opportunity cost of P34 per
minute of order filling time by the amount of time required to fill an order for the new product:
Selling price of Variable cost of the

the new product  new product +
Opportunity cost Amounts of the constrained

per unit of the resource required by a unit
x
constrained resource of the new product
Selling price of 45 seconds

the new product  P4.60 + P34 per minute + 60 seconds per minute
Hence, the selling price of the new product should at least cover both its variable cost of P4.60 and its opportunity cost of P25.50, for
Selling price of
a total of P30.10.
the new product  P4.60 + P34 per minute + 0.75 minute
III. Problems
Selling price of
the Problem
new product  P4.60 + P25.50 = P30.10
6 (Pricing)
Requirement A:
Operating
Result at Full
2005 2006 Capacity
Sales P 100,000 P 400,000 P 480,000
Less Variable cost 130,000 520,000 624,000
Contribution margin (P 30,000) (P120,000) (P144,000)
Less Fixed cost 40,000 40,000 40,000
Net income (loss) (P 70,000) (P160,000) (P184,000)
The company had been operating at a loss because the product had been selling with a negative contribution margin. Hence, the
more units are sold, the higher the loss will be.
Requirement B: P60.14
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Requirement C: P74.29 Requirement D: P56.58
Problem 7 (Make or Buy)

Cost of Making Cost of Buying
Outside purchase P90,000
Direct materials P15,000
Direct labor 30,000
Variable manufacturing overhead 10,000
Fixed manufacturing overhead* 15,000
Total cost P70,000 P90,000
* 1/3 x P45,000 = P15,000
Therefore, the annual advantage to make the parts is P20,000.
Problem 8 (Close or Retain a Store)
Requirement 1 The simplest approach to the solution is:
Gross margin lost if the store is closed............................................. P(228,000)

Less costs that can be avoided:
Direct advertising.......................................................................... P36,000
Sales salaries................................................................................. 45,000
Delivery salaries............................................................................ 7,000
Store rent....................................................................................... 65,000
Store management salaries (new employee would not be hired to fill vacant
position at another store).......................................................... 15,000
General office salaries................................................................... 8,000
Utilities.......................................................................................... 27,200
Insurance on inventories (2/3 × P9,000)...................................... 6,000
Employment taxes*....................................................................... 9,000 218,200
Decrease in company net operating income if the Ortigas Store is closed P( 9,800)
*Salaries avoided by closing the store:

Sales salaries.......................................................................................................... P45,000
Delivery salaries.................................................................................................... 7,000
Store management salaries.................................................................................... 15,000
General office salaries........................................................................................... 8,000
Total salaries.......................................................................................................... 75,000
Employment tax rate.............................................................................................. × 12%
Employment taxes avoided.................................................................................... P 9,000
Requirement 2
The Ortigas Store should not be closed. If the store is closed, overall company net operating income will decrease by P9,800 per
quarter.
Requirement 3
The Ortigas Store should be closed if P200,000 of its sales are picked up by the Makati Store. The net effect of the closure will
be an increase in overall company net operating income by P76,200 per quarter:
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Gross margin lost if the Ortigas Store is closed....................................................................... P(228,000)
Gross margin gained at the Makati Store:
P200,000 × 43%................................................................................................................... 86,000
Net loss in gross margin........................................................................................................... (142,000)
Costs that can be avoided if the Ortigas Store is closed (part 1).............................................. 218,200
Net advantage of closing the Ortigas Store.............................................................................. P 76,200
Problem 9 (Shutting Down or Continuing to Operate a Plant)

Requirement 1
Product KK-8 yields a contribution margin of P14 per gallon (P35 – P21 = P14). If the plant closes, this contribution margin
will be lost on the 22,000 gallons (11,000 gallons per month × 2 = 22,000 gallons) that could have been sold during the two-
month period. However, the company will be able to avoid certain fixed costs as a result of closing down. The analysis is:
Contribution margin lost by closing the plant for two months (P14 per gallon ×
22,000 gallons)............................................................................................ P(308,000)
Costs avoided by closing the plant for two months:
Fixed manufacturing overhead cost
(P60,000 × 2 months = P120,000).......................................................... P120,000
Fixed selling costs
(P310,000 × 10% × 2 months)............................................................... 62,000 182,000
Net disadvantage of closing, before start-up costs.......................................... (126,000)
Add start-up costs............................................................................................ (14,000)
Disadvantage of closing the plant................................................................... P(140,000)
No, the company should not close the plant; it should continue to operate at the reduced level of 11,000 gallons produced and
sold each month. Closing will result in a P140,000 greater loss over the two-month period than if the company continues to
operate. Additional factors are the potential loss of goodwill among the customers who need the 11,000 gallons of KK-8 each
month and the adverse effect on employee morale. By closing down, the needs of customers will not be met (no inventories are
on hand), and their business may be permanently lost to another supplier.
Difference—Net
Operating Income
Plant Kept Open Plant Closed Increase (Decrease)
Sales (11,000 gallons × P35 per gallon × 2)................... P 770,000 P 0 P(770,000)
Less variable expenses (11,000
gallons × P21 per gallon × 2)..................................... 462,000 0 462,000
Contribution margin........................................................ 308,000 0 (308,000)
Less fixed costs:
Fixed manufacturing overhead cost
(P230,000 × 2;
P170,000 × 2)......................................................... 460,000 340,000 120,000
Fixed selling cost (P310,000 × 2; P310,000 × 90% × 2) 620,000 558,000 62,000
Total fixed cost................................................................ 1,080,000 898,000 182,000
Net operating loss before start-up costs.......................... (772,000) (898,000) (126,000)
Start-up costs................................................................... (14,000) (14,000)
Net operating loss............................................................ P (772,000) P(912,000) P(140,000)
Requirement 2
Ignoring the additional factors cited in part (1) above, Kristin Company should be indifferent between closing down or
continuing to operate if the level of sales drops to 12,000 gallons (6,000 gallons per month) over the two-month period. The
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computations are:
Cost avoided by closing the plant for two months (see above)............................... P182,000
Less start-up costs.................................................................................................... 14,000
Net avoidable costs.................................................................................................. P168,000
Net avoidable costs P168,000

=
Contribution margin per gallon P14 per gallon
= 12,000 gallons
Verification: Operate at 12,000
Gallons for Two
Months Close for Two Months
Sales (12,000 gallons × P35 per gallon)............................................... P 420,000 P 0
Less variable expenses (12,000 gallons × P21 per gallon)................... 252,000 0
Contribution margin.............................................................................. 168,000 0
Manufacturing overhead (P230,000 and P170,000 × 2 months)..... 460,000 340,000
Selling (P310,000 and P279,000 × 2 months)................................. 620,000 558,000
Total fixed expenses.............................................................................. 1,080,000 898,000
Start-up costs......................................................................................... 0 14,000
Total costs.............................................................................................. 1,080,000 912,000
Net operating loss.................................................................................. P (912,000) P(912,000)
Problem 10 (The Economists’ Approach to Pricing)
Requirement (1)
The postal service makes more money selling the souvenir sheets at the lower price,
as shown below:
P500 Price P600 Price
Unit sales.......................................................... 50,000 40,000
Sales P25,000,000 P24,000,000

Cost of goods sold @ P60 per unit................... 3,000,000 2,400,000
Contribution margin......................................... P22,000,000 P21,600,000
Requirement (2)
The price elasticity of demand, as defined in the text, is computed as follows:
d In(1 + % change in quantity sold)

=
In(1 + % change in price)
In(1 + 40,000 – 50,000 )
50,000
= 600.00 – 500.00
In(1 + 500.00 )
In(1 – 0.2000)
= 18-282
In(1 + 0.2000)
In(0.8000)
=
In(1.2000)
= –0.2231
0.1823
= –1.2239
Requirement (3)
The profit-maximizing price can be estimated using the following formulas:
Profit-maximizing –1
=
markup on variable cost 1 + d
–1
= = 4.4663
1 + (–1.2239)
Profit-maximizing Profit-maximizing Variable cost

= 1 + x
price markup on variable cost per unit
This price is much lower than the price= the(1postal

+ 4.4663) x P60
service has been =charging
P328 in the past. Rather than immediately dropping the
price to P328, it would be prudent for the postal service to drop the price a bit and observe what happens to unit sales and to
profits. The formula assumes that the price elasticity of demand is constant, which may not be true.
The critical assumption in the calculation of the profit-maximizing price is that the percentage increase (decrease) in quantity
sold is always the same for a given percentage decrease (increase) in price. If this is true, we can estimate the demand schedule
for souvenir sheets as follows:
Price* Quantity Sold§

P600 40,000
P500 50,000
P417 62,500
P348 78,125
P290 97,656
P242 122,070
P202 152,588
P168 190,735
P140 238,419
P117 298,024
*
The price in each cell in the table is computed by taking 5/6 of the price just above it in the table. For example, P500 is 5/6 of
P600 and P417 is 5/6 of P500.
§
The quantity sold in each cell of the table is computed by multiplying the quantity sold just above it in the table by
50,000/40,000. For example, 62,500 is computed by multiplying 50,000 by the fraction 50,000/40,000.
The profit at each price in the above demand schedule can be computed as follows:
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Price Sales Cost of Sales
(a) Quantity Sold (b) (a) × (b) P60 × (b) Contribution Margin
P600 40,000 P24,000,000 P2,400,000 P21,600,000
P500 50,000 P250,00,000 P3,000,000 P22,000,000
P417 62,500 P26,062,500 P3,750,000 P22,312,500
P348 78,125 P27,187,500 P4,687,500 P22,500,000
P290 97,656 P28,320,200 P5,859,400 P22,460,800
P242 122,070 P29,540,900 P7,324,200 P22,216,700
P202 152,588 P30,822,800 P9,155,300 P21,667,500
P168 190,735 P32,043,500 P11,444,100 P20,599,400
P140 238,419 P33,378,700 P14,305,100 P19,073,600
P117 298,024 P34,868,800 P17,881,400 P16,987,400
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The contribution margin is plotted below as a function of the selling price:
23,000,000
22,000,000
Contribution Margin
21,000,000
20,000,000
19,000,000
18,000,000
17,000,000
100.00 200.00 300.00 400.00 500.00 600.00
Selling Price
The plot confirms that the profit-
maximizing price is about P328.
Requirement (4)
If the postal service wants to maximize the contribution margin and profit from sales of souvenir sheets, the new price should
be:
Profit-maximizing price = 5.4663 × P70 = P383
Note that a P100 increase in cost has led to a P55 (P383 – P328) increase in the profit-maximizing price. This is because the
profit-maximizing price is computed by multiplying the variable cost by 5.4663. Since the variable cost has increased by P100,
the profit-maximizing price has increased by P100 × 5.4663, or P55.
Some people may object to such a large increase in price as “unfair” and some may even suggest that only the P10 increase in
cost should be passed on to the consumer. The enduring popularity of full-cost pricing may be explained to some degree by the
notion that prices should be “fair” rather than calculated to maximize profits.
Problem 11 (Ranking Alternatives and Managing with a Constraint)
Requirement (1)
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This problem can be solved by first computing the profitability index of each customer and then ranking the customers based on
that profitability index:
Ji Eun’s
Incremental Time Profitability
Profit Required Index
Customer (A) (B) (A) ÷ (B)
Lalaine.....................................
P1,400 4 P350
Emily.......................................
1,240 4 P310
Anna........................................
1,600 5 P320
Catherine.................................
960 3 P320
Gee Ann...................................
1,900 5 P380
Lily 2,880 8 P360
Lourdes....................................
930 3 P310
Ma. Cecilia..............................
1,360 4 P340
Sheila Raya..............................
2,340 6 P390
Jane 2,040 6 P340
Cumulative
Ji Eun’s Amount of Ji
Profitability Time Eun’s Time
Customer Index Required Required
Sheila Raya........ P390 6 6
Gee Ann............. P380 5 11
Lily P360 8 19
Lalaine............... P350 4 23
Jane P340 6 29
Ma. Cecilia......... P340 4 27
Anna................... P320 5 38
Catherine............ P320 3 41
Emily.................. P310 4 45
Lourdes............... P310 3 48
Given that Ji Eun should not be asked to work more than 33 hours, the four customers below the line in the above table should
be told that their reservations have to be cancelled.
Requirement (2)
The total profit on wedding cakes for the weekend after canceling the four reservations would be:
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Sheila Raya......... P 2,340

Gee Ann.............. 1,900
Lily 2,880
Lalaine................ 1,400
Jane 2,040
Ma. Cecilia......... 1,360
Total P11,920
Notes:
● Both Ji Eun’s time and the cakes would have to be very carefully scheduled to make sure that all cakes are completed on
time. We have assumed that the 33 hours of Ji Eun’s time that are available for cake decorating do not include hours that
have been set aside as a buffer to provide protection from inevitable disruptions in the schedule.
● If the cumulative amount of Ji Eun’s time required did not exactly consume the total amount of time available, some
adjustment might be required in which reservations are cancelled to ensure that the most profitable plan is selected.
Requirement (3)
To avoid disappointing customers, reservations should probably not be accepted for any particular weekend after 33 hours of Ji
Eun’s time have been committed for that weekend’s cakes. To ensure that only the most profitable cake reservations are
accepted, a reservation for any cake with a profitability index of less than P340 should probably not be accepted. This was the
cutoff point for the cakes in the first weekend in June. This cutoff may need to be adjusted upward or downward over time—the
cakes that were reserved for the first weekend in June may not be representative of the cakes that would be reserved for other
weekends. If too many reservations are turned down and Ji Eun’s time is not fully utilized, then the cutoff should be adjusted
downward. If too few reservations are turned down and Ji Eun’s time is once again overbooked or profitable cake orders are
turned away, then the cutoff should be adjusted upward.
Requirement (4)
Ms. Hye Young should consider changing the way prices are set so that they include a charge for Ji Eun’s time. On average, the
prices may be the same, but they should be based not only on the size of the cakes, but also on the amount of cake decorating
that the customer desires. The charge for Ji Eun’s time should be her hourly rate of pay (including any fringe benefits) plus the
opportunity cost of at least P340 per hour. Because Ji Eun will not be working more than 33 hours per week, if another cake
reservation is accepted, some other cake reservation will have to be cancelled. Ms. Hye Young would have to give up at least P34
profit per hour to accept another cake reservation.
Requirement (5)
Making Ji Eun happy involves not asking her to work more than 33 hours per week decorating cakes. Making customers happy
involves not canceling their reservations, not raising prices, and providing top quality wedding cakes. Ms. Hye Young can
accomplish both of these objectives and increase her profits by clever management of the constraint—Ji Eun’s time. The
possibilities include:
 Ms. Hye Young should make sure that none of Ji Eun’s time is wasted on unnecessary tasks. For example, Ji Eun should not
be asked to cream butter by hand for frostings if a machine could do the job as well with less labor time.
 Ms. Hye Young should make sure that none of Ji Eun’s time is wasted on tasks that can be done by other persons. For
example, an assistant can be assigned to prepare frosting and to clean up, relieving Ji Eun of those tasks. As long as the cost
of the assistant’s time is less than P34 per hour, the result will be higher profits and more pleased customers.
 Ms. Hye Young should consider assigning an apprentice to Ji Eun. The apprentice could relieve Ji Eun of some of her
workload while learning the skills to eventually expand the company’s cake decorating capacity.
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 Ms. Hye Young might consider subcontracting some of the less demanding cake decorating to another baker. This would be
profitable as long as the charge is less than P340 per hour.
CHAPTER 20
CAPITAL BUDGETING DECISIONS
I. Questions
1. A capital investment involves a current commitment of funds with the expectation of generating a satisfactory return on
these funds over a relatively extended period of time in the future.
2. Cost of capital is the weighted minimum desired average rate that a company must pay for long-term capital while
discounted rate of return is the maximum rate of interest that could be paid for the capital employed over the life of an
investment without loss on the project.
3. The basic principles in capital budgeting are:
1. Capital investment models are focused on the future cash inflows and outflows - rather than on net income.
2. Investment proposals should be evaluated according to their differential effects on the company’s cash flows as a whole.
3. Financing costs associated with the project are excluded in the analysis of incremental cash flows in order to avoid the
“double-counting” of the cost of money.
4. The concept of the time value of money recognizes that a peso of present return is worth more than a peso of future
return.
5. Choose the investments that will maximize the total net present value of the projects subject to the capital availability
constraint.
4. The major classifications as to purpose are:
1. Replacement projects
- those involving replacements of worn-out assets to avoid disruption of normal operations, or to improve efficiency.
2. Product or process improvement
- projects that aim to produce additional revenue or to realize cost savings.
3. Expansion
- projects that enhance long-term returns due to increased profitable volume.
5. Greater amounts of capital may be used in projects whose combined returns will exceed any alternate combination of total
investment.
6. No. This implies that any equity funds are cost free and this is a dangerous position because it ignores the opportunity cost
or alternative earnings that could be had from the fund.
7. Yes, if there are alternative earnings foregone by stockholders.
8. Capital budgeting screening decisions concern whether a proposed investment project passes a preset hurdle, such as a 15%
rate of return. Capital budgeting preference decisions are concerned with choosing from among two or more alternative
investment projects, each of which has passed the hurdle.
9. The “time value of money” refers to the fact that a peso received today is more valuable than a peso received in the future. A
peso received today can be invested to yield more than a peso in the future.
10. Discounting is the process of computing the present value of a future cash flow. Discounting gives recognition to the time
value of money and makes it possible to meaningfully add together cash flows that occur at different times.
11. Accounting net income is based on accruals rather than on cash flows. Both the net present value and internal rate of return
methods focus on cash flows.
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12. One simplifying assumption is that all cash flows occur at the end of a period. Another is that all cash flows generated by an
investment project are immediately reinvested at a rate of return equal to the discount rate.
13. No. The cost of capital is not simply the interest paid on long-term debt. The cost of capital is a weighted average of the
individual costs of all sources of financing, both debt and equity.
14. The internal rate of return is the rate of return on an investment project over its life. It is computed by finding that discount
rate that results in a zero net present value for the project.
15. The project profitability index is computed by dividing the net present value of the cash flows from an investment project by
the investment required. The index measures the profit (in terms of net present value) provided by each peso of investment
in a project. The higher the project profitability index, the more desirable is the investment project.
16. Neither the payback method nor the simple rate of return method considers the time value of money. Under both methods, a
peso received in the future is weighed the same as a peso received today. Furthermore, the payback method ignores all cash
flows that occur after the initial investment has been recovered.
II. Matching Type
1. A 6. H
2. C 7. D
3. F 8. G
4. B 9. J
5. I 10. E
III. Exercises
Exercise 1 (Simple Rate of Return Method)
The annual incremental net operating income is determined by comparing the operating cost of the old machine to the operating
cost of the new machine and the depreciation that would be taken on the new machine:
Operating cost of old machine................................................................ P33,000

Less operating cost of new machine....................................................... 10,000
Less annual depreciation on the new machine (P80,000 ÷ 10
years)................................................................................................... 8,000
Annual incremental net operating income............................................. P15,000
Cost of the new machine........................................................................ P80,000

Less scrap value of old machine............................................................. 5,000
Initial investment.................................................................................... P75,000
Simple rate Annual incremental net operating income

of return = Initial investment
P15,000
= P75,000 = 20%
Exercise 2 (Basic Present Value Concepts)
1. a. P400,000 × 0.794 = P317,600.

b. P400,000 × 0.712 = P284,800.
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2. a. P5,000 × 4.355 = P21,775.
b. P5,000 × 3.685 = P18,425.
3. The factor for 10% for 20 years is 8.514. Thus, the present value of Tom’s winnings would be:
P50,000 × 8.514 = P425,700.

Whether or not Tom really won a million pesos depends on your point of view. She will receive a million pesos over the
next 20 years; however, in terms of its value right now she won much less than a million pesos as shown by the present
value computation above.
Exercise 3 (After-Tax Costs)
a. Management consulting fee.................................... P100,000

Multiply by 1 – 0.30................................................ × 0.70
After-tax cost........................................................... P 70,000
b. Increased revenues.................................................. P40,000

Multiply by 1 – 0.30................................................ × 0.70
After-tax cash flow (benefit)................................... P28,000
c. The depreciation deduction is P210,000 ÷ 7 years = P30,000 per year, which has
the effect of reducing taxes by 30% of that amount, or P9,000 per year.
Exercise 4 (Basic Net Present Value Analysis)
Present Value of Cash

Year(s) Amount of Cash Flows 12% Factor Flows
Purchase of the stock.......................... Now P(18,000) 1.000 P(18,000)
Annual dividends*.............................. 1-4 P720 3.037 2,187
Sale of the stock.................................. 4 P22,500 0.636 14,310
Net present value................................ P( 1,503)
*900 shares × P0.80 per share per year = P720 per year.
No, Ms. Cruz did not earn a 12% return on the share. The negative net present value indicates that the rate of return on the
investment is less than the discount rate of 12%.
Exercise 5 (Internal Rate of Return and Net Present Value)
1.
Factor of the internal Required investment
rate of return = Annual cash inflow
P136,700
A factor of 5.468 represents an internal rate of return of 16%.
= P25,000 = 5.468
2. Amount of Cash Present Value of Cash
Item Year(s) Flows 16% Factor Flows
Initial investment................................ Now P(136,700) 1.000 P(136,700)
Net annual cash inflows..................... 1-14 P25,000 5.468 136,700
Net present value................................ P 0
The reason for the zero net present value is that 16% (the discount rate) represents the machine’s internal rate of return. The
internal rate of return is the rate that causes the present value of a project’s cash inflows to just equal the present value of the
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investment required.
3.
The 6.835 factor is closest to 6.982, theP136,700
factor for the 11% rate of return. Thus, to the nearest whole percent, the internal rate of
return is 11%. = = 6.835
P20,000
Exercise 6 (Basic Net Present Value and Internal Rate of Return Analysis)
1. Amount of Cash Present Value of Cash

Initial investment........................ Now P(40,350) 1.000 P(40,350)
Annual cash inflows.................... 1-4 P15,000 2.855 42,825
Net present value......................... P 2,475
Yes, this is an acceptable investment. Its net present value is positive, which indicates that its rate of return exceeds the
minimum 15% rate of return required by the company.
2.
Factor of the internal Investment required
rate of return = Net annual cash inflow
P111,500
= P20,000 = 5.575
A factor of 5.575 represents an internal rate of return of 16%.
3. Factor of the internal Investment required

rate of return = Net annual cash inflow
P14,125
A factor of 5.650 represents an internal rate of return of 12%. The company did not make a wise investment because the
return promised by the machine= is lessP2,500 = rate
than the required 5.650
of return
IV. Problems
Problem 1 (Equipment Replacement Sensitivity Analysis)
Requirement 1
Total Present Value
A. New Situation:
Recurring cash operating costs (P26,500 x 2.69) P 71,285
Cost of new equipment 44,000
Disposal value of old equipment now (5,000)
Present value of net cash outflows P110,285
B. Present Situation:
Recurring cash operating costs (P45,000 x 2.69) P121,050
Disposal value of old equipment four years hence
(P2,600 x 0.516) (1,342)
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Present value of net cash inflows P119,708
Difference in favor of replacement P 9,423
Requirement 2
P44,000 – P5,000
Payback period for the new equipment =
P18,500
= 2.1 years
Requirement 3
Let X = annual cash savings

Let O = net present value
X (2.69) + P5,000 - P44,000 - P1,342 = O

2.69X = P40,342
X = P14,997
If the annual cash savings decrease from P18,850 to P14,997 or by P3,503, the point of indifference will be reached.
Another alternative way to get the same answer would be to divide the net present value of P9,423 by 2.690.
Problem 2
Annual cash expenses of the manual bookkeeping

machine system, P9,800 x 12 P117,600
Annual cash expenses of computerized data processing 53,600
Annual cash savings before taxes P 64,000

Annual cash savings (a) P64,000 P64,000 P64,000
Depreciation 20,000 16,000 12,800
Inflow before tax P44,000 P48,000 P51,200
Income tax (50%) (b) 22,000 24,000 25,600
Cash inflow after tax (a - b) P42,000 P40,000 P38,400
After Tax
Cash Inflows PV Factor PV
Year 1 P42,000 x 0.909 P 38,178
Year 2 40,000 x 0.826 33,040
Year 3 38,400 x 0.750 28,800
Year 3 Salvage 20,000 x 0.750 15,000
Year 3 Tax loss 15,600* x 0.750 11,700
P126,718
Investment (I) 100,000
Net present value (NPV) P 26,718
_________________
* The P15,600 tax benefit of the loss on the disposal of the computer at the end of year 3 is computed as follows:
Estimated salvage value P 20,000
Estimated book value:
Historical cost P100,000
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Accumulated depreciation 48,800 51,200
Estimated loss P(31,200)
Tax rate 50%

Tax effect of estimated loss P(15,600)
Since the net present value is positive, the computer should be purchased replacing the manual bookkeeping system.
Problem 3
Requirement 1
(a) Purchase price of new equipment P(300,000)

Disposal of existing equipment:
Selling price P 0
Book value 60,000
Loss on disposal P60,000
Tax rate 0.4
Tax benefit of loss on disposal 24,000
Required investment (I) P(276,000)
(b) Increased cash flows resulting from

change in contribution margin:
Using new equipment [18,000 (P20 - P7)] * P234,000
Using existing equipment [11,000 (P20 - P9)] 121,000
Increased cash flows 113,000
Less: Taxes (0.40 x P113,000) 45,200
Increased cash flows after taxes P 67,800
Depreciation tax shield:
Depreciation on new equipment
(P300,000  5) P60,000
Depreciation on existing equipment
(P60,000  5) 12,000
Increased depreciation charge P48,000
Tax rate 0.40
Depreciation tax shield 19,200
Recurring annual cash flows P 87,000
_________________
* The new equipment is capable of producing 20,000 units, but ETC Products can sell only 18,000 units annually.
The sales manager made several errors in his calculations of required investment and annual cash flows. The errors are as
follows:
Required investment:
- The cost of the market research study (P44,000) is a sunk cost because it was incurred last year and will not change
regardless of whether the investment is made or not.
- The loss on the disposal of the existing equipment does not result in an actual cash cost as shown by the sales manager.
The loss on disposal results in a reduction of taxes, which reduces the cost of the new equipment.
Annual cash flows:
- The sales manager considered only the depreciation on the new equipment rather than just the additional depreciation
which would result from the acquisition of the new equipment.
- The sales manager also failed to consider that the depreciation is a noncash expenditure which provides a tax shield.
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- The sales manager’s use of the discount rate (i.e., cost of capital) was incorrect. The discount rate should be used to
reduce the value of future cash flows to their current equivalent at time period zero.
Requirement 2
Present value of future cash flows (P87,000 x 3.36) P292,320

Required investment (I) 276,000
Net present value P 16,320
Problem 4
Requirement 1: P(507,000)
Problem 5
1. The net annual cost savings is computed as follows:
Reduction in labor costs.................................................................................... P240,000

Reduction in material costs............................................................................... 96,000
Total cost reductions.......................................................................................... 336,000
Less increased maintenance costs (P4,250 × 12).............................................. 51,000
Net annual cost savings..................................................................................... P285,000
2. Using this cost savings figure, and other data provided in the text, the net present value analysis is:
Amount of Cash Present Value of
Year(s) Flows 18% Factor Cash Flows
Cost of the machine..................................... Now P(900,000) 1.000 P (900,000)
Installation and software.............................. Now P(650,000) 1.000 (650,000)
Salvage of the old machine.......................... Now P70,000 1.000 70,000
Annual cost savings..................................... 1-10 P285,000 4.494 1,280,790
Overhaul required........................................ 6 P(90,000) 0.370 (33,300)
Salvage of the new machine........................ 10 P210,000 0.191 40,110
Net present value......................................... P (192,400)
No, the etching machine should not be purchased. It has a negative net present value at an 18% discount rate.
3. The intangible benefits would have to be worth at least P42,813 per year as shown below:
Required increase in net present value P192,400
= 4.494 = P42,813
Factor for 10 years
Thus, the new etching machine should be purchased if management believes that the intangible benefits are worth at least
P42,813 per year to the company.
Problem 6
Items and Computations Year(s) (1) Amount (2) (1) × (2) 12% Present Value
Tax After-Tax Factor of Cash Flows
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Effect Cash Flows
Investment in new trucks........................... Now P(450,000) P(450,000) 1.000 P(450,000)
Salvage from sale of the old trucks............ Now P30,000 1 – 0.30 P21,000 1.000 21,000
Net annual cash receipts............................ 1-8 P108,000 1 – 0.30 P75,600 4.968 375,581
Depreciation deductions*........................... 1-8 P56,250 0.30 P16,875 4.968 83,835
Overhaul of motors.................................... 5 P(45,000) 1 – 0.30 P(31,500) 0.567 (17,861)
Salvage from the new trucks...................... 8 P20,000 1 – 0.30 P14,000 0.404 5,656
Net present value........................................ P 18,211
* P450,000 ÷ 8 years = P56,250 per year

Since the project has a positive net present value, the contract should be accepted.
Problem 7
1. Factor of the internal Required investment

P142,950
= P37,500 = 3.812
A factor of 3.812 equals an 18% rate of return.
Verification of the 18% rate of return:
Amount of Cash Present Value of Cash

Investment in equipment............................... Now P(142,950) 1.000 P(142,950)
Annual cash inflows...................................... 1-7 P37,500 3.812 142,950
Net present value........................................... P 0
2.
We know that the investment is P142,950, and we can determine the factor for an internal rate of return of 14% by looking at
the PV table along the 7-period line. This factor is 4.288. Using these figures in the formula, we get:
P142,950
Annual
Therefore, the cash inflow
annual = would
cash inflow 4.288have to be:
P142,950 ÷ 4.288 = P33,337.
3. a. 5-year life for the equipment:

The factor for the internal rate of return would still be 3.812 [as computed in (1) above]. Reading along the 5-period line of
the PV table, a factor of 3.812 is closest to 3.791, the factor for 10%. Thus, to the nearest whole percent, the internal rate of
return is 10%.
b. 9-year life for the equipment:
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The factor of the internal rate of return would again be 3.812. From the PV table, reading along the 9-period line, a factor of
3.812 is closest to 3.786, the factor for 22%. Thus, to the nearest whole percent, the internal rate of return is 22%.
The 10% return in part (a) is less than the 14% minimum return that Dr. Blue wants to earn on the project. Of equal or even
greater importance, the following diagram should be pointed out to Dr. Blue:
As this illustration shows, a decrease in years has a much greater impact on the rate of return than an increase in years.
This is because of the time value of money; added cash inflows far into the future do little to enhance the rate of return, but
loss of cash inflows in the near term can do much to reduce it. Therefore, Dr. Blue should be very concerned about any
potential decrease in the life of the equipment, while at the same time realizing that any increase in the life of the equipment
will do little to enhance her rate of return.
4. a. The expected annual cash inflow would be:
P37,500 x 120% = P45,000

P142,950
P45,000 = 3.177
Reading along the 7-period line of the PV table, a factor of 3.177 is closest to 3.161, the factor for 25%, and is between that
factor and the factor for 24%. Thus, to the nearest whole percent, the internal rate of return is 25%.
b. The expected annual cash inflow would be:
P37,500 x 80% = P30,000

P142,950
P30,000 = 4.765
Reading along the 7-period line of the PV table, a factor of 4.765 is closest to 4.712, the factor for 11%. Thus, to the nearest
whole percent, the internal rate of return is 11%.
Unlike changes in time, increases and decreases in cash flows at a given point in time have basically the same impact on the
rate of return, as shown below:
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5. Since the cash flows are not even over the five-year period (there is an extra P61,375 cash inflow from sale of the equipment at
the end of the fifth year), some other method must be used to compute the internal rate of return. Using trial-and-error or more
sophisticated methods, it turns out that the actual internal rate of return will be 12%:
Amount of Cash Present Value of

Item Year(s) Flows 12% Factor Cash Flows
Investment in the equipment............................ Now P(142,950) 1.000 P(142,950)
Annual cash inflow........................................... 1-5 P30,000 3.605 108,150
Sale of the equipment....................................... 5 P61,375 0.567 34,800
Net present value.............................................. P 0
Problem 8
1. The income statement would be:
Sales revenue...................................................................... P200,000

Less commissions (40% × P200,000)................................. 80,000
Contribution margin........................................................... 120,000
Maintenance................................................................... P50,000
Insurance......................................................................... 10,000
Depreciation*.................................................................. 36,000
Total fixed expenses............................................................ 96,000
Net operating income.......................................................... P 24,000
*P180,000 ÷ 5 years = P36,000 per year
2. The initial investment in the simple rate of return calculations is net of the salvage value of the old equipment as shown below:
Simple Annual incremental net operating income

rate of return = Initial investment
P24,000 P24,000
= P180,000 – P30,000 = P150,000 = 16%
Yes, the games would be purchased. The return exceeds the 14% threshold set by the company.
3. The payback period would be:
Payback Investment required

period = Net annual cash inflow
P180,000 – P30,000 P150,000
= = = 2.5 years
P60,000* P60,000
*Net annual cash inflow = Net operating income + Depreciation

= P24,000 + P36,000 = P60,000.
Yes, the games would be purchased. The payback period is less than the 3 years.
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1. D 11. D 21. C 31. D

2. C 12. D 22. B 32. C
3. B 13. D 23. C 33. C
4. B 14. C 24. D 34. D
5. A 15. C 25. C 35. D
6. C 16. D 26. C 36. B
7. D 17. D 27. D 37. B
8. B 18. B 28. B 38. B
9. B 19. A 29. D 39. D
10. A 20. A 30. A 40. B
CHAPTER 21
DECENTRALIZED OPERATIONS AND

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SEGMENT REPORTING
I. Questions
1. Decentralization means that decision making in an organization isn’t confined to a few top executives, but rather is spread
throughout the organization with managers at various levels making key operating decisions relating to their sphere of
responsibility.
2. The benefits include: (1) a spreading of decision-making responsibility among managers, thereby relieving top
management from day-to-day problem solving and allowing them to focus their time on long-range planning; (2) training
in decision making for lower-level managers, thereby preparing them to assume greater responsibility; (3) greater job
satisfaction and greater incentive for lower-level managers; (4) better decisions, since decisions are made at the level where
the problem is best understood; and (5) a more effective basis for measuring managerial performance through the creation
of profit and investment centers.
3. The three business practices are (a) omission of some costs in the assignment process, (b) the use of inappropriate
allocation methods, and (c) allocation of common costs to segments.
4. The contribution margin represents the portion of sales revenue remaining after deducting variable expenses. The segment
margin represents the margin still remaining after deducting traceable fixed expenses from the contribution margin.
Generally speaking, the contribution margin is most useful as a planning tool in the short run, when fixed costs don’t
change. The segment margin is most useful as a planning tool in the long run, when fixed costs will be changing, and as a
tool for evaluating long-run segment performance. One concept is no more useful to management than the other; the two
concepts simply relate to different planning horizons.
5. A segment is any part or activity of an organization about which a manager seeks cost, revenue, or profit data. Examples of
segments include departments, operations, sales territories, divisions, product lines, and so forth.
6. Under the contribution approach, costs are assigned to a segment if and only if the costs are traceable to the segment (i.e.,
could be avoided if the segment were eliminated). Common costs are not allocated to segments under the contribution
approach.
7. A traceable cost of a segment is a cost that arises specifically because of the existence of that segment. If the segment were
eliminated, the cost would disappear. A common cost, by contrast, is a cost that supports more than one segment, but is not
traceable in whole or in part to any one of the segments. If the departments of a company are treated as segments, then
examples of the traceable costs of a department would include the salary of the department’s supervisor, depreciation of
machines used exclusively by the department, and the costs of supplies used by the department. Examples of common costs
would include the salary of the general counsel of the entire company, the lease cost of the headquarters building, corporate
image advertising, and periodic depreciation of machines shared by several departments.
II. Problems
Problem 1 (Working with a Segmented Income Statement)
Requirement 1
P75,000 × 40% CM ratio = P30,000 increased contribution margin in Cebu. Since the fixed costs in the office and in the
company as a whole will not change, the entire P30,000 would result in increased net operating income for the company.
It is incorrect to multiply the P75,000 increase in sales by Cebu’s 25% segment margin ratio. This approach assumes that the
segment’s traceable fixed expenses increase in proportion to sales, but if they did, they would not be fixed.
Requirement 2
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a. The segmented income statement follows:

Segments
Total Company Manila Cebu
Amount % Amount % Amount %
Sales............................................. P800,000 100.0% P200,000 100% P600,000 100%
Less variable expenses................. 420,000 52.5 60,000 30 360,000 60
Contribution margin.................... 380,000 47.5 140,000 70 240,000 40
Less traceable fixed expenses......
168,000 21.0 78,000 39 90,000 15
Office segment margin................ 212,000 26.5 P 62,000 31% P150,000 25%
Less common fixed expenses not traceable
to segments...............................
120,000 15.0
Net operating income.................. P 92,000 11.5%
b. The segment margin ratio rises and falls as sales rise and fall due to the presence of fixed costs. The fixed expenses are
spread over a larger base as sales increase.
In contrast to the segment ratio, the contribution margin ratio is a stable figure so long as there is no change in either the
variable expenses or the selling price of a unit of service.
Problem 2 (Segmented Income Statement)
Requirement 1
Geographic Market
Total Company East Central West
Amoun
Amount % Amount % Amount % t %
P1,500,00 P400,00 P600,00 10 P500,00
Sales 0 100.0 0 100 0 0 0 100
208,00 200,00
Less variable expenses 588,000 39.2 0 52 180,000 30 0 40
Contribution margin 912,000 60.8 192,000 48 420,000 70 300,000 60
Less traceable fixed expenses 240,00
770,000 51.3 0 60 330,000 55 200,000 40
Geographic market segment P P100,00
margin 142,000 9.5 P(48,000) (12) 90,000 15 0 20
Less common fixed expenses
not traceable to geographic
markets* 175,000 11.7
Net operating income (loss) P
(33,000) (2.2)
* P945,000 – P770,000 = P175,000.
Requirement 2
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Incremental sales (P600,000 × 15%).................................................................................... P90,000

Contribution margin ratio......................................................................................................
× 70%
Incremental contribution margin........................................................................................... 63,000
Less incremental advertising expense................................................................................... 25,000
Incremental net operating income.........................................................................................P38,000
Yes, the advertising program should be initiated.
Problem 3 (Basic Segmented Income Statement)
Total CD DVD
Sales*...................................................................................... P750,000 P300,000 P450,000
Variable expenses**................................................................ 435,000 120,000 315,000
Contribution margin............................................................... 315,000 180,000 135,000
Traceable fixed expenses........................................................ 183,000 138,000 45,000
Product line segment margin.................................................. 132,000 P 42,000 P 90,000
Common fixed expenses not traceable to products................ 105,000
Net operating income.............................................................. P 27,000
* CD: 37,500 packs × P8.00 per pack = P300,000;

DVD: 18,000 packs × P25.00 per pack= P450,000.
** CD: 37,500 packs × P3.20 per pack = P120,000;
DVD: 18,000 packs × P17.50 per pack= P315,000.
1. B 6. A 11. A
2. C 7. C 12. B
3. B 8. B
4. B 9. D
5. B 10. C
CHAPTER 22
BUSINESS PLANNING
I. Questions
1. Strategy, plans, and budgets are interrelated and affect one another. Strategy describes how an organization matches its
own capabilities with the opportunities in the marketplace to accomplish its overall objectives. Strategy analysis underlies
both long-run and short-run planning. In turn, these plans lead to the formulation of budgets. Budgets provide feedback
to managers about the likely effects of their strategic plans. Managers use this feedback to revise their strategic plans.
2. Budgeted performance is better than past performance for judging managers. Why? Mainly because the inefficiencies
included in past results can be detected and eliminated in budgeting. Also, new opportunities in the future, which did not
exist in the past, may be ignored if past performance is used.
3. A company that shares its own internal budget information with other companies can gain multiple benefits. One benefit
is better coordination with suppliers, which can reduce the likelihood of supply shortages. Better coordination with
customers can result in increased sales as demand by customers is less likely to exceed supply. Better coordination across
the whole supply chain can also help a company reduce inventories and thus reduce the costs of holding inventories.
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4. The sales forecast is typically the cornerstone for budgeting, because production (and, hence, costs) and inventory levels
generally depend on the forecasted level of sales.
5. Sensitivity analysis adds an extra dimension to budgeting. It enables managers to examine how budgeted amounts change
with changes in the underlying assumptions. This assists managers to monitor those assumptions that are most critical to a
company attaining its budget or make timely adjustments to plans when appropriate.
6. Factors reducing the effectiveness of budgeting of companies include:

1. Lack of a well-defined strategy,
2. Lack of a clear linkage of strategy to operational plans,
3. Lack of individual accountability for results, and
4. Lack of meaningful performance measures.
II. Problems
Problem 1 (Budgeted Income Statement)
Globalcom Company
Budgeted Income Statement for 2006
(in thousands)
Net sales P6,996

Equipment (P6,000 x 1.06 x 1.10) 1,908
Maintenance contracts (P1,800 x 1.06)
Total net sales P8,904
Cost of goods sold (P4,600 x 1.03 x 1.06) 5,022
Gross margin 3,882
Operating costs:
Marketing costs (P600 + P250) 850
Distribution costs (P150 x 1.06) 159
Customer maintenance costs (P1,000 + P130) 1,130
Administrative costs 900
Total operating costs 3,039
Operating income P 843
Problem 2 (Comprehensive Operating Budget)
Requirement 1
Schedule 1: Revenue Budget

Units Selling Price Total Revenues

Skateboards 1,000 P450 P450,000
Total
Requirement 2
Schedule 2: Production Budget (in Units)

for the Year Ended December 31, 2006
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Skateboards
Budgeted unit sales (Schedule 1) 1,000
Add target ending finished goods inventory 200
Total requirements 1,200
Deduct beginning finished goods inventory 100
Units to be produced 1,100
Requirement 3
Schedule 3A: Direct Materials Usage Budget

Wood Fiberglass Total
Physical Budget
To be used in production 5,500
(Wood: 1,100 x 5.00 b.f.
Fiberglass: 1,100 x 6.00 yards) 6,600
5,500 6,600
Cost Budget
Available from beginning inventory
(Wood: 2,000 b.f. x P28.00 56,000
Fiberglass: 1,000 b.f. x 4.80) 4,800
To be used from purchases this period
(Wood: (5,500 – 2,000) x P30.00 105,000
Fiberglass: (6,600 – 1,000) x P5.00) 28,000
Total cost of direct materials to be used P161,000 P32,800 P193,800
Schedule 3B: Direct Materials Purchases Budget

Wood Fiberglass Total
Physical Budget
Production usage (from Schedule 3A) 5,500 6,600
Add target ending inventory 1,500 2,000
Total requirements 7,000 8,600
Deduct beginning inventory 2,000 1,000
Purchases 5,000 7,600
Cost Budget
(Wood: 5,000 x P30.00 P150,000
Fiberglass: 7,600 x P5.00) P38,000
P150,000 P38,000 P188,000
Requirement 4
Schedule 4: Direct Manufacturing Labor Budget

Cost DML Hours Total Wage

Labor Category Driver per Driver Hours Rate Total
Units Unit
Manufacturing 1,100 5.00 5,500 P25.00 P137,50
labor 0
Requirement 5
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Schedule 5: Manufacturing Overhead Budget

At Budgeted Levels of 5,500

Direct Manufacturing Labor-Hours
Variable manufacturing overhead costs
(P7.00 x 5,500) P 38,500
Fixed manufacturing overhead costs 66,000
Total manufacturing overhead costs P104,500
Requirement 6
P104,500
Budgeted manufacturing overhead rate: = P19.00 per hour
5,500
Requirement 7
Budgeted manufacturing overhead cost per output unit:

P104,500
=
1,100
= P95.00 per output unit
Requirement 8
Schedule 6A: Computation of Unit Costs of Manufacturing Finished Goods in 2006

Cost per Unit
of Inputa Inputsb Total
Direct materials
Wood P30.00 5.00 P150.00
Fiberglass 5.00 6.00 30.00
Direct manufacturing labor 25.00 5.00 125.00
Total manufacturing overhead 95.00
P400.00
a
cost is per board foot, yard or per hour
b
inputs is the amount of input per board
Requirement 9
Schedule 6B: Ending Inventory Budget

December 31, 2006
Units Cost per Unit Total
Direct materials
Wood 1,500 P 30.00 P 45,000
Fiberglass 2,000 5.00 10,000
Finished goods
Skateboards 200 400.00 80,000
Total Ending Inventory P135,000
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Requirement 10
Schedule 7: Cost of Goods Sold Budget

for the year Ended December 31, 2006
From Schedule Total

Beginning finished goods
inventory, January 1,
2006 Given P 37,480
Direct materials used 3A P193,800
Direct manufacturing labor 4 137,500
Manufacturing overhead 5 104,500
Cost of goods manufactured 435,800
Cost of goods available for
sale 473,280
Deduct ending finished goods
inventory, December 31,
2006 6B 80,000
Cost of goods sold P393,280
Requirement 11
Budgeted Income Statement for Pacific

for the Year Ended December 31, 2006
Revenues Schedule 1 P450,000
Costs
Cost of goods sold Schedule 7 393,280
Gross margin 56,720
Operating costs
Marketing costs
(P250 x 30) P 7,500
Other costs 30,000 37,500
Operating income P 19,220
6. A 11. A 11. D
7. B 12. B 12. D
8. C 13. D 13. B
9. D 14. A 14. C
10. D 15. C 15. A
CHAPTER 23
STRATEGIC COST MANAGEMENT;

BALANCED SCORECARD
I. Questions
1.
Strategy Weakness
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Cost leadership The tendency to cut costs in a way that undermines

demand for the product or service.
Differentiation The firm’s tendency to undermine its strength by
attempting to lower costs or by lacking a continual and
aggressive marketing plan to reinforce the perceived
difference.
Focus The market niche may suddenly disappear due to
technological change in the industry or change in
consumer tastes.
2. The balanced scorecard is an accounting report that includes the firm’s critical success factors in four areas: customer
satisfaction, financial performance, internal business processes, and innovation and learning (human resources). The
primary objective of the balanced scorecard is to serve as an action plan, a basis for implementing the strategy expressed in
the critical success factors.
3. The balanced scorecard is important to integrate both financial and non-financial information into management reports.
Financial measures reflect only a partial- and short-term measure of the firm’s progress. Without strategic non-financial
information, the firm is likely to stray from its competitive course and to make strategically wrong product decisions – to
choose the wrong products, the wrong customers. The balanced scorecard provides a basis for a more complete analysis
than is possible with financial data alone.
4. An analyst can incorporate other factors such as the growth in the overall market and reductions in selling prices resulting
from productivity gains into a strategic analysis of operating income. To do so, the analyst attributes the sources of
operating income changes to the particular factors of interests. For example, the analyst will combine the operating income
effects of strategic price reductions and any resulting growth with the productivity component to evaluate a company’s cost
leadership strategy.
5. A company’s balanced scorecard should be derived from and support its strategy. Since different companies have different
strategies, their balanced scorecards should be different.
6. The difference between the delivery cycle time and the throughput time is the waiting period between when an order is
received and when production on the order is started. The throughput time is made up of process time, inspection time,
move time, and queue time. These four elements can be classified between value-added time (process time) and non-value-
added time (inspection time, move time, and queue time).
7. The balanced scorecard is constructed to support the company’s strategy, which is a theory about what actions will further
the company’s goals. Assuming that the company has financial goals, measures of financial performance must be included
in the balanced scorecard as a check on the reality of the theory. If the internal business processes improve, but the financial
outcomes do not improve, the theory may be flawed and the strategy should be changed.
8. If a company has an MCE of less than 1, it means the production process includes non-value-added time. An MCE of 0.40,
for example, would mean that 40% of the throughput time consists of actual processing, and that the other 60% consists of
moving, inspection, and other non-value-added activities.
II. Problem (Measures of Internal Business Process Performance)
Requirement 1
a, b, and c
Month
1 2 3 4
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Throughput time in days:
Process time........................................................... 0.6 0.5 0.5 0.4
Inspection time....................................................... 0.7 0.7 0.4 0.3
Move time.............................................................. 0.5 0.5 0.4 0.5
Queue time............................................................. 3.6 3.6 2.6 1.7
Total throughput time............................................ 5.4 5.3 3.9 2.9
Manufacturing cycle efficiency (MCE):
Process time  Throughput time........................ 11.1% 9.4% 12.8% 13.8%
Delivery cycle time in days:

Wait time................................................................ 9.6 8.7 5.3 4.7
Total throughput time............................................ 5.4 5.3 3.9 2.9
Total delivery cycle time........................................ 15.0 14.0 9.2 7.6
Requirement 2
The general trend is favorable in all of the performance measures except for total sales. On-time delivery is up, process time is
down, inspection time is down, move time is basically unchanged, queue time is down, manufacturing cycle efficiency is up, and
the delivery time is down. Even though the company has improved its operations, it has not yet increased its sales. This may
have happened because management attention has been focused on the factory – working to improve operations. However, it
may be time now to exploit these improvements to go after more sales – perhaps by increased product promotion and better
marketing strategies. It will ultimately be necessary to increase sales so as to translate the operational improvements into more
profits.
Requirement 3
a and b
Month
5 6
Throughput time in days:
Process time........................................................... 0.4 0.4
Inspection time....................................................... 0.3
Move time.............................................................. 0.5 0.5
Queue time.............................................................
Total throughput time............................................ 1.2 0.9
Manufacturing cycle efficiency (MCE):

Process time  Throughput time........................ 33.3% 44.4%
As a company pares away non-value-added activities, the manufacturing cycle efficiency improves. The goal, of course, is to
have an efficiency of 100%. This will be achieved when all non-value-added activities have been eliminated and process time
equals throughput time.
11. D 16. C
12. D 17. D
13. C 18. C
14. A 19. D
15. A 20. A
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CHAPTER 24
ADVANCED ANALYSIS AND

APPRAISAL OF PERFORMANCE:
FINANCIAL AND NONFINANCIAL
I. Questions
1. Return on investment (ROI) is the ratio of profit to amount invested for the business unit.
2. The measurement issues for ROI are:
a. The effect of accounting policies, which affect the determination of net income.
b. Other measurement issues for income, which include the handling of non-recurring items in the income statement,
differences in the effect of income taxes across units, differential effect of foreign currency exchange, and the effect of
cost allocation when two or more units share a facility or cost.
c. Measuring investment: which assets to include.
d. Measuring investment: allocating the cost of shared assets.
3. The advantages of return on investment are:
a. It is intuitive and easily understood.
b. It provides a useful basis for comparison among SBUs.
c. It is widely used.
The limitations of return on investment are:
a. It has an excessive short-term focus.
b. Investment planning uses discounted cash flow analysis while managers are evaluated on ROI.
c. It contains a disincentive for new investment by the most profitable units.
4. The key advantage of residual income is that it deals effectively with the limitation of ROI, that is ROI has a disincentive
for the managers of the most profitable units to make new investments. With residual income, no matter how profitable the
unit, there is still an incentive for new profitable investment. In contrast, a key limitation is that since residual income is
not a percentage, it suffers the same problem of profit SBUs in that it is not useful for comparing units of significantly
difference sizes. It favors larger units that would be expected to have larger residual incomes, even with relatively poor
performance. Moreover, relatively small changes in the desired minimum rate of return can dramatically affect the residual
income for different size units. And, in contrast to ROI, some managers do not find residual income to be as intuitive and
as easily understood.
5. Economic value added (EVA) is a business unit’s income after taxes and after deducting the cost of capital. The idea is very
similar to what we have explained as residual income. The objectives of the measures are the same – to effectively motivate
investment SBU managers and to properly measure their performance. In contrast to residual income, EVA uses the firm’s
cost of capital instead of a desired rate of return. For many firms the desired rate of return and the cost of capital will be
nearly the same, with small differences due to adjustments for risk and for strategic goals such as the desired growth rate for
the firm. Also, while residual income is intended to deal with the undesirable effects of ROI, EVA is used to focus
managers’ attention on creating value for shareholders, by earning profits greater than the firm’s cost of capital.
6. Examples of financial and nonfinancial measures of performance are:
Financial: ROI, residual income, and return on sales.
Nonfinancial: Manufacturing lead time, on-time performance, number of new product launches, and number of new
patents filed.
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7. The six steps in designing an accounting-based performance measure are:
a. Choose performance measures that align with top management’s financial goal(s).
b. Choose the time horizon of each performance measure in Step 1.
c. Choose a definition of the components in each performance measure in Step 1.
d. Choose a measurement alternative for each performance measure in Step 1.
e. Choose a target level of performance.
f. Choose the timing of feedback.
8. Yes. Residual income (RI) is not identical to return on investment (ROI). ROI is a percentage with investment as the
denominator of the computation. RI is an absolute amount in which investment is used to calculate an imputed interest
charge.
9. Economic value added (EVA) is a specific type of residual income measure that is calculated as follows:
Economic After tax Weighted Total Assets
value added = operating  Average Cost x minus Current
(EVA) income of Capital Liabilities
10. Definitions of investment used in practice when computing ROI are:

a. Total assets available.
b. Total assets employed.
c. Working capital (current assets minus current liabilities) plus other assets.
d. Equity.
11. Present value is the asset measure based on DCF estimates. Current cost is the cost of purchasing an asset today identical to
the one currently held if identical assets can currently be purchased; it is the cost of purchasing the services provided by that
asset if identical assets cannot currently be purchased. Historical-cost-based measures of ROI compute the asset base as the
original purchase cost of an asset minus any accumulated depreciation.
Some commentators argue that present value is future-oriented and current cost is oriented to current prices, while
historical cost is past-oriented.
12. Special problems arise when evaluating the performance of divisions in multinational companies because
a. The economic, legal, political, social, and cultural environments differ significantly across countries.
b. Governments in some countries may impose controls and limit selling prices of products.
c. Availability of materials and skilled labor, as well as costs of materials, labor, and infrastructure may differ significantly
across countries.
d. Divisions operating in different countries keep score of their performance in different currencies.
13. a. Consider each activity and the organization itself from the customer’s perspective,
b. Evaluate each activity using customer-validated measures of performance,
c. Consider all facets of activity performance that affect customers and are comprehensive, and
d. Provide feedback to help organization members identify problems and opportunities for improvement.
II. Exercises
Exercise 1 (ROI and Residual Income)
Requirement 1
A quick inspection of the data shows mortgage loans with a higher ROI to be more successful. But see requirement 2 below.
Requirement 2
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Division A Division B
(Mortgage Loans) (Consumer Loans)
Total Assets P2,000 P10,000
Operating Income 400 1,500
Return on Investment 25% 15%
Residual Income:
(a) * at 11% P180 P400
(b) ** at 15% 100 0
(c) *** at 17% 60 (200)
* P400 – (P2,000 x 0.11) = P180 P1,500 – (P10,000 x 0.11) = P 400

** P400 – (P2,000 x 0.15) = P100 P1,500 – (P10,000 x 0.15) = P 0
*** P400 – (P2,000 x 0.17) = P 60 P1,500 – (P10,000 x 0.17) = P(200)
There is no simple answer to which is more successful in terms of residual income. Division B is more successful at low rates,
while A is more successful at high rates. This reflects an important limitation of residual income; larger divisions (Division B in
this case) are favored when the desired return used to determine residual income is relatively low.
Exercise 2 (Return on Investment; Comparisons of Three Companies)
Companies in the Same Industry

A B C
Sales P1,500,000 P 750,000 P3,750,000
Income 200,000 75,000 18,750
Investment (assets) 500,000 7,500,000 2,500,000
Return on sales 13% 10% 0.5%
Asset turnover 3 0.1 1.5
Return on investment 40% 1% 0.75%
Exercise 3 (ROI, RI, ROS, Management Incentives)
Requirement 1
If Magic Industries uses return on investment to measure the Jump-Start Division’s (JSD’s) performance, Tan may be reluctant
to invest in the new plant because, as shown below, return on investment for the plant of 19.2% is lower than JSD’s current ROI
of 24%.
Operating income for new plant P480,000

New investment P2,500,000
Return on investment for new plant 19.2%
Investing in the new plant would lower JSD’s ROI and, hence, limit Tan’s bonus.
Requirement 2
The residual income computation for the new plant is as follows:

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Residual income = Income - (Imputed interest x Investment)
Investment P2,500,000
Operating income for new plant P 480,000
Charge for funds
(Investment, P2,500,000 x 15%) 375,000
Residual income P 105,000
Investing in the new plant would add P105,000 to JSD’s residual income. Consequently, if Magic Industries could be persuaded
to use residual income to measure performance, Tan would be more willing to invest in the new plant.
Requirement 3
Operating income 480,000
Return on Sales (ROS) = Sales = 2,400,000 =
20%
If Magic Industries uses ROS to determine Tan’s bonus, Tan will be more willing to invest in the new plant because ROS for the
new plant of 20% exceeds the current ROS of 19%.
The advantages of using ROS are (a) that it is simpler to calculate and (b) that it avoids the negative short-run effects of ROI
measures that may induce Tan to not make the investment in the new plant. Tan may favor ROS because she believes that
eventually increases in ROS will increase ROI and RI.
The main disadvantage of using ROS is that it ignores the amount of investment needed to earn a return. For example, ROS
may be high but not high enough to justify the level of investment needed to earn the required return on an investment.
III. Problems
Problem 1 (RI, EVA)
Requirement 1
Truck Rental Transportation
Division Division
Total assets P650,000 P950,000
Current liabilities 120,000 200,000
Investment
(Total assets – current liabilities) 530,000 750,000
Required return (12% x Investment) 63,600 90,000
Operating income before tax 75,000 160,000
Residual income
(Operating income before tax –
required return) 11,400 70,000
Requirement 2
After-tax cost of debt financing = (1 – 0.4) x 10% = 6%

After-tax cost of equity financing = 15%
Weighted average = P900,000 x 6% + 600,000 x 15%

cost of capital P900,000 + 600,000 =
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Required return for EVA

9.6% x Investment
(9.6% x P530,000; 9.6% x P750,000)
P50,880 P72,000
Operating income after tax

0.6 x operating income before tax 45,000 96,000
EVA (Operating income after tax –

required return) (5,880) 24,000
Requirement 3
Both the residual income and the EVA calculations indicate that the Transportation Division is performing better than the Truck
Rental Division. The Transportation Division has a higher residual income (P70,000 versus P11,400) and a higher EVA
[P24,000 versus P(5,880)]. The negative EVA for the Truck Rental Division indicates that, on an after-tax basis, the division is
destroying value – the after-tax economic return from the Truck Rental Division’s assets is less than the required return. If EVA
continues to be negative, Lighthouse may have to consider shutting down the Truck Rental Division.
Problem 2 (ROI, RI, Measurement of Assets)
The method for computing profitability preferred by each manager follows:
Manager of Method Chosen

S Residual income based on net book value
P Residual income based on gross book value
F ROI based on either gross or net book value
Supporting Calculations:
Return on Investment Calculations

Operating Income Operating Income
Division Gross Book Value Net Book Value*
S P94,700  P800,000 = 11.84% (3) P94,700  P370,000 = 25.59% (3)
P P91,700  P760,000 = 12.07% (2) P91,700  P350,000 = 26.20% (2)
F P61,400  P500,000 = 12.28% (1) P61,400  P220,000 = 27.91% (1)
Residual Income Calculations

Division Operating Income – 10% Gross BV Operating Income – 10% Net BV*
S P94,700 – P80,000 = P14,700 (2) P94,700 – P37,000 = P57,700 (1)
P P91,700 – P76,000 = P15,700 (1) P91,700 – P35,000 = P56,700 (2)
F P61,400 – P50,000 = P11,400 (3) P61,400 – P22,000 = P39,400 (3)
* Net book value is gross book value minus accumulated depreciation.
The biggest weakness of ROI is the tendency to reject projects that will lower historical ROI even though the prospective ROI
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exceeds the required ROI. RI achieves goal congruence because subunits will make investments as long as they earn a rate in
excess of the required return for investments. The biggest weakness of residual income is it favors larger divisions in ranking
performance. The greater the amount of the investment (the size of the division), the more likely that larger divisions will be
favored assuming that income grows proportionately.
Problem 3 (Multinational Performance Measurement, ROI, RI)
Requirement 1
(a)
Operating income Operating income
Phil. Division’s ROI in 2005 = Total assets = P8,000,000 =
15%
Hence, operating income = 15% x P8,000,000 = P1,200,000.
(b)
9,180,000 kronas
Swedish Division’s ROI in 2005 in kronas = 60,000,000 kronas =
15.3%
Requirement 2
Convert total assets into pesos at December 31, 2004 exchange rate, the rate prevailing when the assets were acquired (8 kronas
= P1)
60,000,000 kronas
24,000,000 kronas = = P7,500,000
8 kronas per peso
Convert operating income into pesos at the average exchange rate prevailing when during 2005 when operating income was
earned equal to
9,180,000 kronas
8.5 kronas per peso = P1,080,000
P1,080,000
Comparable ROI for Swedish Division = P7,500,000 =
14.4%
The Swedish Division’s ROI calculated in kronas is helped by the inflation that occurs in Sweden in 2005. Inflation boosts the
division’s operating income. Since the assets are acquired at the start of the year on 1-1-2005, the asset values are not increased
by the inflation that occurs during the year. The net effect of inflation on ROI calculated in kronas is to use an inflated value for
the numerator relative to the denominator. Adjusting for inflationary and currency differences negates the effects of any
differences in inflation rates between the two countries on the calculation of ROI. After these adjustments, the Phil. Division
shows a higher ROI than the Swedish Division.
Requirement 3
Phil. Division’s RI in 2005 = P1,200,000 – 12% x P8,000,000

= P1,200,000 – P960,000 = P240,000
Swedish Division’s RI in 2005 (in Phil. pesos) is
P1,080,000 – 12% x P7,500,000 = P1,080,000 – P900,000 = P180,000.
The Phil. Division’s RI also exceeds the Swedish Division’s RI in 2005 by P60,000 (P240,000 – P180,000).
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Problem 4 (ROI Performance Measures Based on Historical Cost and Current Cost)
Requirement 1
ROI using historical cost measures:
P130,000
Luzon Division = 38.24%
P340,000
P220,000
Visayas Division = 19.13%
P1,150,000
P380,000
Mindanao Division = 23.46%
P1,620,000
The Luzon Division appears to be considerably more efficient than the Visayas and Mindanao Divisions.
Requirement 2
The gross book values (i.e., the original costs of the plants) under historical cost are calculated as the useful life of each plant
(12) x the annual depreciation:
Luzon 12 x P 70,000 = P 840,000

Visayas 12 x P100,000 = P1,200,000
Mindanao 12 x P120,000 = P1,440,000
Step 1: Restate long-term assets from gross book value at historical costs to gross book value at current cost as of the end of
2005.
Gross book value of
Construction cost index in 2005
long-term assets at x
Construction cost index in year of construction
historical cost
Luzon P 840,000 x (170  100) = P1,428,000
Visayas P1,200,000 x (170  136) = P1,500,000
Mindanao P1,440,000 x (170  160) = P1,530,000
Step 2: Derive net book value of long-term assets at current cost as of the end of 2005. (Estimated useful life of each plant is
12 years).
Gross book value of
long-term assets at Estimated useful life remaining
current cost at the x
Estimated total useful life
end of 2005
Luzon P1,428,000 x (2  12) = P 238,000
Visayas P1,500,000 x (9  12) = P1,125,000
Mindanao P1,530,000 x (11  12) = P1,402,500
Step 3: Compute current cost of total assets at the end of 2005. (Assume current assets of each plant are expressed in 2005
pesos.)
Current assets at the end Net book value of long-term assets at

of 2005 (given) + current cost at the end of 2005 (Step 2)
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Luzon P200,000 + P238,000 = P 438,000

Visayas P250,000 + P1,125,000 = P1,375,000
Mindanao P300,000 + P1,402,500 = P1,702,500
Step 4: Compute current-cost depreciation expense in 2005 pesos.
Gross book value of long-term assets at current cost at the end of 2005 (from Step 1) x (1  12)
Luzon P1,428,000 x (1  12) = P119,000

Visayas P1,500,000 x (1  12) = P125,000
Mindanao P1,530,000 x (1  12) = P127,500
Step 5: Compute 2005 operating income using 2005 current-cost depreciation.
Historical-cost Current-cost depreciation Historical-cost

operating income – in 2005 pesos (Step 4) – depreciation
Luzon P130,000 – (P119,000 – P70,000) = P 81,000
Visayas P220,000 – (P125,000 – P100,000) = P195,000
Mindanao P380,000 – (P127,500 – P120,000) = P372,500
Step 6: Compute ROI using current-cost estimate for long-term assets and depreciation.
Operating income for 2005 using 2005 current cost depreciation (Step 5)
Current cost of total assets at the end of 2005 (Step 3)
Luzon P 81,000  P 438,000 = 18.49%
Visayas P195,000  P1,375,000 = 14.18%
Mindanao P372,500  P1,702,500 = 21.88%
ROI: Historical Cost ROI: Current Cost

Luzon 38.24% 18.49%
Visayas 19.13% 14.18%
Mindanao 23.46% 21.88%
Use of current cost results in the Mindanao Division appearing to be the most efficient. The Luzon ROI is reduced substantially
when the ten-year-old plant is restated for the 70% increase in construction costs over the 1995 to 2005 period.
Requirement 3
Use of current costs increases the comparability of ROI measures across divisions’ operating plants built at different construction
cost price levels. Use of current cost also will increase the willingness of managers, evaluated on the basis of ROI, to move from
divisions with assets purchased many years ago to division with assets purchased in recent years.
16. A 11. B 21. C 31. A

17. B 12. D 22. D 32. A
18. C 13. C 23. C 33. B
19. C 14. A 24. A 34. A
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20. D 15. C 25. C 35. C
21. B 16. C 26. D 36. B
22. A 17. A 27. A 37. D
23. C 18. C 28. C
24. B 19. B 29. D
25. A 20. A 30. D
CHAPTER 25
MANAGING PRODUCTIVITY AND

MARKETING EFFECTIVENESS
I. Questions
1. Productivity is the relationship between the output and the input resources required for generating the output.
2. A critical success factor for a firm that competes as a cost leader is to be the low cost provider. A low cost provider needs to
perform the required tasks for the same output with fewer resources than its competitors.
3. Among criteria that often are used in assessing productivity and their advantages and disadvantages are:
Using a prior year’s productivity as the criterion
Advantages:
 Data readily available
 Facilitates monitoring of continuous improvements
Disadvantages:
 Difficult to assess adequacy of productivity improvements
 Hard to compare productivity improvements between the years
Using the best performance as the criterion

Advantages:
 Provides as the benchmark the utmost performance
 Motivates people to strive for the maximum potential
Disadvantages:
 The standard can be too high for the operation and frustrating to workers
 Data may be difficult to obtain
 The criteria on which the operation is based may not be comparable
4. An operational productivity is the ratio of the output to the number of units of an input resource.
A financial productivity measures the relationship between the output and the cost of one or more of the input resources.
5. A partial productivity is a productivity measure that focuses only on the relationship between the amount of one of the input
resources and the output attained.
A total productivity measures the relationship between the output and the total input costs of all the required input resources
for the output.
6. Manufacturing personnel often prefer operational productivity measures over financial productivity measures because all
the input data for computing operational productivity measures are either results of their activities or resources consumed
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for these activities. Financial productivity measures use costs of resources that often are results of activities by personnel
outside of manufacturing functions.
7. Measurements of marketing effectiveness include market share, sales price, sales mix, and sales quantity variances.
8. Sales quantity variance is a component of sales volume variance. A sales volume variance can be the result of both sales
mix and sales quantity variances.
9. A market size variance measures the effect on the contribution margin and operating income of a firm because of changes in
the total market size for all firms in the same industry or product segment. A market share variance examines the effect on
the contribution margin and operating income of a firm because of deviations of the firm’s actual market shares from its
budgeted market shares.
10. a. No. A multi-product firm can still have an unfavorable sales volume variance even if it sells more than the budgeted
units of sales. The unfavorable sales volume variance is a result of selling more of less profitable products and less of
more profitable products.
b. A favorable sales quantity variance reflects the marketing manager’s excellent performances only if there is no adverse
change in selling prices, sales mix, or market size. A favorable sales quantity variance is hardly favorable to the firm if
the firm has lowered its selling prices or sold more of low-priced, low-margin and less of high-priced, high-margin
products. Increases in the total market size in which the firm operates often also leads to a favorable sales quantity
variance. A favorable sales quantity variance in an expanding total market may not be favorable to the firm
strategically if the firm also has an unfavorable market share variance.
A firm can have a favorable market size variance and an unfavorable market share variance if the proportional increase
of the firm’s total sales is less than those of the total market.
c. Yes. The Wall Street Journal reported on April 14, 1994 (p. B4) that Colgate-Palmolive had slashed marketing
spending to reach its ambitious target of 15 percent annual earnings growth. The firm, for example, spent P88.8
million on advertising in 1993, compared with P97.5 million in 1992. The firm met the goal of a 15 percent increase
in per share earnings and its CEO, Mr. Mark, expected the company to announce a similar increase for first quarter
earnings soon. The market share of the firm, however, have decreased in all categories.
11. The sales volume variance is the sum of sales quantity and sales mix variances. The sales quantity variance is the sum of
market size and market share variances.
II. Problems
Problem 1 (Operational and Financial Partial Productivity)
Requirement 1
Star Company
Comparative Income Statement
For the years 2005 and 2006
2005 2006
Sales 15,000 x P40 P600,00 18,000 x P40 P720,000
= 0 =
Variable cost of sales:
Materials 12,000 x P 8 P 12,600 x P10 P126,000
= 96,000 =
Labor 6,000 x P20 = 120,000 5,000 x P25 = 125,000
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Power 1,000 x P 2 = 2,00 2,000 x P 2 = 4,000
0
Total variable costs of P218,00 P255,000
sales 0
Contribution margin P382,00 P465,000
0
Change in profits from 2005: P465,000 – P382,000 = P83,000 increase

Requirement 2
Operational Partial Productivity
2006 2005
DM 18,000 / 12,600 = 1.4286 15,000 / 12,000 = 1.25
DL 18,000 / 5,000 = 3.6 15,000 / 6,000 = 2.5
Power 18,000 / 2,000 = 9 15,000 / 1,000 = 15
Requirement 3
Total cost of production factors
2006 2005
DM 12,600 x P10= P126,000 12,000 x P 8 = P 96,000
DL 5,000 x P25 = P125,000 6,000 x P20 = P120,000
Power 2,000 x P 2 = P 4,000 1,000 x P 2 = P 2,000
Financial Partial Productivity
2006 2005
DM 18,000 / 126,000 = 0.1429 15,000 / 96,000 = 0.15625
DL 18,000 / 125,000 = 0.144 15,000 / 120,000 = 0.125
Power 18,000 / 4,000 = 4.5 15,000 / 2,000 = 7.5
Requirement 4
Both direct materials and direct labor operation partial productivity improved from 2005 to 2006. In 2006 the firm was able to
manufacture more output units for each unit of materials placed into production and for each hour spent on production. The
operational productivity of power in 2006 deteriorated from 2005. It is likely that the firm used more equipment in production
in 2006 that reduced consumption of materials and production hours.
The financial partial productivity for both direct materials and power deteriorated from 2005 to 2006. Increases in direct
materials costs were more than the improvements in operational partial productivity for direct materials. Like the operational
partial productivity, the financial partial productivity for direct labor also improved. The extent of improvements, however, is
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much lower in financial partial productivity. The direct labor operational partial productivity improved 44 percent in 2006 over
those of 2005. The financial partial productivity, however, improved only 15.2 percent between the two years. The decrease in
financial partial productivity is likely a result of increases in direct labor wages.
Requirement 5
Operating Data for Decomposing Financial Productivity Measure
2006 Output, 2006 Output 2006 Output 2005 Output

1/2006 1/2005 1/2005 1/2005
Productivity Productivity Productivity Productivity
2006 Input cost 2006 Input cost 2005 Input cost 2005 Input cost
(1) Output (unit):

18,000 18,000 18,000 15,000
(2) 1/Productivity
DM: 12,600/18,000 12,000/15,000 12,000/15,000 12,000/15,000
= 0.7 = 0.8 = 0.8 = 0.8
DL: 5,000/18,000 6,000/15,000 6,000/15,000 6,000/15,000
= 0.2778 = 0.4 = 0.4 = 0.4
Power: 2,000/18,000 1,000/15,000 1,000/15,000 1,000/15,000
= 0.1111 = 0.0667 = 0.0667 = 0.0667
(3) Cost per unit of input

DM: P10 P10 P 8 P 8
DL: P25 P25 P20 P20
Power: P 2 P 2 P 2 P 2
(4) Output x (1/Productivity) x Input cost

DM: 18,000 x 0.7 x 10 18,000 x 0.8 x 10 18,000 x 0.8 x 8 15,000 x 0.8 x 8
= P126,000 = P144,000 = P115,200 = P96,000
DL: 18,000 x 0.2778 x 18,000 x 0.4 x 25 18,000 x 0.4 x 20 15,000 x 0.4 x 20
25 = P180,000 = P144,000 = P120,000
= P125,010
Power: 18,000 x 0.1111 18,000 x 0.0667 x 18,000 x 0.0667 x 2 15,000 x 0.0667 x 2
x 2 = P4,000 2 = P2,401 = P2,001
= P2,401
Total P255,010 P326,401 P261,601 P218,001
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Decomposition
DM: 18,000 / 18,000 / 144,000 18,000 / 115,200 15,000 / 96,000
126,000 = 0.125 = 0.15625 = 0.15625
= 0.1429
DL: 18,000 / 125,010 18,000 / 180,000 18,000 / 144,000 15,000 / 120,000
= 0.1440 = 0.1 = 0.125 = 0.125
Power: 18,000 / 18,000 / 2,401 18,000 / 2,401 15,000 / 2,001
4,000 = 7.4969 = 7.4969 = 7.4963
= 4.5
Productivity change Input price change Output change
DM: 0.1429 – 0.125 0.125 – 0.15625 0.15625 – 0.15625

= 0.0179 F = 0.03125 U =0
DL: 0.144 – 0.1 0.1 – 0.125 0.125 – 0.125
= 0.044 F = 0.025 U =0
Power: 4.5 – 7.4969 7.4969 – 7.4969 7.4969 – 7.4963
= 2.9969 U =0 = 0.0006 (rounding)
Summary of Result
Change as % of 2005 Productivity
Productivity Input Price Total Productivity Input Price Total
Change Change Change Change Change Change
DM: 0.0179 F 0.03125 0.01335 11.46% 20% U 8.54%
U U F U
DL: 0.044 F 0.025 0.019 35.2% 20% U 15.2%
U F F F
Power: 2.9969 U 0 2.9969 39.98% 0 39.98%
U U U
Requirement 6
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Productivity for both direct materials and direct labor improved in 2006. The percentages of improvements in productivity are
11.46 and 35.2 for direct materials and direct labor, respectively, of the 2005 productivity. However, cost increases in direct
materials and direct labor reduced the gains in productivity on these two manufacturing factors
Problem 2 (Direct Labor Rate and Efficiency Variances, Productivity Measures, and Standard Costs)
Requirement 1
Assembly Department Direct Labor Variances

2005:
Total actual direct labor hours: 25 x 20,000 = 500,000
Total standard direct labor hours: 24 x 20,000 = 480,000
P30 x 500,000 P28 x 500,000 P28 x 480,000

= P15,000,000 = P14,000,000 = P13,440,000
Rate variance Efficiency variance

= P1,000,000 U = P560,000 U
2006:
P36 x 400,000 P35 x 400,000 P35 x 420,000

= P14,400,000 = P14,000,000 = P14,700,000

= P400,000 U = P700,000 F
Testing Department Direct Labor Variances

2005:
P20 x 240,000 P21 x 240,000 P21 x 280,000

= P4,800,000 = P5,040,000 = P5,880,000
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= P240,000 F = P840,000 F
2006:
P24 x 200,000 P25 x 200,000 P25 x 220,000

= P4,800,000 = P5,000,000 = P5,500,000

= P200,000 F = P500,000 F
Recap:
Assembly Department Testing Department
2005 2006 2005 2006
Rate variance P1,000,000 U P400,000 U P240,000 F P200,000 F
Efficiency variance P560,000 U P700,000 F P840,000 F P500,000 F
Requirement 2
Assembly Department Operational Partial Productivity
2005: 20,000 / 500,000 = 0.04

2006: 20,000 / 400,000 = 0.05
Testing Department Operational Partial Productivity
2005: 20,000 / 240,000 = 0.0833

2006: 20,000 / 200,000 = 0.1
Requirement 3
Assembly Department Financial Partial Productivity
2005: 20,000 / P15,000,000 = 0.001333

2006: 20,000 / P14,400,000 = 0.001389
Testing Department Financial Partial Productivity
2005: 20,000 / P4,800,000 = 0.004167

2006: 20,000 / P4,800,000 = 0.004167
Requirement 4
Operational partial productivity
2005 2006 Change

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Assembly 0.04 0.05 0.01 F 25% F
Testing 0.0833 0.1 0.0167 F 20% F
Financial partial productivity
2005 2006 Change

Assembly 0.001333 0.001389 0.000056 F 4.2% F
Testing 0.004167 0.004167 -0- -0-
Operational partial productivity improved in both departments from 2005 to 2006. The financial partial productivity in the
Assembly also improved while the Testing remains unchanged.
Requirement 5
The standards in a standard costing system often are determined independently and incorporate changes in operating factors.
The standard for the operation of a year may change because of changes in, for example, technology, quality of materials,
experience of production workers, designs, or processes.
Productivity measures use as the criterion the productivity of a prior year without adjusting for changes occurred or the expected
changes for the current year. As a result, assessments of productivity may depict an entirely different picture than those of
variance analyses in a standard costing system.
Problem 3 (Sales Variance)
Requirement 1
Selling price variances (in 000)

Flexible budget sales:
Master Budget for 2005 Budgeted Total Units Flexible

Total Selling Price Sold in Budget
Sales Units Per Unit 2005 Sales
Premium P36,000  240 = P150 x 180 = P27,000
Regular P43,200  360 = P120 x 540 = P64,800
Premium Regular
Selling Selling
Flexible Price Flexible Price
Actual Budget Variance Actual Budget Variance
Barrels 180 180 540 540
Sales P28,800 P27,000 P1,800 F P62,100 P64,800 P2,700
U
Total selling price variance of the firm = P1,800 F + P2,700 U = P900 U

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Requirement 2
Sales volume variances for the period for each of the products and for the firm
Flexible budget variable expenses:
Master Budget for 2005 Budgeted Total Flexible

Total Variable Units Budget
Variable Number of Expenses Sold in Variable
Expenses Units Per Unit 2005 Expenses
Premium P21,600  240 = P90 x 180 = P16,200
Regular P27,000  360 = P75 x 540 = P40,500
Premium Regular
Sales Sales
Flexible Master Volume Flexible Master Volume
Budget Budget Variance Budget Budget Variance
Barrels 180 180 540 360
Sales P27,000 P36,000 P64,800 P43,200
Variable
expenses 16,200 21,600 40,500 27,000
Contribution
margin P10,800 P14,400 P3,600 P24,300 P16,200 P8,100 F
U
Fixed
expenses 10,000 10,000 5,000 5,000 –
–
Operating
income P 800 P 4,400 P3,600 P19,300 P11,200 P8,100 F
U
Total sales volume variance of the firm = P3,600 U + P8,100 F = P4,500 F
Requirement 3
Sales quantity variances for the firm and for each of the products. (See next page.)
Requirement 4
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Sales mix variances for the period for each of the products and for the firm (000 omitted).
Calculation for sales mixes:
Budgeted Actual
Total Sales Sales Total Sales Sales
in Units Mix in Units Mix
Premium 240 0.40 180 0.25
Regular 360 0.60 540 0.75
600 1.00 720 1.00
Flexible Budget Master Budget

Total actual units of all products Total actual units Total budgeted units of
sold x Actual sales mix x of all products sold sales for all products x
Standard contribution margin x Budgeted sales Budgeted sales mix x
per unit mix x Standard Standard contribution
contribution margin per unit
margin per unit
Premium
720 x 0.25 x P60 = 720 x 0.40 x P60 = 600 x 0.40 x P60 = P14,400
P10,800 P17,280
Sales mix variance Sales quantity variance

= P6,480 U = P2,880 F
Sales volume variance

= P10,800 – P14,400
= P3,600 U
To verify: Sales volume variance

= Sales mix variance + Sales quantity variance
= P6,480 U + P2,880 F
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= P3,600 U
Regular
720 x 0.75 x P45 = 720 x 0.60 x P45 = 600 x 0.60 x P45 = P16,200
P24,300 P19,440
Sales mix variance Sales quantity variance

= P4,860 F = P3,240 F
Sales volume variance

= P24,300 – P16,200
= P8,100 F
To verify: Sales volume variance

= Sales mix variance + Sales quantity variance
= P4,860 F + P3,240 F
= P8,100 F
Total
Sales mix variance = P6,480 U + P4,860 F = P1,620 U
Sales quantity variance = P2,880 U + P3,240 F = P6,120 F
Requirement 5
Verification
Sales mix variance + Sales quantity variance = Sales

volume variance
Premium P6,480 U P2,880 F P3,600 U
Regular P4,860 F P3,240 F P8,100 F
Total P1,620 U P6,120 F P4,500 F
Requirement 6
Market size variances. (See below.)
Requirement 7
Market share variances (000 omitted. See below.)

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Weighted average budgeted contribution margin per unit

Master budget total contribution margin P30,600
Master budget total sales units  600
Weighted-average budgeted contribution margin per unit P 51
Calculation for market shares:
Budgeted: Total sales in units 600  Total sales of the industry 1,500 = 0.40
Actual: Total sales in units 720  Total sales of the industry 1,600 = 0.45
Calculation for variances:

Actual total market Actual total market x Budgeted total market size x
size x Actual market Budgeted market Budgeted market share x
share x Average share x Average Average budgeted contribution
budgeted contribution budgeted contribution margin per unit
margin per unit margin per unit
1,600 x 0.45 x P51 1,600 x 0.40 x P51 1,500 x 0.40 x P51
= P36,720 = P32,640 = P30,600
Market share variance Market size variance

= P4,080 F = P2,040 F
Sales quantity variance

= P4,080 F + P2,040 F
= P6,120 F
Requirement 8
The sum of market size variance and market share variance and verification that this total equals the sales quantity variance.
Total market size variance Total market share Total quantity variance
+ variance =
P2,040 F P4,080 F P6,120 F
Problem 4 (Productivity and Ethics)
Requirement 1
The operational partial productivity deteriorates slightly from 0.0051 in 2005 (500/99,000) to 0.005 in 2006 (560/112,000).
Manipulating accounting numbers in order to show a desirable result is an unethical behavior regardless the intention.
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Requirement 2
Tan should not follow the order without following a consistent accounting method. If the firm believes that certain cost items
should be reclassified as indirect costs, the same procedure should be followed for all years. Tan should then go back and revise
operating results of previous years.
Problem 5 (Small Business Market Size and Share Variances)
Requirement 1
Budget Actual
Empress’ Empress’
Designs Industry Share Designs Industry Share
WS 50 500 10.0% 45 425 45/425
DH 25 200 12.5% 35 150 35/150
Requirement 2
Weighted Average Budgeted Contribution Margin Per Unit:

(50 welcome signs x P2) + (25 doghouses x P5.20) / 75 = P3.07
Market Share Variance

Welcome Signs: (45/425 – 0.1) x 425 x P3.07 = P7.68 F
Doghouses: (35/150 – 25/200) x 150 x P3.07 = P49.89 F
Requirement 3
Market Size Variance

Welcome Signs: (45 – 500) x 50/500 x P3.07 = P23.03 U
Doghouses: (150 – 200) x 25/200 x P3.07 = P19.19 U
Requirement 4
Among possible reasons are quality changes, pricing changes, less producers due to seasonal variations, and market no longer
there.
Requirement 5
Among alternatives are improving costs through adopting activity based costing, making different signs, using less expensive
wood, finding competitive advantage.
21. A 16. A 31. A

22. C 17. B 32. D
23. B 18. A 33. C
24. D 19. B 34. D
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25. A 20. C
26. C 21. D
27. C 22. B
28. B 23. C
29. C 24. A
30. D 25. D
Operational partial productivity
2005 2006
Input Partial Input Partial
Resource Productivit Resource Productivit
Output Used y Output Used y
X-45 60,000  75,000 = 0.8 64,000  89,600 = 0.7143
(1)
Direct
labor 60,000  10,000 = 6.0 64,000  10,847 = 5.9002
(2)
Financial partial productivity
2005 2006
Cost of Cost of
Input Partial Input Partial
Units of Resource Productivit Units of Resource Productivit
Output Used y Output Used y
X-45 60,000  P540,000= 0.1111 64,000  P609,280 = 0.1050
(3)
Direct
labor 60,000  300,000 = 0.2 64,000  P347,104 = 0.1844
Total productivity in units (4)
2005 2006
(a) Total units manufactured 60,000 64,000
(b) Total variable manufacturing costs
incurred P840,000 P956,384
(c) Total productivity (a)  (b) 0.071429 (5) 0.066919
(d) Decrease in productivity 0.071429 – 0.066919 = 0.00451 (6)
Total productivity in sales pesos

2005 2006
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(a) Total sales P1,500,000 P1,600,000
(b) Total variable manufacturing costs
incurred P840,000 P956,384
(c) Total productivity (a)  (b) P1.7857 (5) P1.6730
(d) Decrease in productivity P1.7857 – P1.6730 = P0.1127 (6)
(7) Operational partial productivity:

Actual Production 9,500
Operational Partial Productivity = Actual Input = 8,950 = 1.06
(8) Financial partial productivity:

2005 2006
(1) Output 400,000 486,000
(2) Direct materials:
Quantity 160 180
Unit cost x P3,375 x P3,125
Total direct materials cost P540,000 P562,500
(3) DM financial partial
productivity (1) (2) 0.7407 0.864
(4) Direct labor:
Hour spent 10,000 13,500
Hourly wage x P26 x P25
Total direct labor cost P260,000 P337,500
(5) DL financial partial productivity
(1) (4) 1.5385 1.44
(9) Total productivity:

2005 2006
(1) Output 400,000 486,000
Total cost:
Direct materials cost P540,000 P562,500
Direct labor cost 260,000 337,500
(2) Total cost P800,000 P900,000
(3) Total productivity (1) (2) 0.5 0.54
Market Share
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Firm Total Market Market Share

Actual 100,000 / 2,000,000 = 5%
Budget 90,000 / 1,500,000 = 6%
1. Market size variance: (2,000,000 – 1,500,000) x 0.06 x P8 = P240,000 F (10)

2. Market share variance: (5% - 6%) x 2,000,000 x P8 = P160,000 U (11)
3. Sales quantity variance: (100,000 – 90,000) x P8 = P 80,000 F (12)
(13)
Product A Product B Total
Budgeted sales unit 30,000 60,000 90,000
Budgeted contribution margin per
unit x P4.00 x P10.00
Budgeted total contribution margin P120,000 P600,000 P720,000
Budgeted average contribution
margin per unit P8.00
(14)
Product A Product B Total
Actual units sold 35,000 65,000
Budgets sales unit – 30,000 – 60,000
Differences in sales units 5,000 5,000
Budgeted contribution margin per
unit x P4.00 x P10.00
Sales volume contribution margin
variance P20,000 F P50,000 F P70,000 F
Sales mixes:
Budgeted Actual
Unit % Unit %
Product A 30,000 1/3 35,000 35
Product B 60,000 2/3 65,000 65
TOTAL 90,000 100 100,000 100
(15)Sales mix contribution margin variance:

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Product A: (0.35 – 1/3) x 100,000 x P4 = P 6,667 F
Product B: (0.65 – 2/3) x 100,000 x P10 = 16,667 U
Total sales mix contribution margin variance P10,000 U
(16)Sales quantity contribution margin variance:

Product A: (100,000 – 90,000) x 1/3 x P4 = P13,333 F
Product B: (100,000 – 90,000) x 2/3 x P10 = 66,667 F
Total sales quantity contribution margin variance P80,000 F
(17)Weighted average budget contribution margin per unit:

P8.00 (calculated in no. 13)
Market size contribution margin variance:
(2,000,000 – 1,500,000) x 90,000 / 1,500,000 x P8 = P240,000 F
(18)Market share contribution margin variance:

(100,000 / 2,000,000 – 90,000 / 1,500,000) x 2,000,000 x P8 =
P160,000 U
(19)Flexible budget contribution margin variance:

Flexible
Budget
Total Contribution margin Contribution
Actual Operating Flexible Budget Margin
Result Variance
Product A 35,000 x P3 = 35,000 x P4 = P 35,000 U
P105,000 P140,000
Product B 65,000 x P12 = 65,000 x P10 = P130,000 F
P780,000 P650,000
TOTAL P885,000 P790,000 P 95,000 F
(20)Total contribution margin price variance (given) P50,000 F

Sales price variance:
Product A: (P12 – P10) x 35,000 = P70,000 F
Product B: (P24 – P25) x 65,000 = P65,000 U
Total sales price variance – 5,000 F
Total variable cost price variance P45,000 F
(21)Total flexible budget contribution margin variance P95,000 F

Total contribution margin price variance (given) 50,000 F
Total variance cost efficiency variance P45,000 F
(22)Sales mix ratio:

Actual Budget
Quantity Ratio Quantity Ratio
R66 1,000 0.50 1,200 0.75
R100 1,000 0.50 400 0.25
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TOTAL 2,000 1.00 1,600 1.00
R66 sales quantity variance: (2,000 – 1,600) x 0.75 x P10 = P3,000 F
(23)R100 sales mix variance: (0.5 – 0.25) x 2,000 x P70 = P35,000 F
(24)Total sales volume variance:
R66: (1,000 – 1,200) x P10 = P 2,000 U

R100: (1,000 – 400) x P70 = 42,000 F
Total P40,000 F
CHAPTER 26
EXECUTIVE PERFORMANCE MEASURES

AND COMPENSATION
I. Questions
1. Incentive compensation is a monetary reward that is based on measured performance. Organizations where employees have
been given the responsibility to make decisions are best suited for incentive compensation systems.
2. The four guidelines are: fairness, participation, basic wage level, and independent wage policy.
Fairness deals with the ratio of salaries of the highest paid to lowest paid employees.
Participation states that all employees should be included in a compensation plan. Although, they do not need to be
included in the same one.
Basic wage level states that a market wage should be paid, and incentive compensation should not be used to adjust the
market wage downward.
Independent wage policy states that the incentive compensation system for the most senior levels of the organization should
be set by a group that is independent of senior management.
3. a. based on salary – easy to administer, likely to be considered fair, and, to the extent that salary reflects the relative ability
to contribute to results, is based on contribution;
based on equal share – easy to administer, likely to be considered fair, and reflects how people often divide up rewards
when left to their own devices;
based on position – same as based on salary;
based on individual performance – ties reward most closely to performance and likely to have the highest
motivational impact.
b. based on salary – may convince lower level employees that they have little to contribute, does not necessarily reflect
contributions;
based on equal share – may have little motivational effect, may lead to feeling of inequity if some people contribute
nothing;
based on position – same as based on salary;
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based on individual performance – may be difficult and costly to administer, may lead to arguments about interpreting
the performance measure.
4. A cash bonus is a cash reward tied to measured performance. A cash bonus is a bonus that is best related to activities
oriented to short-run performance that should be rewarded immediately to provide a reinforcement effect. Cash bonuses are
best tied to measures of achieved operating performance such as quality improvement, sales increases, and success at short-
run cost control.
Profit-sharing is a cash bonus incentive compensation plan where the total of all cash bonuses paid to all employees is
determined by a formula involving the organization’s, or an organization unit’s, reported profit. Profit-sharing is used to
focus organization members on team activities to improve the organization’s short-term performance.
Gain-sharing is a cash bonus incentive compensation plan where the total of all cash bonuses paid to all employees is
determined by a formula involving cost performance (on materials or labor that the group is deemed able to control) relative
to some standard. Gain sharing is best used when there is a visible and agreed performance standard and the employees can
work as a group to improve performance relative to that standard.
A stock option plan is a process where employees, deemed to be able to affect the value of an organization’s shares, are
given the option to purchase those shares at a specified price which is usually higher than the share price at the time the
option is issued. Stock options are best used to focus attention of senior people, who can affect the organization’s long-run
performance by their decisions, on long-run performance.
II. Problems
Problem 1
Requirement (a)
P20,000,000 – (0.18 x P60,000,000) = P9,200,000

P9,200,000 x 0.20 = P1,840,000
Therefore, P2,000,000 would be larger.
Requirement (b)
P50,000 / P12,000,000 x P2,000,000 = P8,333.33
Problem 2
Requirement (a)
P30,000,000 – (0.18 x P72,000,000) = P17,040,000

P17,040,000 x 0.25 = P4,260,000
Therefore, P4,260,000 would be larger.
Requirement (b)
P40,000 / P10,000,000 x P4,260,000 = P17,040
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26. C 21. C 35. C
27. A 22. B 36. D
28. D 23. D 37. B
29. C 24. B 38. D
30. B 25. A
31. D 26. D
32. D 27. C
33. A 28. B
34. D 29. B
35. B 30. B
CHAPTER 27
MANAGING ACCOUNTING IN
A CHANGING ENVIRONMENT
I. Questions
1. The American Heritage Dictionary defines quality as “1. a characteristic or attribute of something; property; a feature. 2.
the natural or essential character of something. 3. excellence; superiority.”
Quality for a product or service can be defined as a “product or service that conforms with a design which meets or exceeds
the expectations of customers at a price they are willing to pay.”
2. Procter & Gamble defines TQM as “the unyielding and continually improving effort by everyone in an organization to
understand, meet, and exceed the expectations of customers.” Typical characteristics of TQM include focusing on satisfying
customers, striving for continuous improvement, and involving the entire workforce.
TQM is a continual effort and never completes. Global competition, new technology, and ever-changing customer
expectations make TQM a continual effort for a successful firm.
3. The core principles of TQM include (1) focusing on satisfying the customer, (2) striving for continuous improvement, and
(3) involving the entire work force.
4. Continuous improvement (Kaizen) in total quality management is the belief that quality is not a destination; rather, it is a
way of life and firms need to continuously strive for better products with lower costs.
In today’s global competition, where firms are forever trying to outperform the competition and customers present ever-
changing expectations, a firm can never reach the ideal quality standard and needs to continuously improve quality and
reduce costs to remain competitive.
5. The Institute of Management Accountants (IMA) believes an effective implementation of total quality management will take
between three and five years and involves the following tasks:
Year 1
 Create a quality council and staff
 Conduct executive quality training programs
 Conduct quality audits
 Prepare gap analysis
 Develop strategic quality improvement plans
Year 2
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 Conduct employee communication and training programs
 Establish quality teams
 Create measurement systems and set goals
Year 3
 Revise compensation / appraisal / recognition systems
 Launch external initiatives with suppliers
 Review and revise
6. Reward and recognition are the best means of reinforcing the emphasis on TQM. Moreover, proper reward and recognition
structures can be very powerful stimuli to promote TQM. Efforts and progress will most likely be short-lived if no change is
made to the compensation / appraisal / recognition systems to make them in line with the objectives of the firm’s TQM.
7. The purposes of conducting a quality audit are to identify strengths and weaknesses in quality practices and levels of a
firm’s quality and to help the firm identify the target areas for quality improvements.
8. A gap analysis is a type of benchmarking that includes analyzing the differences in practices between the firm and the best-
in-class. The objective of gap analyses is to identify strengths, weaknesses, and target areas for quality improvement.
9. Some examples of costs associated with cost of quality categories are:
Prevention costs: Training costs such as instructors’ fees, purchase of training equipment, tuition for external training,
training wages and salaries; salaries for quality planning and executions, cost of preventive equipment, printing and
promotion costs for quality programs, awards for quality.
Appraisal costs: Costs of raw materials, work-in-process, and finished goods inspections.
Internal failure costs: Scrap, rework, loss due to downgrades, reinspection costs, and loss due to work interruptions.
External failure costs: Sales returns and allowance due to quality deficiency, warranty cost, and canceled sales orders due to
quality deficiency.
10. Prevention costs rise during the early years of implementing TQM as the firm engages in education to prepare its employees
and in the planning and promotion of the quality program. Appraisal costs will also likely rise during the early years of
TQM, because the firm needs to ensure that quality is actually being achieved. The increase in appraisal cost, however, is
most likely to occur at a slower pace than those of the prevention costs because at the beginning of a TQM program there
will be substantial increases in quality training and in promotion to raise awareness on the importance of quality.
The firm may see some decreases in internal and external failure costs in the early years of implementing a TQM.
However, these two costs most likely will remain at about the same level as before during the first several years of TQM.
Many firms may actually see internal failure cost rise, because of the higher standard demanded by the TQM or the higher
level of employees’ awareness on the critical importance of perfection in every step of the process. As the firm makes
progress in TQM, both internal failure and external failure costs should decrease.
11. Costs of conformance are costs incurred to ensure that products or services meet quality standards and include prevention
costs and appraisal costs.
Internal and external failure costs are costs of non-conformance. They are costs incurred or opportunity costs because of
rejection of products or services.
12. Better prevention of poor quality often reduces all other costs of quality. With fewer problems in quality, appraisal is needed
because the products are made right the first time. Fewer defective units also reduce internal and external failure costs as
the occasion for repairs, rework, and recalls decrease.
It is easier to design and build quality in than try to inspect or repair quality in. Theoretically, if prevention efforts are
completely successful, there will be no need to incur appraisal costs and there will be no internal failure or external failure
costs. In practice, appraisal costs usually do not decrease, partly because management needs to ensure that quality is there
as expected. Nonconformance costs, however, decrease at a much faster pace than prevention costs increase.
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13. The role of management accountants in total quality management includes gathering all relevant quality information,
participating actively in all phases of the quality program, and reviewing and disseminating quality cost reports.
14. To meet the challenges of total quality management, management accountants need to have a clear understanding of TQM
methodology. They must be able to design, create, or modify information systems that measure and monitor quality and
evaluate progress toward total quality as expected of each organizational unit and the total enterprise.
15. Just-in-time (JIT) purchasing is the purchase of goods or materials such that a delivery immediately precedes demand or
use. Benefits include lower inventory holdings (reduced warehouse space required and less money tied up in inventory) and
less risk of inventory obsolescence and spoilage.
16. The sequence of activities involved in placing a purchase order can be facilitated by use of the Internet. A company can
streamline the procurement process for its customers – e.g., having online a complete price list, information about expected
shipment dates, and a service order capability that is available 24 hours a day with email or fax confirmation.
17. Just-in-time (JIT) production is a “demand-pull” manufacturing system that has the following features:
 Organize production in manufacturing cells,
 Hire and retain workers who are multiskilled,
 Aggressively pursue total quality management (TQM) to eliminate defects,
 Place emphasis on reducing both setup time and manufacturing lead time, and
 Carefully select suppliers who are capable of delivering quality materials in a timely manner.
18. Reengineering is the fundamental rethinking and redesign of business processes to achieve improvements in critical
measures of performance such as cost, quality, service, speed, and customer satisfaction.
19. The three main measures used in the theory of constraints are:
a. Throughput contribution equal to sales revenue minus direct materials costs.
b. Investments (inventory) equal to the sum of materials costs of direct materials inventory, work-in-process inventory and
finished goods inventory, research and development costs, and costs of equipment and buildings.
c. Other operating costs equal to all operating costs (other than direct materials) incurred to earn throughput contribution.
20. The four key steps in managing bottleneck resources are:
Step 1: Recognize that the bottleneck operation determines throughput contribution.
Step 2: Search for, and find the bottleneck.
Step 3: Keep the bottleneck busy, and subordinate all nonbottleneck operations to the bottleneck operation.
Step 4: Increase bottleneck efficiency and capacity.
21. (a) Product warranty costs should be lower because a world-class manufacturer (WCM) will make fewer defectives.
(b) Salaries of quality control inspectors should be lower because a WCM will have its workers inspect as they go, rather
than having separate inspections. Nor will a WCM inspect incoming materials and components because it will deal
only with vendors whose quality has been demonstrated.
(c) Amounts paid to vendors for parts and components should be higher because a WCM will not search out the lowest
prices, but will seek high-quality components delivered when needed.
(d) Wages rates for direct laborers should be higher because a WCM’s workers will multiskilled and should therefore
command premium wages.
(e) Total supervisory salaries should be lower because a WCM’s workers will not need as much supervision.
(f) Warehousing costs should be lower because a WCM will produce as needed and so will not require storage space for
materials or finished product.
22. At the final assembly stage in a JIT system, a signal is sent to the preceding workstation as to the exact parts and materials
that will be needed over the next few hours for the final assembly of products. Only those parts and materials are provided.
The same signal is sent back through each preceding workstation so that a smooth flow of parts and materials is maintained
with no buildup of inventories at any point. Thus, all workstations respond to the “pull” exerted by the final assembly stage.
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The “pull” approach just described can be contrasted to the “push” approach used in conventional systems. In a
conventional system, inventories of parts and materials are built up—often simply to keep everyone busy. These semi-
completed parts and materials are “pushed” forward to the next workstation whether or not there is actually any customer
demand for the products they will become part of. The result is large stockpiles of work in process inventories.
23. A number of benefits accrue from reduced setup time. First, reduced setup time allows a company to produce in smaller
batches, which in turn reduces the level of inventories. Second, reduced setup time allows a company to spend more time
producing goods and less time getting ready to produce. Third, the ability to rapidly change from making one product to
making another allows the company to respond more quickly to customers. Finally, smaller batches make it easier to spot
manufacturing problems before they result in a large number of defective units.
II. Exercises
Exercise 1 (Quality Cost Classification)
Preventio Internal External

n Appraisal Failure Failure
a. Warranty repairs x
b. Scrap x
c. Allowance granted due
to blemish
x
d. Contribution margins
of lost sales
x
e. Tuition for quality
courses x
f. Raw materials
inspections x
g. Work-in-process
inspection x
h. Shipping cost for
replacements x
i. Recalls x
j. Attorney’s fee for
unsuccessful defense of
complaints about quality x
k. Inspection of reworks x
l. Overtime caused by
reworking x
m. Machine maintenance x
n. Tuning of testing
equipment x
Exercise 2 (Cost of Quality Report)
Requirements 1 & 2
Bali Company
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Cost of Quality Report
For 2005 and 2006
Cost of Quality 2006 2005

Category Peso % Peso %
Prevention costs:
Quality manual P 40,000 P 50,000
Product design 300,000 P 340,000 5.67 270,000 P320,000 5.33
Appraisal costs:
Testing P 80,000 80,000 1.33 P 60,000 60,000 1.00
Internal failure costs:
Rework P200,000 P250,000
Retesting 50,000 90,000
Disposal of defective units 90,000 340,000 5.67 85,000 425,000 7.08
External failure costs:
Product recalls P360,000 P500,000
Field service 230,000 590,000 9.83 350,000 850,000 14.17
Total cost of quality P1,350,000 22.50 P1,655,000 27.58
a. There were slight increases in both prevention and appraisal costs from 2005 to 2006. Each of these two cost of quality
increased by approximately 0.33 percent of the total sales. These two costs increased by P40,000 over the two years.
b. Both internal failure costs and external failure costs decreased substantially in 2006 as compared to those in 2005. The firm
experienced a 1.41 percent decrease in internal failure and a 4.34 percent decrease in external failure costs with the total
savings of P345,000. The savings was 863 percent of the increases in prevention and appraisal costs.
Requirement 3
Among nonfinancial measures the firm may want to monitor are:

 The number of defects or the processes yield (ratio of good output to total output)
 The percentage of defective units shipped to customers to total units of products shipped
 The number of customer complaints
 Difference between delivery date requested by the customer
 On-time delivery percentage (total units shipped on or before the scheduled date to the total units shipped)
 Surveys of customer satisfaction
It should be noted that nonfinancial measures by themselves often have limited meaning. Nonfinancial measures are more
informative when trends of the same measure over time are examined.
Exercise 3 (Cost of Quality Category)
Requirement 1
Prevention Appraisal Internal External
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Costs of Quality Failure Failure
Rework P 6,000
Recalls P15,000
Reengineering efforts P 9,000
Repair 12,000
Replacements 12,000
Retesting 5,000
Supervision P18,000
Scrap 9,000
Training 15,000
Testing of incoming
materials 7,000
Inspection of work in
process 18,000
Downtime 10,000
Product liability
insurance 9,000
Quality audits 5,000
Continuous
improvement 1,000
Warranty repairs 15,000
Requirement 2
Total spent by
category P25,000 P48,000 P42,000 P51,000
Requirement 3
The company is currently spending the least on preventive costs. They should concentrate their efforts on preventive costs
because they prevent poor quality products from being manufactured.
By increasing amount spent on prevention, they could reduce spending on the other cost of quality categories.
Exercise 4 (Cost of Quality Analysis, Nonfinancial Quality Measures)
Requirements 1 and 2
2006 2005
Revenues P12,500,000 P10,000,000
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Percentage Percentage
of Revenues of Revenues
Cost (2) = (1)  Cost (4) = (3) 
Costs of Quality (1) P12,500,000 (3) P10,000,000
Prevention costs
Design engineering P240,000 P100,000
Preventive
maintenance 90,000 35,000
Training 120,000 45,000
Supplier evaluation 50,000 20,000
Total prevention
costs 500,000 4.0% 200,000 2.0%
Appraisal costs
Line inspection 85,000 110,000
Product-testing
equipment 50,000 50,000
Incoming materials
inspection 40,000 20,000
Product-testing labor 75,000 220,000
Total appraisal costs 250,000 2.0% 400,000 4.0%
Internal failure costs

Scrap 200,000 250,000
Rework 135,000 160,000
Breakdown
maintenance 40,000 90,000
Total internal failure
costs 375,000 3.0% 500,000 5.0%
External failure costs

Returned goods 145,000 60,000
Customer support 30,000 40,000
Product liability claims 100,000 200,000
Warranty repair 200,000 300,000
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475,000 3.8% 600,000 6.0%
Total costs of quality P1,600,000 12.8% P1,700,000 17.0%
Between 2005 and 2006, Gabriel’s costs of quality have declined from 17% of sales to 12.8% of sales. The analysis of individual
costs of quality categories indicates that Gabriel began allocating more resources to prevention activities – design engineering,
preventive maintenance, training and supplier evaluations in 2006 relative to 2005. As a result, appraisal costs declined from
4% of sales to 2%, costs of internal failure fell from 5% of sales to 3%, and external failure costs decreased from 6% of sales to
3.8%. The one concern here is that, although external failure costs have decreased, the cost of returned goods has increased.
Gabriel’s management should investigate the reasons for this and initiate corrective action.
Requirement 3
Examples of nonfinancial quality measures that Gabriel Corporation could monitor are:
a. Number of defective grinders shipped to customers as a percentage of total units of grinders shipped.
b. Ratio of good output to total output at each production process.
c. Employee turnover.
Exercise 5 (Costs of Quality Analysis, Nonfinancial Quality Measures)
Requirements 1 and 2
Revenues, Costs of Quality and Costs of Quality as a

Percentage of Revenues for Victoria
Revenues = P2,000 x 10,000 units = P20,000,000
Percentage of
Revenues
Costs (2) = (1) 
Costs of Quality (1) P20,000,000
Prevention costs
Design engineering (P75 x
6,000 hours) P 450,000 2.25%
Appraisal costs
Testing and inspection (P40 x 1
hour x 10,000 units) 400,000 2.00%
Rework (P500 x 5% x 10,000
units) 250,000 1.25%
Repair (P600 x 4% x 10,000
units) 240,000 1.20%
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Total costs of quality P1,340,000 6.70%
Revenues, Costs of Quality and Costs of Quality as a

Percentage of Revenues for Vancouver
Revenues = P1,500 x 5,000 units = P7,500,000
Percentage of
Revenues
Costs (2) = (1) 
Costs of Quality (1) P7,500,000
Prevention costs
Design engineering (P75 x
1,000 hours) P 75,000 1.00%
Appraisal costs
Testing and inspection (P40 x
0.5 x 5,000 units) 100,000 1.33%
Rework (P400 x 10% x 5,000
units) 200,000 2.67%
Repair (P450 x 8% x 5,000
units) 180,000 2.40%
Estimated forgone contribution
margin on lost sales
[(P1,500 – P800) x 300] 210,000 2.80%
Total external failure costs 390,000 5.20%
Total costs of quality P765,000 10.20%
Costs of quality as a percentage of sales are significantly different for Vancouver (10.20%) compared with Victoria (6.70%).
Canada spends very little on prevention and appraisal activities for Vancouver, and incurs high costs of internal and external
failures. Canada follows a different strategy with respect to Victoria, spending a greater percentage of sales on prevention and
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appraisal activities. The result: fewer internal and external failure costs and lower overall costs of quality as a percentage of
sales compared with Vancouver.
Requirement 3
Examples of nonfinancial quality measures that Canada Industries could monitor as part of a total quality-control effort are:
a. Outgoing quality yield for each product

b. Returned refrigerator percentage for each product
c. On-time delivery
d. Employee turnover
III. Problems
Problem 1 (Quality Improvement, Relevant Cost Analysis)
Requirement 1
Cost of new equipment and installation P12,000,000

Training 3,000,000
Total additional cost of the new process P15,000,000
Requirement 2
Quality cost if no change is made:
Rework 3,000 x 40% x P2,000 = P 2,400,000

Repair 3,000 x 15% x P2,500 = 1,125,000
Appraisal 600,000
Inspection 3,000 x P50 = 150,000
Lost contribution:
Contribution margin per unit P12,000 x 85% - P2,500 = P7,700
Lost sales 3,000  0.8 – 3,000 = x 750 5,775,000
Total current cost of quality P10,050,000
Quality cost with the new process:
Warranty repair 3,000  0.8 x 5% x P1,000 = – 187,500
Savings from the new process each year P 9,862,500
Years effective x 3
Total P29,587,500
Appraisal and inspection cost in Year 1 – 750,000
Total savings over 3 years P28,837,500
Requirement 3
Yes. The cost of the new process is P15,000,000 and the expected benefits is P28,837,500 over three years. The firm can expect
to earn a return of over 90%.
Requirement 4
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The following factors should be considered before making the final decision:
a. Accuracy of cost estimates including

 Contribution margin per unit
 Costs of current repair and rework
 Cost of repair with the new process
 Cost of the new process
b. Reliability of estimations of
 Rates of rework and repair
 Lost sales
 Amount of time before the current product become obsolete
c. Reaction of competitors
Requirement 5
The member of the board would be right if we ignore the financial payoff of the new process and if the firm is going to be in
business for only three years. Having high quality products, especially for a high-end product such as the one the firm is selling,
is crucial for a long term success.
Problem 2 (Preparing a Cost of Quality Report)
The Adoracion Company

Comparative Costs of Quality Report
Increase
Costs Categories 2005 2006 (Decrease)
Prevention costs:
Training P 75,000 P 100,000 P 25,000
Product design 150,000 175,000 25,000
Total prevention 225,000 275,000 50,000
Appraisal costs:
Testing 50,000 150,000 100,000
Calibration 75,000 100,000 25,000
Total appraisal 125,000 250,000 125,000
Internal failure costs:

Rework 325,000 100,000 (225,000)
Retesting 250,000 200,000 (50,000)
Total internal failure 575,000 300,000 (275,000)
External failure costs:

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Warranty repairs 150,000 75,000 (75,000)
Product recalls 400,000 200,000 (200,000)
Product liability 125,000 75,000 (50,000)
Total external failure 675,000 350,000 (325,000)
Total costs of quality P1,600,000 P1,175,000 P (425,000)
Problem 3 (JIT Production, Relevant Benefits, Relevant Costs)
Requirement 1
Incremental Costs Incremental Costs

under Current under JIT
Production Production
Relevant Items System System
Annual tooling costs – P150,000
Required return on investment
12% per year x P900,000 of average
inventory per year P108,000
12% per year x P200,000 of average
inventory per year 24,000
Insurance, space, materials handling,
and setup costs 200,000 140,000a
Rework costs 350,000 280,000b
Incremental revenues from higher
selling prices – (90,000)c
Total net incremental costs P658,000 P504,000
Annual difference in favor of JIT
production P154,000
a
P200,000 (1 – 0.30) = P140,000
b
P350,000 (1 – 0.20) = P280,000
c
P3 x 30,000 units = P90,000
Requirement 2
Other nonfinancial and qualitative factors that Francisco should consider in deciding whether it should implement a JIT system
include:
a. The possibility of developing and implementing a detailed system for integrating the sequential operations of the
manufacturing process. Direct materials must arrive when needed for each subassembly so that the production process
functions smoothly.
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b. The ability to design products that use standardized parts and reduce manufacturing time.
c. The ease of obtaining reliable vendors who can deliver quality direct materials on time with minimum lead time.
d. Willingness of suppliers to deliver smaller and more frequent orders.
e. The confidence of being able to deliver quality products on time. Failure to do so would result in customer
dissatisfaction.
f. The skill levels of workers to perform multiple tasks such as minor repairs, maintenance, quality testing and inspection.
Problem 4 (JIT Purchasing, Relevant Benefits, Relevant Costs)
Requirement 1
Incremental Costs
under Current Incremental Costs
Purchasing under JIT
System Purchasing Policy
Required return on investment
20% per year x P600,000 of
average inventory per year P120,000
20% per year x P0 of inventory per
year P 0
Annual insurance costs 14,000 0
Warehouse rent 60,000 (13,500)a
Overtime costs
No overtime 0
Overtime premium 40,000
Stockout costs
No stockouts 0
P6.50b contribution margin per unit
x 20,000 units 130,000
Total incremental costs P194,000 P156,500
Difference in favor of JIT purchasing
P37,500
a
P(13,500) = Warehouse rental revenues, [(75% x 12,000) x P1.50].
b
Calculation of unit contribution margin
Selling price (P10,800,000  900,000 units) P12.00
Variable costs per unit:
Variable manufacturing costs per unit
(P4,050,000  900,000 units) P4.50
Variable marketing and distribution
costs per unit
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(P900,000  900,000 units) 1.00
Total variable costs per unit 5.50
Contribution margin per unit P6.50
Note that the incremental costs of P40,000 for overtime premiums to make the additional 15,000 units are less than the
contribution margin from losing these sales equal to P97,500 (P6.50 x 15,000). Josefina would rather incur overtime than lose
15,000 units of sales.
Problem 5 (Theory of Constraints, Throughput Contribution, Relevant Costs)
Requirement 1
Finishing is a bottleneck operation. Hence, producing 1,000 more units will generate additional throughput contribution and
operating income.
Increase in throughput contribution (P72 – P32) x 1,000 P40,000

Incremental costs of the jigs and tools 30,000
Net benefit of investing in jigs and tools P10,000
Zashi should invest in the modern jigs and tools because the benefit of higher throughput contribution of P40,000 exceeds the
cost of P30,000.
Requirement 2
The Machining Department has excess capacity and is not a bottleneck operation. Increasing its capacity further will not
increase throughput contribution. There is, therefore, no benefit from spending P5,000 to increase the Machining Department’s
capacity by 10,000 units. Zashi should not implement the change to do setups faster.
Problem 6 (Theory of Constraints, Throughput Contribution, Relevant Costs)
Requirement 1
Finishing is a bottleneck operation. Hence, getting an outside contractor to produce 12,000 units will increase throughput
contribution.
Increase in throughput contribution (P72 – P32) x 12,000 P480,000

Incremental contracting costs P10 x 12,000 120,000
Net benefit of contracting 12,000 units of finishing P360,000
Zashi should contract with an outside contractor to do 12,000 units of finishing at P10 per unit because the benefit of higher
throughput contribution of P480,000 exceeds the cost of P120,000. The fact that the costs of P10 are double Zashi’s finishing
cost of P5 per unit are irrelevant.
Requirement 2
Operating costs in the Machining Department of P640,00, or P8 per unit, are fixed costs. Zashi will not save any of these costs
by subcontracting machining of 4,000 units to Rainee Corporation. Total costs will be greater by P16,000 (P4 per unit x 4,000
units) under the subcontracting alternative. Machining more filing cabinets will not increase throughput contribution, which is
constrained by the finishing capacity. Zashi should not accept Rainee’s offer. The fact that Rainee’s costs of machining per unit
are half of what it costs Zashi in-house is irrelevant.
Problem 7 (Theory of Constraints, Throughput Contribution, Quality)

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Requirement 1
Cost of defective unit at machining operation which is not a bottleneck operation is the loss in direct materials (variable costs) of
P32 per unit. Producing 2,000 units of defectives does not result in loss of throughput contribution. Despite the defective
production, machining can produce and transfer 80,000 units to finishing. Therefore, cost of 2,000 defective units at the
machining operation is P32 x 2,000 = P64,000.
Requirement 2
A defective unit produced at the bottleneck finishing operation costs Zashi materials costs plus the opportunity cost of lost
throughput contribution. Bottleneck capacity not wasted in producing defective units could be used to generate additional sales
and throughput contribution. Cost of 2,000 defective units at the finishing operation is:
Lost of direct materials P32 x 2,000 P 64,000

Forgone throughput contribution (P72 – P32) x 2,000 80,000
Total cost of 2,000 defective units P144,000
Alternatively, the cost of 2,000 defective units at the finishing operation can be calculated as the lost revenue of P72 x 2,000 =
P144,000. This line of reasoning takes the position that direct materials costs of P32 x 2,000 = P64,000 and all fixed operating
costs in the machining and finishing operations would be incurred anyway whether a defective or good unit is produced. The
cost of producing a defective unit is the revenue lost of P144,000.
Problem 8
Requirement (a)
The following table reclassified the cost-of-quality expenses:
Anthony Foods
Quality Costs
2005-2006
(Millions)
2005 2006
Q1 Q2 Q3 Q4 Q1 Q4 Q2 Q3
Quality
assurance P 6.20 P 6.52 P 6.86 P P P P P10.53
administratio 7.19 7.93 8.74 9.61
n
Training 13.10 14.39 15.90 17.46 21.12 25.50 30.37 36.35
Process
engineering 2.2 2.4 2.7 3.1 3.8 4.8 6.1 7.5
0 6 6 1 7 6 3 8
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Prevention 21.5 23.3 25.5 27.7 32.9 39.1 46.1 54.4
0 7 2 6 2 0 1 6
Inspection 1.40 1.56 1.75 1.95 2.39 2.96 3.63 4.46
Testing 1.6 1.7 1.8 1.9 2.2 2.6 3.0 3.4
0 2 5 9 9 2 1 5
Appraisal 3.0 3.2 3.6 3.9 4.6 5.5 6.6 7.9
0 8 0 4 8 8 4 1
Rework 15.80 12.65 10.03 8.49 7.25 6.16 5.56 5.00
Scrap 17.6 14.4 11.9 10.3 8.9 7.7 7.0 6.3
0 8 2 2 2 2 0 4
Internal failure 33.4 27.1 21.9 18.8 16.1 13.8 12.5 11.3
0 3 5 1 7 8 6 4
Returns 26.90 21.09 16.35 13.53 11.32 9.50 8.43 7.52
Customer
complaint 3.90 3.45 3.03 2.76 2.50 2.27 2.14 2.01
dept.
Lost sales 49.2 40.3 33.1 28.4 24.4 21.0 19.2 17.4
0 1 1 2 5 8 0 4
External failure 80.0 64.8 52.4 44.7 38.2 32.8 29.7 26.9
0 5 9 1 7 5 7 7
Total costs P137.9 P118.63 P103.5 P95.22 P92.04 P91.41 P95.08 P100.6
0 6 8
Requirement (b)
From the preceding data we see that prevention and appraisal costs are increasing while internal and external failure costs have
been decreasing. The following graph plots three series: prevention and appraisal costs, failure costs, and total quality costs.
140
120
100
80
60
40
20
0
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
2005 Quarters 2006
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Appraisal and prevention costs

Failure costs
Total quality costs
A preliminary conclusion from the graph is that Anthony Foods is probably now spending too much on trying to improve
quality. Assuming that the underlying production processes have not changed over time, quality costs were minimized in the
second quarter of 2006. Since then, the additional money spent on appraisal and prevention has yielded smaller internal- and
external-failure costs savings.
Problem 9 (Applying TQM in Manufacturing versus Administration)
The ability of TQM to deliver cost savings and performance enhancements depends directly on how easy it is to measure and
observe the output of the process. If a TQM team’s output is easy to measure, it is easier to hold the team members responsible
for improving quality. If quality improvements are difficult to observe, then holding team members responsible imposes more
risk on them. It is easier for them to argue that they didn’t achieve their goals because they were hard to observe. If the benefits
from TQM are lower because it is more difficult to observe the TQM output, less will be invested in such activities.
Measuring quality improvements in a manufactured process tends to be easier than a service. Engineering standards can be set
for a manufactured good and conformance to the standards can be relatively easy to measure. But the output of many
administrative departments is multidimensional and often hard to observe. Manufacturing involves repetitive processes with
few exceptions. Administrative functions often involve handling numerous exceptions. It is likely to be easier to observe quality
improvements in a television set than it is in a human resources department or a legal department.
31. C 26. C
32. B 27. A
33. C 28. C
34. D 29. B
35. D 30. C
36. A 31. D
37. C 32. D
38. C 33. D
39. D 34. A
40. D 35. A
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MANAGEMENT ACCOUNTING - Solutions Manual

Chapter 1 1-1 – 1-19

2 Management Accounting and the Business Environment 2-1 – 2-5

4 Financial Statements Analysis – I 4-1 – 4-9

2 Capital Budgeting Decisions 20-1– 20-16

MANAGEMENT ACCOUNTING: AN OVERVIEW

1. Use of the word “need” in the quoted passage is pejorative. It implies an

2. a. Historical costs are of limited use in making planning decisions in a

6. Line authority is exerted downward over subordinates. Staff authority is the

7. Cost accounting is the controller’s primary means of implementing the 7-point

VP, VP, Finance VP, Sales

Special Cost Tax Internal General System

Cost Budget & Performa

Cost Payroll Account Accoun Billing General

9. Management accountants contribute to strategic decisions by providing

10. In most organizations, management accountants perform multiple roles:

12. Management accounting is an integral part of the controller’s function in an

13. Management accountants have ethical responsibilities that are related to

Scope: Disaggregate; inform local decisions and actions

16. The competitive environment has changed dramatically. Companies

17. As measurements are made on operations and, especially, on individuals and

a. (1) Problem solving

Problem 1 (Problem Solving, Scorekeeping, and Attention Directing)

Problem 2 (Management Accounting Information System)

Problem 3 (Role of Management Accountants)

Planning. The management accountant gains an understanding of the impact on

Controlling. The management accountant ensures the integrity of financial

Evaluating Performance. The management accountant judges and analyzes the

Ensuring Accountability of Resources. The management accountant implements a

External Reporting. The management accountant prepares reports in accordance

Problem 4 (Line Versus Staff)

Stephen Santos is a line manager. He has direct responsibility for producing a

Problem 5 (Professional Ethics and End-of-Year Games)

The “Standards of Ethical Conduct…” require management accountants to:

Case 1 (Financial vs. Managerial Accounting)

1. Disclosure of the components of financial performance, i.e., nature and

Case 2 (You get what you measure!)

In all of the above situations, customer patronage could eventually be adversely

Case 3 (The Roles of Managers and Management Accountants)

1. Managerial accounting, Financial accounting

Case 4 (Ethics in Business)

If cashiers routinely short-changed customers whenever the opportunity presented

Case 5 (Ethics and the Manager)

Case 6 (Preparing an Organization Chart)

Case 7 (Ethics in Business)

corporate officers…cannot escape culpability by asserting that they acted as ‘good

Manager, Manager, Manager,

(Departments) (Departments) (Departments) (Departments)

Case 8 (Ethics in Business)

Communication of confidential information to anyone outside the company is

to resign from the organization and submit an informative memorandum to an

V. Multiple Choice Questions

1. D 11. D 21. B 31. D 41. A 51. B

1. Managerial accounting information often brings to the attention of managers

3. Managers rely on many information systems in addition to managerial-

4. Becoming the low-cost producer in an industry requires a clear understanding

5. Some activities in the value chain of a manufacturer of cotton shirts are as

6. Strategic cost management is the process of understanding and managing, to

8. A value chain is a sequence of business functions whose objective is to provide

An organization can become more effective by focusing on whether each link in

9. Cost: Organizations are under continuous pressure to reduce the cost of

15. Customer satisfaction is often thought to be a qualitative measure of

17. Competitive benchmarking is an organization’s search for, and implementation