SOLUTIONS MANUAL FOR Introduction to Management Accounting 17th Edition. (Global Edition) by welldoneassistant

Introduction to Management Accounting 17e (Global Edition) By Horngren Sundem Stratton Burgstahler Schatzberg (Solutions Manual All Chapters, 100% Original Verified, A+ Grade) CHAPTER 1 COVERAGE OF LEARNING OBJECTIVES

LEARNING OBJECTIVE LO1: Explain why accounting is essential for decision makers and managers. LO2: Describe the major users and uses of accounting information. LO3: Explain the role of budgets and performance reports in planning and control. LO4: Describe the costbenefit and behavioral issues involved in designing an accounting system. LO5: Discuss the role accountants play in the company’s value chain functions. LO6: Identify current trends in management accounting. LO7: Explain why ethics and standards of ethical conduct are important to accountants.

FUNDAMENTAL ASSIGNMENT MATERIAL B3

ADDITIONAL ASSIGNMENT MATERIAL 30, 30, 31, 31, 39

A1, B1, B3

28, 29, 33, 39, 39, 40, 40, 42, 42 5, 5, 6, 6, 32, 32, 45, 45

A2, B2, B3

CASES, EXCEL, COLLAB., & INTERNET EXERCISES 52, 55

55 53

41, 43

A1, B1, B3

B3 A3, B3

17, 30, 30, 31, 31, 34, 34, 35, 36, 39, 42, 42, 44, 45, 46, 46 24 37, 38, 38, 47, 48, 48, 49

54 51, 52, 55

CHAPTER 1 Managerial Accounting, the Business Organization, and Professional Ethics 1-A1 (10-15 min.) Information is often useful for more than one function, so the following classifications for each activity are not definitive but serve as a starting point for discussion: 1. Scorekeeping. A depreciation schedule is used in preparing financial statements to report the results of activities. 2. Problem solving. Helps a manager assess the impact of a purchase decision. 3. Scorekeeping. Reports on the results of an operation. Could also be attention directing if scrap is an area that might require management attention. 4. Attention directing. Focuses attention on areas that need attention. 5. Attention directing. Helps managers learn about the information contained in a performance report. 6. Scorekeeping. The statement reports what has happened. Could also be attention directing if the report highlights a problem or issue. 7. Problem solving. Assuming the cost comparison is to help the manager decide between two alternatives, this is problem solving. 8. Attention directing. Variances point out areas where results differ from expectations. Interpreting them directs attention to possible causes of the differences. 9. Problem solving. Aids a decision about where to make parts. 10. Attention directing and problem solving. Budgeting involves making decisions about planned activities -- hence, aiding problem solving. Budgets also direct attention to areas of opportunity or concern -- hence, directing attention. Reporting against the budget also has a scorekeeping dimension.

1-A2 (15-20 min.) 1. Room rental Food Entertainment Decorations Total 2.

Budgeted Amounts $ 170 660 570 210 $1,610

Actual Amounts $ 170 875 570 270 $1,885

Deviations or Variances $ 0 215U 0 60U $275U

Because of the management by exception rule, room rental and entertainment require no explanation. The actual expenditure for food exceeded the budget by $215. Of this $215, $132 is explained by attendance of 16 persons more than budgeted (the budget of $660/80 = $8.25 per person for food and 16 x $8.25 = $132) and the remaining $83 ($215 – $132) is explained by expenditures above $8.25 per person. Actual expenditures for decorations were $60 more than the budget. The decorations committee should be asked for an explanation of the excess expenditures.

1-A3 (10 min.) All of the situations raise possibilities for violation of the integrity standard. In addition, the manager in each situation must address an additional ethical standard: 1. 2.

The General Mills manager must respect the confidentiality standard. He or she should not disclose any information about the new cereal. Felix must address his level of competence for the assignment. If his supervisor knows his level of expertise and wants an analysis from a “layperson” point of view, he should do it. However, if the supervisor expects an expert analysis, Felix must disclose his lack of competence. The credibility standard should cause Mary Sue to decline to omit the information from the budget. It is relevant information, and its omission may mislead readers of the budget.

1-B1

(15-20 min.)

Information is often useful for more than one function, so the following classifications for each activity are not definitive but serve as a starting point for discussion: 1. Problem solving. Provides information for deciding between two alternative courses of action. 2. Scorekeeping. Recording what has happened. If amounts are compared with expectations, this could also serve an attention-directing function. 3. Problem solving. Helps a manager decide among alternatives. 4. Attention directing. Directs attention to the use of overtime labor. Also scorekeeping. 5. Problem solving. Provides information to managers for deciding whether to move corporate headquarters. 6. Attention directing. Directs attention to why nursing costs increased. 7. Attention directing. Directs attention to areas where actual results differed from the budget. 8. Problem solving. Helps the vice-president decide which course of action is best. 9. Problem solving. Produces information to help the marketing department make a decision about a marketing campaign. 10. Scorekeeping. Records actual overtime costs. If results are compared with expectations, also attention directing. 11. Attention directing. Directs attention to stores with either high or low ratios of advertising expenses to sales. 12. Attention directing. Directs attention to causes of returns of the drug. 13. Attention directing or problem solving, depending on the use of the schedule. If it is to identify areas of high fuel usage it is attention directing. If it is to plan for purchases of fuel, it is problem solving. 14. Scorekeeping. Records items needed for financial statements.

1-B2

(10-15 min.)

1 & 2. Sales Costs: Fireworks Labor Other Total cost Profit

Budget $80,000

Actual $79,440

Variance $ 560U

$40,000 10,000 7,000 57,000 $23,000

$39,400 13,100 6,900 59,400 $20,040

$600F 3,100U 100F 2,400U $2,960U

The cost of fireworks was $600 ÷ $40,000 = 1.5% under budget while sales were just $560 ÷ $80,000 = .7% under budget. Did fireworks suppliers lower their prices? Were selling prices set higher than expected? There should be some explanation for the lower cost of fireworks. The labor cost was $3,100 ÷ $10,000 =31% over budget. Sales and other costs were close to budget in percentage terms. Why was labor cost so much higher than expected?

1-B3

(15 - 20 min.)

A code of conduct is a document specifying the ethical standards of an organization .

Different companies include different elements in their codes of conduct. Some of the items included in companies’ codes of conduct include maintaining a dress code, avoiding illegal drugs, following instructions of superiors, being reliable and prompt, maintaining confidentiality, not accepting personal gifts from stakeholders as a result of company role, avoiding racial or sexual discrimination, avoiding conflict of interest, complying with laws and regulations, not using organization’s property for personal use, and reporting illegal or questionable activity. Some companies have a simple code with little detail, and others have long lists of rules and regulations regarding appropriate conduct. The key is that the code of conduct must fit with the corporate culture.

Simply having a code of conduct does not guarantee ethical behavior by employees. Most important is top management’s ethical example and its support of the code of conduct. A company’s performance evaluation and reward system must be consistent with its code of conduct. If unethical actions are rewarded, they will be encouraged even if they violate the code of conduct.

1-1 a. b.

Internal managers and external parties use accounting information: Internal reporting is used by managers for planning and controlling operations, special decision-making, and long-range planning. External reporting is used by stockholders, investors, taxing authorities, government regulators, and other interested parties.

1-2 The emphasis of financial accounting has traditionally been on the historical data presented in the external reports. Management accounting is more future-oriented and emphasizes planning, control, and decision-making. 1-3

The branch of accounting described in the quotation is management accounting.

1-4 Scorekeeping is the recording (including accumulation and classification) of data for a later evaluation of performance. Attention directing is the reporting and interpretation of information for the purpose of focusing on inefficiencies of operation, opportunities for improvement, and imperfections and operating problems. Problem solving is analysis of alternative courses of action to evaluate the best course of action. 1-5

The three categories are: a. The financial reports prepared by public companies for external users must adhere to a set of standards known as generally accepted accounting principles (GAAP). b. Every company is subject to various reporting requirements as specified by the tax rules and regulations of the host country. c. Many companies are subject to various other government regulations relating to corporate governance (e.g. Sarbanes-Oxley Act in the United States), prevention of fraud, etc.

1-6 Internal auditors review and evaluate a company’s accounting system as well as the adequacy of the internal accounting control system. They also conduct the management audit, which is a review to determine whether the policies and procedures specified by the top management are actually implemented or not. 1-7 Many managers believe that the costs of applying the provisions of the SarbanesOxley act are greater then the benefits. This is especially true about the mandated auditing of companies’ internal control systems. 1-8 Users cannot easily observe the quality of accounting information. Thus, they rely on the integrity of accountants to be sure the information is accurate. If accountants do not have a reputation for integrity, the information they produce will not have value to users. 1-9 No. The ethics developed as a student carry over into one’s professional life. Integrity is important at all stages of development. Students who use unethical means to achieve success are likely to try similar methods when in business. ..

1-10 Public accounting firms, law firms, management consultants, real estate firms, transportation companies, banks, insurance companies, and hotels are examples of service organizations. Service organizations tend to be labor intensive, have outputs that are difficult to define and measure, and have both inputs and outputs that are difficult or impossible to store. 1-11 Two considerations are cost-benefit balance and behavioral effects. Cost-benefit balance refers to how well an accounting system helps achieve management's goals in relation to the cost of the system. The behavioral-effects consideration specifies that an accounting system should be judged by how it will affect the behavior (that is, decisions) of managers. 1-12 Yes. Measurement and recording is an integral part of management. For example, cash receipts and disbursements must be traced, and receivables and payables must be recorded in order to manage operating activities such as sales and purchases. 1-13 A budget is a quantitative expression of a plan of action; a performance report compares actual results with the budget; and a variance measures the differences between budget and actual. 1-14 No. Management by exception means that management directs more attention to those areas that seem to be out of control and less to areas that are functioning as planned. This method is an efficient way for managers to decide where to put their time and effort. 1-15 Information that is relevant for decisions about a product depends on the product's life-cycle stage. Therefore, to prepare and interpret information, accountants should be aware of the current stage of a product's life cycle. 1-16 The six functions are: (1) research and development – generation and experimentation with new ideas for products, services, or processes; (2) product, service, and process design – detailed design and engineering of products, services, or processes; (3) production – use of resources to produce a product or service; (4) marketing informing customers of the value and features of products or services; (5) distribution – delivering products or services to customers; and (6) customer service – support provided to customers after a sale. 1-17 Accountants play a vital role in a company’s post production value chain functions. They perform the cost-benefit analysis of a proposed marketing program and help managers in choosing a distribution channel, such as selling directly through own retail chain or through wholesalers and retailers. They also assist the managers in selecting the most economical mode of transportation by providing the cost data of the available choices. Accountants also provide relevant cost data associated with customer warranty, cost of repair, and cost of goods returned, thereby helping the managers to

compare the same against the benefits generated by customer services to evaluate the effectiveness of such service programs. 1-18 Line managers are directly responsible for the production and sale of goods or services. Staff managers have an advisory function – they support line managers. 1-19 Management accountants are the information specialists. In non-hierarchical companies, they are more directly involved with managers and are often parts of crossfunctional teams. 1- 20 A treasurer is concerned mainly with the company's financial matters, the controller with operating matters. In large organizations, there are sufficient activities associated with both financial and operating matters to justify two separate positions. In a small organization the same person might be both treasurer and controller. 1-21 The two parts of the CMA examination are: (1) financial planning, performance, and control, and (2) financial decision making. 1-22 This is not true. About one-third of CEOs in companies with revenues greater than $500 million come from finance or accounting backgrounds. Accounting is excellent preparation for top management positions because accountants are often exposed to many parts of the company early in their careers. 1-23 Changes in technology are affecting how accountants operate. Increasing computing capabilities and decreasing computing costs have changed how accountants gather, store, manipulate, and report data. Today accountants must be able to account for transactions efficiently and safely, integrate their accounting systems into ERP systems, and use XBRL to communicate information electronically. 1-24 Lean manufacturing is a management approach focused on efficiency. Lean manufacturing applies continuous process improvements to eliminate waste from an enterprise. For example, some companies can significantly reduce the production time by replacing conveyor belts with clusters of robots. Successful lean manufacturing can make the manufacturing process significantly more effective and subsequently enhance the company’s profitability. 1-25 Moving tools and products that are in process from one location to another in a plant is an activity that does not add value to the product. So changing the plant layout to eliminate wasted movement and time improves production efficiency. 1-26 The four major responsibilities are: (1) competence - develop knowledge; know and obey laws, regulations, and technical standards; and perform appropriate analyses, (2) confidentiality - refrain from disclosing or using confidential information, (3) integrity avoid conflicts of interest, refuse gifts that might influence actions, recognize limitations,

and avoid activities that might discredit the profession, and (4) credibility - communicate information fairly, objectively, and completely, within confidentiality constraints. 1-27 Standards do not always provide the needed guidance. Sometimes an action borders on being unethical, but it is not clearly a violation of an ethical standard. Other times two ethical standards conflict. In situations such as these, accountants must make ethical judgments. 1-28

(5-10 min.)

Typical activities associated with the treasurer function include:  Provision of capital  Investor relations  Short-term financing  Banking and custody  Credit management and collections of cash  Investments  Risk management Typical activities associated with the controller function include:  Planning for control  Reporting and interpreting  Evaluating and consulting  Tax administration  Government reporting  Protection of assets  Economic appraisal 1-29

(10 - 15 min.)

Controller. Financial statements are generally produced by the controller's department. Controller. Advising managers aids operating decisions. Controller. Advice on cost analysis aids managers' operating decisions. Treasurer. Analysts affect the company's ability to raise capital, which is the responsibility of the treasurer. Treasurer. Financing the business is the responsibility of the treasurer. Controller. Tax returns are part of the accounting process overseen by the controller. Treasurer. Insurance, as with other risk management activities, is usually the responsibility of the treasurer. Treasurer. Allowing credit is a financial decision.

2. 3. 4. 5. 6. 7. 8.

1-30 (5-10 min.) Activities 2, 3, 5, and possibly 6, are primarily associated with marketing decisions. The management accountant would assist in these decisions as follows: Blue Star’s pricing decision requires the cost data relevant to the new method of distributing spare parts. Walmart needs to calculate the cost of the advertising program as well as the additional costs of other value chain functions resulting from increased sales. McDonald’s must determine the incremental cost and revenue associated with the customization order. Symphony needs to study the impact of closing one of its stores on both its revenues and costs. 1-31 (5-10 min.) Activities 1, 7, and 8 are primarily associated with production decisions. The management accountant would assist in these decisions as follows: Hyundai Motors needs an analysis of the costs associated with purchasing said part compared to the costs of producing the part in-house. ASUS must draw up the cost of the training program and project the savings resulting from increased efficiency in the setup and changeover activities. Octopus Energy needs to know the costs and salvage values of the replacement equipment, the proceeds of the sale of the old equipment, and the operating savings associated with the use of the new equipment. 1-32

(5 min.) 1. Financial 2. Management 3. Management

4. Management 5. Financial 6. Management

7. Management

1-33

(10 min.)

1. Performance Report Revenues Advertising cost Net

Budget $356,400

Actual $351,400

Variance $5,000 U

33,000

35,640

2,640 U

Explanation Additional sales below budget* New advertising campaign

$7,640 U

* From the New Products Report, seven new products were added which exceeded the plan to add six. However, the increase in sales was $5,000 less than budgeted 2. Factors that may not have been considered include: a. Raw material costs for new products may have been higher than budgeted. b. Customer satisfaction with new products may have been low, resulting in unanticipated costs of replacement products given to dissatisfied customers. c. External uncontrollable factors such as increases in operating costs, adverse weather, changes in the overall economy, new competitors entering the market, or key employee turnover may have decreased efficiency. 1-34

(5 min.)

1. Line, support 2. Line, marketing

3. Line, Product Design 4. Staff, support

5. Staff, support 6. Line, production

1-35

(30 min.)

Microsoft is a company that most students will know and have some understanding of what functions its managers perform. Nevertheless, this may not be an easy exercise for those who have little knowledge of how companies operate. Research & development – Because software companies must continually come out with new products and upgrades to their current products, this is a critical function for Microsoft. More than one-fourth of Microsoft’s operating expenses are devoted to R&D. Product and process design – For Microsoft the design and R&D process overlap considerably. Product design is critical; process design is probably less critical. One essential part of design is beta testing – that is, field testing of new software. This quality-control step is essential to prevent customer dissatisfaction with new products. Production – Microsoft produces disks and CD-ROMs and the manuals and packaging to go with them. However, software is increasingly delivered and updated over the Internet, which takes an initial process design and then few resources. Thus, production of physical items is becoming a less important focus for Microsoft. Marketing – Microsoft spends more on sales and marketing than on any other operating expense. Increasing competition in software sales makes marketing essential to the company’s future. This function includes advertising and direct marketing activities, but it also includes activities of the company’s sales force. Distribution – This function is becoming simpler for Microsoft as it delivers more and more software over the Internet. As long as the company does not fall behind competitors in delivery methods, this is not likely to create a major competitive advantage or disadvantage for Microsoft. Customer service – Customer service is important, but Microsoft tries to minimize costs in this area by good product design – making things work right for customers without deep computer expertise. Poor customer service can severely impact a company, so Microsoft must attend to it. Support functions – Most of the time these are not a major focus. One major exception for Microsoft is legal support – the future of the company depended on some recent court decisions.

1-36

(15-20 min.)

The management accountant's major purpose is to provide information that helps line managers plan and control operations and make decisions. The accountant supplies information for scorekeeping, attention directing, and problem solving. In turn, managers use this and other information for routine and non-routine decisions and for evaluating subordinates and the performance of sub-parts of the organization. Management accountants must walk a delicate line between (1) making sure that managers use information properly and (2) making sure that the managers, not the accountants, are doing the actual managing. Management accountants are increasingly a part of management teams that make important decisions. 1-37

(5 min.)

Costs of a poor ethical environment include legal costs and costs due to absenteeism and high employee turnover. Benefits of a good ethical environment include improved morale, lower absenteeism and employee turnover, lower loss from internal theft, and improved customer satisfaction resulting from better quality and service (that result from a more productive work environment). 1-38

(5 min.)

There are numerous examples. “You understand how important it is to record this sale before year end, don’t you?” “Doing it this way is common for all companies in our business, so don’t worry!” “Trust me, the inventory is at the warehouse.” “I don’t know how you will do it. Just get it done.” “Don’t worry. It won’t be disclosed to anyone else.” “You must do something. We can’t afford to lose this opportunity.”

1-39

(15-20 min.)

This problem can form the basis of an introductory discussion on the entire field of management accounting. Text Exhibit 1-1 provides more details. 1.

The focus of management accounting is on helping internal users make better decisions, whereas the focus of financial accounting is on helping external users make better decisions. Management accounting helps in making a host of decisions, including pricing, product choices, investments in equipment, making or buying goods and services, and manager rewards.

Generally accepted accounting principles constrain financial accounting but not management accounting. For example, if an organization wants to account for assets on the basis of replacement costs for internal purposes, no outside agency can prohibit such accounting. Of course, this means that the organizations may set up an additional system to keep track of this cost. There is nothing immoral or unethical about having multiple accounting systems, but they come at a cost. Accounting datasets are commodities, just like butter or eggs, and an additional internal accounting system must meet the same cost–benefit test as other commodities. That is, the perceived increases in benefits from the commodity must exceed the perceived increases in costs. Ultimately, benefits are measured by whether managers make better decisions that result in increased net profits.

Budgets, the formal expressions of the management’s plans, are a major feature of management accounting, whereas they are not as prominent in financial accounting. Budgets are major devices for compelling and disciplined management planning.

An important use of management accounting information is the evaluation of performance and provision of incentives and feedback to improve future decisions.

Accounting systems have an enormous influence on the behavior of individuals affected by them. Management accounting is more concerned with the likely behavioral impacts of various accounting alternatives as compared to financial accounting.

1-40

(10 min.)

When flat fees are being received for different products or services, it is essential for the hospital to have detailed knowledge of the cost of each product or service. Accurate cost information is crucial for decisions regarding which products and services should be emphasized or de-emphasized. Hospitals will increasingly identify costs by product (type of case), not just by departments. In contrast, when all costs are reimbursed, it is less important to the hospital to know which products or services cause costs, because all costs are reimbursed by someone. Even though reimbursors are concerned about how costs are assigned to products and services, the hospital has less reason to be concerned about assigning costs accurately. When somebody’s money is at stake, accounting systems get more attention. Accountability is important for many reasons, including justification of prices, cost control, and response to criticisms by stakeholders (whether they be investors, donors, taxpayers, or others). 1-41

(10 min.)

Paperwork and systems often seem to become ends in themselves. However, the rationale that should underlie systems design is the cost-benefit philosophy that is implied in the quotation. The aim is for the improvement in revenue and/or reduction in costs due to better decisions to outweigh the costs of the accounting system. Marks & Spencer should look at each of the management accounting reports it produces with an eye toward how it helps managers make better decisions. Does it provide needed scorekeeping? Does it direct attention to aspects of operations that might need altering? Does it provide information for specific management decisions? These types of questions will help identify the benefit of the information in the report. Then the company must consider the cost – not just the cost of collecting the data and preparing the reports, but the cost of educating managers to use the information and the cost of the time to read, digest, and act on the information. Too much information may be costly because it makes it time-consuming (and thus costly) to sift through the reams of information to find the few items that are important. An additional cost may be the loss of important information because the total volume of information makes it too difficult to ferret out the important items.

1-42 (10 min.) Financial information is important in all companies. But how managers get and use financial information can differ depending on the culture and philosophies of the company. Top executives of a company often represent a functional area critical to the competitive economic advantage of the company. When technology is crucial, engineers generally hold important executive positions. If marketing differentiates the company from others, marketing executives usually dominate. But regardless of the source of a company’s competitive advantage, its success will eventually be measured in economic terms. The company must attend to financial aspects to thrive and often even to survive. Management accountants must work with the dominant managers in any organization. The modern trend toward use of cross-functional teams places management accountants at the center of the action regardless of what type of managers and executives dominate. Most companies realize that there is a financial dimension to almost every major decision, so they want the financial experts, management accountants, involved in the decisions. But to be accepted as an important part of these teams, the management accountants must know how to help managers in various functional areas. In Hitachi, if they do not understand the information needs of engineers, they will not provide value. 1-43

(10-15 min.)

Boeing's competitive environment and manufacturing processes changed greatly in recent years. An accounting system that served them well in their old environment would not necessarily be optimal in today. Boeing's management probably thought that changes in the accounting system were necessary to produce the kind of information necessary to remain competitive.

A cost-benefit criterion was probably used. Boeing's management may not have quantified all the costs and benefits, but they certainly assessed whether the new system would help decisions enough to warrant the cost of the system. Many of the benefits of a better accounting system are hard to measure. They affect many strategic decisions of an organization. Without accurate product costs, management will find it difficult to accurately assess the consequences of their decisions.

More accurate product costs will usually result in better management decisions. But if the cost of the accounting system that produces the more accurate costs is too high, it may be best to forego increased accuracy. The benefit of better decisions must exceed the added cost of the system for a change to be desirable.

1-44

(10 min.)

There are many possible activities for each function of Nike's value chain. Some possibilities are: Research and development -- Determining changes in customers' tastes and preferences for shoes and sportswear to come up with new products (maybe the next "Air Jordans"). Product, service, and process design -- Design a shoe to meet the increasing demands of competitive athletes. Production -- Determine where to produce products and negotiate contracts with the companies producing them. Marketing -- Signing prominent athletes to endorse Nike's products. Distribution -- Select the best locations for warehouses for distribution to retail outlets. Customer service -- Formulate return policies for products that customers perceive to be defective.

Accounting information that aids managers' decisions includes: Research and development -- Trends in sales for various products, to determine which are becoming more and less popular. Product, service, and process design -- Production costs of various shoe designs. Production -- Measure total costs, including both production cost and transportation costs, for production in various parts of the world. Marketing -- The added profits generated by the added sales due to product endorsements. Distribution -- Storage and shipping costs for alternative warehouse locations. Customer service -- The net cost of returned merchandise, to be compared with the benefits of better customer relations.

1-45 (10-15 min.) This problem can lead to a long discussion. Pointing out the problems can be done reasonably quickly but formulating solutions can take much longer. 1.

The appropriate accounting information presented correctly should be helpful to managers. It is clear that Smith does not regard the accounting performance reports as helpful. Some key problems are: • Smith refers to “their” budget, meaning that the budget belongs to the controller’s department, not to him and his department. Managers should be involved in formulating the budget so that they accept it as a reasonable target. • The controller’s office shows up only when costs are over budget. Controllers should not be “policemen.” They should be business advisors who provide continual assistance not occasional reprimands. • Smith clearly does not understand the performance reports. An important role for the controller is education of managers on how to use accounting information. • Smith believes the performance report has nothing to do with what happens in reality. He may be right. Accounting reports often arrive too late and are not specific enough to be useful to front-line managers. If so, the reports should be changed or the results used differently. • Paperwork takes time away from other activities. This is especially a problem when the numbers have little value to those putting in the time. • Budgeting is not taken seriously, so the numbers reported by Smith and his subordinates are not reliable. • Things have gotten so bad that Smith has an attitude problem toward the controller’s office. Daniel is meeting him for the first time, and he is already disrespectful of him.

Daniel has major problems. His first task is to get the cooperation of Smith and his subordinates. This will probably involve changing the accounting reports received by the line managers, and it will certainly involve changes in how these reports are presented and used. If the reports are not useful, he needs to find out why. Then he can change the reports so that the managers find them helpful. He needs to show managers how they can use information to make better decisions. Foremost, Daniel has to change the attitudes of the line managers toward the controller’s department. This will take time, and it will require some specific instances where the controller or his staff provides information that the managers perceive as useful. To do this, he may need to change the accounting system to produce better information, and he needs to teach his controller’s department staff how to present information in a nonthreatening way. There is no one solution to Daniel’s problems. Different managers would handle it in different ways. If students have had experience, there will be many suggestions about how to proceed. For students with little experience, it may be sufficient to point out the variety of possible approaches.

1-46

(10-15 min.)

Accountants become the information experts in many companies. In a multinational company, with its varied subsidiaries, the accounting system provides a link between the various operating companies. The accountants provide information about the operations of an individual unit, and they also show how the units fit together as parts of the group. Management accountants should work together with managers to determine what information the managers would find useful. Then the accountants should help devise systems to produce that information, provided that its value is greater than its cost. As such, management accountants are information consultants to managers. Decisions are still the domain of managers, but the accountants provide advice to help managers make better decisions. Accountants have sometimes been viewed as “corporate cops,” staff members who reported on the failings of managers. They were primarily scorekeepers, but when the score showed something awry, they became informants—carriers of bad news to corporate headquarters. Managers resented them. But today, good management accountants are allies of managers. They provide information that helps managers make better decisions, which makes the managers look good. Everyone is better off when management accountants focus on providing the information that aids management decisions. To be effective internal consultants, accountants must have a background in accounting and information systems. In addition, they must have knowledge of all the functions of business and all the areas of the value chain.

1-47

(10-15 min.)

Brigham’s decisions violate standards of competence and integrity. Competence is violated because the most competent persons apparently are not being hired, jeopardizing the competence of the accounting department. Further, Brigham may be violating equal opportunity employment laws and regulations. Integrity requires an accountant to avoid conflicts of interest, and hiring the sons of personal friends certainly appears to be a conflict of interest. Such hiring was possibly for the personal gain of Brigham at the expense of the company. Further, this practice subverts the company’s equal employment opportunity policy.

Merton’s first step normally would be to discuss this situation with his boss. However, because the alleged unethical behavior is by his boss and Merton has already confronted him and been rebuffed, the next step seems warranted. This would involve going to Brigham’s superior. (Alternately, some organizations have an individual, possibly called an ombudsperson, to whom Merton could report such concerns.) If the matter could not be resolved at that level, he should continue up the line until reaching Creighton, the president. If equal employment opportunity is genuinely a company priority, Creighton should be very concerned about Brigham’s actions. What if the situation is not resolved to Merton’s satisfaction after following the steps in the preceding paragraph? The final step is to go directly to the Board of Directors. If that is unsatisfactory, there may be no recourse but to resign, sending an explanatory memo to an appropriate high-level official of the company. Should Merton go to the press so that they will put on pressure to change the hiring practices? Such a step is generally not appropriate. It would put Merton in the position of violating the ethical standard of confidentiality. The only person external to the firm with whom it is appropriate to discuss this issue is a confidential objective advisor.

1-48

(15-20 min.)

Because of the standard of confidentiality, the information in the geologist's report should not be revealed.

The standard of integrity would require one to reject the Europe tour offer.

This is a difficult ethical problem, one that deserves discussion. Two ethical standards apparently conflict. Confidentiality would lead to nondisclosure, provided there was no legal requirement to do so. But credibility would indicate that the information about the additional losses should be used in making the earnings prediction. The authors think that credibility should take precedence here, but others might disagree.

The standard of competence (and the standard of integrity) would lead one to research the tax law before deciding whether to exclude the dividend income from the taxable income.

1-49

(15-25 min.)

There are various possible answers. These are just some of the items that might be mentioned. 1) Environment - Evaluation of environmental disclosure, environmental policies (including management systems), and environmental performance (including toxic emissions, waste management, evidence of chemical and oil spills and environmental fines). Top companies were IBM and Johnson Controls. 2) Climate Change - Climate change disclosure (including the Carbon Disclosure Project, as well as company websites and reports) and climate change policies (including offsets and reduction goals). Top companies were IBM and Johnson Controls. 3) Human rights – Evaluation of disclosure, policy (including codes of conduct and performance goals), and exposure to 45 countries of concern. Companies with higher exposure need to earn higher scores in disclosure and policy to do well. Top among the top ten companies were Johnson Controls, Campbell Soup, Mattel, and Accenture. 4) Employee relations – Evaluates unionization rates, publicly disclosed employee benefits, and Equal Employment Opportunity Commission complaints. Top among the top ten companies: Hewlett-Packard and Campbell Soup. 5) Corporate governance - A majority of a board of directors and key committees of the board must be independent of management. In addition, ratings include general board accountability and demographics (board tenure, age of directors, over-commitment of directors to multiple boards, and annual election of all directors), and the percentage of CEO pay that is incentive based. Of the top ten companies, six were tied for the highest score on governance – Campbell Soup, Bristol-Myers Squibb, Mattel, 3M, HewlettPackard, and Nike. 6) Philanthropy – Includes corporate giving that has a substantial and positive impact on society and evaluates giving levels and policies (including employee match programs). Top among the top ten companies were Johnson Controls and Accenture. 7) Financial – Evaluates the three-year return on investment in the company stock, based on Morningstar rankings. Companies without a three-year return to shareholders were not considered for the ranking. Top among the top ten companies were Nike and Mattel.

1-50

(10-15 min.)

Line authority is held by those managers directly responsible for the production and sales of goods or services. Staff authority is held by persons who have an indirect responsibility for the production and sale of goods and services. Staff members provide expertise, advice, and support for line positions; line managers are directly responsible for achieving the basic objectives of the organization. Conflicts between line and staff can arise for many reasons, ranging from the types of people that are generally attracted to each type of position to their responsibilities in the organization. Among the reasons are:  Staff personnel tend to be younger, better educated, more professionally established.  Line managers see staff managers as threats to their authority.  Line managers are uncomfortable when they must rely on the knowledge and expertise of staff.  Line managers often think staff managers overstep their authority and have a narrow view of the world.  Staff managers often think line managers ignore their advice and resist their ideas.

Chen has a staff position, providing advice to the controller. His main conflicts will probably arise with the chief accountant and the managers under him. He reports to the chief accountant’s superior, but he prepares reports that affect operations in the chief accountant’s area of responsibility. Paperman is in a staff position because accounting is not directly involved with sales or delivery of leasing services. He provides counsel and advice to all the line managers and most of the staff managers in the company. Conflicts may arise if he tries to exert authority instead of just giving advice or if the other managers ignore his advice. Hodge is in a line position because she is an integral part of the company’s main line of business, leasing equipment. Her main conflicts are likely to arise in areas such as requisitioning of equipment and billing of customers where she must rely on other departments over which she has no authority. Shevlin is in a staff position and offers advice to most other managers in the company. Conflicts might arise if managers perceive her advertising of positions or screening of candidates as not fulfilling their needs, or if she tries to insert her preferences instead of the hiring department’s preferences into the advertising and screening activities. Conflicts can also arise in the performance evaluation functions, where she may be enforcing an unpopular policy.

1-51

(20-30 min.)

In accordance with Exhibit 1-7, IMA Statement of Ethical Professional Practice, 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:

•

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. Rachel O’Casey may have a legal responsibility to take some action.

•

integrity. Management accountants have a responsibility to - refrain from engaging in any conduct that would prejudice carrying out duties ethically. - refrain from engaging in or supporting any activity that would discredit the profession.

•

credibility. Management accountants have a responsibility to communicate information fairly and objectively. They also should disclose all relevant information that could reasonably be expected to influence a user’s understanding of reports, analyses, and recommendations.

In accordance with Exhibit 1-7, the first alternative being considered by Rachel O’Casey, seeking the advice of her boss, is appropriate. To resolve an ethical conflict, the first step recommended 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 O’Casey’s boss is involved. Releasing the information to the local newspaper would be an inappropriate course of action. Communication of confidential information to anyone outside of the company is inappropriate unless there is a legal obligation to do so, in which case O’Casey should contact the proper authorities. Contacting a member of the board of directors would be an inappropriate action at this time. In accordance with Exhibit 1-7, O’Casey should report the conflict to successively higher levels within the organization. Thus, the problem should be reported to the board of directors only if the problem is not resolved at lower levels.

Assuming there is no established company policy in place to resolve the conflict, O’Casey should report the problem to successively higher levels of management until it is satisfactorily resolved. There is no requirement for O’Casey to inform

her immediate supervisor of this action, because he is involved in the conflict. O’Casey could also clarify the situation by confidential discussion with an objective advisor to obtain an understanding of possible courses of action. If the conflict is not resolved after exhausting all courses of internal review, O’Casey may have no other recourse than to resign from the organization and submit an informative memorandum to an appropriate representative of the organization. 1-52 (15-25 min.) These answers are based on information in the Nike 10K for the year ended May 31, 2011. 1.

Nike’s principal business activity is the design, development and worldwide marketing of high quality footwear, apparel, equipment, and accessory products. Nike is the largest seller of athletic footwear and athletic apparel in the world, selling in over 170 countries.

About 43% of Nike revenue comes from sales in the U.S. and 57% from sales abroad. There are 363 retail stores in the U.S.

Nike’s CFO is Donald W. Blair. He came to Nike from Pepsico in 1999. Before that he was a certified public accountant (CPA) with Deloitte, Haskins, and Sells (now Deloitte & Touche).

Nike manufactures 39 percent, 33 percent, 24 percent and 2 percent of total NIKE brand footwear in Vietnam, China, Indonesia, and India, respectively. Almost all of the brand apparel manufacturing is also outside the United States, by independent contract manufacturers in 33 countries. Although Nike imposes on these contractors a code of conduct and other environmental, health, and safety standards, it is difficult to ensure that all of the contractors are always in compliance. This could harm Nike’s reputation for high ethical standards.

1-53 (20-30 min.) For the solution to this Excel Application Exercise, follow the stepby-step instructions provided in the textbook chapter.

1-54

(90 min. or more)

The purpose of this exercise is to learn about the practice of management accounting. Students often have the mistaken impression that accountants sit in the back room and prepare reports. These articles illustrate the varied skills and abilities that are necessary to be a successful management accountant. The exercise also focuses on critical reading -- identifying the most important points made in an article. It also shows how different students will focus on different aspects of each article. What one student considers important, others might think unimportant. Prioritizing the lessons will bring out differences in opinion and create a need to form consensus from possibly conflicting views. Finally, students should come away with a better understanding of why they are studying management accounting, whether they plan to be an accountant or simply a user of accounting information and services. 1-55 (30-45 min.) NOTE TO INSTRUCTOR: This solution is based on the web site as it existed in early 2012. Be sure to examine the current web site before assigning this problem, as the information there may have changed. 1.

The Institute of Management Accountants is "to provide a forum for research, practice development, education, knowledge sharing, and the advocacy of the highest ethical and best business practices in management accounting and finance."

The IMA offers more than 300 NASBA-approved courses on topics from general finance and accounting standards to strategic management.

The IMA has a detailed code of ethics. It specifies accountants’ obligations to the public, their profession, their organization, and to themselves. It also addresses how to resolve ethical conflicts. It makes it clear that for accountants to fulfill their function in an organization, they must both be ethical and be perceived as being ethical.

CHAPTER 2 COVERAGE OF LEARNING OBJECTIVES

FUNDAMENTAL ASSIGN-MENT MATERIAL A1, B1, B4

CASES, NIKE 10K, EXCEL, COLLAB., & INTERNET EXERCISES 68

ADDITIONAL ASSIGNMENT LEARNING OBJECTIVE MATERIAL LO1: Explain how cost 25, 26, 27, 28, 30, drivers affect cost behavior. 31, 47, 47, 49, 51, 53, 56, 68, LO2: Show how changes in A1, B1, A2, A3, B2, 25, 26, 29, 30, 31, 68, 69, 73 activity cost-driver levels B3, B4 32, 32, 41, 48, 47, affect variable and fixed costs. 47, 48, 49, 51, 52, 53, 54, 56, 59, 59, 60, 60, 63, 68 LO3: Explain step- and A4,B4 24,36,37, 37, 38, 75 mixed-cost behavior. 38, 39 LO4: Create a cost-volumeB4 33, 33, 34, 34, profit graph and understand 35,40, 49 the assumptions behind it. LO5: Calculate break-even A2, A3, B2, B3 14, 40, 41,42, 42, 68, 69, 73, 74 sales volume in total dollars 43, 47, 47, 50, 52, and total units. 54, 55, 57, 57, 59, 59, 61, 68 LO6: Calculate sales volume A2 , B3 B4 15, 33, 33, 34, 34, 69 in total dollars and total units 42, 43, 47, 47,50, to reach a target profit. 52, 54, 55, 57, 57, 59, 62, 62 LO7: Differentiate between 61 contribution margin and gross margin. LO8: Explain the effects of B4 44, 47, 64, 65 70 sales mix on profits (Appendix 2A). LO9: Compute cost-volume45, 46, 66, 67 71 profit relationships on an aftertax basis (Appendix 2B). ..

CHAPTER 2 Introduction to Cost Behavior and Cost-Volume Relationships 2-A1 (20-25 Min.) 1. The cost driver for both resources is number of times the plant is cleaned. Labor cost is a fixed-cost resource, and cleaning supplies is a variable cost. Costs for cleaning between 4 and 8 times a month are: Number of times plant Square Feet Cleaning Supplies is cleaned Cleaned Labor Cost Cost** Total cost * *** 4 200,000 $21,000 $ 8,000 $29,000 5 250,000 21,000 10,000 31,000 6 300,000 21,000 12,000 33,000 7 350,000 21,000 14,000 35,000 8 400,000 21,000 16,000 37,000 * 4 × 50,000 square feet ** Cleaning supplies cost per time the plant is cleaned = $8,000 ÷ 4 = $2,000 *** $2,000 per cleaning × number of times plant is cleaned

Cost per Cleaning $7,250 $6,200 $5,500 $5,000 $4,625

The predicted total cost to clean the plant during the next quarter is the sum of the total costs for monthly cleanings of 5, 6, and 8 times. This is $31,000 + $33,000 + $37,000 = $101,000 2. If Napco hires the outside cleaning company, all its cleaning costs will be variable at a rate of $5,700 per cleaning. The cost driver will be “number of times cleaned.” The predicted cost to clean a total of 5 + 6 + 8 = 19 times is 19 × $5,700 = $108,300. Thus, Napco will save by not hiring the outside cleaning company. The table below shows the total costs for the two alternatives. If Napco expects average “times cleaned” to be 6 or more, it would save by cleaning with its own employees. If Napco expects to average 5 or fewer cleanings per month, it would save by outsourcing. Napco Cleans Plant Times Cleaned Napco 4 $ 29,000 5 31,000 6 33,000 7 35,000 8 37,000

Outsource Cleaning Plant Times Cleaned Outside 4 $22,800 5 28,500 6 34,200 7 39,900 8 45,600

2-A2 1.

(20-25 min.) Let N Sales $1.00 N $.32 N N Let S S .32 S S

= number of units = Fixed expenses + Variable expenses + Net income = $4,000 + $.68 N + 0 = $4,000 = 12,500 units = sales in dollars = $4,000 + .68 S + 0 = $4,000 = $12,500

Alternatively, the 12,500 units may be multiplied by the $1.00 to obtain $12,500. In formula form: In units

Fixed costs + Net income ($4,000 + 0) = = 12,500 units Contribution margin per unit $.32 In dollars

Fixed costs + Net income ($4,000 + 0) = = $12,500 Contribution margin percentage .32 2.

The quick way: (45,000 – 12,500) × $.32 = $10,400 Compare income statements:

Volume in units Sales Deduct expenses: Variable Fixed Total expenses Effect on net income

3. ..

Break-even Point 12,500 $12,500

Increment 32,500 $32,500

Total 45,000 $45,000

8,500 4,000 12,500 $ 0

22,100 --22,100 $ 10,400

30,600 4,000 34,600 $ 10,400

Total fixed expenses would be $4,000 + $1,600 = $5,600 29

$5,600 $5,600 = 17,500 units; = $17,500 sales $.32/unit .32 or 17,500 units × $1.00 / unit 4.

= $17,500 sales

New contribution margin is $1.00 – $.68 – $.07 = $.25 per unit Breakeven = Fixed cost ÷ contribution margin = $4,000 ÷ $.25 = 16,000 units 16,000 units × $1.00 = $16,000 in sales

The quick way: (45,000 – 12,500) × $.21 = $6,825. On a graph, the slope of the total cost line would have a kink upward, beginning at the break-even point.

2-A3

(20-30 min.)

The following format is only one of many ways to present a solution. This situation is really a demonstration of "sensitivity analysis," whereby a basic solution is tested to see how much it is affected by changes in critical factors. Much discussion can ensue, particularly about the final three changes. The basic contribution margin per revenue mile is $2.00 - $1.60 = $.40

1. 2.

(a) (b) (c) (d) (e) (f) (g)

(1)

(2)

(4)

(5) (3)-(4)

Contribution Margin Per Revenue Mile

(3) (1)×(2) Total Contribution Margin

Revenue Miles Sold

Fixed Expenses

Net Income

500,000

$.40

$200,000

$50,000

$ 150,000

500,000 650,000 500,000 500,000 575,000 350,000 575,000

1.00 .40 (.08) .40 .35 .41 .40

500,000 260,000 (40,000) 200,000 201,250 143,500 230,000

50,000 50,000 50,000 65,000 50,000 50,000 65,000

450,000 210,000 (90,000) 135,000 151,250 93,500 165,000

2-A4 (20-25 min.) Some of these answers are controversial, and reasonable cases can be built for alternative classifications. Class discussion of these answers should lead to worthwhile disagreements about anticipated cost behavior with regard to alternative cost drivers. 1. ..

(b) Fixed cost. 30

2. 3. 4. 5. 6. 7. 8. 9. 10. 11.

(d) Step cost. (a) Variable cost with respect to revenue. (a) Variable cost with respect to miles flown. (c) Mixed cost with respect to miles driven. (b) Fixed cost. (b) Fixed cost. (b) Fixed cost. (a) Variable cost with respect to cases of 7-Up. (b) Fixed cost. (b) Fixed cost.

2-B1 (20-25 Min.) 1. The cost driver for both resources is number of times the restaurant is cleaned. Labor cost is a fixed-cost resource, and cleaning supplies is a variable cost. Costs for cleaning between 35 and 50 times are: Square Feet Cleaned 210,000* 240,000 270,000 300,000

Cleaning Supplies Cost** $ 16,800 19,200 21,600 24,000

Times Labor Total Cost per Cleaned Cost Cost Cleaning 35 $21,000 $37,800 $1,080 40 21,000 40,200 $1,005 45 21,000 42,600 $ 947 50 21,000 45,000 $ 900 * 35 × 6,000 ** The cost of cleaning supplies per cleaning = $16,800 ÷ 35 = $480 per cleaning. The cost per square foot is $480 ÷ $6,000 = $.08 or $16,800 ÷ 210,000 = $.08. The total cleaning supplies cost is either $480 × number of cleanings or $.08 × square feet cleaned. The predicted total cost to clean during the November and December is the sum of the total costs for monthly cleanings of 45 and 50 times. This is $42,600 + $45,000 = $87,600 2. If Applejack hires the outside cleaning company, all its cleaning costs will be variable at a rate of $0.25 per square foot cleaned. The predicted cost to clean a total of 45 + 50 = 95 times is 95 × 6,000 × $0.25 = $142,500. Thus, Applejack will not save by hiring the outside cleaning company. To determine whether outsourcing is a good decision on a permanent basis, Applejack needs to know the expected demand for the cost driver over an extended time frame. As the following table shows, outsourcing becomes less attractive when cost driver levels are high. If average demand for cleaning is expected to be more than the number of cleanings at which the cost of outsourcing equals the internal cost, Applejack should continue to do its own cleaning. This point is C cleanings, where: $.25 × C × 6,000 = $21,000 + ( $.08 × C × 6,000) C = $21,000 ÷ ($.17× 6,000) = 20.588 cleanings Applejack should also consider such factors as quality and cost control when an outside cleaning company is used.

(1) Times (2) Square Feet (3) Applejack Outside Cleaning Cost * Cleaned Cleaned Total Cleaning Cost $.25 × (2) 35 210,000 $37,800 $52,500 40 240,000 40,200 60,000 45 270,000 42,600 67,500 50 300,000 45,000 75,000 * From requirement 1, total cost is $21,000 + $.08 x square feet cleaned ..

2-B2

(15-25 min.)

$2,340 ÷ ($30 - $12) = 130 child-days or 130 × $30 = $3,900 revenue.

176 × ($30 - $12) - $2,340 = $3,168 - $2,340 = $828

198 × ($30 - $12) - $2,340 = $3,564 - $2,340 = $1,224 or (22 × $18) + $828 = $396 + $828 = $1,224

176 × ($30 - $14) - $2,340 = $2,816 - $2,340 = $476 or $828 - ($2 × 176) = $476

$828 - $220 = $608

[(9.5 × 22) × ($30 - $12)] - ($2,340 + $300) = $3,762 - $2,640 = $1,122

[(7 × 22) × ($33 - $12)] - $2,340 = $3,234 - $2,340 = $894

2-B3

(15-20 min.)

$9,100 $9,100 = = 1,300 units $7 ($25 - $18)

Contribution margin ratio:

($43,000 - $30,100) = 30% $43,000

$8,400 ÷ 30% = $28,000 3.

$38,400 ($30,400 + $8,000) = = 2,400 units $16 ($29 - $13)

($51,000 - $18,000) × (120%) = $39,600 contribution margin; $39,600 - $18,000 = $21,600

New contribution margin:

$48 - ($36 - 25% of $36) = $48 - ($36 - $9) = $21;

New fixed expenses: $106,000 × 115% = $121,900;

$144,900 ($121,900 + $23,000) = = 6,900 units $21 $21

2-B4

(20-25 min.)

The following classifications are open to debate. With appropriate assumptions, other answers could be equally supportable. For example, in #2, the health insurance would be a fixed cost if the number of employees will not change. This problem provides an opportunity to discuss various aspects of cost behavior. Students should make an assumption regarding the time period involved. For example, if the time period is short, say one month, more costs tend to be fixed. Over longer periods, more costs are variable. They also must assume something about the nature of the cost. For example, consider #4. Repairs and maintenance are often thought of as a single cost. However, repairs are more likely to vary with the amount of usage, making them variable, while maintenance is often on a fixed schedule regardless of activity, making them fixed. Another important point to make is the cost/benefit criterion applied to determining “true” cost behavior. A manager may accept a cost driver that is plausible but may have less reliability than an alternative due to the cost associated with maintaining data for the more reliable cost driver. Cost

Cost Behavior

Likely Cost Driver(s)

1.X-ray operating cost

Mixed

Number of x-rays

2.Insurance

Step (or variable)

Number of employees

3. Cancer research

Fixed

4. Repairs

Variable

5.Training cost

Fixed

6.Depreciation

Fixed

7. Consulting

Fixed

8. Nursing supervisors

Step

Number of patients

Number of nurses, patient-days

2-1 This is a good characterization of cost behavior. Identifying cost drivers will identify activities that affect costs, and the relationship between a cost driver and costs specifies how the cost driver influences costs. 2-2

Two rules of thumb to use are: a. Total fixed costs remain unchanged regardless of changes in cost-driver activity level. b. The per-unit variable cost remains unchanged regardless of changes in costdriver activity level.

2-3 Examples of variable costs are the costs of merchandise, materials, parts, supplies, sales commissions, and many types of labor. Examples of fixed costs are real estate taxes, real estate insurance, many executive and supervisor salaries, and space rentals. 2-4 Fixed costs, by definition, do not vary in total as volume changes within the relevant range and during the time period specified (a month, year, etc.). However, when the cost-driver level is outside the relevant range (either less than or greater than the limits) management must decide whether to decrease or increase the capacity of the resource, expressed in cost-driver units. In the long run, all costs are subject to change. For example, the costs of occupancy such as a long-term non-cancellable lease cannot be changed for the term of the lease, but at the end of the lease management can change this cost. In a few cases, fixed costs may be changed by entities outside the company rather than by internal management – an example is the fixed, base charge for some utilities that is set by utility commissions. 2-5 Yes. Fixed costs per unit change as the volume of activity changes. Therefore, for fixed cost per unit to be meaningful, you must identify an appropriate volume level. In contrast, total fixed costs are independent of volume level. 2-6 No. Cost behavior is much more complex than a simple dichotomy into fixed or variable. For example, some costs are not linear, and some have more than one cost driver. Division of costs into fixed and variable categories is a useful simplification, but it is not a complete description of cost behavior in most situations. 2-7 No. The relevant range pertains to both variable and fixed costs. Outside a relevant range, some variable costs, such as fuel consumed, may behave differently per unit of activity volume. 2-8 The major simplifying assumption is that we can classify costs as either variable or fixed with respect to a single measure of the volume of output activity. 2-9 The same cost may be regarded as variable in one decision situation and fixed in a second decision situation. For example, fuel costs are fixed with respect to the addition of one more passenger on a bus because the added passenger has almost no effect on total fuel costs. In contrast, total fuel costs are variable in relation to the decision of whether to add one more mile to a city bus route. ..

2-10 No. Contribution margin is the excess of sales over all variable costs, not fixed costs. It may be expressed as a total, as a ratio, as a percentage, or per unit. 2-11 A "break-even analysis" does not describe the real value of a CVP analysis, which shows profit at any volume of activity within the relevant range. The break-even point is often only incidental in studies of cost-volume relationships. CVP analysis predicts how managers’ decisions will affect sales, costs, and net income. It can be an important part of a company’s planning process. 2-12 No. break-even points can vary greatly within an industry. For example, Rolls Royce has a much lower break-even volume than does Honda (or Ford, Toyota, and other high-volume auto producers). 2-13 No. The CVP technique you choose is a matter of personal preference or convenience. The equation technique is the most general, but it may not be the easiest to apply. All three techniques yield the same results. 2-14 For a given contribution margin per unit, an increase in fixed costs will increase the break-even point, whereas a decrease in fixed costs will reduce the break-even point. Again, given a particular level of fixed costs, any reduction in the unit contribution margin will result in an increase in the break-even point and an increase in the contribution margin per unit will lead to a fall in the break-even point. 2-15 Spreadsheet-based CVP modeling simplifies the analysis of several changes in the key parameters that determine the break-even point. Thus, managers can evaluate simultaneous changes in selling price, unit variable costs, fixed costs, and target profit. Spreadsheets can calculate the results for alternative assumptions extremely quickly and can display the results both numerically and graphically. Moreover, complex real-life situations involving multiple cost drivers, non-linear relationships between costs and cost drivers, and varying sales mixes can easily be evaluated using spreadsheet-based CVP models. 2-16 Operating leverage is a firm's ratio of fixed to variable costs. A highly leveraged company has relatively high fixed costs and low variable costs. Such a firm is risky because small changes in volume lead to large changes in net income. This is good when volume increases but can be disastrous when volumes fall. 2-17 An increase in demand for a company’s products will drive almost all other costdriver levels higher. This will cause cost drivers to exceed capacity or the upper end of the relevant range for its fixed-cost resources. Since fixed-cost resources must be purchased in “chunks” of capacity, the proportional increase in cost may exceed the proportional increase in the use of the related cost-driver. Thus cost per cost-driver unit may increase.

2-18 The margin of safety shows how far sales can fall before losses occur – that is before the company reaches the break-even sales level. 2-19 No. In retailing, the contribution margin is likely to be smaller than the gross margin. For instance, sales commissions are deducted in computing the contribution margin but not the gross margin. In manufacturing companies the opposite is likely to be true because there are many fixed manufacturing costs deducted in computing gross margin. 2-20 No. CVP relationships pertain to both profit-seeking and nonprofit organizations. In particular, managers of nonprofit organizations must deal with tradeoffs between variable and fixed costs. To many government department managers, lump-sum budget appropriations are regarded as the available revenues. 2-21 Contribution margin could be lower because the proportion of sales of the product bearing the higher unit contribution margin is lower than the proportion budgeted. 2-22 Target income before income taxes

Target after-tax net income 1 - tax rate

2-23

Change in Change in volume Contribution margin = × × (1 - tax rate) per unit net income in units 2-24 The fixed salary portion of the compensation is a fixed cost. It is independent of how much is sold. In contrast, the 5% commission is a variable cost. It varies directly with the amount of sales. Because the compensation is part fixed cost and part variable cost, it is considered a mixed cost. 2-25 The key to determining cost behavior is to ask, “If there is a change in the level of the cost driver, will the total cost of the resource change immediately?” If the answer is yes, the resource cost is variable. If the answer is no, the resource cost is fixed. Using this question as a guide, the cost of advertisements is normally variable as a function of the number of advertisements. Note that because the number of advertisements may not vary with the level of sales, advertising cost may be fixed with respect to the cost driver “level of sales.” Salaries of marketing personnel are a fixed cost. Travel costs and entertainment costs can be either variable or fixed depending on the policy of management. The key question is whether it is necessary to incur additional travel and entertainment costs to generate added sales. 2-26 The key to determining cost behavior is to ask, “If there is a change in the level of the cost driver, will the total cost of the resource change immediately?” If the answer is yes, the resource cost is variable. If the answer is no, the resource cost is fixed. Using this question as a guide, the cost of labor can be fixed or variable as a function of the ..

number of hours worked. Regular wages may be fixed if there is a commitment to the laborers that they will be paid for normal hours regardless of the workload. However, overtime and temporary labor wages are variable. The depreciation on plant and machinery is not a function of the number of machine hours used and so this cost is fixed. 2-27

Suggested value chain functions are listed below.

New Products   

Marketing R&D Design

2-28

New Technology  

R&D Design

New Pricing 

Marketing

(10-15 min.)

Situation 1.

Best Cost Driver Number of Setups

Setup Time

Cubic Feet

Cubic Feet Weeks

Number of Orders

New Positioning Strategies  Marketing  Support functions

Justification Because each setup takes the same amount of time, the best cost driver is number of setups. Data is both plausible, reliable, and easy to maintain. Longer setup times result in more consumption of mechanics’ time. Simply using number of setups as in situation 1 will not capture the diversity associated with this activity. Assuming that all products are stored in the warehouse for about the same time (that is inventory turnover is about the same for all products), and that products are stacked, the volume occupied by products is the best cost driver. If some types of product are stored for more time than others, the volume occupied must be multiplied by a time dimension. For example, if product A occupies 100 cubic feet for an average of 2 weeks and product B occupies only 40 cubic feet but for an average of 10 weeks, product B should receive twice as much allocation of warehouse occupancy costs. Because each order takes the same amount of time, the best cost driver is number of orders. Data is both plausible, reliable, and easy to maintain. Each order is for different types of products but there is not diversity between them in terms of the time it takes to process the order. (If there was variability in the number of product types ordered, the best driver would be number of order line items.) 38

2-29

(5-10 min.)

Contribution margin Net income

= $960,000 - $533,000 = $427,000 - $310,000

= $427,000 = $117,000

Variable expenses Fixed expenses

= $550,000 - $300,000 = $300,000 - $ 46,000

= $250,000 = $254,000

Sales Net income

= $500,000 + $520,000 = $520,000 - $200,000

= $1,020,000 = $320,000

2-30

(5-10 min.) The $278,000 annual advertising fee is a fixed cost. The $6,100 cost for each advertisement is a variable cost. If the total number of ads is 46 the total cost of advertising is $278,000 + 46 × $6,100 = $558,600 If the total number of ads is 92 the total cost of advertising is $278,000 + 92 × $6,100 = $839,200. The total cost of advertising does not double in response to a doubling of the number of ads because the fixed costs do not change.

2-31 (5-10 min.) With respect to the cost driver sales dollars, the $3,200,000 annual salaries of sales personnel is a fixed cost. The sales commissions, travel costs, and entertainment costs are variable costs. If the total sales dollars is $24 million, the total cost of the selling activity is $3,200,000 + .20 × $24,000,000 = $8,000,000 If the total sales dollars is only $12 million, the total cost of the selling activity is $3,200,000 + .20 × $12,000,000 = $5,600,000. The total cost of the selling activity does not decrease by 50% when the cost driver decreases by 50% because the fixed costs do not change.

2-32

(10-20 min.)

d ₤720,000 b f

d = c × (a – b) = 100,000 × (₤11 – ₤7) = ₤400,000 f =d–e = ₤400,000 – ₤300,000 = ₤100,000

c = d ÷ (a – b) = ₤60,000 ÷ ₤3 = 20,000 units e =d–f = ₤63,000 – ₤15,000 = ₤48,000

d = c × (a – b) = 60,000 × (₤25 – ₤15) = ₤600,000 e =d–f = ₤600,000 – ₤50,000 = ₤550,000

d ₤160,000 a f

= c × (a – b) = 120,000 × (₤25 – b) = ₤19 =d–e = ₤720,000 – ₤650,000 = ₤70,000

= c × (a – b) = 80,000 × (a – ₤13) = ₤15 =d–e = ₤160,000 – ₤120,000 = $40,000

2-33 (10 min.)

Using the graph above, the estimated breakeven point in total units sold is about 75,000 (where revenue = ₤825,000 and total costs = ₤300,000 + ₤525,000 = ₤825,000). The estimated net income for 100,000 units sold is ₤100,000 (revenue of $1,100,000 – total costs of $300,000 + ₤700,000 = ₤1,000,000).

2-34 (10 min.)

Using the graph above, the estimated breakeven point in total units sold is about 55,000. The estimated net loss for 50,000 units sold is ₤50,000 (revenue of ₤1,250,000 – total cost of ₤1,300,000 or contribution margin of ₤500,000 – less fixed cost of ₤550,000).

2-35 (20–25 min.) Square Feet 100,000 125,000 150,000 175,000 200,000

Labor Cost per Square Foot $ 0.240 $ 0.192 $ 0.160 $ 0.137 $ 0.120

Labor Cost $24,000 24,000 24,000 24,000 24,000

Supplies Cost $ 5,000 6,250 7,500 8,750 10,000

Supplies Cost per Square Foot $0.050 0.050 0.050 0.050 0.050

Labor Cost per Square Foot L abo r Co st p er S qu are F oo t

$0.30 $0.25 $0.20 $0.15 $0.10 $0.05 $-

Fixed-Cost per Unit Behavior 100,000

125,000

150,000

175,000

200,000

Square Feet

S u p p lie s C o s t p e r S q u a re Foot

Supplies Cost per Square Foot $0.06 $0.05 $0.04 $0.03

Variable-Cost per Unit Behavior

$0.02 $0.01 $100,000

125,000

150,000

175,000

200,000

Square Feet ..

2-36 (20-25 min.) Square Feet

Labor Cost Per Square Foot (Estimated)

100,000 125,000 150,000

$0.12 0.096 0.08

Total Labor Cost

Supplies Cost per Square Foot

Supplies Cost

$12,000 12,000 12,000

$0.06 0.06 0.06

$ 6,000 7,500 9,000

Total Labor Cost $14,000

Labor Costs

$12,000 $10,000 $8,000 $6,000 $4,000 $2,000 $0 100,000

125,000

150,000

Square Feet

Supplies Cost

Total Supplies Cost $10,000 $9,000 $8,000 $7,000 $6,000 $5,000 $4,000 $3,000 $2,000 $1,000 $0 100,000

125,000

150,000

Square Feet

Labor cost shows a fixed-cost behavior, while supplies cost shows a variable-cost behavior.

2-37

(5 min.) Only (b) is a step cost. (a) This is a fixed cost. The same cost applies to all volumes in the relevant range. (b) This is a true step cost. Each time 200 new spectators come to buy tickets, the cost increases by the price of one additional counter. (c) This is a variable cost that remains fixed per unit of output. It is not a step cost. Why? Because each unit of the product requires a particular amount of cloth, regardless of the form in which the cotton cloth is purchased.

2-38

(5 min.) Here, the ₩12,000 is a fixed cost irrespective of the units consumed and the ₩103.60 per unit is the variable cost that varies directly with the number of units consumed. By definition, adding a fixed cost and a variable cost together produces a mixed cost.

2-39

(10-15 min.)

Machining labor: G, number of units completed or labor hours

Raw material: B, units produced; could also be D if the company’s purchases do not affect the price of the raw material.

Annual wage: C or E (depending on work levels), labor hours

Water bill: H, gallons of water used

Quantity discounts: A, amount purchased

Depreciation: E, capacity

Sheet steel: D, number of farm implements of various types

Salaries: F, number of solicitors

Natural gas bill: C, cubic feet of usage

2-40

(10 min.)

Let TR TR - .25(TR) -$45,000,000 .75(TR) TR

= total revenue = 0 = $45,000,000 = $60,000,000

Daily revenue per patient = $60,000,000 ÷ 37,500 = $1,600. This may appear high, but it includes the room charge plus additional charges for drugs, x-rays, and so forth.

2-41

(10 min.)

The break-even point in total revenue is fixed cost divided by the contributionmargin ratio (CMR). CMR equals 1 – Variable-Cost Ratio. Break-even Point = Fixed Cost ÷ CMR = $42,000,000 ÷ (1 – 0.7) = $140,000,000.

2. a.

Total revenue Variable cost (.7 × 150,000,000) Contribution margin Fixed costs Net profit

$150,000,000 105,000,000 45,000,000 42,000,000 $ 3,000,000

Total revenue Variable cost (1.1 × .7 × 150,000,000) Contribution margin Fixed costs Net loss

$150,000,000 115,500,000 34,500,000 42,000,000 $ (7,500,000)

2-42

(15 min.)

1. Room revenue @ ₹5,000 Variable costs @ ₹4,200 Contribution margin Fixed costs Net income (loss)

a 100% Full

b 50% Full

₹219,000,000a 183,960,000 35,040,000 29,000,000 ₹ 6,040,000

₹ 109,500,000 b 91,980,000 17,520,000 29,000,000 ₹ (11,480,000)

a 120 × 365 = 43,800 beds per year 43,800 × ₹5000 = ₹219,000,000 b ₹219,000,000 ÷ = ₹109,500,000 2. Let N = Number of beds ₹5,000N – ₹4,200N – ₹29,000,000 = 0 N = ₹29,000,000 ÷ ₹800 = 36,250 beds Percentage occupancy = 36,250 ÷ 43,800 = 82.76% 2-43

(15 min.)

$23. To compute this, let X be the variable cost that generates $1 million in profits: ($48 - X ) × 800,000 - $19,000,000 = $1,000,000 ($48 - X) = ($1,000,000 + $19,000,000) ÷ 800,000 $48 - X = $200 ÷ 8 = $25 X = $48 - $25 = $23

Loss of $600,000: ($48 - $25) × 800,000 - $19,000,000 = ($23 × 800,000) - $19,000,000 = $18,400,000 - $19,000,000 = ($600,000)

2-44 1.

(15-20 min.) Let 2R = pints of raspberries and 5R = pints of strawberries sales - variable expenses - fixed expenses = zero net income ($1.05×5R) + ($1.30×2R) – ($.85×5R) – ($.90×2R) - $15,300 = 0 ($5.25 × R) + ($2.60 × R) – ($4.25 × R) – ($1.80 × R) -$15,300 = 0 $1.8 × R - $15,300 = 0 R = 8,500 2R = 17,000 pints of raspberries 5R = 42,500 pints of strawberries

Let S = pints of strawberries ($1.05 - $.85) × S - $15,300 = 0 .20S - $15,300 = 0 S = 76,500 pints of strawberries

Let R = pints of raspberries ($1.30 - $.90) × R - $15,300 = 0 ($.40 × R) - $15,300 = 0 R = 38,250 pints of raspberries

2-45 1.

(10 min.) ($1.50 × N) – ($1.20 × N) – $18,000 = $864 ÷ (1 - .25) ($.30 × N) = $18,000 + ($864 ÷ .75) ($.30 × N) = $18,000 + $1,152 N = $19,152 ÷ $.30 = 63,840 units

($1.50 × N) – ($1.20 × N) - $18,000 = $1,440 ÷ (1 - .25) ($.30 × N) = $18,000 +( $1,440 ÷ .75) ($.30 × N) = $18,000 + $1,920 N = $19,920 ÷ $.30 = 66,400 units

2-46

(15 min.) Several variations of the following general approach are possible: Target after-tax net income Sales - Variable expenses - Fixed expenses = 1 - tax rate $136,000 S - .55S - $664,000 = (1 - .32) .45S = $664,000 + $200,000 S = $864,000 ÷ .45 = $1,920,000

Check:

Sales Variable expenses (55%) Contribution margin Fixed expenses Income before taxes Income taxes @ 32% Net income

$1,920,000 1,056,000 864,000 664,000 $ 200,000 64,000 $ 136,000

2-47 (40-50 min.) 1.

Several variations of the following general approach are possible:

Let N = Unit sales Sales – Variable expenses – Fixed expenses = Profit $4N – $2.80N – ($2,000 x 2 + $2,600) = $600 $1.20N – $6,600 = $600 N = $7,200 ÷ $1.20 = 6,000 boxes of doughnuts Check: Sales (6,000 × $4) Variable expenses (6,000 × $2.80) Contribution margin Fixed expenses Profit

$24,000 16,800 $7,200 6,600 $ 600

2. Let N = Unit Sales Sales – Variable expenses – Fixed expenses = Profit $4N – $2.80N – $6,600 = .10 × ($4N) $1.20N - $6,600 = $.40N N = $6,600 ÷ ($1.20 – $.40) = 8,250 boxes of doughnuts 3. Fixed cost ÷ (Sales price – Cost of meat – Cost of buns – Cost of other ingredients) = # of hamburgers $1,900 ÷ ($1.50 – $.40 – $.13 – $.21) = 2,500 hamburgers 4. (2,000 × $.76) + (4,000 × $1.20) – $1,900 = $1,520 + $4,800 – $1,900 = $4,420 added profit 5. $1,900 ÷ ($.76 + $1.20) = 969 new customers are needed to break-even on the new business. A sensitivity analysis would help provide Andrew with an assessment of the financial risks associated with the new hamburger business. Suppose that Terry is confident that the demand for hamburgers would range between break-even ± 500 new customers and that expected fixed costs will not change within this range. The contribution margin generated by each new customer is $1.96 so Andrew will realize a maximum loss or profit from the new business in the range ± $1.96 × 500 = ± $980. Another way to assess the financial risk that Andrew should be aware of is the company’s operating leverage (the ratio of fixed to variable costs). A highly leveraged company has relatively high fixed costs and low variable costs. Such a firm is risky because small ..

changes in volume lead to large changes in net income. This is good when volume increases but can be disastrous when volumes fall. 6. The additional cost of higher quality hamburger ingredients is .5 × $.74 = $.37. Any price for the higher quality hamburgers above the current price of $1.50 plus $.37, or $1.87, will improve profits, assuming the same number of customers purchase hamburgers.

2-48 (30-40 min.) 1. The cost of labor and equipment rent is fixed at ₹42,000 per month. The cost of cleaning supplies varies in proportion to the number of times the store is cleaned. The cost per cleaning is ₹24,000 ÷ 60 = ₹400. Number of Times the Store Is Cleaned 35 40 45 50 55 60

Labor & Rent Cost ₹42,000 42,000 42,000 42,000 42,000 42,000

Cleaning Supplies Cost at ₹400 per Cleaning ₹14,000 16,000 18,000 20,000 22,000 24,000

Total Cost ₹56,000 58,000 60,000 62,000 64,000 66,000

Cost per Cleaning ₹1,600.00 1,450.00 1,333.33 1,240.00 1,163.64 1,100.00

The total cost of cleaning for the next quarter is: Total cost = = = =

Total fixed cost + Total variable cost 3 × ₹42,000 + ((50 + 46 + 35) × ₹400 per cleaning) ₹126,000 + ₹52,400 ₹178,400

2. The graph is as follows:

3. Number of Times the Store Month Is Cleaned June 35 May 46 April 50

Costs of Suraksha Polyclinic Labor & Cleaning Rent Supplies Total Cost Cost Cost ₹42,000 ₹14,000 ₹56,000 42,000 18,400 60,400 42,000 20,000 62,000 ₹178,400

Outside Cleaning Cost ₹50,400 66,240 72,000 ₹188,640

Suraksha Polyclinic will save ₹188,640 – ₹178,400 = ₹10,240 by continuing to do its own cleaning rather than using the outside cleaning company, as shown in the above schedule. 2-49

(10-15 min.)

The budget for professional salaries for the coming year is $1,100,000. Refined analysis: Key professional salaries $1,200,000 1,100,000 1,000,000

$2,000,000

$2,400,000

Billings

$2,000,000

$2,400,000

Billings

Simplified analysis: Key professional salaries $1,200,000 1,100,000 1,000,000

Relevant Range ..

2-50

(15-20 min.)

1. Microsoft: ($60,420 - $11,598) ÷ $60,420 = .81 or 81% Procter & Gamble: ($83,503 - $40,695) ÷ $83,503) = .51 or 51% There is very little variable cost for each unit of software sold by Microsoft, as the variable cost percentage is only 19%. The variable cost percentage for the soap, cosmetics, foods, and other products of Procter & Gamble is much higher at 49%. 2. Microsoft: $10,000,000 × .81 = $8,100,000 Procter & Gamble: $10,000,000 × .51 = $5,100,000 3. We know that the total contribution margin generated by any added sales will be added to the operating income. Thus, we can simply multiply the contribution margin percentage by the changes in sales to get the change in operating income. The main assumption we make is that the sales volume remains in the relevant range so that total fixed costs do not change and unit variable cost remain unchanged. This generally means that such predictions will apply only to small changes in volume – changes that do not cause either the addition or reduction of capacity.

2-51

(15-20 min.) Film

Revenue from admissions Variable costs Contribution margin Fixed costs: Auditorium rental Labor Operating income a b c

Refreshments

¥225,000 112,500 ¥112,500

¥31,500 a

17,325 ¥14,175

b c

¥33,000 43,500

Total ¥256,500 129,825 ¥126,675

76,500 ¥50,175

.50 × ¥225,000 = ¥112,500 .14 × ¥225,000 = ¥31,500 .55 × ¥31,500 = ¥17,325

Some labor might be exclusively devoted to refreshments. Labor might be allocated, but such a discussion is not the major point of this chapter. Film 2.

Revenue from admissions Variable costs Contribution margin Fixed costs: Auditorium rental Labor Operating income (loss)

Refreshments

¥140,000 75,000 ¥65,000 ¥33,000 43,500

¥19,600 a

10,780 ¥8,820

b c

Total ¥159,600 85,780 ¥73,820

76,500 ¥(2,680)

a Guarantee is ¥75,000 b .14 × ¥14,000 = ¥19,600 c .55 × ¥19,600= ¥10,780 3.

The offer would shift the risk completely to the movie producer, whereas ordinarily, the theatre owner bears a great deal of the risk. The owner is assured of a specified income; the producer then reaps the reward or bears the cost of the actual attendance level.

2-52

(15 min.)

Let X = amount of additional fixed costs for advertising (1,300,000 × £15) +£270,000 -.20(1,300,000 × £15) - (£7,300,000 + X) = 0 £19,500,000 + £270,000 - £3,900,000 - £7,300,000 - X = 0 X = £19,770,000 - £11,200,000 X = £8,570,000

Let Y = number of seats sold £15Y + £270,000 - .20 × £15Y - £11,000,000 = £490,000 £12Y = £11,220,000 Y = 935,000 seats

2-53 (45-55 min.) 1.

Exhibit A shows the relationships between the receiving activity and the resources used. This information can now be used for cost control purposes. Knowing the two rates, gallons per part received and machine hours operated per part received, will help operating managers predict costs. These rates are measures of productivity in the receiving department. Exhibit A

EQUIPMENT RESOURCE $45,000

1,500 Hours/30,000 Parts = 0.05 Hours/Part Received

FUEL RESOURCE $24,000 ÷ 6,000 Gal. = $4 Per Gallon Used

6,000 Gal./30,000 Parts = 0.2 Gal./Part Received

RECEIVING ACTIVITY Cost Driver Number of Parts Received, 30,000 2.

When the activity level increases, the use of resources will increase. Thus, the output measures or cost driver levels will increase – that is, total hours and total gallons. Normally, productivity rates such as gallons per part received and hours operated per part received will not change significantly unless a) there is action taken to improve efficiency, or b) factors act to decrease efficiency. An equation can be derived to predict total cost using the above concept. Total Cost = Variable Cost of Fuel + Fixed Cost of Equipment = (Number of Parts Received × Gallon/Part × Price/Gallon) + $45,000 The total cost of receiving 40,000 parts is (40,000 parts × 0.2 Gallon/Part × $4/Gallon) + $45,000 = $77,000

The new fuel consumption rate will be .80 × 0.2 gallons/part received = 0.16 gallons per part received. The predicted cost of receiving 30,000 parts is (30,000 Parts × 0.16 Gallons/Part × $4.00 per Gallon) + $45,000 = $19,200 + $45,000 = $64,200. The receiving department will not achieve the 10% cost reduction goal of $62,100 even though productivity in fuel usage improved by 20%. Although the variable cost of fuel declines by 20%, the fixed cost of equipment does not decline at all, and the fixed equipment costs are a large portion of the total cost of receiving. Perhaps management should consider setting cost reduction goals in the light of knowledge of cost behavior.

The new model contains productivity measures that are controllable by operating managers who are responsible for costs incurred. As a result, management can expect higher levels exerted effort by managers as well as improvement in cost control.

One refinement is to note that total fuel usage is a function of both the efficiency in machine use as well as efficiency in fuel consumption. In terms of productivity metrics this can be expressed as follows:

Current model: Total Fuel Cost = $/Gallon × Gallons/Part Received × Total Number of Parts Received. Refined model: Total Fuel Cost = $/Gallon × Gallons Used/Operating Hour × Operating Hours/Part Received × Total Number of Parts Received. The refined model has two productivity measures instead of only one. Both these measures are controllable by operating managers in the receiving department. As a result, management can focus effort in two areas of potential improvement. For example, if there was a 20% improvement in both these productivity measures, the total fuel cost would be Total fuel cost = $4/Gal. × .8 × 4 Gal./Hour Operated × .8 × .05* Hours Operated/Part Received × 30,000 Parts Received = $15,360. * 1,500 operating hours/30,000 parts received The predicted total cost of receiving would then be $15,360 + $45,000 = $60,360 and the target goal would be achieved.

2-54

(20-30 min.) Many shortcuts are available, but this solution uses the equation technique.

Let N = Sales $18N N= N=

meals sold Variable expenses - Fixed expenses = Profit before taxes $9.50N - $17,000 = $8,500 $25,500 ÷ $8.50 3,000 meals

$18N - $9.50N - $17,000 = $0 N = $17,000 ÷ $8.50 N = 2,000 meals

$22N - $11.40N - $25,420 = $8,500 N = $33,920 ÷ $10.60 N = 3,200 meals

Profit = ($22 × 2,550) – ($11.40 × 2,550) - $25,420 Profit = $1,610

Profit = ($22 × 2,800) –($11.40 × 2,800) - ($25,420 + $2,300) Profit = $29,680 - $27,720 Profit = $1,960, an increase of $350. A shortcut, incremental approach follows: Increase in contribution margin, 250 × $10.60 Increase in fixed costs Increase in profit

$2,650 2,300 $ 350

2-55

(10-15 min.)

1. Contribution margin per unit = $40 – $20 = $20 Annual fixed cost = $10,000 Break-even point = $10,000 ÷ $20 = 500 units 2. Target profit (before tax) = Target profit after tax ÷ (1 – Tax rate) = $24,000 ÷ 0.60 = $40,000 Target sales =

= 2,500 units

During the first five months, only 350 units of the target have been sold. So, the company needs to sell further (2,500 – 350) = 2,150 units in the remaining seven months. 3. Calculation of total profit under different alternatives:

a. Contribution margin during first five months ($20 x 350)

$7,000

$36.0

$37.0

$38.0

($40 – $4)

($40 – $3)

($40 – 5% of $40)

20.0

17.5

20.0

b. Contribution from remaining months Selling price per unit

Variable cost per unit

($20 – $2.5)

Contribution margin per unit

$16.0

$19.5

$18.0

Expected sales unit

2,700

2,200

2,100

Total contribution

$43,200

$42,900

$37,800

c. Total Contribution for the entire year (a + b)

$50,200

$49,900

$44,800

d. Fixed costs

$10,000

$9,000

$39,900

($10000 – $1000) $35,800

e. Expected profit (c – d)

$40,200

The company should choose alternative A.

2-56

(10-15 min.) Amounts are in millions (rounded with slight rounding errors). Net sales (.9 × $82,559) Variable costs: Cost of goods sold (.9 × $40,768) Contribution margin Fixed costs: Selling, administrative, and general expenses Operating income

$74,303 36,691 37,612 25,973 $11,639

The percentage decrease in operating income would be 1 – ($11,639  $15,818) = 1 – .736 or 26.4%, compared with a 10% decrease in sales. The contribution margin would decrease by 10% or .10 × ($82,559 - $40,768) = $4,179 million. Because fixed costs would not change (assuming the new volume is within the relevant range), operating income would also decrease by $4,179 million, from $15,818 million to $11,639 million. Because of the existence of fixed costs, the percentage decrease in operating income will exceed the percentage decrease in sales. If all costs had been variable, fixed costs would have decreased by an additional .10 × $25,973 = $2,597 million, making operating income $11,639 + $2,597 = $14,236 million, a 10% decrease from the 2011 operating income of $15,818 million.

2-57

(15-25 min.)

Average revenue per person Total revenue, 200 @ €20.00 = Rent Total available for prizes and operating income

€16.00 + 4(€1.00) = €20.00 €4,000 1,900 €2,100

The church could award cash prizes of €2,100 and break-even. 2.

Number of persons Total revenue @ €20.00 Fixed costs: Rent Prizes Operating income (loss)

€1,900 2,100

60 €1,200

200 €4,000

400 €8,000

4,000 €(2,800)

4,000 €0

4,000 €4,000

Note how “leverage” works. Being highly leveraged means having relatively high fixed costs. In this case, there are no variable costs. Therefore, the revenue is the same as the contribution margin. As volume departs from the break-even point, operating income is affected at a significant rate of €20 per person. 3.

Number of persons Revenue Variable costs Contribution margin Fixed costs: Rent Prizes Operating income (loss)

€1,400 2,100

60 €1,200 120 € 1,080

200 €4,000 400 €3,600

400 €8,000 800 €7,200

3,500 €(2,420)

3,500 €100

3,500 €3,700

The risk is lower with the revised cost structure because of lower operating leverage—fixed costs are lower and variable costs are higher. Some of the risk has been shifted to the hotel. As a result, when attendance is low, the club will not lose as much money, and when attendance is high, the club will not make as much money. For example, the income at 400 persons is €3,700 versus €4,000 and the loss at 60 persons is €(2,420) instead of €(2,800).

2-58 (10-20 min.) 1. To compute eBay’s operating income, we need to know fixed and variable costs. We are given that its fixed costs are $37 million. Variable costs in the first quarter of 2001 were: Operating expenses - Fixed costs $123 million - $37 million

= Variable costs = $86 million

Variable costs were $86 million ÷ $154 million = 55.84% of sales. If this percentage also applied to 2002, variable costs in 2002 should have been 55.84% × $245 million = 136.8 million. Since sales increased by 1 – ($245 million ÷ $154 million) = 59.09% in 2002, variable costs should also have increased by 59.09%: 2002 variable costs = 1.5909 × $86 million = $136.8 million Therefore, we calculate 2002 operating income as follows: operating income = revenues – variable cost – fixed cost =$245 million - $136.8 million - $37 million = $71.2 million This is a 130% increase in operating income: ($71.2 million ÷ $31 million) – 1 = 130% 2. When sales increased 59%, operating income increased by 130%. This is an example of the effect of operating leverage. The variable cost percentage is approximately $86 ÷ $154 = 56%. Thus, the contribution margin percentage is 100% - 56% = 44%. Every dollar of sales generates $.44 of operating income. The sales increase of $245 million $154 million = $91 million generated $91 million × 44% = $40 million of operating income, while the original $154 million of sales had generated only $31 million of operating income. This is because the same $37 million of fixed cost applied at both level of sales. The additional $91 million of sales caused no additional fixed costs, so its total contribution margin all becomes operating income.

2-59

(15-25 min.)

Let N = Number of plates of fish and chips per month AUD 4.50N = AUD 3.70N + AUD 1,800 AUD .80N = AUD 1,800 N = 2,250 per month, or 2,250 ÷ 30 = 75 per day

Multiply the answers in (1) by AUD 4.50 2,250 × AUD 4.50 = AUD 10,125 per month 75 × AUD 4.50 = AUD 337.50 per day

Fish and chips plates per month, 3,200 ÷ 2 Revenue per month, 1,600 × AUD 4.50 Variable expenses, 1,600 × AUD 3.70 Contribution margin, 1,600 × AUD .80 Fixed expenses Operating income (loss)

Contribution margin on extra meat pies:

1,600 AUD 7,200 5,920 AUD 1,280 1,800 AUD (520)

Per day: 80 × AUD .60 = AUD 48 Per month, 30 × AUD 48 = AUD 1,440 Income from additional sales of meat pies would increase by AUD 1,440, which more than offsets the AUD 520 loss on the fish and chips sales, making the net effect on operating income of selling fish and chips and selling additional meat pie because of the meat pie sales equal to AUD – 520 + AUD 1,440 = AUD 920. 5.

Operating loss on fish and chips Desired contribution margin on extra meat pies Overall effect on operating income

AUD (520) 520 AUD 0

Desired number of extra meat pies to provide an overall effect on operating income of zero: Per month = AUD 520 ÷ .60 = 867 meat pies Per day = 867 ÷ 30 = 29 meat pies Or, desired contribution margin per day is AUD 520 ÷ 30 = AUD 17.3 Daily number of meat pies = AUD 17.3 ÷ AUD .60 = 29 ..

Therefore, if Ethan believes that the extra meat pies sold amount to 29 daily instead of 80, the fish and chips operation would provide an overall effect on operating income of zero.

2-60 (15-20 min.) Note how, in requirements 2 and 3, the percentage declines exceed the 15% budget reduction. 1.

Let N = Number of orphanages Revenue – Variable expenses – Fixed expenses = 0 ₤1,800,000 – ₤10,000N – ₤560,000 = 0 ₤10,000N = ₤1,800,000 – ₤560,000 N = ₤1,240,000 ÷ ₤10,000 N = 124 orphanages

Revenue is now .85(₤1,800,000) = ₤1,530,000 Let N = Number of orphanages Revenue – Variable expenses – Fixed expenses = 0 ₤1,530,000 – ₤10,000N – ₤560,000 = 0 ₤10,000N = ₤1,530,000 – ₤560,000 N = ₤970,000 ÷ ₤10,000 N = 97 orphanages Percentage drop: (124 – 97) ÷ 124 = 21.8%

Let y = Monetary support per orphanage ₤1,530,000 – 124y – ₤560,000 = 0 124y = ₤1530,000 – ₤560,000 y = ₤970,000 ÷ 124 y = ₤7,822 Percentage drop: (₤10,000 – ₤7,822) ÷ ₤10,000 = 21.8% Regarding requirements 2 and 3, note that the cut in service can be measured by a formula: % cut in service = % budget change ÷ % variable cost The variable cost ratio is ₤1,240,000 ÷ ₤1,800,000 = 68.9% % cut in service = 15% ÷ 68.9% = 21.8%

2-61

(15-20 min.) Answers are in millions.

Sales Variable costs: Variable costs of goods sold Variable other operating expenses Contribution margin

$6,022 $3,735 487

4,222 $ 1,800

Contribution margin percentage = $1,800  $6,022 = 29.9% The contribution margin equals sales less all variable costs, while gross margin equals sales less cost of goods sold. The variable costs include part of the costs of goods sold and also part of the other operating costs. Note that contribution margin can be either larger than or smaller than the gross margin. If most of the cost of goods sold and a good portion of the other operating costs are variable, then variable costs may exceed the cost of goods sold, and the contribution margin will be smaller than the gross margin. However, if a large portion of both the cost of goods sold and the other expenses are fixed, cost of goods sold may exceed the variable cost, resulting in the contribution margin exceeding gross margin. 2.

Predicted sales increase = $6,022 × .10 = $602.20 Additional contribution margin = $602.20 × .299 = $180 Fixed costs do not change Predicted operating loss = $(600) + $180 = $(420) Percentage decrease in operating loss = $180  $(600) = 30% Note that a 10% increase in sales would decrease the operating loss by 30%.

Assumptions include:  Expenses can be classified into variable and fixed categories that completely describe their behavior within the relevant range.  Costs and revenues are linear within the relevant range.  Predicted sales volume is within the relevant range.  Efficiency and productivity are unchanged.  Sales mix is unchanged.  Changes in inventory levels are insignificant.

2-62

(20-30 min.)

Variable costs per box are ($.15 + $.10 + $.20), ($.15 + $.10 + $.12), and ($.15 + $.10 + $.03), or $.45, $.37, and $.28, respectively 1.

Let N = Volume level in packets that would earn same profit $15,680 + $.45N = $22,400 + $.37N $.08N = $6,720 N = 84,000 packets

As volume increases, the more expensive models would generate more profits. Compare the super and supreme models: Let N = Volume level in packets that would earn same profit $40,400 + $.28N = $22,400 + .37N $.09N = $18,000 N = 200,000 packets Therefore, the decision rule is as shown below. Anticipated Annual Sales Between 0 – 84,000 84,000 – 200,000 200,000 and above

Use Model Standard Super Supreme

The decision rule places volume well within the capacity of each model.

2-63

(10-15 min.)

1. Nestle has the higher fixed cost, while Sicca has the higher variable cost. Thus, the contribution margin for Nestle will be higher. Nestle will have more risk. Its profits increase faster as sales increase, but its profits decrease faster (or losses increase faster) as sales decrease. 2. Sicca provides more incentive to its sales force to increase sales. For each $1 of increased sales, Sicca pays more of that increase to the sales force, while Nestle retains more of the increase for the company’s profit. 3. A possible negative of the increased incentive for the Sicca sales force to increase sales is a motivation to increase those short-term sales at any cost. That is, the Sicca sales force might be motivated to sell customers product they don’t need or to record sales that are not yet final. Many companies have found that too much emphasis on sales volumes can cause managers to take unethical actions to increase their sales levels.

2-64

(20-25 min.)

Net income (loss)

Let B 2B

= (200,000 × $1) + (100,000 × $2) - $680,000 = $200,000 + $200,000 - $680,000 = $(280,000)

= number of units of beef enchiladas to break even = number of units of chicken tacos to break even (C)

Total contribution margin - fixed expenses = zero net income ($2 × B) + ($1 × 2B) - $680,000 $4 ×B B 2B

=0 = $680,000 = 170,000 = 340,000 = C

The break-even point is 170,000 units of beef enchiladas plus 340,000 units of chicken tacos, a grand total of 510,000 units. 3.

If tacos, break-even would be $680,000 ÷ $1 = 680,000 units. If enchiladas, break-even would be $680,000 ÷ $2 = 340,000 units.

Net income (loss)

= (225,000 × $1) + (75,000 × $2) - $680,000 = $225,000 + $150,000 - $680,000 = $(305,000)

Let B = number of units of beef enchiladas to break even 3B = number of units of chicken tacos to break even (C) Total contribution margin - fixed expenses = zero net income ($2 × B) + ($1 × 3B) - $680,000 $5 × B B 3B

=0 = $680,000 = 136,000 = 408,000 = C

The major lesson of this problem is that changes in sales mix affect break-even points and net incomes.

2-65 1.

(20-25 min.)

Let S = number of self-pay patients (S) 3S = number of other patients (G) ($1,250 × S) + ($950 × 3S) – ($750 × S) – ($750 × 3S) - $52,800,000 ($1,250 × S) + ($2,850 × S) – ($750 × S) – ($2,250 × S) $1,100 × S S 3S

=0 = $52,800,000 = $52,800,000 = 48,000 = 144,000 = G

The break-even point is 48,000 self-pay patient days plus 48,000 × 3 = 144,000 other patient days, a grand total of 192,000 patient days. 2.

Contribution margins: S = $1,250 - $750 = $500 per patient day G = $950 - $750 = $200 per patient day Patient days: S = .40 × 172,000 = 68,800 G = .60 × 172,000 = 103,200 Net income = (68,800 × $500) + (103,200 × $200) - $52,800,000 = $34,400,000 + $20,640,000 - $52,800,000 = $2,240,000 Let S = number of self-pay patients (S) 1.5S = number of other patients (G)

($1,250 × S) + ($950 ×1.5S) – ($750 × S) – ($750 ×1.5S) - $52,800,000 = 0 ($1,250 × S) + ($1,425 × S) – ($750 × S) – ($1,125 × S) = $52,800,000 $800 × S = $52,800,000 S = 66,000 1.5S = 99,000 = G The break-even point is now lower (66,000 + 99,000 = 165,000 patient days instead of 48,000 + 144,000 = 192,000 patient days).

2-66

(15-25 min.)

Let N = number of rooms $801,000 (1 - .25) ($48 × N) - $8,700,000 = $1,068,000 $48 ×N = $9,768,000 N = 203,500 rooms

($90 × N) – ($42 × N) - $8,700,000 =

$400,500 (1 - .25) ($48 × N) - $8,700,000 = $534,000 $48 × N = $9,234,000 N = 192,375 rooms

($48 × N) - $8,700,000 =

($90 × N) – ($42 × N) - $8,700,000 = 0 $48 × N = $8,700,000 N = 181,250 rooms Number of rooms at 100% capacity = 570 × 365 = 208,050 Percentage occupancy to break even = 181,250 ÷ 208,050 = 87.1%

Using the shortcut approach described in the chapter appendix: Change in net income = Change in vol. in units × Cont. margin/unit × (1 - tax rate) = 6,000 × $48 × (1 - .25) = 6,000 × $36 = $216,000. Note that a 3% increase in rooms rented increased net income by $216,000 ÷ $675,000 or 32%. Rooms rented Contribution margin @ $48 Fixed expenses Income before taxes Income taxes @ 25% Net income Increase in net income Percentage increase

200,000 $9,600,000 8,700,000 900,000 225,000 $ 675,000

206,000 $9,888,000 8,700,000 1,188,000 297,000 $ 891,000

$216,000 32%

2-67

(15-25 min.)

Current contribution margin = $15 - $8 - $4 = $3. New variable costs per disk will be (125% x $8 ) + $4 = $10 + $4 = $14. $714,000 $15- ($8 + $4)

Break-even point =

= 238,000 CDs

Contribution margin: $15 - ($8 + $4) = $3 Increased after-tax income after 15% increase in volume: Change in net income = Increase in vol. in units × Cont. margin/unit × (1 - tax rate) = 25,500 × $3 × (1 - .40) = $45,900 increase in income

Let N = target sales in units

25% increase in unit purchase price will increase purchase price to $10 (from previous value of $8) so variable costs per unit will be $10 + $4 = $14. target after-tax net income Target sales – Variable costs – Fixed costs = 1 - tax rate ($15 × N) – ($14 × N) - $714,000 = $90,000 ÷ (1 - .4) ($15 × N) – ($14 × N) - $714,000 = $150,000 $1 × N = $864,000 N = 864,000 units $15 × N = $12,960,000 4.

Let P = new selling price Current contribution ratio is $3 ÷ $15 New contribution ratio is (P - $14) ÷ P .20P .80P P P

= .20 = .20 = P - $14 = $14 = $14 ÷ .80 = $17.5

2-68

(25-35 min.)

1. Calculation for profit for the year 2020 Charges collected from patients

BDT6,991,250

Less: Variable cost of the center

2,714,250

Contribution

4,277,000

Less: Fixed costs Fixed costs of the center

1,245,000

Apportionment of general administration charges

2,000,000

Salary of the Nurses (6 x 60,000)

360,000

Profit

3,605,000 672,000

Note: Annual bed days for 2020 = BDT6,991,250 ÷ 425 = 16,450. So, six nurses had been employed in 2020. Calculation for profit for the year 2020 Charges collected from patients (occupancy being unchanged)

BDT6,991,250

Less: Variable cost of the center (2,714,250 x 110%)

2,985,675

Contribution

4,005,575

Less: Fixed costs

Profit

Fixed costs of the center (1,245,000 x 110%)

1,369,500

Apportionment of general administration charges

2,500,000

Salary of the Nurses (6 x 72000)

432,000

4,301,500 (295,925)

Thus, at the same level of occupancy with similar charges per bed day, the center will incur a loss of BDT295,925. 2. Contribution margin per bed day for 2021 = BDT4,005,575 ÷ 16,450 = BDT243.50 Break-even bed capacity = Fixed cost ÷ contribution margin per bed day = BDT4,301,500 ÷ BDT243.50 = 17,665 bed days

3. The management will be ready to run the center only if they can fully recover the fixed costs of the center by the contribution available at the current occupancy level. Current occupancy level = 16,450 bed days. Target contribution per bed day = BDT4,301,500 ÷ 16,450 = BDT261.49 Variable cost per bed day = 2,985,675 ÷ 16,450 = BDT181.50 Target charges per bed day = BDT181.50 + BDT261.49 = BDT442.99 So, the increase in charges required = BDT442.99 – BDT425.00 = BDT17.99

2-69

(15-20 min.)

Old: (Contribution margin × 600,000) - $580,000 = Budgeted profit [($3.10 - $2.10) × 600,000] - $580,000 = $20,000 New: (Contribution margin × 600,000) - $1,140,000 = Budgeted profit [($3.10 - 1.10) × 600,000] - $1,140,000 = $60,000

Old: $580,000 ÷ $1.00 = 580,000 units New: $1,140,000 ÷ $2.00 = 570,000 units

A fall in volume will be more devastating under the new system because the high fixed costs will not be affected by the fall in volume: Old: ($1.00 × 500,000) - $580,000 = –$80,000 (an $80,000 loss) New: ($2.00 × 500,000) - $1,140,000 = –$140,000 (a $140,000 loss) The 100,000 unit fall in volume caused a $20,000 - (- $80,000) = $100,000 decrease in profits in the old environment and a $60,000 - ( - $140,000) = $200,000 decrease in the new environment.

Increases in volume create larger increases in profit in the new environment: Old: ($1.00 × 700,000) - $580,000 = $120,000 New: ($2.00 × 700,000) - $1,140,000 = $260,000 The 100,000 unit increase in volume caused a $120,000 - $20,000 = $100,000 increase in profit under the old environment and a $260,000 - $60,000 = $200,000 increase under the new environment.

Changes in volume affect profits in the new environment (a high fixed cost, low variable cost environment) more than they affect profits in the old environment. Therefore, profits in the old environment are more stable and less risky. The higher risk new environment promises greater rewards when conditions are favorable, but also leads to greater losses when conditions are unfavorable, a more risky situation.

2-70 (25-30 min.) This case is based on real data that has been simplified so that the numbers are easier to handle. 1.

Daily break-even volume is 85 dinners and 170 lunches: First compute contribution margins on lunches and dinners: Variable cost percentage = ($1,246,500 + $222,380) ÷ $2,098,400 = 70% Contribution margin percentage = 1 - variable cost percentage = 1 - 70% = 30% Lunch contribution margin = .30 × $20 = $6 Dinner contribution margin = .30 × $40 = $12 Annual fixed cost is $170,940 + $451,500 = $622,440 Let X = number of dinners and 2X = number of lunches ($12×X) + ($6×2X) - $622,440 = 0 $24(X) = $622,440 X = 25,935 dinners annually to break even 2X = 51,870 lunches annually to break even On a daily basis: Dinners to break even = 25,935 ÷ 305 = 85 dinners daily Lunches to break even = 85 × 2 = 170 lunches daily or 51,870 ÷ 305 = 170 lunches daily. To determine the actual volume, let Y be a combination of 1 dinner and 2 lunches. The price of Y is $40 + (2 × $20) = $80, and total volume in units of Y is $2,098,400 ÷ $80 = 26,230 and daily volume is 26,230 ÷ 305 = 86. Therefore, 86 dinners and 2 × 86 = 172 lunches were served on an average day. This is 1 dinner and 2 lunches above the break-even volume.

The extra annual contribution margin from the 3 dinners and 6 lunches is: 3 × $40 × .30 × 305 = $10,980 + 6 × $20 × .30 × 305 = 10,980 Total $21,960 The added contribution margin is greater than the $15,000 advertising expenditure. Therefore, the advertising expenditure would be warranted. It would increase operating income by $21,960 - $15,000 = $6,960.

Let Y again be a combination of 1 dinner and 2 lunches, priced at $80. Variable costs are .70 × $80 = $56, of which $56 × .25 = $14 is food cost. Cutting food costs by 20% reduces variable costs by .20 × $14 = $2.80, making the variable cost of Y $56 - $2.80 = $53.20 and the contribution margin $80 - $53.20 = $26.80. (This could also be determined by adding the $2.80 saving in food cost directly to the old contribution margin of $24.) The required annual volume in Y needed to keep operating income at $7,080 is: $26.80 (Y) - $622,440 = $7,080 $26.80 (Y) = $629,520 Y = 23,490 Therefore, daily volume = 23,490 ÷ 305 = 77 (rounded) If volume drops no more than 86 - 77 = 9 dinners and 172 - 154 = 18 lunches, using the less costly food is more profitable. However, there are many subjective factors to be considered. Volume may not fall in the short run, but the decline in quality may eventually affect repeat business and cause a long-run decline. Much may depend on the skill of the chef. If the quality difference is not readily noticeable, so that volume falls less than, say, 10%, saving money on the purchases of food may be desirable.

2-71

(25-30 min.)

Break-even in pounds = Annual fixed costs ÷ Contribution margin/pound $566,250 = = 283,125 pounds (5.00 - $3.00)

Contribution margin ratio = $2.00 ÷ $5.00 = 40% Old variable cost = $3.00 Only the cost of salmon is affected: New variable cost = $3.00 + (.15 ×$2.50) = $3.375 Let S Selling price - Variable costs (S - $3.375) .60S S

= Selling price = Contribution margin = .40S = $3.375 = $5.625

Check: ($5.625 - $3.375) ÷ $5.625 = 40% 3.

Current income before taxes: = 390,000 × ($5.00 - $3.00) - $566,250 = $780,000 - $566,250 = $213,750 Current income after taxes: = $213,750 × .60 = $128,250 The problem can be solved by using units and then converting to dollar sales. Let N = sales in pounds Net income 1 - tax rate =$128,250 ÷ (1 - .4) = $213,750 = $780,000 = 480,000 pounds = $2,400,000 sales

Sales - Variable expenses - Fixed expenses = ($5.00 × N) – {[($3.00 + .15×$2.50)] × N} - $566,250 ($5.00 × N) – ($3.375 × N) - $566,250 $1.625 × N N $5.00 × N

An alternative way to get the solution is: New contribution margin ratio = ($5.00- $3.375) ÷ $5.00 = .325 New variable-cost ratio = 1.000 - .325 = .675 Let S = Sales S = (.675 × S) + $566,250 + [$128,250 ÷ (1 - .4)] .325 × S = $780,000 S = $2,400,000 ..

Strategies might include: (a) Increase selling price by the $.375 cost increase. (b) Decrease other variable costs by $.375 per pound. (c) Decrease fixed costs by $.375 × 390,000 = $146,250. (d) Increase unit sales by 480,000 - 390,000 = 90,000 pounds. (e) Some combination of the above.

2-72 (15-20 min.) 1.

The following table shows the comparison between percentage changes in total revenue and income before taxes for the six major regions of Nike.

Percent Change Region in Revenue North America 13% Western Europe –2% Central & Eastern Europe 4% Greater China 18% Japan –13% Emerging Markets 24%

Percent Change in Pre-tax Income 14% –16% –8% 22% –37% 32%

The term operating leverage means that a substantial portion of the resources used to generate income were fixed-cost resources and did not increase in response to increased revenue-generating activities. As a result, income changes more than proportional to the change in revenue. 2.

There are many possible explanations. One possibility is that while revenues increased, variable costs may have increased so that the overall contribution margin fell, resulting in a decrease in income. Another possibility is that even if variable costs did not increase, fixed costs may have increased by an amount that more than offset the increased contribution from increased sales.

Nike’s operating leverage is the ratio of its fixed costs to variable costs. A large percentage of Nike’s costs is cost of goods sold, which is primarily a variable cost, making operating leverage low. However, Nike also has many fixed costs. Many of Nike’s fixed costs are related to its distribution function. The costs of the distribution center, equipment, and salaries of regular employees and management all contribute to a substantial fixed-cost component of total cost. Another significant component of fixed costs is the Nike World Campus in Beaverton, Oregon with 16 buildings and almost 6,000 management staff.

2-73

(30-40 min.) For the solution to this Excel Application Exercise, follow the stepby-step instructions provided in the textbook chapter. Answers to the questions follow: Proposal A: Break even in units: $110,000 ÷ ($99 - $55) = 2,500 units Break even in dollars: 2,500 × $99 = $247,500

Proposal B: ..

Break even in units: $110,000 ÷ ($129 - $55) = 1,486 units Break even in dollars: 1,486 × $129 = $191,694 Proposal C: Break even in units: $110,000 ÷ ($99 - $49) = 2,200 units Break even in dollars: 2,200 × $99 = $217,800 2.

The break-even points are much smaller because the contribution margin is larger while the fixed costs are unchanged.

The increase in contribution margin was not nearly as large, $6 in proposal C compared to $30 in proposal B.

2-74

(30 min. or more) The purpose of this problem is to develop an intuitive feel for the costs involved in a simple production process and to assess whether various costs are fixed or variable. Then students must assess the market to determine a price so that they can compute a break-even point. Completing this problem can be done quickly or it can take much time. It might even be done in class, with students suggesting the various costs and predicting their levels. A complete analysis might involve finding the actual prices of the resources needed to make the product or service. This could lead to time-consuming research. Whatever approach is taken, students are led to see the real-world application of what they are learning.

2-75 (30-40 min.) NOTE TO INSTRUCTOR: This solution is based on the web site as it was in early 2012. Be sure to examine the current web site before assigning this problem, as the information there may have changed. 1.

Answers to the questions depend on the student's location and choices of dates. Fares available include business select, anytime, and “wanna get away”. Different fares are offered because of the different costs incurred by SWA to serve customers who have different flying needs. Another factor causing different fares is the need to match products offered by competing airlines. Restrictions such as the requirement to make reservations at least 7 days in advance of travel are necessary to give SWA planning information in advance. Limiting the number of reduced-price wanna get away fares on each flight is necessary in order to keep open seats for customers who must travel on short notice.

It is likely that the fares one week in advance are higher than the fares one month in advance. Customers who need to travel with short notice are willing to pay more. Many business travelers fly with very short notice.

On a particular flight, price paid for a seat (assuming the same class seat) is not a cost driver. The various costs incurred by SWA will change only slightly – possibly the type of food served will vary as a function of the price paid for a seat on a particular trip, but almost all the other costs are independent of the price paid for the seat.

Operating revenues and operating expenses are reported for the current and prior year along with the percentage change. The operating revenues increased from $12.104 billion in 2010 to $15.658 billion in 2011, an increase of 29.4%. Operating expenses increased from $11.116 billion in 2011 to $14.965 billion in 2011, an increase of 34.6%. With expenses rising faster than revenues, profits will fall – as shown by the 29.8% decrease in operating income.

To describe a particular cost as fixed or variable, we must identify the cost driver, the time period involved, and the relevant range. In this case, assume that the period is one year and the relevant range is the number of ASMs that can be available without adding to or subtracting from the current fleet of airplanes. Thus, adding ASMs means flying the existing airplanes for more hours. Costs that would probably vary with ASMs are salaries, wages, and benefits, employee retirement plans, fuel and oil, maintenance materials and repairs, landing fees and other rentals. Aircraft rentals and depreciation would probably be fixed costs. Some of these costs might be more directly caused by other cost drivers. For example, revenue passenger miles (RPM), that is number of passengers times the miles each flies, might drive agency commissions and possibly some salaries (for example, flight attendants whose number depends on how many passengers are on a particular flight).

CHAPTER 3 COVERAGE OF LEARNING OBJECTIVES

LEARNING OBJECTIVE LO1: Explain management influences on cost behavior. LO2: Measure and mathematically express cost functions and use them to predict costs. LO3: Describe the importance of activity analysis for measuring cost functions. LO4: Measure cost behavior using the engineering analysis, account analysis, highlow, visual-fit, and least-squares regression methods.

CASES, NIKE 10K, EXCEL, FUNDAMENTAL ADDITIONAL COLLAB., & ASSIGNMENT ASSIGNMENT INTERNET MATERIAL MATERIAL EXERCISES B2

10, 26, 33, 33, 39, 52

52, 56

27, 29, 30, 30, 31, 31, 34, 35, 36, 37, 37, 38, 39, 40, 40, 41, 44, 44, 46, 46, 48, 50, 51

57, 56, 58

A1, B1, B2

42, 42, 45

53, 55

A2, B2, B2

20, 28, 29, 30, 30, 34, 35, 36, 37, 37, 38, 43, 46, 46, 47, 48, 49, 51

54, 58

CHAPTER 3 Measurement of Cost Behavior

3-A1

(25-30 min.)

Support costs based on 75% of the cost of materials: Direct materials cost Support cost (75% of materials cost)

Sign A $300 $225

Sign B $800 $600

Sign A 10 $700

Sign B 2 $140

Support costs based on $70 per power tool operation: Power tool operations Support cost 2.

If the activity analysis is reliable, by using the current method, Dogwood Signs is predicting too much cost for signs that use few power tool operations and is predicting too little cost for signs that use many power tool operations. As a result the company could be losing jobs that require few power tool operations because its bids are too high -- it could afford to bid less on these jobs. Conversely, the company could be getting too many jobs that require many power tool operations, because its bids are too low -- given what the "true" costs will be, the company cannot afford these jobs at those prices. Either way, the sign business could be more profitable if the owner better understood and used activity analysis. Dogwood Signs would be advised to adopt the activityanalysis recommendation, but also to closely monitor costs to see if the activityanalysis predictions of support costs are accurate.

3-A2 (25-30 min.) 1.

High-Low Method: High month = May Low month = September Difference

Support Cost $22,000 18,000 $ 4,000

Machine Hours 1,700 1,300 400

Variable cost per machine hour = Change in cost ÷ Change in cost driver = $4,000 ÷ 400 = $10.00 Fixed support cost per month = Total support cost - Variable support cost At the high point: = $22,000 - $10.00 × 1,700 = $22,000 - $17,000 = $ 5,000 or at the low point:

= $ 18,000 - $10.00 × 1,300 = $ 18,000 - $13,000 = $ 5,000

The high-low method uses the high and low activity levels to determine the cost function. Since the new October data for machine hours does not change either the high or low level there would be no change in the analysis.

The regression analysis results differ from the results of the high-low method. As a result, estimates of total support cost may differ considerably depending on the expected machine hour usage. For example, consider the following support cost estimates at three levels of machine hour usage (all within the relevant range): Machine Hour Usage High-Low: Fixed Variable:

1,500 Hours

1,600 Hours

$5,000 14,000

$ 5,000

15,000

Total

$19,000

$20,000

16,000 $21,000

Regression: Fixed Variable:

$4,050 14,700

$ 4,050

Total ..

$10.00 × 1,400 $10.00 × 1,500 $10.00 × 1,600

1,400 Hours

$10.50 × 1,400 $10.50 × 1,500 $10.50 × 1,600

15,750 $18,750

$ 19,800

16,800 $20,850 85

Because the high-low method has a lower variable cost estimate and a higher fixed cost estimate than the regression-based predictions, the estimates of total support cost differ depending on the expected machine hour usage. The highlow method used only two data points, so the results may not be reliable. Molly would be advised to use the regression results, which are based on all relevant data.

3-B1 (25-30 min.) Mark-up method: Material cost Support costs (100%) Activity analysis method: Manual operations Support costs (@$6)

Board Z15

Board Q52

$46 $46

$65 $65

19 $114

8 $48

The support costs are different because different cost behavior is assumed by the two methods. If the activity analyses are reliable, then boards with few manual operations are overcosted with the markup method, and boards with many manual operations are undercosted with the markup method. 3-B2

(25-30 min.)

Variable cost per machine hour = Change in Repair Cost ÷ Change in Machine Hours = (P272,000,000 – P202,000,000) ÷ (11,900 – 7,900) = P17,500 per machine hour Fixed cost per month

= total cost - variable cost = P272,000,000 – P17,500 × 11,900 = P272,000,000 – P208,250,000 = P 63,750,000 per month

= P202,000,000 – P17,500 × 7,900 = P202,000,000 – P138,250,000 = P 63,750,000 per month

3-1

A cost driver is any output measure that is believed to cause costs to fluctuate in a predictable manner. For example, direct labor costs are probably driven by direct labor hours; materials costs are probably driven by levels of product output; and support costs may be driven by a variety of drivers, such as output levels, product complexity, number of different products and/or parts, and so on.

3-2

Linear cost behavior assumes that costs behave as a straight line. This line is anchored by an intercept, or fixed cost estimate, and total costs increase proportionately as cost driver activity increases. The slope of the line is the estimate of variable cost per unit of cost driver activity.

3-3

Whether to categorize a step cost either as a fixed cost or as a variable cost depends on the "size" of the steps (height and width) and on the desired accuracy of the description of step cost behavior. If the steps are wide, covering a wide range of cost driver activity, then within each range the cost may be regarded as fixed. If the steps are narrow and not too high, with small changes in cost, then the cost may be regarded as variable over a wide range of activity level, with little error. If the steps are narrow and high, covering big changes in cost, then the cost probably should not be regarded as variable, since small changes in activity level can result in large changes in cost.

3-4

Mixed costs are costs that contain both fixed and variable elements. A mixed cost has a fixed portion that is usually a cost per time period. This is the minimum mixed cost per period. A mixed cost also has a variable portion that is a cost per unit of cost driver activity. The variable portion of a mixed cost increases proportionately with increases in the cost driver. In order to achieve the goals set for the organization, management makes critical choices -- choices that guide the future activities of the organization. These choices include decisions about locations, products, services, organization structure, and so on. Choices about product or service attributes (mix, quality, features, performance, etc.), capacity (committed and discretionary fixed costs), technology (capital/labor considerations, alternative technologies), and incentives (standard-based performance evaluation) can greatly affect cost behavior.

3-5

3-6

Some fixed costs are called capacity costs because the levels of these fixed costs are determined by management's strategic decisions about the organization's expected levels of activities, or capacity.

3-7

Committed fixed costs are costs that are often driven by the planned scale of operations. These costs typically cannot be changed easily or quickly without drastically changing the operations of the organization. Typical committed fixed costs include lease or mortgage payments, property taxes, and long-term management compensation. Discretionary fixed costs are costs that may be necessary to achieve certain operational goals, but there are no contractual obligations to continue these payments. Typical discretionary fixed costs include advertising, research and development, and employee training programs. The distinction between committed and discretionary fixed costs is that discretionary fixed costs are flexible and could be increased, decreased, or eliminated entirely on short notice if necessary, but committed fixed costs usually must be incurred for some time -- greater effort is needed to change or eliminate them.

3-8

Committed fixed costs are the most difficult to change because long-term commitments generally have been made. These long-term commitments may involve legal contracts that would be costly to renegotiate or dissolve. Committed fixed costs also are difficult to change because doing so may mean greatly changing the way the organization conducts its activities. Changing these committed fixed costs may also mean changing organization structure, location, employment levels, and products or services.

3-9

An organization’s capacity generally determines its committed fixed costs. Management’s choice is the main influence on discretionary fixed costs. Both committed and discretionary fixed costs depend on the organization's strategy relating to capacity, product attributes, and technology. These elements will determine long-term cost commitments (committed costs) and flexible spending responses to changes in the environment (discretionary costs).

3-10

There is no apparent relationship between discretionary fixed costs and the levels of capacity or output activity. They are determined as a part of an organization’s periodic planning process; the management determines how much to spend on discretionary fixed costs in each period. As a result, the level of such costs can certainly vary from period to period or in other words the costs can be considered fixed only for the relevant period.

3-11

High technology production systems often mean higher fixed costs and lower variable costs.

3-12

Incentives to control costs are means of making cost control in the best interests of the people responsible for making cost expenditures. A simple example will illustrate the use of incentives to control costs. Assume that you are an executive who travels for business, purchases professional literature, and keeps current with personal computer technology. Under one incentive system, you simply bill the organization for all your travel and professional expenses. Under another system, you are given an annual budget for travel and professional needs. Which system do you think would cause you to be more careful about how you spend money for travel and professional needs? Most likely, the latter system would be more effective in controlling costs. Usually these incentives are economic, but other non-financial incentives may also be effective.

3-13

Use of cost functions, or algebraic representations of cost behavior, allows cost analysts or management to build models of the organization's cost behavior. These models can be used to aid planning and control activities. One common use of cost functions is in financial planning models, which are algebraic models of the cost and revenue behavior of the firm, essentially extended C-V-P models similar to those discussed in Chapter 2. Understanding relationships between costs and cost drivers allows managers to make better decisions.

3-14

A "plausible" cost function is one that is intuitively sound. A cost function is plausible if a knowledgeable analyst can make sound economic justifications why a particular cost driver could cause the cost in question. A "reliable" cost function is one that accurately and consistently describes actual cost behavior, past and future. Both plausibility and reliability are essential to useful cost functions. It is difficult to say that one is more important than the other, but one would not have much confidence in the future use of a cost function that is not plausible, even if past reliability (e.g., based on statistical measures) has been high. Likewise, one would not be confident using a cost function that is highly plausible, but that has not been shown to be reliable. The cost analyst should strive for plausible and reliable cost functions.

3-15

Activity analysis identifies underlying causes of cost behavior (appropriate cost drivers) and measures the relationships of costs to their cost drivers. A variety of methods may be used to measure cost functions, including engineering analysis and account analysis.

3-16

Engineering analysis is a method of identifying and measuring cost and cost driver relationships that does not require the use of historical data. Engineering analysis proceeds by the use of interviews, experimentation, and observation of current cost generating activities. Engineering analysis will be more reliable if the organization has had past experience with the activities. Account analysis is a method of identifying and measuring costs and cost driver relationships that depend explicitly on historical cost data. An analyst selects a single cost driver and classifies each cost account as fixed or variable with respect to that cost driver. Account analysis will be reliable if the analyst is skilled and if the data are relevant to future uses of the derived cost function.

3-17

There are four general methods covered in this text to measure mixed costs using historical data: (1) account analysis, (2) high-low, (3) visual fit, and (4) regression. • Account analysis looks to the organization's cost accounts and classifies each cost as either fixed, variable, or mixed with regard to an appropriate cost driver. • High-low analysis algebraically measures mixed cost behavior by constructing a straight line between the cost at the highest activity level and that at the lowest activity level. • Visual-fit analysis seeks to place a straight line among data points on a plot of each cost and its appropriate cost driver. • Regression analysis fits a straight line to cost and activity data according to statistical criteria.

3-18

Engineering analysis and account analysis often are combined. One of the problems of account analysis is that historical data may contain past inefficiencies. Therefore, account analysis measures what costs were, not necessarily what they should be. Differences in future costs may be desired and/or anticipated, and account analysis alone usually will not account for these differences. Engineering analysis may be combined with account analysis to revise account-based measures for desired improvements in efficiency and/or planned changes in inputs or processes.

3-19

The strengths of the high-low method are also its weaknesses -- the method is simple to apply since it does not require extensive data or statistical sophistication. This simplicity also means that the method may not be reliable because it may not use all the relevant data that are available, and choice of the two points to measure the linear cost relationship is subjective. The method itself also does not give any measures of reliability. The visual-fit method is an improvement over the high-low method because it uses all the available (relevant) data. However, this method, too, may not be reliable since it relies on the analyst's judgment on where to place the line.

3-20

High-low method of cost allocation identifies the high and low points within a given range and then calculates the variable cost first by dividing the change in total costs by the change in activity. Fixed cost is then determined by subtracting the variable cost at any of the two levels from the total cost of that level. Since the method considers only two points among many activity levels within a given range, while determining the costs, it ignores all other information available. As a result of this inefficient use of information, the cost allocation may not be accurate.

3-21

Regression analysis is usually preferred to the high-low method (and the visual-fit method) because regression analysis uses all the relevant data and because easyto-use computer software does the analysis and provides useful measures of cost function reliability. The major disadvantage of regression analysis is that it requires statistical sophistication to use properly. Because the software is easy to use, many users of regression analysis may not be able to critically evaluate the output and may be misled to believe that they have developed a reliable cost function when they have not.

3-22

This is a deceptive statement, because it is true on the face of it, but regression also has many pitfalls for the unwary. Yes, regression software provides useful output that can be used to evaluate the reliability of the measured cost function. If one understands the assumptions of least-squares regression, this output can be used to critically evaluate the measured function. However, the regression software cannot evaluate the relevance or accuracy of the data that are used. Even though regression analysis is statistically objective, irrelevant or inaccurate data used as input will lead to unreliable cost functions, regardless of the strength of the statistical indicators of reliability.

3-23

Plotting data helps to identify outliers, that is, observations that are unusual and may indicate a situation that is not representative of the environment for which cost predictions are being made. It can also show nonlinear cost behavior that can lead to transformations of the data before applying linear regression methods.

3-24

R2 is a goodness-of-fit statistic that describes the percentage of variation in cost explained by changes in the cost driver.

3-25

Control of costs does require measurement of cost behavior, either what costs have been or what costs should be. Problems of work rules and the like may make changing cost behavior difficult. There are tradeoffs, of course, and the instructor should expect that students could get into an impassioned debate over where the balance lies -- union job protection versus improved efficiency. This debate gets to one of the major roles of accounting in organizations, and it is important that students realize that accounting does matter greatly to individuals, and, ultimately, to society.

3-26

Both depreciation and research and development costs are fixed costs because they are independent of the volume of operations. Depreciation is generally a committed fixed cost. Managers have little discretion over the amount of the cost. In contrast, research and development costs are discretionary fixed costs because their size is often the result of management’s judgment.

3-27

Decision makers should know a product’s cost function if their decisions affect the amount of product produced. To know the cost impact of their decisions, decision makers apply the cost function to each possible volume of production. This is important in many decisions, such as pricing decisions, promotion and advertising decisions, sales staff deployment decisions, and many more decisions that affect the volume of product that the company produces.

3-28

Regression analysis is a statistical method of fitting a cost-function line to observed costs. It is objective; that is, each cost analyst would come up with the same regression line, whereas different analysts might have different cost functions when using a visual fit method. In addition, regression analysis provides measures of how well the cost-function line fits the data, so that managers know how much reliance they can put on cost predictions that use the cost function.

3-29 (15 min.) The analysis is faulty because of the following errors. 1.

The scales used for both axes are incorrect. The space between equal intervals in number of orders and order-department costs should be the same.

The visual-fit line is too high, and the slope is too steep. It appears that the line has been purposely drawn to pass through the (100,450) data point and the $200 point on the y-axis to simplify the analysis. A visual-fit line most often will not pass through any one data point. Choosing one point (any point) or a data point and the Y-intercept makes this similar to the high-low method, ignoring much of the information contained in the rest of the data.

The total cost for 90 orders is wrong. Either the fixed costs should be expressed in thousands of dollars or the unit variable costs should be $2,000 per order. Even if the derived total cost function was accurate, the resulting cost prediction is incorrect. The formula should be expressed as:

Total cost (thousands of dollars) = $200 + $2.50 × Number of orders processed, or Total cost = $200,000 + $2,500 × Number of orders processed This would result in a predicted total cost for 90 orders of: Total cost (thousands of dollars) = $200 + $2.50 × 90 = $425, or Total cost = $200,000 + $2,500 × 90 = $425,000. Correct Analysis The following graph has correctly constructed scales. The visual fit line shown indicates that fixed costs are about $200,000 and variable cost is about $2,250 per order – a lower slope than that shown in the text. Order Department Costs 80, 420

$450

100, 450

$400 (Thousands)

Order Department Costs

$500

$350

20, 280 10, 240

$300 $250

70, 320 40, 240

$200 $150 $100

$180

$50 $0

100

120

Orders Processed

The total cost function is: Total cost (thousands of dollars) = $200 + $2.25 × Number of orders, or Total cost = $200,000 + $2,250 × Number of orders Variable cost (thousands of dollars)  $180 ÷ 80 orders = $2.25 The predicted total cost for 90 orders is: Total cost = $200,000 + $2,250 × 90 = $200,000 + $202,500 = $402,500.