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Chapter 9 Activity-Based Costing

Learning Objectives
1. Understand the potential effects of using externally reported product costs for decision making. 2. Explain how a two-stage product costing system works. 3. Compare and contrast plantwide and department allocation methods. 4. Explain how activity-based costing and a two-stage product system are related. 5. Compute product costs using activity-based costing. 6. Compare activity-based product costing to traditional department product costing methods. 7. Demonstrate the flow of costs through accounts using activity-based costing. 8. Apply activity-based costing to marketing and administrative services.

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Chapter Outline
I. II. REPORTED PRODUCT COSTS AND DECISION MAKING A. Dropping a product B. The death spiral TWO-STAGE COST ALLOCATION A. Two-stage cost allocation and the choice of cost drivers B. Plantwide versus department-specific rates C. Choice of cost allocation methods: A cost-benefit decision ACTIVITY-BASED COSTING Developing activity-based costs Identifying activities that use resources Choosing cost drivers Computing a cost rate per cost driver Assigning costs to products COST HIERARCHIES ACTIVITY-BASED COSTING ILLUSTRATED A. Step 1: Identify the activities B. Step 2: Identify the cost drivers C. Step 3: Compute the cost driver rates D. Step 4: Assign costs using activity-based costing E. Unit costs compared COST FLOW THROUGH ACCOUNTS CHOICE OF ACTIVITY BASES IN MODERN PRODUCTION SETTINGS ACTIVITY-BASED COSTING IN ADMINISTRATION WHO USES ABC? SUMMARY

III.

IV. V.

VI. VII. VIII. IX. X.

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Key Concepts
LO1 Understand the potential effects of using externally reported product costs for decision making.
Basic approach to product costing involves assigning direct costs to products and allocating manufacturing overhead costs to products. For financial reporting purposes, the product costs computed are used primarily for developing inventory balances and cost of goods sold amounts, and are based on traditional systems that allocate manufacturing costs using a handful of allocation bases (e.g., direct labor, direct materials, or machine utilization). In a traditional system, once a predetermined overhead rate is calculated, it is applied as if all overhead costs were variable with respect to the allocation base, which is not true in most cases for two reasons: (1) Some of the overhead items could be fixed, and reducing the number of units produced does not result in lower fixed costs. Examples of such fixed costs include cost of supervision, machine and plant depreciation, and miscellaneous items that do not vary with the allocation base. (2) Some of the overhead items could vary, but with cost drivers other than those traditionally chosen ones. If managers attempt to recover the costs with a smaller number of units, they are likely to meet resistance in the market, resulting in demand for even fewer units. With the smaller production, the reported product costs increase even more. Example 1: MCR Manufacturing is considering the introduction of a new memory card reader for use with digital cameras. Estimated unit variable cost is $5 and annual fixed costs would be $100,000. The managers decide to price the new product with an industry-standard markup of 16 percent (based on full cost). The sales are initially estimated to be 10,000 units. So the introductory price will be $17.4 = ($5 +

$100,000 ) (1 + 16%). 10,000 units

From the recent marketing report, the sales forecast is revised downward to 8,000 units. To recover the production cost in a hurry, the managers set a newer (and higher) price of

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$20.3 = ($5 +

$100,000 ) (1 + 16%), 8,000 units

driving away even more would-be customers. If the managers stick with the same costing practice (and pricing strategy), the new memory card reader will soon disappear from the retail shelf. Death spiral is a phenomenon that begins by attempting to increase price to meet higher reported product costs, losing demand, reporting still higher costs, and so on until the firm is pricing itself out of business. Death spiral may occur when the demand falls while fixed costs remain the same. Death spiral may also occur when capacity (and associated fixed overhead costs) is increased in anticipation of growing demand in the future. Either way, the prices have to go up in order to recover the ever higher reported product costs in a vicious cycle that eventually drives away remaining customers. [Assign Problems 9-34, 9-35, 9-36, 9-42, Integrative Cases 9-44, 9-45, 9-46, 9-47, 9-48]

LO2 Explain how a two-stage product costing system works.


The basic approach in product costing is to allocate costs in the cost pools that record manufacturing costs and assign, or allocate, these costs to the products or services of interest, by using appropriate cost allocation bases or cost drivers. Alternative cost-allocation approaches should be evaluated based on (1) decision usefulness, and (2) cost-benefit considerations. Two-stage approach to product costing was discussed in Chapter 6 and involves the following: Direct costs: Direct materials, Direct labor Indirect costs: Manufacturing overhead First stage allocation Cost pools Assigned to Cost objects: Products or services

Second stage allocation

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The first-stage cost objects (cost pools) are the overhead accounts (e.g., machine-related costs and direct labor-related costs) captured by the cost accounting system, as shown in Exhibit 9.4. The two-stage approach separates plant, or manufacturing, overhead into two or more cost pools based on the account in which the costs were recorded. The allocation in the first stage permits selection of multiple cost drivers that can be used to allocate costs to products. Another common choice for first-stage cost objects is to use production departments or product lines within the plant, as shown in Exhibit 9.5. The allocation of overhead costs to departments is not as simple as it is when overhead accounts are used because the costs are not necessarily recorded at the department level. Complexity and special handling required during production may distort the product costs reported when the traditional costing method is used. The two-stage system, on the other hand, allows the firm to develop product costing systems that more closely align the allocation of costs with the use of resources. [Assign Exercises 9-21, 9-22]

LO3 Compare and contrast plantwide and departmental allocation method.


The single-stage approach was introduced in Chapter 6 and depicted below: Direct costs: Direct materials, Direct labor Indirect costs: Manufacturing overhead Single stage Assigned to Cost objects: Products or services

Allocated to

The plantwide allocation method is an allocation method that uses one cost pool (of indirect costs) for the entire plant (e.g., an entire factory, store, hospital, or other multidepartment segment of a company), as in the single stage approach mentioned earlier. It uses one overhead allocation rate, or one set of rates, for all of the departments in a particular plant. Although it is called plantwide allocation, this allocation concept can be used in both manufacturing and nonmanufacturing organizations.

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In plantwide allocation, all overhead costs are recorded in one cost pool in the Manufacturing Overhead Control account for the plant without regard to the department or activity that caused them. That is,
Manufacturing overhead control Materials inventory Wages payable Accounts payable Prepaid expense Accumulated depreciation xx xx xx xx xx xx xx

A single overhead rate is used to apply overhead to products, crediting Applied Manufacturing Overhead account. That is,
Work-in-process inventory xx Applied manufacturing overhead

xx

Example 2: A company estimated its annual overhead costs to be $240,000. The company uses the plantwide allocation method to assign overhead costs to its two products, AA and BB, using machine hours, budgeted to be 12,000 for the coming year. Then the single plantwide rate would be $20 (= $240,000 12,000 machine hours). In March, 400 units of product AA were produced using 800 machine hours; 100 units of product BB were produced using 400 machine hours. Then overhead allocation would be To AA: $20 per machine hour 800 machine hours = $16,000, or $16,000 400 units = $40 per unit. To BB: $20 per machine hour 400 machine hours = $8,000, or $8,000 100 units = $80 per unit. The journal entry would be
Work-in-process inventory (AA) 16,000 Work-in-process inventory (BB) 8,000 Applied manufacturing overhead

24,000

The amount of the credit to the Applied Manufacturing Overhead account and the total amount of the debit to Work in Process for overhead costs equal the overhead rate per

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machine hour times the total number of machine-hours worked for each product. Companies using a single plantwide rate generally use an allocation base related to the volume of output, such as direct labor hours, machine hours, units of output, or materials costs. ======================

Demonstration Problem 1
ABC Manufacturing, Inc. produces three gadgets (Ace, Best, and Champ) in two departments, Machining and Assembly. Each product requires one hour of direct labor for completion. The following table provides production and cost data for the year. Number of units Machine hours Direct materials Direct labor Overhead Machining Assembly Total overhead Tot costs
Ace 25,000 2,500 Best 15,000 1,500 Champ 5,000 2,000 Total 45,000 6,000

$1,000,000 375,000

$450,000 225,000

$275,000 75,000

$1,725,000 675,000 900,000 450,000 1,350,000 $3,750,000

Required: Use the plantwide allocation method to determine the unit cost for each product. The allocation bases to choose from are 1. Machine hours. 2. Direct labor costs. Solution: 1. The overhead allocation rate when machine hours were used as the allocation base was $225 per machine hour (= $1,350,000 6,000 machine hours). The unit cost report would show the following: Units produced Machine hours per unit Direct materials Direct labor Applied overhead ($225 per machine hour) Unit cost
Ace 25,000 0.1 Best 15,000 0.1 Champ 5,000 0.4

$40.0 15.0 22.5 $77.5

$30.0 15.0 22.5 $67.5

$55.0 15.0 90.0 $160.0

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2. The overhead allocation rate when direct hour costs were used as the allocation base was 200% (= $1,350,000 $675,000). The unit cost report would show the following: Units produced Direct materials Direct labor Applied overhead (200% direct labor costs) Unit cost
Ace 25,000 Best 15,000 Champ 5,000

$40.0 15.0 30.0 $85.0

$30.0 15.0 30.0 $75.0

$55.0 15.0 30.0 $100.0

Please note that the same results can be obtained using the number of units produced as the allocation base because each product requires one hour of direct labor for completion and the direct labor costs are in direct proportion to the number of units produced. The overhead allocation rate would be $30 per unit (= $1,350,000 45,000 units) as shown above. ====================== The department allocation method uses a separate cost pool for each department. Each department has its own overhead allocation rate or set of rates. This is a variation of the two-stage allocation approach in which the cost pools happen to be departments. If the company manufactures products that are quite similar and all use the same set of resources, the plantwide rate is probably sufficient. If there are multiple products that require manufacturing facilities in many different ways, departmental rates provide a better picture of the use of manufacturing resources by the different products. The choice between a plantwide rate and departmental rates is based on the costs and benefits of the information inherent in each system. Any incremental costs of additional information must be justified by an increase in benefits from improved decisions. ======================

Demonstration Problem 2
(Continued from Demonstration Problem 1) Considering the nature of the production processes, the cost accountant of ABC Manufacturing decided to experiment with the department-specific allocation approach and determined that the Machining Department can use machine hours as the allocation base for overhead assignment while the Assembly Department can use direct labor costs instead.

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Required: Use the department allocation method to determine the unit cost for each product. Solution: For the Machining Department, the overhead allocation rate would be $150 per machine hour (= $900,000 6,000 machine hours). For the Assembly Department, the overhead allocation rate would be 66.67% (= $450,000 $675,000). Units produced Machine hours per unit Direct materials Direct labor Applied overhead Machining ($150 per machine hour) Assembly (66.67% of direct labor costs) Unit cost ======================
Ace 25,000 0.1 Best 15,000 0.1 Champ 5,000 0.4

$40.0 15.0 15.0 10.0 $80.0

$30.0 15.0 15.0 10.0 $70.0

$55.0 15.0 60.0 10.0 $140.0

[Assign Exercises 9-21, 9-22, 9-27, 9-28, 9-29, Problems 9-37, 9-38, 9-39, 9-40, 9-41, 9-43, Integrative Cases 9-45, 9-46, 9-47, 9-48]

LO4 Explain how activity-based costing and a two-stage product system are related.
Activity-based costing (ABC) is a two-stage product costing method that first assigns costs to activities and then allocates them to products based on the each products consumption of activities. The cost pools in the two-stage approach now accumulate activity-related costs. An activity is any discrete task that an organization undertakes to make or deliver a product or service. Activity-based costing is based on the concept that products consume activities and activities consume resources. Activity-based costing can be used by any organization that wants a better understanding of the costs of the goods and services it provides, including manufacturing, service, and even nonprofit organizations (see In Action item for a case study).

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Activity-based costing involves the following four steps: (1) Identify the activities that consume resources and assign costs to them. (2) Identify the cost driver(s) associated with each activity. A cost driver is any factor that causes, or drives, an activitys costs. (3) Compute a cost rate per cost driver unit or transaction. Each activity could have multiple cost drivers. (4) Assign costs to products by multiplying the cost driver rate by the volume of cost driver units consumed by the product. Identifying activities that use resources is the most interesting and challenging part of the process, from which much of the value of activity-based costing comes. A costbenefit consideration dictates that companies identify only the most important activities. Many nonvalue-added activities are identified as well. These activities may be eliminated to improve efficiency and profitability (to be discussed in Chapter 10). Examples of cost drivers are shown in Exhibit 9.10. Most of the cost drivers are related either to the volume of production or to the complexity of the production or marketing process. Cost drivers are selected based on three criteria: (1) Causal relation. Ideally, choose a cost driver that causes the cost. This is the best cost drive available. (2) Benefits received. Choose a cost driver to assign costs in proportion to benefits received. (3) Reasonableness or fairness. When the first two criteria fail, assign costs on the basis of fairness or reasonableness. For any indirect cost, a predetermined rate can be computed as follows: Predetermined rate =

Estimated indirect cost . Estimated volume of allocation base

For activity-based costing, the first stage consists of activities. Each activity has an associated cost pool and requires a cost driver rate using the formula above. The second stage in a two-stage system using activity-based costing allocates costs to products by multiplying the cost driver rates by the number of units of the cost driver (i.e., volume of activities) consumed in each product. Exhibit 9.11 illustrates such a process. The distinctive feature of activity-based costing is that it recognizes that overhead costs are caused by activities and that activities may not be caused solely by volume, but by other types of activities. Cost drivers for the activities should reflect the cost incurrence in the activity, even if cost is not caused by volume.

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Cost hierarchy represents a classification of cost drivers into general levels of activity, volume, batch, product, etc. Four possible levels of cost hierarchy are (1) volume-related, (2) batch-related, (3) product-related, and (4) facility-related. Exhibit 9.12 provides example of costs and cost drivers associated with each of the four levels. Not all activity-based costing systems need to have all four levels in the hierarchy, and some can have more than four. The important factor is whether the cost drivers for the activities reflect the cost incurred by the activity. [Assign Exercises 9-23, 9-24, 9-25, 9-26, 9-27, 9-28, 9-29]

LO5 Compute product costs using activity-based costing.


In this section, the reported product costs under activity-based costing are computed in a comprehensive example. Step 1: Identify the activities. A cost accountant interviewed the production manager to determine the major activities used in the manufacturing process. Step 2: Identify the cost drivers. The cost accountant interviewed production supervisors, who in turn discussed with line employees, to determine the cost drivers and the expected volume of each driver. The information is presented in Exhibit 9.13. Step 3: Compute the cost driver rates. Once the overhead costs incurred in the facility were determined, the cost accountant calculated the cost driver rates by dividing overhead cost by the estimated volume for each activity identified in Step 1. Exhibit 9.14 shows the calculation. Step 4: Assign costs using activity-based costing. Exhibit 9.15 shows the cost flow diagram that assigns overhead costs to activity pools in the first stage and allocates activity costs to products in the second stage. For each product, the direct costs (direct materials and direct labor) are the same regardless of the costing methods used. The difference is in the assignment of overhead costs. There are two ways to calculate unit cost for each product.

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(1) The total cost of production for each product is calculated first. Then the total cost is divided by the number of units produced to arrive at the unit cost. This approach is shown in Exhibit 9.16. (2) The cost driver rate per unit of product for each of the cost drivers can be calculated first, which then is multiplied by the volume of activity consumption per unit of product. The resulting sum across the cost drivers will also determine the unit cost. ======================

Demonstration Problem 3
(Continued from Demonstration Problems 2 and 3) The cost accountant of ABC Manufacturing attended a workshop on activity-based costing and was impressed by the results. After consulting with the production personnel, he prepared the following information on cost drivers and the estimated volume for each driver. Activity Machining Setup Machining Assembly Assembly Inspection Cost driver Number of setups Machine hours Direct labor hours Number of inspections Cost driver volume Ace Best Champ 125 75 50 2,500 1,500 2,000 25,000 50 15,000 25 5,000 25 Total 250 6,000 45,000 100

The cost accountant also determined how much overhead costs were incurred in each of the four activities as follows: Activity Machining Setup Machining Total Machining department overhead Assembly Assembly Inspection Total Assembly department overhead Total overhead costs Overhead costs $150,000 750,000 $900,000 $360,000 90,000 $450,000 $1,350,000

Required: 1. Determine the cost driver rate for each activity cost pool. 2. Use the activity-based costing method to determine the unit cost for each product. 3. Summarize and comment the results.

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Solution: 1. Activity Machining Setup Machining Assembly Assembly Inspection

Cost drive rate $600 per setup (= $150,000 250 setups) $125 per machine hour (= $750,000 6,000 machine hours) $8 per direct labor hour (= $360,000 45,000 direct labor hours) $900 per inspection (= $90,000 100 inspections)

2. In the following table, the total costs are divided by the number of units to arrive at the unit cost for each product. Direct materials Direct labor Applied overhead Setup ($600 per setup) Machining ($125 per machine hour) Assembly ($8 per direct labor hour) Inspection ($900 per inspection) Total overhead costs Total costs Number of units Unit cost
Ace $1,000,000 375,000 Best $450,000 225,000 Champ $275,000 75,000

$75,000 312,500 200,000 45,000 $632,500 $2,007,500 25,000 $80.3

$45,000 187,500 120,000 22,500 $375,000 $1,050,000 15,000 $70.0

$30,000 250,000 40,000 22,500 $342,500 $692,500 5,000 $138.5

Alternatively, the following table shows direct calculation of unit cost for each product based on consumption of the activities for each unit of the products. Units produced Number of setups per unit Machine hours per unit Direct labor hours per unit Number of inspections per unit Direct materials Direct labor Applied overhead Setup ($600 per setup) Machining ($125 per machine hour) Assembly ($8 per direct labor hour) Inspection ($900 per inspection) Unit cost
Ace 25,000 0.005 0.1 1 0.002 Best 15,000 0.005 0.1 1 0.00167 Champ 5,000 0.01 0.4 1 0.005

$40.0 15.0 3.0 12.5 8.0 1.8 $80.3

$30.0 15.0 3.0 12.5 8.0 1.5 $70.0

$55.0 15.0 6.0 50.0 8.0 4.5 $138.5

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3. In summary, a comparison of the methods used to calculate unit cost for each product is presented below. Plantwide rate based on machine hours Plantwide rate based on direct labor costs Department rates Activity-based costing
Ace $77.5 85.0 80.0 80.3 Best $67.5 75.0 70.0 70.0 Champ $160.0 100.0 140.0 138.5

In this series of demonstration problems, both of the plantwide allocation methods distort product costs. Since Champ uses four times as much machine hours as the other two products, it inevitably receives more cost assignment from the plantwide method based on machine hours; the opposite is the case when direct labor costs are used as the allocation base. The department allocation method and activity-based costing produce comparable numbers that portray consumption of resources closer to reality. Since it is less costly to implement the department allocation method than the activity-based costing method, the managers of ABC Manufacturing should probably use the department allocation method to handle overhead costs in the future. ====================== [Assign Exercises 9-23, 9-24, 9-25, 9-26, 9-27, 9-28, 9-29, 9-30, 9-31, 9-32, Problem 9-34, 9-35, 9-36, 9-37, 9-38, 9-39, 9-40, 9-41, 9-43, Integrative Cases 9-45, 9-46, 9-47, 9-48]

LO6 Compare activity-based product costing to traditional department product costing methods.
As summarized in Exhibit 9.17, both the plantwide rate and the department rate systems assumed that overhead was incurred proportionally with the volume of output. The activitybased costing system recognized that overhead was related to activity usage, not necessarily to the volume of output. Different cost allocation methods result in different estimates of how much it costs to make a product. Activity-based costing provides more detailed measures of costs than do plantwide or department allocation methods. Production also benefits because activity-based costing provides better information about how much each activity costs. It helps identify cost drivers that previously were unknown. Activity-based costing provides more information about product costs but requires more record keeping.

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Installing activity-based costing requires teamwork between accounting, production, marketing, management, and other non-accounting personnel. [Assign Exercises 9-25, 9-26, Problem 9-34, 9-35, 9-36, 9-37, 9-38, 9-39, 9-40, 9-41, 9-42, 9-43, Integrative Cases 9-45, 9-46, 9-47, 9-48]

LO7 Demonstrate the flow of costs through accounts using activity-based costing.
Exhibit 9.18 shows the flow of costs through accounts using activity-based costing. The overhead accounts (both incurred and applied) are grouped by activities. Early industries were labor intensive, and much of the overhead cost was related to the support of labor. At that time, it made sense to allocate overhead to products based on the amount of labor component in the products. Nowadays, labor is still a major product cost in many companies, especially service organizations such as consulting, law, and public accounting firms. In those cases, overhead is often allocated to products (jobs) on the basis of the amount of labor in the product. When the labor component drops in the products and overhead cost increases, companies that continue to allocate overhead to products based on direct labor are experiencing substantial overhead rate increases. Even small errors in cost allocation can be magnified many times. It also sends the wrong signal that direct labor is more expensive than it really is and drives managers to reduce the already slim labor content of products. The magnitude of the overhead rate based on direct labor is of less concern when all resources are used proportionally. In modern manufacturing settings, proportionality between machine hours and direct labor hours is much less so. Costs are a function of both volume and complexity. Low-volume products often require more machine setups for a given level of production output because they are produced in smaller batches. Low-volume product adds complexity to the operation by disrupting the production flow of the high-volume items. Volume-based allocation methods allocate a high proportion of overhead costs to highvolume products, which subsidize low-volume products and hide the cost effects of

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keeping a large number of low-volume products. The result is that high-volume products tend to be overcosted while low-volume products undercosted. [Assign Exercises 9-30, 9-31]

LO8 Apply activity-based costing to marketing and administrative services.


Activity-based costing can be applied to administrative activities. The principles and methods are the same as those discussed earlier. Activity-based costing in administration involves these steps: (1) (2) (3) (4) Identify the activities that consume resources. Identify the cost driver associated with each activity. Compute a cost rate per cost driver for each unit or transaction. Assign costs to the marketing or administration activity by multiplying the cost driver rate by the volume of cost driver units consumed for that activity.

Instead of computing the cost of a product, accountants compute the cost of performing an administrative service. Time-related factors (and therefore cost drivers) are common for an administrative function or a service business. Exhibit 9.19 shows other common cost drivers in a typical purchasing department for various activities performed. There are three problems with identifying users of ABC. (1) ABC means different things to different observers. (2) ABC can be applied in parts of an organization but not everywhere. (3) While firms may publicly announce the adoption of ABC, they are less likely to announce its discontinuance. The adopters of ABC include a wide range of organizations with various sizes, from manufacturing firms to government agencies, and from a small, regional financial service firm to a multinational manufacturing firm. See Exhibit 9.20 for examples. All organizations are interested in getting better cost information for decision making, and ABC implementation serves the purpose well. [Assign Exercises 9-32, 9-33]

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Matching
A. Activity-based costing B. Cost driver C. Cost hierarchy D. Death spiral E. Department allocation method F. Plantwide allocation method

_____ 1. Represents a classification of cost drivers into general levels of activity, volume, batch, product, etc. _____ 2. A phenomenon that begins by attempting to increase price to meet higher reported product costs, losing demand, reporting still higher costs, and so on until the firm is pricing itself out of business. _____ 3. An allocation method that uses one cost pool (of indirect costs) for the entire plant. _____ 4. Uses a separate cost pool for each department. _____ 5. A two-stage product costing method that first assigns costs to activities and then allocates them to products based on the each products consumption of activities. _____ 6. Any factor that causes, or drives, an activitys costs.

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Answers
1. C 2. D 3. F 4. E 5. A 6. B

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Multiple Choice
1. Death spiral a. Happens when managers try to set higher prices to recover increasing reported costs. b. Occurs when capacity is reduced. c. May happen when the market share is gaining. d. Has to do with costs other than overhead. 2. In a two-stage cost allocation system, a. The first stage involves assigning overhead costs to cost pools. b. The cost pools may be departments. c. Each cost pool requires an allocation rate. d. All of the above. 3. One of the cost pools at Toylands Store is Personnel department that provides recruiting and training for Sales and Administrative departments and has an estimated overhead of $45,000. Sales department has 12 employees and Administrative department has 3. How much of the overhead cost of the Personnel department should be allocated to the Sales department? a. $9,000. b. $22,000. c. $36,000. d. $38,000. The following information is for questions 4 7. The accountant of Toylands Manufacturing collected the following information: Activity Machining Dept. Setup Machining Packaging Dept. Assembly Inspection Overhead costs Cost driver $200,000 Number of setups 700,000 Machine hours 300,000 Direct labor hours 180,000 Number of inspections
Product X1 Product X2

200 20,000 40,000 120

50 15,000 60,000 60

4. If Toylands Manufacturing uses a plantwide rate based on direct labor hours to allocate overhead costs, how much is product X1s share of overhead? a. $324,000. b. $416,000. c. $638,000. d. $552,000.

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5. If the department allocation method is used, what is the overhead rate for the Machining department with machine hours as the allocation base? a. $39.43 per machine hour. b. $13.71 per machine hour. c. $20 per machine hour. d. $25.71 per machine hour. 6. When activity-based costing is used, what is product X2s share of the Packaging department overhead costs? a. $270,000. b. $240,000. c. $580,000. d. $380,000. 7. When activity-based costing is used, how much of the overhead cost is allocated to product X1? a. $580,000. b. $800,000. c. $950,000. d. $670,000. 8. Which of the following is true of activity-based costing relative to traditional costing? a. It requires less detailed cost measures. b. Accounting department alone can handle all the work. c. It needs more cost pools. d. It is less costly to implement. 9. Activity-based costing can be beneficial to a. Banks. b. Nonprofit organizations. c. Law firms d. All of the above. 10. Low-volume products, relative to high-volume ones, a. Entail less complexity during production. b. Often require more machine setups. c. Will not disrupt the production flow of high-volume items. d. Are usually overcosted. 11. What are the steps required for activity-based costing in administration? a. Identify activities that consume resources. b. Identify cost drivers associated with activities. c. Compute activity rate per cost driver. d. All of the above.

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12. Which of the following statements is incorrect? a. Nowadays, labor is still a major product cost in many companies, especially service organizations. b. When the labor component drops, it is prudent to allocate overhead based on direct labor. c. When the labor component drops, the overhead rate based on direct labor tends to increase substantially. d. When all resources are used proportionally, allocation of overhead based on machine hours is acceptable.

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Answers
1. 2. 3. a d c LO1 LO2 LO2

$45, 000 = $3,000 per employees. 12 + 3 $3,000 12 employees at Sales department = $36,000.
4. d LO2

$200,000 + $700,000 + $300,000 + $180,000 = $1,380,000. $1,380, 000 = $13.8 per direct labor hour. 40, 000 + 60, 000 $13.8 40,000 direct labor hours = $552,000. 5. d LO2

$700,000 + $200,000 = $900,000. $900, 000 = $25.71 per machine hour. 20, 000 + 15, 000 6. b LO4, LO5

$300, 000 = $3 per direct labor hour. 40, 000 + 60, 000 $180, 000 = $1,000 per inspection. 120 + 60 $3 per direct labor 60,000 direct labor hours + $1,000 per inspection 60 inspections = $240,000. 7. b LO4, LO5

$200, 000 = $800 per setup. 200 + 50 $700, 000 = $20 per machine hour. 20, 000 + 15, 000 $800 per setup 200 setups + $20 per machine hour 20,000 machine hours + $3 per direct labor hour 40,000 direct labor hours + $1,000 per inspection 120 inspections = $800,000. 8.
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9.

LO8 LO7 LO8 LO7

10. b 11. d 12. b

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Chapter 11 Service Department and Joint Cost Allocation


Learning Objectives
1. Explain why service costs are allocated. 2. Allocate service department costs using the direct method. 3. Allocate service department costs using the step method. 4. Allocate service department costs using the reciprocal method. 5. Use the reciprocal method for decisions. 6. Explain why joint costs are allocated. 7. Allocate joint costs using the net realizable value method. 8. Allocate joint costs using the physical quantities method. 9. Explain how cost data are used in the sell-or-process-further decision. 10. Account for by-products. 11. (Appendix) Use spreadsheets to solve reciprocal cost allocation problems.

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Chapter Outline
I. II. SERVICE DEPARTMENT COST ALLOCATION METHODS OF ALLOCATING SERVICE DEPARTMENT COSTS A. Allocation bases B. Direct method 1. Allocate information systems department costs 2. Allocate administration department costs 3. Limitations of the direct method C. Step method 1. Allocate service department costs 2. Limitations of the step method D. Reciprocal method Allocating service department costs E. Comparison of direct, step, and reciprocal methods THE RECIPROCAL METHOD AND DECISION MAKING ALLOCATION OF JOINT COSTS A. Joint costing defined B. Reasons for allocating joint costs JOINT COST ALLOCATION METHODS A. Net realizable value method Estimation of net realizable value B. Physical quantities method C. Evaluation of joint cost methods DECIDING WHETHER TO SELL GOODS NOW OR PROCESS THEM FURTHER DECIDING WHAT TO DO WITH BY-PRODUCTS SUMMARY APPENDIX: CALCULATION OF THE RECIPROCAL METHOD USING COMPUTER SPREADSHEETS

III. IV. V.

VI. VII. VIII. IX.

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Key Concepts
LO1 Explain why service costs are allocated.
In the first stage of the two-stage cost allocation, part of the overhead costs are incurred for departments that do not produce the service or product directly. Service departments provide services to other departments in the organization. Examples of service departments and what they do: (1) Personnel, accounting, and purchasing departments provide services to production departments. (2) An information systems department provides support for information technology support to other departments. (3) A human resources department provides hiring and training services to other departments. User departments use the functions of service departments. For example, the production department uses the services provided by the information systems and human resources departments. User departments could be other service departments or production or marketing departments that produce or market the organizations products. As shown in Exhibit 11.1, most user departments make use of all service departments. Depending on the situation, the service departments also provide service to each other. An intermediate cost center is any cost center whose costs are charged to other departments in the organization. A final cost center is a cost center, such as a production or marketing department, whose costs are not allocated to another cost center. All organizations (service, merchandising, and manufacturing) have production or marketing departments and service departments. Three methods to allocate service department overhead costs are: (1) Direct method, (2) Step method, and (3) Reciprocal method. Service department costs are allocated for two purposes: (1) To determine the cost to produce and market products or services.

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(2) To encourage operating department managers to monitor service department costs (cross-department monitoring). Each service department is an intermediate cost center whose costs are recorded as incurred and then distributed to other cost centers. An important decision in cost allocation is to choose which allocation base to use. The usual criteria (cause and effect, reasonableness, and fairness) are still important here. [Assign Exercise 11-21]

LO2 Allocate service department costs using the direct method.


Direct method is a cost allocation method that charges costs of service departments to user departments without making allocations between or among service departments. The direct method allocates costs directly to the final users of a service, ignoring intermediate users. Exhibit 11.4 is the cost flow diagram that illustrates the direct method. Using the direct method, there are no allocations between service departments. It ignores the costs that the service departments themselves incur when they use services from other departments. Cross-department monitoring is lost in that regard. The application of the direct method of cost allocation is shown in Exhibit 11.3. Exhibit 11.5 shows the flow of costs in T-accounts and the allocations to be recognized for the departments when the direct method is used. (1) The direct costs of service departments are first recorded in those service departments and shown on the debit side of the service department accounts. (2) Then service department costs are allocated to the user departments. (3) The user departments also have direct costs (indicated as the direct overhead costs) do not have to be allocated to the user departments because they are debited to the department accounts when incurred. ======================

Demonstration Problem 1
Kirby Industries has two service departments (S1 and S2) and three production departments (P1, P2, and P3). The following table shows the costs incurred at the two service departments, as well as the proportion of services provided by the two service departments to the other departments.

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Proportion of services provided to: Costs incurred $1,000,000 260,000 Service department S1 S2 S1 40% S2 20% P1 30% 20% P2 40% 15% P3 10% 25%

For example, service department S1 incurred $1,000,000 while providing 20 percent of its services to service department S2, 30 percent to production department P1, 40 percent to production department P2, and 10 percent to production department P3. For simplicity, the direct costs incurred by the production departments are ignored. The general manager of Kirby Industries wanted to know how the service department costs can be allocated to the production departments in order to facilitate performance evaluation. Required: Allocate the service department costs to the production departments using the direct method. Solution: The proportion of services to be allocated has to be revised since allocations between the two service departments are not allowed under the direct method. These are relative usages that ignore the mutual support between the service departments. (Revised) Proportion of services to be allocated: Service department S1 S2
a b

S1 -

S2 -

P1 37.5%a 33.3%b

P2 50.0% 25.0%

P3 12.5% 41.7%

37.5% = 30% (30% + 40% + 10%). 33.3% = 20% (20% + 15% + 25%). Costs allocated to: S2 P1 $260,000 $0 0 375,000c (260,000) 86,667d $0 $461,667

From: Costs incurred S1 S2 Total


c d

S1 $1,000,000 (1,000,000) 0 $0

P2 $0 500,000 65,000 $565,000

P3 $0 125,000 108,333 $233,333

$375,000 = $1,000,000 37.5%. $86,667 = $260,000 33.3%.

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S1 To P1: $375,000 To P2: $500,000 To P3: $125,000

S2 To P1: $86,667 To P2: $65,000 To P3: $108,333

P1 From S1: $375,000 From S2: $86,667 ======================

P2 From S1: $500,000 From S2: $65,000

P3 From S1: $125,000 From S2: $108,333

[Assign Exercises 11-22,11-23, 11-24, 11-30, Problems 11-42, 11-43, 11-48, 11-49]

LO3 Allocate service department costs using the step method.


Step method is the method of service department cost allocation that allocates some service department costs to other service departments. The step method recognizes that some services are provided by one service department to others. The sequence of allocation is determined so that the allocation begins with (1) the service department that has provided the largest proportion of its total services to other service departments, or (2) the service department with the largest cost. The percentage of service costs ignored in the step allocation process is minimized by choosing either of the allocation orders suggested. Once an allocation is made from a service department, no further allocations are made back to that department. A service department that provides services to, and receives services from, another service department has only one of these two relationships recognized. Exhibit 11.6 shows the computation of the step method. Exhibit 11.7 is the cost flow diagram for the step method example. The flow of costs through the accounts is shown in Exhibit 11.8.

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The step method may result in more reasonable allocations than the direct method because it recognizes that some service departments use other service departments for support. The step method does not recognize reciprocal services. The step method is not necessarily better than the direct method when both the costs and benefits of using cost allocation are considered. A company already uses the direct method can find it uneconomical to switch methods. ======================

Demonstration Problem 2
(Continued from Demonstration Problem 1) The data were reproduced here. Proportion of services provided to: Costs incurred $1,000,000 260,000 Service department S1 S2 S1 40% S2 20% P1 30% 20% P2 40% 15% P3 10% 25%

Required: Allocate the service department costs to the production departments using the step method (where the allocation begins with the service department that provides the largest proportion of its total services to other service departments). Solution: Since the service department S2 provides the largest proportion of its services to the other service department (40 percent vs. S1s 20 percent), S2s costs would be allocated first to all other departments. Once it is done, S1s costs should not be allocated back to S2. (Revised) Proportion of services to be allocated: Service department S2 S1
a

S1 40.0% -

S2 -

P1 20.0% 37.5%a

P2 15.0% 50.0%

P3 25.0% 12.5%

37.5% = 30% (30% + 40% + 10%).

S1s total costs to be allocated include both the $1,000,000 incurred directly by S1 and the $104,000 allocated from S2.

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From: Costs incurred S2 S1 Total


b c

S1 $1,000,000 104,000b (1,104,000) $0

Costs allocated to: S2 P1 $260,000 $0 (260,000) 52,000 0 414,000c $0 $466,000

P2 $0 39,000 552,000 $591,000

P3 $0 65,000 138,000 $203,000

$104,000 = $260,000 40.0%. $414,000 = $1,104,000 37.5%.

S1 To P1: $414,000 To P2: $552,000 To P3: $138,000 $104,000

S2 To S1: $104,000 To P1: $52,000 To P2: $39,000 To P3: $65,000

P1 From S1: $414,000 From S2: $52,000 ======================

P2 From S1: $552,000 From S2: $39,000

P3 From S1: $138,000 From S2: $65,000

[Assign Exercises 11-25, 11-26, 11-30, Problems 11-41, 11-42, 11-44, 11-46, 11-47, 11-48, 1149]

LO4 Allocate service department costs using the reciprocal method.


Reciprocal method is the method to allocate service department costs that recognizes all services provided by any service department, including services provided to other service departments. The reciprocal method is identical to the actual process by which services are exchanged among departments within organizations. The total costs of each service department are expressed as: Total service department costs Direct costs of = the service + department Cost allocated to the service department

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There is a single equation for each of the service departments and there is a single unknown (the total cost of the service department) for each service department in the organization. The system of equations is solved simultaneously using matrix algebra. For this reason, the reciprocal method is also called the simultaneous solution method. In the case with two service departments, define the unknowns S1 and S2 to be the total service department costs for the two service departments. Then the simultaneous equations can be set up as S1= Direct costs of the first service department + S2, and S2 = Direct costs of the second service department + S1, where = Proportion of services provided by the second service department to the first. = Proportion of services provided by the first service department to the second. The reciprocal method accounts for cost flows in both directions among service departments that provide services to each other. Exhibit 11.9 shows the computation of the reciprocal method Both the step method and the direct method could understate the cost of running service departments because these methods omit costs of certain services consumed by one service department that were provided by other service departments. When there are only two service departments, simple algebra can be used to solve the allocation problem. Exhibit 11.10 is the cost flow diagram for the reciprocal method. The flow of costs through the accounts is shown in Exhibit 11.11. ======================

Demonstration Problem 3
(Continued from Demonstration Problem 1) The data were reproduced here.

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Proportion of services provided to: Costs incurred $1,000,000 260,000 Service department S1 S2 S1 40% S2 20% P1 30% 20% P2 40% 15% P3 10% 25%

Required: Allocate the service department costs to the production departments using the reciprocal method. Solution: Define S1 and S2 to be the total service department costs for departments S1 and S2, respectively. The service department S1 incurred $1,000,000 for providing services to other departments. The service department S2 provided 40 percent of its services to S1. Together, the total service department costs for S1 can be expressed as: S1 = $1,000,000 + .4 S2. The service department S2 incurred $260,000 for providing services to other departments. The service department S1 provided 20 percent of its services to S2. Together, the total service department costs for S2 can be expressed as: S2 = $260,000 + .2 S1. Next, insert S1 information into S2. That is, S2 = $260,000 + .2 [$1,000,000 + .4 S2]. Then, S2 = $260,000 + $200,000 + .08 S2. .92 S2 = $460,000. S2 = $500,000. S1 = $1,200,000. The original service proportions will apply. Proportion of services to be allocated: Service department S1 S2 S1 40% S2 20% P1 30% 20% P2 40% 15% P3 10% 25%

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From: Costs incurred S1 S2 Total


a b

S1 $1,000,000 (1,200,000) 200,000b $0

Costs allocated to: S2 P1 $260,000 $0 a 240,000 360,000 (500,000) 100,000 $0 $460,000

P2 $0 480,000 75,000 $555,000

P3 $0 120,000 125,000 $245,000

$240,000 = $1,200,000 20.0%. $200,000 = $500,000 40.0%.

S1 To S2: $240,000 To P1: $360,000 To P2: $480,000 To P3: $120,000

To S2: $240,000 To S1: $200,000

S2 To S1: $200,000 To P1: $100,000 To P2: $75,000 To P3: $125,000

P1 From S1: $360,000 From S2: $100,000 ======================

P2 From S1: $480,000 From S2: $75,000

P3 From S1: $120,000 From S2: $125,000

The three service department allocation methods can be compared in two ways. The first is to examine how each allocates costs to departments receiving services. As shown in Exhibit 11.12, only the reciprocal method allocates costs to all departments receiving services from other departments. The second way is to examine the costs each ultimately allocates to manufacturing and marketing departments, as shown in Exhibit 11.13. Each method allocates the same total cost. The direct method results sometimes are closer to the reciprocal method results than the results using the step method. All three allocation methods are arbitrary. If one production department stops using the service of a service department, the costs saved by the firm are unlikely to be equal to the costs allocated by any of the methods.

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[Assign Exercises 11-27, 11-28, 11-29, 11-30, 11-31, 11-32, Problems 11-42, 11-45, 11-46, 1147, 11-49, 11-50, 11-51, 11-52]

LO5 Use the reciprocal method for decisions.


The primary purpose of allocating service department costs to the production departments is to obtain the manufacturing costs for each of the production departments for product costing and inventory valuation. The cost information is also developed to assist managers in making decisions, such as whether to outsource some or all of the activities of the service departments. The cost savings will depend on how much an outside vendor will charge and how much cost in the service departments can be eliminated if outsourced. If there are no reciprocal services among the service departments, the cost savings are the cost of the eliminated service department that is avoidable (= variable costs + any avoidable fixed costs). If there are reciprocal services, the manager has to consider the effect of eliminating one of the service departments on the service requirements of the remaining service departments. Because the reciprocal method explicitly recognizes the use of one service department by another, it provides an estimate of what one department costs when reciprocal service costs are included. ======================

Demonstration Problem 4
(Revised from Demonstration Problem 3) Kirby Industries is considering the possibility of outsourcing the activities of service department S1. In order to evaluate the bids from qualified vendors, Kirbys accountant provides the following revised data that reflect only the variable costs incurred. Variable costs incurred $300,000 104,000 Proportion of services provided to: Service department S1 S2 S1 40% S2 20% P1 30% 20% P2 40% 15% P3 10% 25%

The avoidable fixed costs of running service department S1 are estimated to be $390,000.

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Required: Determine the possible cost savings from eliminating service department S1. Solution: Define S1 and S2 to be the variable service department costs for departments S1 and S2, respectively. The service department S1 incurred $300,000 for providing services to other departments. The service department S2 provided 40 percent of its services to S1. Together, the total service department costs for S1 can be expressed as: S1 = $300,000 + .4 S2. The service department S2 incurred $104,000 for providing services to other departments. The service department S1 provided 20 percent of its services to S2. Together, the total service department costs for S2 can be expressed as: S2 = $104,000 + .2 S1. Next, insert S1 information into S2. That is, S2 = $104,000 + .2 [$300,000 + .4 S2]. Then, S2 = $104,000 + $60,000 + .08 S2. .92 S2 = $164,000. S2 = $178,261. S1 = $371,304. The total variable cost of service department S1 is $371,304. This figure includes S1s direct cost ($300,000) and 40 percent of S2s cost ($71,304 = $178,261 40%). Out of the fixed cost of service department S1 of $700,000 (= $1,000,000 total costs $300,000 variable costs), $390,000 is estimated to be avoidable. When managers of Kirby Industries evaluate bids from outside vendors, their benchmark will be the avoidable costs which can be saved from eliminating service department S1, $761,304 (= $371,304 variable costs + $390,000 avoidable fixed costs). ====================== [Assign Exercises 11-31, 11-32, Problems 11-50, 11-51, 11-52]

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LO6 Explain why joint costs are allocated.


Joint cost is a cost of a manufacturing process with two or more different outputs. Joint products are such outputs from a common input and common production process. The problem is whether and how to allocate the joint cost of the input to the joint products. Split-off point is the stage of processing when two or more products are separated. Processing costs incurred prior to the split-off point are the joint costs. Example 1: The following shows a joint production process and its joint costs. After the split-off point, two discernable joint products, A and B, emerge from the process. The costs before the split-off point are joint; any costs spent afterwards are separable. Split-off point Joint product A Raw materials Joint production process (with additional materials, labor and overhead) Joint product B Joint cost

Exhibit 11.14 shows a diagram of joint cost flows. Cost allocations are often used to determine departmental or division costs for measuring executive performance. When a single raw material is converted into products sold by two or more departments, the cost of the raw material must be allocated to the products involved. Manufacturing companies must allocate joint costs to measure the inventory value of the products that result from the joint process. When companies are subject to rate regulation, the allocation of joint costs can be a significant factor in determining the regulated rates.

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Any cost allocation method contains an element of arbitrariness and must be clearly stated before being implemented.

LO7 Allocate joint costs using the net realizable value method.
The two major methods of allocating joint costs are (1) the net realizable value method, and (2) the physical quantities method. Net realizable value method allocates joint costs based on the proportional net realizable value of the joint products at the split-off point. The net realizable value is the estimated sales value of each product at the split-off point. If the joint products can be sold at the split-off point, the market value or sales price should be used for this allocation. ======================

Demonstration Problem 5
Superior Refinery produces oil products in a joint production process. For the month of October, $450,000 of materials, labor and overhead were added to produce the three main products: M1, M2, and M3. The sale values were available right after the split-off point. The following diagram shows the process.

M1 Sale value $200,000 Joint costs $450,000 M2 Sale value $300,000 M3 Sale value $500,000 Required: Allocate the joint costs to the products using the net realizable value method. Solution: The cost allocation follows the proportional distribution of net realizable values.

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Product M1 M2 M3 Total
a b

Sale value Proportion $200,000 20%a 300,000 30% 500,000 50% $1,000,000

Allocation $90,000b 135,000 225,000 $450,000

20% = $200,000 $1,000,000. $90,000 = $450,000 20%. ====================== If the products require further processing before they are marketable, it may be necessary to estimate the net realizable value at the split-off point using the estimated net realizable value method (sometimes called the netback or workback method). Sales price of a Estimated net realizable = final product after further processing value Additional processing costs necessary to prepare a product for sale

Under the net realizable value method, revenue dollars from any joint product are assumed to make the same percentage contribution at the split-off point as the revenue dollars from any other joint product. That is, each joint product gets the same gross margin percentage. Example 2: For Demonstration Problem 5 above, the gross margin for all the joint products can be calculated as follows. Sales Allocated joint costs Gross margin Gross margin percentage M1 $200,000 90,000 $110,000 55% M2 $300,000 135,000 $165,000 55% M3 $500,000 225,000 $275,000 55% Total $1,000,000 450,000 $550,000 55%

The gross margin percentage is the same for all the joint products when the net realizable value method is used. The net realizable value method implies a matching of input costs with revenues generated by each output.

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======================

Demonstration Problem 6
(Continued from Demonstration Problem 5) Products M1 and M2 needed further processing with additional costs before they could be marketable. Product M3 was immediately available for sale. The following diagram shows the process.

M1 Processing cost $120,000, Sale value $300,000 Joint costs $450,000 M2 Processing cost $80,000, Sale value $400,000 M3 Sale value $500,000 Required: Allocate the joint costs to the products using the estimated net realizable value method. Solution: The estimated net realizable value is used for joint cost allocation in the same way as an actual market value at the split-off point. Product M1 M2 M3 Total
a b

Sale value (1) $300,000 400,000 500,000

Processing cost (2) $120,000 80,000 0

Estimated net realizable value Proportion (1) (2) $180,000 18%a 320,000 32% 500,000 50% $1,000,000

Allocation $81,000b 144,000 225,000 $450,000

18% = $180,000 $1,000,000. $81,000 = $450,000 18%. ====================== [Assign Exercises 11-33, 11-34, 11-35, 11-36, 11-37, 11-38, Problems 11-53, 11-54, 11-55, 1156, 11-57, 11-58, 11-59, Integrative Case 11-60]

LO8 Allocate joint costs using the physical quantities method.

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Physical quantities method allocates joint costs based on measurement of the volume, weight, or other physical measure of the joint products at the split-off point. The physical quantities method is used when (1) output product prices are highly volatile, (2) significant processing occurs between the split-off point and the first point of marketability, or (3) product prices are not set by the market. Many companies allocate joint costs incurred in producing oil and gas on the basis of energy equivalent (BTU content). ======================

Demonstration Problem 7
(Continued from Demonstration Problem 5) Superior Refinery produces oil products in a joint production process. For the month of October, $450,000 of materials, labor and overhead were added to produce the three main products: M1, M2, and M3. The physical quantities of the outputs are considered relevant for cost allocation purposes. The following diagram shows the process.

M1 15,000 units Joint costs $450,000 M2 20,000 units M3 25,000 units Required: Allocate the joint costs to the products using the physical quantities method. Solution: The allocation of joint costs is based on the physical units in this case. Product M1 M2 M3 Total Units Proportion 15,000 25.0%a 20,000 33.3% 25,000 41.7% 60,000 Allocation $112,500b 150,000 187,500 $450,000

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25% = 15,000 60,000. $112,500 = $450,000 25%. ======================


b

The jointness of joint production process makes it impossible to separate the portion of joint costs attributable to one product from another on a cause-and-effect basis. Accountants and managers realize that no one allocation method is appropriate for all situations. If allocated joint costs are used for decision-making purposes, they should be used only with full recognition of their limitations. [Assign Exercises 11-39, 11-40, Problems 11-59, Integrative Case 11-60]

LO9 Explain how cost data are used in the sell-or-process-further decision.
Managers must decide whether it is more profitable to sell the output at an intermediate stage or to process it further. The relevant data to be considered are (1) the additional revenue after further processing, and (2) the additional costs of processing further. The decision rules about whether to process further are as follows. Sell at split-off point if: Sales value at split-off > (Sales value after process Additional processing cost) Process further if: Sales value at split off < (Sales value after process Additional processing cost)

It is important to note that the allocation of the joint costs is irrelevant for the current decision. The only costs and revenues relevant to the decision are those that result from it. ======================

Demonstration Problem 8
(Continued from Demonstration Problems 5 and 6) Products M1 and M2 can be sold immediately after the split-off point. They can also be processed further and sold at higher prices. The following diagram shows the process.

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M1 Sale value at the split-off point $200,000 Processing cost $120,000, New sale value $300,000 Joint costs $450,000 M2 Sale value at the split-off point $300,000 Processing cost $80,000, New sale value $400,000 M3 Sale value $500,000 Required: Determine whether to sell M1 and M2 right after the split-off point, or process them further to be sold at higher prices. Solution: Product M1 M2 Sale value at split-off point (1) $200,000 300,000 Sale value after Processing processing cost (2) (3) $300,000 $120,000 400,000 80,000 Margin (4) = (2) (3) $180,000 320,000 Additional profit from processing further (4) (1) $(20,000) 20,000

Processing M1 further will reduce profit by $20,000 while processing M2 further will increase profit by $20,000. It is beneficial to sell M1 right after the split-off point and process M2 further to improve revenue. ====================== [Assign Problems 11-54, 11-59, Integrative Case 11-60]

LO10 Account for by-products.


By-products are outputs from a joint production process that are relatively minor in quantity and/or value when compared to the main products. By-product accounting attempts to reflect the economic relationship between the byproducts and the main products with a minimum of recordkeeping for inventory valuation purposes. Two common methods of accounting for by-products are:

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(1) The net realizable value from sale of the by-products is deducted from the joint cost of the main product(s). The remaining joint costs are allocated to the main products. (2) The proceeds from sale of the by-products are treated as other revenue. All joint costs are allocated to the main products. A complication can arise under both methods if the cost of processing by-products occurs in one period but they are not sold until the next period. Companies may find it necessary to keep an inventory of the by-product processing cost in the Additional byproduct cost account until the by-products are sold. Some companies expense the by-products costs in the period they are incurred and then record the total revenue from by-products when they are sold, a simple approach that technically violates the matching principle. ======================

Demonstration Problem 9
(Continued from Demonstration Problem 5) Superior Refinery produces oil products in a joint production process. For the month of October, $450,000 of materials, labor and overhead were added to produce the three main products: M1, M2, and M3. The sale values were available right after the split-off point. Superior Refinery also produced a by-product, B, in October that was sold for $30,000. The following diagram shows the process.

M1 Sale value $200,000 Joint costs $450,000 M2 Sale value $300,000 M3 Sale value $500,000 B Sale value $30,000 Required: Discuss the accounting treatments for the by-product.

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Solution: There are two methods of accounting for by-products. The first method deducts the net realizable value from sale of the by-products from the cost of the main products, as shown below. Total costs to be allocated = Joint costs Net realizable value from the by-product, or $420,000 = $450,000 - $30,000. Product M1 M2 M3 Total
a b

Sale value Proportion $200,000 20%a 300,000 30% 500,000 50% $1,000,000

Allocation $84,000b 126,000 210,000 $420,000

20% = $200,000 $1,000,000. $84,000 = $420,000 20%.

The second method treats the proceeds from sale of the by-product as other revenue. The joint costs will be allocated to the main products without adjustment, as in Demonstration Problem 5. ====================== [Assign Exercises 11-37, 11-40, Problems 11-56, 11-58]

LO11 (Appendix) Use spreadsheets to solve reciprocal cost allocation problems.


The reciprocal method requires that cost relationships be written in equation form. The method then solves the equations for the total costs to be allocated to each department. For any department (both service and production), the following equation applies: Total costs = Direct costs + Allocated costs. The total costs are the unknowns that will be solved. The analysis can be expanded to any number of service departments and production departments. The set of equations can be rewritten and expressed in matrix form, and solved using the matrix functions of a spreadsheet program such as Microsoft Excel. The process has three steps:

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Step 1. The coefficients of the service matrix are entered. Step 2. The inverse of the service matrix is computed. Step 3. Multiply the inverse matrix by the vector (or array) of direct costs of the departments. [Assign Problem 11-45]

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Matching
A. B. C. D. E. F. Direct method Estimated net realizable value Final cost center Joint cost Physical quantities method Reciprocal method G. H. I. J. K. L. Service department Split-off point Step method User Department By-products Intermediate cost center

_____ 1. The method to allocate service department costs that recognizes all services provided by any service department, including services provided to other service departments. _____ 2. The stage of processing when two or more products are separated. _____ 3. Allocates joint costs based on measurement of the volume, weight, or other physical measure of the joint products at the split-off point. _____ 4. Outputs from a joint production process that are relatively minor in quantity and/or value when compared to the main products. _____ 5. Sales price of a final product Additional processing costs necessary to prepare after further processing a product for sale

_____ 6. The method of service department cost allocation that allocates some service department costs to other service departments. _____ 7. A cost center, such as a production or marketing department, whose costs are not allocated to another cost center. _____ 8. Uses the functions of service departments. _____ 9. A cost of a manufacturing process with two or more different outputs. _____ 10. A cost allocation method that charges costs of service departments to user departments without making allocations between or among service departments. _____ 11. Any cost center whose costs are charged to other departments in the organization. _____ 12. Provides services to other departments in the organization.

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Answers
1. F 2. H 3. E 4. K 5. B 6. I 7. C 8. J 9. D 10. A 11. L 12. G

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Multiple Choice
1. Which of the following statements is incorrect? a. Service departments provide services to other departments. b. Service departments are not the same as user departments. c. An intermediate cost center is any cost center whose costs are charged to other departments. d. A final cost center is any cost center whose costs are not allocated to other cost centers. The following information is for questions 2 6. A company has two service departments (S1 and S2) and two manufacturing divisions (M1 and M2). The following information is available. Proportion of services provided to: Costs incurred $290,000 500,000 Service department S1 S2 S1 50% S2 20% M1 30% 20% M2 50% 30%

2. Using the direct method, what proportion of S1s costs will be allocated to M2? a. 20%. b. 37.5%. c. 50%. d. 62.5%. 3. Using the direct method, how much of the service department costs will be allocated to M1? a. $195,250. b. $205,750. c. $308,750. d. $326,450. 4. Using the step method, how much of the service department costs will be allocated to M1? a. $243,000. b. $265,700. c. $295,400. d. $302,500. 5. Using the reciprocal method, how should the total service department costs of S1 be expressed? a. S1 = $290,000 + .5 S2. b. S1 = $290,000 + .2 S2. c. S1 = $290,000 + .3 S2. d. S1 = $500,000 + .5 S2.

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6. Using the reciprocal method, how much of the service department costs will be allocated to M1? a. $241,000. b. $286,000. c. $304,000. d. $403,000. The following information is for questions 7 9. A joint production process that cost $240,000 generated two main products. P1 has 15,000 units and can be sold at split-off point for $300,000. P2 has 25,000 units and can be sold at split-off point for $200,000. A by-product can be sold for $30,000. 7. Using the net realizable value method, how much of the joint costs would be allocated to P1? a. $120,000. b. $144,000. c. $156,000. d. $183,000. 8. Using the physical quantities method, how much of the joint costs would be allocated to P1? a. $90,000. b. $120,000. c. $150,000. d. $180,000. 9. If the sale value of the by-product is deducted from the joint costs of the main products, how much is P1s share of the total costs? a. $126,000. b. $216,000. c. $105,000. d. $184,000. 10. The relevant data for deciding whether to process further are a. Additional revenue after further processing. b. Joint costs. c. Additional costs of processing further. d. Both a and c. 11. Which of the following is not a service department? a. Human resources. b. Accounting. c. Mailroom. d. Production.

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12. Which of the following allocation methods does not consider any mutual support among service departments? a. Step method. b. Direct method. c. Reciprocal method. d. None of the above.

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Answers
1. b 2. d LO1 LO2

62.5% = 50% (30% + 50%). 3. c LO2

$308,750 = $290,000 4. d LO3

30% 20% + $500,000 . 30% + 50% 20% + 30%

Using the step method, S2s costs will be allocated first. $302,500 = $500,000 20% + [$290,000 + $500,000 50%]

30% . 30% + 50%

5. a 6. c

LO4 LO4

S1 = $290,000 + .5 S2. S2 = $500,000 + .2 S1. S1 = $600,000 and S2 = $620,000. $304,000 = $600,000 30% + $620,000 20%. 7. b LO7
$300, 000 . $300,000 + $200,000

$144,000 = $240,000
8. a LO8

$90,000 = $240,000 9. a

15, 000 . 15,000 + 25,000

LO10 $300, 000 . $300,000 + $200,000

$126,000 = ($240,000 - $30,000) 10. d LO9

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11. d 12. b

LO1 LO2, LO3, LO4

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Chapter 13 Planning and Budgeting


Learning Objectives
1. Understand the role of budgets in overall organization plans. 2. Understand the importance of people in the budgeting process. 3. Estimate sales. 4. Develop production and cost budgets. 5. Estimate cash flows. 6. Develop budgeted financial statements. 7. Explain budgeting in merchandising and service organizations. 8. Explain why ethical issues arise in budgeting. 9. Explain how to use sensitivity analysis to budget under uncertainty.

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Chapter Outline
I. II. HOW STRATEGIC PLANNING INCREASES COMPETITIVENESS OVERALL PLAN A. Organization goals B. Strategic long-range profit plan C. Master budget (Tactical short-range profit plan): Tying the strategic plan to the operating plan III. HUMAN ELEMENT IN BUDGETING Value of employee participation IV. DEVELOPING THE MASTER BUDGET: WHERE TO START? Sales forecasting 1. Sales staff 2. Market researchers 3. Delphi technique 4. Trend analysis 5. Econometric model V. COMPREHENSIVE ILLUSTRATION A. Forecasting production B. Forecasting production costs 1. Direct materials 2. Direct labor 3. Overhead C. Completing the budgeted cost of goods sold D. Revising the initial budget VI. MARKETING AND ADMINISTRATIVE BUDGET VII. PULLING IT TOGETHER INTO THE INCOME STATEMENT VIII. KEY RELATIONSHIPS: THE SALES CYCLE IX. USING CASH FLOW BUDGETS TO ESTIMATE CASH NEEDS Multiperiod Cash Flows X. PLANNING FOR THE ASSETS AND LIABILITIES ON THE BUDGETED BALANCE SHEETS XI. BIG PICTURE: HOW IT ALL FITS TOGETHER XII. BUDGETING IN RETAIL AND WHOLESALE ORGANIZATIONS XIII. BUDGETING IN SERVICE ORGANIZATIONS XIV. ETHICAL PROBLEMS IN BUDGETING XV. BUDGETING UNDER UNCERTAINTY XVI. SUMMARY

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Key Concepts
LO1 Understand the role of budgets in overall organization plans.
Critical success factors are strengths of a company that enable it to outperform competitors. By identifying critical success factors and ensuring that they are incorporated into the strategic plan, companies are able to maintain an edge over competitors. Important critical success factors can be exploited to improve the companys overall competitiveness. Budget is a financial plan of the resources needed to carry out activities and meet financial goals. A recent study shows that small businesses rely on budgets to help manage cash flow, among things (see In-Action item for more information). Budgeting process is widely used and necessary for success. The usual problems with budgeting are the use of budgets as targets and the dysfunctional effects caused by that use. An overall organization plan is made up of three components: (1) The organization goals, (2) The strategic long-range profit plan, and (3) The master budget (i.e., the tactical short-range profit plan). Organization goals are a companys broad objectives established by management that employees work to achieve. Strategic long-range profit plan is a statement detailing steps to take to achieve a companys organization goals. The plan provides a general framework for guiding managements operating decisions. Strategic plans discuss the major capital investments required to maintain present facilities, increase capacity, diversify products and/or processes, and develop particular markets. Master budget (also known as the static budget, the budget plan, or the planning budget) is the financial plan of an organization for the coming year or other planning period. Profit plan is the income statement portion of the master budget.

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The master budget indicates the sales levels, production and cost levels, income, and cash flows anticipated for the coming year. In addition, these budget data are used to construct a budgeted balance sheet. Budgeting is a dynamic process that ties together goals, plans, decision making, and employee performance evaluation. Exhibit 13.1 shows the master budget and its relationship to other plans, accounting reports, and management decision-making processes. The master budget is derived from the long-range plan in consideration of conditions expected during the coming period. Such plans are subject to change as the events of the year unfold. Benchmarking is the continuous process of measuring products, services, or activities against competitors performance. Competitive intelligence can be part of a benchmarking activity in which some companies gather information by speaking to their competitors, customers, and suppliers.

LO2 Understand the importance of people in the budgeting process.


Although budgets are often viewed in purely quantitative, technical terms, managers personal goals and values will affect their beliefs about the coming period. Budget preparation rests on human estimates of an unknown future. Peoples forecasts are likely to be greatly influenced by their experiences with various segments of the company. One challenge of budgeting is to identify who in the organization is best able to provide the most accurate information about particular topics. Participative budgeting (also called grass roots budgeting) is the use of input from lower- and middle-management employees for budget preparation. Participative budgeting is time consuming, yet it enhances employee motivation and acceptance of goals, and provides information that enables employees to associate rewards and penalties with performance. It also serves a training or development role for managers. Studies have found that managers often provide inaccurate data when asked to give budget estimates. Managers who believe that the budget will be used as a norm for evaluating their performance could provide an estimate that will not be too hard to achieve.

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Ideally, the budget will motivate people and facilitate their activities so that the organization can achieve its goals. [Assign Exercise 13-32]

LO3 Estimate sales.


All budgeting processes share some common elements. After organization goals, strategies, and long-range plans have been developed, work begins on the master budget, a detailed budget for the coming fiscal year with some lessdetailed figures for subsequent years. The bulk of the work preparing the master budget is usually done in the six months immediately preceding the beginning of the coming fiscal year. Final budget approvals by the chief executive and board of directors are made one month to six weeks before the beginning of the coming fiscal year. Beginning with a sales forecast, the firm can plan the activities over which it has more control. As better information about sales becomes available, it is reasonably easy to adjust the rest of the budget. In most firms, forecasting sales is the most difficult aspect of budgeting because it is most uncertain. If, on the other hand, production is more uncertain than sales because of unpredictable supply of materials, the firm may want to begin with a raw material and production forecast. Salespeople are in the unique position of being close to the customers, and they may possess the best information and the best local knowledge in the company about customers immediate and near-term needs. Salespeople realize that they will be evaluated based, in part, on the budget. As a result, they have an incentive to bias their sales forecasts. Incentive compensation plans can be designed to motivate different behaviors, each with their own strengths and weaknesses. Market researchers do not have the same incentives that sales personnel have to bias the budget. Market researchers have a different perspective on the market. That is, they can predict long-term trends in attitudes and the effects of social and economic changes on the companys sales, potential markets, and products.

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Delphi technique is a forecasting method in which individual forecasts of group members are submitted anonymously and evaluated by the group as a whole. Each group member obtains a copy of all forecasts but is unaware of their sources. Differences among individual forecasts can be addressed and reconciled without involving the personality or position of individual forecasters. After the differences are discussed, the process is repeated until the forecasts converge on a single best estimate of the coming years sales level. Trend analysis is a forecasting method that ranges from simple visual extrapolation of points on a graph to highly sophisticated computerized time series analysis. Time series techniques use only past observations of the data series to be forecasted. This approach is relatively economical. Forecasting techniques based on trend analysis often requires long series of past data to derive a suitable solution. When used in accounting applications, monthly data are required to obtain an adequate number of observations. Econometric models are statistical methods of forecasting economic data using regression models. Econometric models can include many relevant predictors. Manipulating the assumed values of the predictors makes it possible to examine a variety of hypothetical conditions and relate them to the sales forecast. No model removes the uncertainty surrounding sales forecasts. Cost-benefit tests should be used to determine which methods are most appropriate. [Assign Exercises 13-16, 13-17, 13-18, 13-32]

LO4 Develop production and cost budgets.


Production budget is the production plan of resources needed to meet current sales demand and ensure that inventory levels are sufficient for future sales. It is necessary to determine the required inventory level for the beginning and end of the budget period.

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The basic cost flow equation (also known as the basic inventory formula) can be adapted for inventories, production, and sales to solve for the required production. Recall from Chapter 6 the inventory equation: Beginning balance (BB) + Transfer in (TI) Transfer out (TO) = Ending balance (EB). Rearranging the terms, this revised equation states that production equals the sales demand plus or minus an inventory adjustment. Required = production (units) Budgeted sales (units) + Units in ending inventory Units in beginning inventory

Another way to solve the required production is to go through the following T-account: Finished goods Inventory Units in beginning inventory Budgeted sales Required production (?) (from sales forecast) Units in ending inventory Production and inventory are stated in equivalent finished units. Exhibit 13.2 presents a production budget example. Management of the production facilities reviews the production budget to ascertain whether the budgeted level of production can be reached with the capacity available. One benefit of the budgeting process is that it facilitates the coordination of activities. ======================

Demonstration Problem 1
East Mountain Bike expects to sell 25,000 electronic bicycles next year. The management estimates that the beginning and ending inventory will be 2,000 units and 3,500 units, respectively. Required: Prepare a production budget for next year.

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Solution: East Mountain Bike Production Budget For the budget year ended December 31 (in units) Expected sales Add: Desired ending inventory of finished goods Total needs Less: Beginning inventory of finished goods Units to be produced ====================== 25,000 3,500 28,500 (2,000) 26,500

Once the sales and production budgets have been developed and the efforts of the sales and production groups have been coordinated, the next step is to estimate costs of direct materials, direct labor, and manufacturing overhead at budgeted levels of production so the budgeted cost of goods sold can be prepared. Direct materials purchases needed for the budget period are derived from the equation: Required material = purchases Materials to be used in production + Estimated ending materials inventory Estimated beginning materials inventory

Another way to solve the required materials purchases is to go through the following Taccount: Materials Inventory Estimated beginning inventory Required usage (converted from production Required purchases (?) budget) Estimated ending inventory Required usage = Required production Materials needed per unit of output. Cost of materials to be purchased = Required purchases Cost of materials per unit. Exhibit 13.3 shows the direct materials budget. ======================

Demonstration Problem 2
(Continued from Demonstration Problem 1)

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Each electronic bicycle produced at East Mountain Bike requires two major parts (frame and tires) and an electronic subassembly from its suppliers as inputs. The following information is available: Material per bike Unit cost Beginning inventory Ending inventory Frame 1 $900 1,100 2,500 Tires 2 $30 2,000 3,200 Electronic subassembly 1 $420 950 1,800

Required: Prepare the direct material budget for next year. Solution: East Mountain Bike Direct Materials Budget For the budget year ended December 31 Units to be produced next year (from the production budget above): 26,500 Electronic Frame Tires subassembly 1 2 1 26,500 53,000 26,500 2,500 3,200 1,800 29,000 56,200 28,300 (1,100) (2,000) (950) 27,900 54,200 27,350 $900 $30 $420 $25,110,000 $1,626,000 $11,487,000 $38,223,000

Direct material needed per bike Total production needs Add: Desired ending inventory Total direct materials needs Less: Beginning inventory Direct materials to be purchased Unit cost Total cost of direct materials to be purchased Total materials cost ======================

Estimates of direct labor costs often are obtained from engineering and production management. Direct labor usage = Required production Labor hours needed per unit of output. Direct labor cost = Direct labor usage Direct labor cost per hour. Exhibit 13.4 shows a direct labor budget. Overhead is composed of many different types of costs with varying cost behaviors.

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Budgeting overhead requires an estimate based on production levels, management discretion, long-range capacity and other corporate policies, and external factors such as increases in property taxes. To simplify the budgeting process, overhead costs are usually divided into fixed and variable components, with discretionary and semi-fixed costs treated as fixed costs within the relevant range. Exhibit 13.5 presents a sample schedule of budgeted manufacturing overhead. The total manufacturing costs can be determined by adding materials, labor, and overhead together. Exhibit 13.6 shows the calculation for the budgeted statement of cost of goods sold. In most companies, estimates of work-in-process inventories are omitted from the budget because they have a minimal impact on the budget. The calculation of the cost of goods sold follows the equation: Estimated cost of goods sold = Estimated beginning finished goods inventory + Estimated cost of goods manufactured Estimated ending finished goods inventory

Another way to determine the estimated cost of goods sold is to go through the finished goods T-account: Finished goods Inventory Beginning inventory Cost of goods manufactured Ending inventory Cost of goods sold (?)

This part of the budgeting effort can be extremely complex for manufacturing companies. It can be very difficult to coordinate production schedules among numerous plants; it is also difficult to coordinate production schedules with sales forecasts. The budget usually undergoes a good deal of coordinating and revising before it is considered final. Not part of the budget is really formally adopted until the board of directors finally approves the master budget. Budgeting marketing and administrative costs is very difficult because managers have discretion about how much money is spent and the timing of the expenditures.

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The budgeting objective is to estimate the amount of marketing and administrative costs required to operate the company at its projected level of sales and production, and to achieve long-term company goals. An easy and inexpensive way is to start with a previous periods actual or budgeted amounts and make adjustments for inflation, changes in operations, and similar changes between periods. Exhibit 13.7 shows a schedule of budgeted marketing and administrative costs. Variable marketing costs vary with sales. Fixed marketing costs are usually those that can be changed at managements discretion. The budgeting process culminates in the projected operating profits reported in the budgeted income statement, as shown in Exhibit 13.8. The budgeted income statement also includes estimated federal and other income taxes. The process will be repeated to see if sales revenue can be increased, or costs cut, until the desired financial results can be reached. ======================

Demonstration Problem 3
Emerson Manufacturing Company produces two products: Model S and Model Z. The following income statement shows this years operating results. Emerson Manufacturing Company Income Statement For the year ended December 31 Revenue: Model S Model Z Cost of goods sold: Model S Model Z Gross margin Operating costs: Marketing Distribution Depreciation Administration Operating income $300,000 200,000 $150,000 120,000 $60,000 50,000 21,000 30,000

$500,000 (270,000) $230,000

(161,000) $69,000

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Emersons management is in the process of preparing next years budget. The following information is under consideration. 1. Selling price of Model S is expected to remain the same, but the units sold will increase by 6 percent 2. Selling price and units of Model Z will increase by 5 percent and 10 percent, respectively. 3. As indicated by the suppliers of key components, the cost of each unit sold will increase by 3 percent. 4. Marketing costs are expected to increase by $20,000. 5. Distribution costs remain the same fixed percentage of total sales revenue. 6. Depreciation costs remain unchanged. 7. A new administrative aide will be hired part time for $25,000. 8. There is no beginning or ending inventory. Required: Prepare a budgeted income statement for next year. Solution: Emerson Manufacturing Company Budgeted Income Statement For the budget year ended December 31 Revenue: Model S Model Z Cost of goods sold: Model S Model Z Gross margin Operating costs: Marketing Distribution Depreciation Administration Operating income
a b

$318,000a 231,000b $154,500c 123,600d $80,000e 54,900f 21,000 55,000g

$549,000 (278,100) $270,900

(210,900) $60,000

$300,000 1.06 = $318,000. $200,000 1.05 1.10 = $231,000. c $150,000 1.03 = $154,500. d $120,000 1.03 = $123,600. e $60,000 + $20,000 = $80,000. f $50,000 $500,000 = 0.1. $549,000 0.1 = $54,900. g $30,000 + $25,000 = $55,000. ======================

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The master budget is rooted in some key relations among sales, accounts receivable, and cash flows in the sales cycle. That is, Sales Budgeted sales Accounts receivable BB Budgeted Collection sales EB Cash BB Collection on Disbursements account Other receipts EB

BB and EB refer to beginning and ending balances, respectively. All sales are assumed to be on account. If an amount in the sales cycle is unknown, the basic accounting equation (BB + TI TO = EB) can be used to find it. [Assign Exercises 13-19, 13-20, 13-21, 13-22, 13-23, Problems 13-38, 13-40, 13-41, 13-42, 1343, 13-44, 13-45, Integrative Case 13-46]

LO5 Estimate cash flows.


Cash budget refers to a statement of cash on hand at the start of the budget period, expected cash receipts, expected cash disbursements, and the resulting cash balance at the end of the budget period. Cash budgeting is important to ensure company solvency, maximize interest earned on cash balances, and determine whether the company is generating enough cash for present and future operations. Preparing a cash budget requires that all revenues, costs, and other transactions be examined in terms of their effects on cash. Cash receipts come from the collection of accounts receivable, cash sales, sale of assets, borrowing, issuing stock, and other cash-generating activities. Cash disbursements are used to pay for materials purchases, manufacturing and other operations, federal income taxes, and stockholder dividends. A cash budget is shown in Exhibit 13.9. A more detailed analysis looks at multiperiod cash receipts (Exhibit 13.10) and cash disbursements (Exhibit 13.11) to ensure that the company will not run out of cash during the year.

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======================

Demonstration Problem 4
The management at Emerson Manufacturing Company is studying the cash inflow pattern in preparation for its cash budget. The following information is available. Cash collected from current months sales Cash collected from last months sales Cash discount taken Uncollectible sales 40% 55% 2% 3% 100%

For the second quarter of next year, the beginning balance of accounts receivable ($23,000) is expected to be collected in full in April. The expected credit sales of the second quarter are: April May June $40,000 45,000 50,000

Required: Prepare a multiperiod schedule of cash collections for the second quarter of next year. Solution: Emerson Manufacturing Company Multiperiod Shedule of Cash Collections For the quarter ended June 30 Month Accounts receivable, April 1 April credit sales May credit sales June credit sales Total cash collection $40,000 40% = $16,000. $40,000 55% = $22,000. c $45,000 40% = $18,000. d $45,000 55% = $24,750. e $50,000 40% = $20,000. ======================
b a

April May $23,000 16,000a $22,000b 18,000c $39,000 $40,000

June $24,750d 20,000e $44,750

Total $23,000 38,000 42,750 20,000 $123,750

[Assign Exercises 13-22, 13-23, 13-24, 13-25, 13-26, 13-27, 13-28, Problems 13-37, 13-39, 1343, 13-44, 13-45, Integrative Case 13-46]

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LO6 Develop budgeted financial statements.


Budgeted balance sheets are statements of budgeted financial position. Budgeted balance sheets combine an estimate of financial position at the beginning of the budget period with the estimated results of operations for the period and estimated changes in assets and liabilities. Decision making in these areas is, for the most part, the treasurers function. Exhibit 13.12 presents budgeted balance sheets at the beginning and end of the budget period. A model of the budgeting process for a manufacturing firm is presented in Exhibit 13.13. Assembling a master budget is a complex process requiring careful coordination of many different organization segments. [Assign Exercises 13-29, 13-30, 13-31, Problems 13-36, 13-38, 13-43, 13-44, 13-45, Integrative Case 13-46]

LO7 Explain budgeting in merchandising and service organizations.


Budgeting is used extensively in different types of organizations. As in manufacturing, the sales budget in retail and wholesale (often called merchandising) businesses drives the rest of the budgeted income statement. A merchandiser has no production budget but a merchandise purchases budget, which is much like the direct materials purchases budget in manufacturing. Exhibit 13.14 presents a merchandise purchases budget. Because of the critical importance of timing and seasonality in merchandising, special attention is usually given to short-term budgets. The budget helps formalize an ongoing process of coordinating buying and selling. A key difference in the master budget of a service enterprise is the absence of product or material inventories. Neither a production budget (for manufacturing firms) nor a merchandise purchases budget (for merchandising firms) is needed. Service businesses need to carefully coordinate sales with the necessary labor. Managers must ensure that personnel with the right skills are available at the right times.

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Example: Revenue projections for a consulting firm may be based on estimates of the number and types of clients to be served in the budget year and the amount of services requested. The forecasts stem primarily from services provided in previous years with adjustments for new clients, new services to existing clients, loss of clients, and changes in the rates charged for services. Once the amount of services is forecast, the firm develops its budget for personnel. The firm faces a trade-off between not having the staff to do the work and having costly staff who are underemployed. In governmental organizations, the budget serves as an expression of the legislatures desires and is a legally binding authorization. [Assign Integrative Case 13-46]

LO8 Explain why ethical issues arise in budgeting.


Budgeting creates serious ethical issues for many people. Managers and employees provide much of the information for the budget. Their performance then is compared with the budget they help develop. Part of the problem is the form of the merit pay schedule that creates strong incentives right around the target. The company must recognize the trade-off between encouraging unbiased reporting by local managers and the use of this information in performance evaluation and reward. While the conflict cannot be avoided, managers who are aware of the potential problems are in a position to take steps to mitigate the consequences. [Assign Exercises 13-32, 13-33]

LO9 Explain how to use sensitivity analysis to budget under uncertainty.


Formal planning models allow many alternatives and options to be explored in the planning process. Any projection of the future is uncertain. Managers often perform sensitivity analysis on their projections.

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By asking and answering hypothetical questions during the planning phase, management can determine the risk of various phases of its operations and can develop contingency plans. Local managers can be asked to provide three forecasts of prices and quantities: a best estimate, an optimistic estimate (an estimate so high that there is only a 10 percent or less chance that conditions will be better than the optimistic estimate), and a pessimistic estimate (an estimate so low that there is only a 10 percent or less chance that conditions will be worse than the pessimistic estimate). Nine possible scenarios can be defined by selling prices and sales quantity combinations. The incorporation of uncertainty into budget estimates can be quite useful. Spreadsheets are extremely useful in preparing budgets, which require considerable what-if thinking. Exhibit13.15 shows a spreadsheet analysis of alternative budgeting scenarios. [Assign Exercises 13-34, 13-35]

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Matching
A. B. C. D. E. F. Budget Cash budget Critical success factors Delphi technique Econometric models Master budget G. H. I. J. K. L. Organization goals Participative budgeting Production budget Profit plan Strategic long-range plan Trend analysis

_____ 1. A statement of cash on hand at the start of the budget period, expected cash receipts, expected cash disbursements, and the resulting cash balance at the end of the budget period. _____ 2. A companys broad objectives established by management that employees work to achieve. _____ 3. Strengths of a company that enable it to outperform competitors. _____ 4. A forecasting method in which individual forecasts of group members are submitted anonymously and evaluated by the group as a whole. _____ 5. The financial plan of an organization for the coming year or other planning period. _____ 6. The use of input from lower- and middle-management employees for budget preparation. _____ 7. The income statement portion of the master budget. _____ 8. A forecasting method that ranges from simple visual extrapolation of points on a graph to highly sophisticated computerized time series analysis. _____ 9. Statistical methods of forecasting economic data using regression models. _____ 10. A financial plan of the resources needed to carry out activities and meet financial goals. _____ 11. A statement detailing steps to take to achieve a companys organization goals. _____ 12. The production plan of resources needed to meet current sales demand and ensure that inventory levels are sufficient for future sales.

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Answers
1. B 2. G 3. C 4. D 5. F 6. H 7. J 8. L 9. E 10. A 11. K 12. I

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Multiple Choice
1. Which of the following statements is correct? a. Critical success factors are strengths of a company that enable it to outperform competitors. b. Strategic long-range profit plan is a statement detailing steps to take to achieve a companys budget. c. Master budget is a long-range financial plan of an organization. d. Budgeting is a static process. 2. Which of the following method(s) can be used to extract sales forecast? a. Delphi technique. b. Trend analysis. c. Econometric models. d. All of the above. 3. Jim is preparing the production budget for his company. He estimates that 21,000 units have to be produced to meet the sales forecast of 18,000 units and the desired ending inventory of 4,000 units. How many units should be in the beginning inventory? a. 750 units. b. 800 units. c. 1,000 units. d. 1,200 units. 4. For next year, 21,000 units of finished goods have to be produced, each consuming 3 units of materials at $6. The expected beginning and ending materials inventories are 8,000 units and 12,000 units, respectively. How much is expected to spend for materials purchases next year? a. $360,000. b. $372,000. c. $390,000. d. $402,000. 5. For next year, 21,000 units of finished goods have to be produced, each requiring 1.5 hours of labor. The prevailing hourly rate is expected to be $12 per hour. What is the direct labor cost for next year? a. $332,000. b. $356,000. c. $378,000. d. $412,000.

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6. Which of the following statements is incorrect? a. To simplify the budgeting process, overhead costs are usually divided into fixed and variable components. b. Most companies estimate work-in-process inventories. c. The budget usually undergoes a good deal of coordinating and revising. d. Budgeting marketing and administrative costs is very difficult because managers have discretion about how much money is spent and the timing of the expenditures. 7. The following information is available. Cash collected from current months sales Cash collected from last months sales Uncollectible sales 40% 55% 5% 100%

The expected credit sales of the second quarter are: April May June $400,000 450,000 500,000

How much cash will be collected in May? a. $360,000. b. $400,000. c. $420,000. d. $480,000. 8. The following information is available. Cash payment for current months purchases Cash payment for last months purchases Cash discount taken 30% 67% 3% 100%

The expected credit purchases of the second quarter are: April May June How much cash will be paid in May? a. $184,500. b. $195,600. c. $200,750. d. $221,400. $180,000 250,000 300,000

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9. Which of the following statements is incorrect? a. A key difference in the master budget between a service enterprise and a manufacturing firm is the absence of product or material inventories. b. Service businesses need to carefully coordinate sales with the necessary labor. c. The purchase budget in retail and wholesale businesses drives the rest of the budgeted income statement. d. A merchandiser has no production budget. 10. Which of the following statements is correct? a. Managers and employees provide much of the information for the budget. b. Performance of managers and employees is compared with the budget they help develop. c. The company must recognize the trade-off between encouraging unbiased reporting by managers and the use of this information in performance evaluation and reward. d. All of the above. 11. Participative budgeting a. Relies on input from top management for budget preparation. b. Is also called grass root budgeting. c. Is efficient and expedient. d. Prevents employees from accepting the goals of their organization. 12. Which of the following statements is correct? a. Sales forecast can be done after sales budget is prepared. b. Market researchers are concerned with short-term sales. c. Salespeople have an incentive to bias their sales forecasts. d. Delphi technique encourages participants to identify themselves and foster communication.

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Answers
1. a 2. d 3. c LO1 LO3 LO4

BB + 21,000 18,000 = 4,000. BB = 1,000 units. 4. d LO4

8,000 units + TI 21,000 3 = 12,000 units. TI = 67,000 units. Cost of materials purchases = $6 67,000 units = $402,000. 5. c LO4

$12 1.5 hours 21,000 units = $378,000. 6. b 7. b LO4 LO5

$400,000 55% + $450,000 40% = $400,000. 8. b LO5

$180,000 67% + $250,000 30% = $195,600. 9. c 10. d 11. b 12. c LO7 LO8 LO2 LO3

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Chapter 16 Fundamentals of Variance Analysis


Learning Objectives
1. Use budgets for performance evaluation. 2. Develop and use flexible budgets. 3. Compute and interpret the sales activity variance. 4. Prepare and use a profit variance analysis. 5. Compute and use variable cost variances. 6. Compute and use fixed cost variances. 7. (Appendix) Understand how to record costs in a standard costing system.

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Chapter Outline
I. II. III. IV. V. USING BUDGETS FOR PERFORMANCE EVALUATION PROFIT VARIANCE Why are actual and budgeted results different? FLEXIBLE BUDGETING COMPARING BUDGETS AND RESULTS Sales activity variance PROFIT VARIANCE ANALYSIS AS A KEY TOOL FOR MANAGERS A. Sales price variance B. Variable production cost variances C. Fixed production cost variance D. Marketing and administrative variances PERFORMANCE MEASUREMENT AND CONTROL IN A COST CENTER Variable production costs 1. Direct materials 2. Direct labor 3. Variable production overhead VARIABLE COST VARIANCE ANALYSIS A. General model B. Direct materials Responsibility for direct materials variances C. Direct labor 1. Direct labor price variance 2. Labor efficiency variance D. Variable production overhead 1. Variable production overhead price variance 2. Variable overhead efficiency variance E. Variable cost variances summarized in graphic form FIXED COST VARIANCES A. Fixed cost variances with variable costing B. Absorption costing: The production volume variance 1. Developing the standard unit cost for fixed production costs 2. Compare with the fixed production cost price variance SUMMARY OF OVERHEAD VARIANCES Key points SUMMARY APPENDIX: RECORDING COSTS IN A STANDARD COST SYSTEM A. Direct materials B. Direct labor C. Variable manufacturing overhead D. Fixed manufacturing overhead E. Transfer to finished goods inventory and to cost of goods sold F. Close out variance accounts to cost of goods sold

VI.

VII.

VIII.

IX. X. XI.

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Key Concepts
LO1 Use budgets for performance evaluation.
The development of the master budget is the first step in the budgetary planning and control cycle. The budgeting process provides a means to coordinate activities among units of the organization, to communicate the organizations goals to individual units, and to ensure that adequate resources are available to carry out the planned activities. In the control and evaluation activity, the performance of units and managers is evaluated and actions are taken in an attempt to improve performance. Budget serves as the benchmark for units of the firm or for organizations that do not routinely prepare public reports. Budget is managements plan for financial performance. The master budget includes operating budgets (such as budgeted income statement, production budget, budgeted cost of goods sold, and supporting budgets) and financial budgets (budgets of financial resources, including the cash budget and the budgeted balance sheet). When management uses the master budget for control purposes, it focuses on the key items that must be controlled to ensure the companys success. Income statement is the most important financial statement that managers use to control operations. Variance is the difference between planned result and actual outcome. That is, Variance = Actual result Budgeted performance. Variance analysis is used to (1) evaluate the performance of individuals and business units, and (2) identify possible sources of deviations between budgeted and actual performance. The simplest measure of performance is the variance between actual income and budgeted income. Favorable variance is the variance that, taken alone, results in an addition to operating profit. Unfavorable variance is the variance that, taken alone, reduces operating profit.

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When discussing revenue, income, or contribution margin, a favorable variance means the actual result is better than the budgeted result. When discussing costs, a favorable variance indicates that actual costs are less than budgeted costs. The labels favorable and unfavorable should not be considered as evaluations of performance without additional investigation. Although a simple comparison of planned and actual profit suggests that performance was better (or worse) than planned, the additional data (such as those in Exhibit 16.2) provide information on the impact on profit performance from each of the revenue and cost line items. The additional information is useful for two reasons. (1) It allows the manager to investigate more efficiently the causes of off-budget performance, and (2) It allows the manager to evaluate subordinate managers responsible for various aspects of the firms operations. An important part of variance analysis is to understand (1) what might cause a difference between actual and budgeted results, and (2) what portion of the total profit variance is due to each cause. The following table summarizes the variance analysis between actual results and master budget for line items comprising the operating profit Actual (1) xx $xx (xx) $xx (xx) $xx Variancea (3) = (1) (2) xx F or U $xx F or U (xx) F or U $xx F or U (xx) F or U $xx F or U Master Budget (2) xx $xx (xx) $xx (xx) $xx

Units Sales revenue Less: Variable costsb Contribution margin Less: Fixed costsc Operating profit
a

For revenue, income, or contribution margin, (F)avorable variance results when (3) > 0. For cost items, (F)avorable variance results when (3) < 0. b Including variable manufacturing costs and variable selling and administrative costs. c Including fixed manufacturing overhead and fixed selling and administrative costs.

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======================

Demonstration Problem 1
The accountant at EZ Toys, Inc. is analyzing the production and cost data for its Trucks Division. For October, the actual results and the master budget data are presented below. Actual results 10,000 trucks produced and sold Unit selling price $15 Variable costs: Direct materials $52,800 Direct labor 51,000 Variable overhead 23,000 Total variable costs $126,800 Fixed overhead $9,000 Budget data 12,000 trucks planned Unit selling price Unit variable cost: Direct materials Direct labor Variable overhead Total unit variable costs Fixed overhead

$14 $5 4 2 $11 $9,600

Required: Prepare a variance analysis to compare actual results and master budget. Solution: Actual (1) 10,000 $150,000 $52,800 51,000 23,000 $126,800 $23,200 9,000 $14,200 Variance (3) = (1) (2) 2,000 U $18,000 U $7,200 F 3,000 U 1,000 F $5,200 F $12,800 U 600 F $12,200 U Master Budget (2) 12,000 $168,000a $60,000b 48,000c 24,000d $132,000 $36,000 9,600 $26,400

Units Sales revenue Less: Costs Variable costs Direct materials Direct labor Variable overhead Total variable costs Contribution margin Fixed overhead Operating profit F = Favorable variance. U = Unfavorable variance. 12,000 units @ $14. 12,000 units @ $5. c 12,000 units @ $4. d 12,000 units @ $2. ======================
b a

[Assign Exercises 16-25, 16-26, Problems 16-54, 16-55, Integrative Case 16-61]

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LO2 Develop and use flexible budgets.


One obvious reason that actual results might differ from budgeted results is that the actual activity itself differed from the budgeted or expected activity. Static budget is developed in detail for one level of anticipated activity, such as a master budget. Flexible budget indicates budgeted revenues, costs, and profits for virtually all feasible levels of activities. Because variable costs and revenues change with changes in activity levels, these amounts are budgeted to be different at each activity level in the flexible budget. Flexible budget line is the expected costs at different output levels and can be represented by the following formula: Total budgeted costs = Budgeted fixed cost + Budgeted unit variable cost Activity level (Units produced and sold).

The flexible budget line (see Exhibit 16.3) is an estimated cost-volume line because it shows the budgeted costs allowed for each level of activity. The master budget is based on an ex ante (before-the-fact) prediction of the activity level. The flexible budget is based on ex post (after-the-fact) knowledge of the actual activity level. [Assign Exercises 16-16, 16-19, 16-20, 16-21, 16-22, Problems 16-39, 16-42, 16-43, 16-46, 1656, Integrative Case 16-61]

LO3 Compute and interpret the sales activity variance.


A comparison of the master budget with the flexible budget and with actual results is the basis for analyzing differences between plans and actual performance. Sales activity variance (also known as sales volume variance) is the difference between operating profit in the master budget and operating profit in flexible budget that arises because the actual number of units sold is different from the budgeted number. That is, Sales activity variance For sales revenue: = Flexible budget (based on actual activity) Budgeted unit price Actual units Master budget (based on planned activity). Budgeted unit price Budgeted units

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For variable costs:

Budgeted unit cost Actual units

Budgeted unit cost Budgeted units

The budgeted unit price and budgeted unit cost are used in flexible budget instead of the actual unit price and actual unit cost in order to isolate the effects of volume alone. Sales activity variance, as shown in Exhibit 16.4, is useful for management because (1) It isolates the change in operating profits caused by the actual activity being different from the master budget level. (2) The resulting flexible budget shows budgeted sales, costs, and operating profits after considering the activity change but before considering differences in unit selling prices, variable costs, and fixed costs from the master budget. Variable costs are expected to decrease when volume is lower than planned, resulting in favorable variances. [Assign Exercises 16-17, 16-23, Problems 16-44, 16-47, Integrative Case 16-61]

LO4 Prepare and use a profit variance analysis.


Profit variance analysis shows the causes of differences between budgeted profits and the actual profits earned. The actual results can be compared with both the flexible budget and the master budget in a profit variance analysis, as shown in Exhibit 16.5.

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(1) Actual (based on actual activity) $xx (xx) (xx) $xx (xx) (xx) $xx

(2)

(3)

(4)

(5) Flexible budget (based on actual activity) $xx (xx)

(6)

(7) Master budget (based on planned activity) $xx (xx) (xx) $xx (xx) (xx) $xx

Manufacturing variances

Marketing and Administrative variance

Sales revenue Less: Variable costs Variable manufacturing cost Variable marketing and administrative cost Contribution margin Less: Fixed costs Fixed manufacturing cost Fixed marketing and administrative cost Operating profit

Sales price variance $xx U or F

Sales activity variance $xx U or F (xx) U or F (xx) U or F $xx U or F 0 0 $xx U or F

$xx U or F $xx U or F

(xx) $xx (xx)

xx U or F $xx U or F xx U or F $xx U or F $xx U or F

(xx) $xx

Total variance from flexible budget Total variance from master budget

Column (1) is the reported income statement based on the actual sales. Column (2) summarizes production variances. Column (3) shows marketing and administrative variances. Cost variances result from deviations in costs and efficiencies in operating the company. They are important for measuring productivity and for helping to control costs. Variable cost variances in Columns (2) and (3) are input variances; variable cost variances in Column (6) are part of the sales activity variance. Column (4) shows the sales price variance as derived from the difference between the actual revenue and budgeted selling price multiplied by the actual number of units sold. That is, Sales price variance = = Actual revenue (Actual selling price Budgeted selling price Budgeted selling price) Actual units sold Actual units sold.

Variable costs in Column (5) represent what should have been spent given the actual sales volume. The fixed production cost variance is the difference between actual and budgeted costs because the flexible budgets fixed costs equal the master budgets fixed costs.

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Marketing and administrative costs are treated like production costs. Variable costs are expected to change as activity changes. Fixed marketing and administrative costs do not change as volume changes. ======================

Demonstration Problem 2
(Continued from Demonstration Problem 1) Required: Prepare a profit variance analysis. Solution:
Actual (based on actual activity of 10,000 units sold) $150,000 $52,800 51,000 23,000 $126,800 $23,200 9,000 $14,200 Flexible budget (based on actual activity of 10,000 units sold) $140,000a $50,000b 40,000c 20,000d $110,000 $30,000 9,600 $20,400 Master budget (based on 12,000 units planned) $168,000 $60,000 48,000 24,000 $132,000 $36,000 9,600 $26,400

Manufacturing variances

Sales revenue Less: Costs Variable costs Direct materials Direct labor Variable overhead Total variable costs Contribution margin Fixed overhead Operating profit

Sales price variance $10,000 F

Sales activity variance $28,000 U $10,000 F 8,000 F 4,000 F $22,000 F $6,000 U 0 $6,000 U

$2,800 U 11,000 U 3,000 U 600 F $16,200 U

$10,000 F

F = Favorable variance. U = Unfavorable variance.


a

10,000 units @ $14. 10,000 units @ $5. c 10,000 units @ $4. d 10,000 units @ $2. ======================
b

For cost centers whose production managers typically do not control what they are asked to produce, the actual unit production (not sales) should be used as a baseline. For any unit variable cost (such as direct materials), the variable cost in the budget is determined by multiplying the budgeted amount of the direct material in each unit of output by the expected price of each unit of direct material.

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Standard cost sheet is a form that provides standard quantities of inputs (direct material, direct labor, and variable production overhead) required to produce a unit of output and the standard (budgeted) unit prices for the inputs. See Exhibit 16.6 for an example. For each input, Standard cost per unit of output = Standard input price or rate per unit of input Standard quantity of input per unit of output.

The purchasing manager estimates the cost of direct materials with the correct specification and quality. The standard labor rate includes wages earned as well as fringe benefits. Most companies develop one standard for each labor category. The overhead quantity is expressed in terms of the units of the cost driver chosen (such as direct labor hours) because that is what is being used to apply the overhead. To determine the variable production overhead rate, management reviews prior period activities and costs, estimates how costs will change in the future, and performs a regression analysis in which overhead cost is the dependent variable and certain cost driver (such as direct labor hours) the independent variable. [Assign Exercises 16-18, 16-24, Problems 16-39, 16-40, 16-41, 16-45, 16-48, 16-54, Integrative Case 16-61]

LO5 Compute and use variable cost variances.


Comparing the budget (based on standard costing) to actual results identifies production cost variances. Cost variance analysis uses a conceptual model that compares actual input amounts and prices with standard input amounts and prices. Both the actual and standard input quantities are for the actual output attained. Price variance is the difference between actual costs and budgeted costs arising from changes in the cost of inputs to a production process or other activity. Price variance = (AP AQ) (SP AQ) = (AP SP) AQ.

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Efficiency variance is the difference between budgeted and actual results arising from differences between the inputs that were budgeted per unit of output and the inputs actually used. Efficiency variance = (SP AQ) (SP SQ) = SP (AQ SQ). Managers who are responsible for price variances would not be held responsible for efficiency variances and vice versa. Total cost variance is the difference between budgeted and actual results (equal to the sum of the price and efficiency variances). Total cost variance = (AP AQ) (SP SQ). The general model is applied to each variable cost incurred and is outlined in Exhibit 16.7. That is, Actual costs = Actual input quantity at actual input price (AP x AQ) Actual input quantity at standard input price (SP x AQ) Flexible production budget = Standard input quantity allowed for actual output at standard input price (SP x SQ)

Price (Rate, or Spending) Variance (AP SP) AQ

Quantity (Usage, or Efficiency) Variance SP (AQ SQ)

Total cost variance (AP AQ) (SP SQ) The comprehensive cost variance analysis will ultimately explain, in detail, the variable manufacturing cost variance calculated earlier. Flexible production budget is calculated as standard input price times standard quantity of input allowed for actual good output. It is based on actual production volume. An alternative way to view these variances graphically is shown below. Quantities are presented on the horizontal axis and prices on the vertical axis. The three areas are standard cost (SP SQ), price variance ((AP SP) AQ), and efficiency variance (SP (AQ - SQ)), respectively.

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Prices AP Price Variance = (AP SP) AQ SP Standard Cost = SP SQ Efficiency Variance = SP (AQ SQ)

SQ

AQ

Quantities

Exhibit 16.8 applies the general model to direct materials variances. Responsibility for the direct materials price variance is usually assigned to the purchasing department. Explanations for materials price variance include failure to take purchase discounts, higher transportation costs than expected, different grade of direct materials purchased, or changes in the market price of direct materials. Direct materials efficiency variances are typically the responsibility of production departments and may be due to defects in direct materials, inexperienced workers, poor supervision, and so on. ======================

Demonstration Problem 3
(Continued from Demonstration Problem 1) Information about the use of direct materials at EZ Toys Trucks Division for October follows: Standard costs 2 units per truck @ $2.5 per unit Trucks produced in October Actual materials purchased and used 22,000 units @ $2.4 per unit There was no beginning inventory on October 1. = = = $5 per truck 10,000 $52,800

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Required: Prepare Truck Divisions direct materials variances for October. Solution: Actual costs = Actual input quantity at actual input price $2.4 22,000 = $52,800 Flexible production budget = Standard input quantity allowed for actual output at standard input price $2.5 20,000 = $50,000

Actual input quantity at standard input price $2.5 22,000 = $55,000

Price Variance $2,200 F Total cost variance $2,800 U ======================

Efficiency Variance $5,000 U

Exhibit 16.9 applies the general model to direct labor variances. The direct labor price variance may be caused by hiring less experienced employees. If the wage rates used in setting standards are the same as those in the union contract, labor price variances will not occur. The labor efficiency variance is a measure of labor productivity and is usually controlled by production managers. Unfavorable labor efficiency variances may be due to poorly motivated or trained workers, poor materials or faulty equipment, poor supervision and scheduling problems. One event, such as hiring inexperienced employees, can affect more than one variance. ======================

Demonstration Problem 4
(Continued from Demonstration Problem 1) Information about the use of direct labor at EZ Toys Trucks Division for October follows:

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Standard costs 0.4 hour per truck @ $10 per hour Trucks produced in October Actual direct labor costs Actual hours worked Total actual labor cost Average cost per hour

= = = = =

$4 per truck 10,000 5,000 $51,000 $10.2

Required: Prepare Truck Divisions direct labor variances for October. Solution: Actual costs = Actual input quantity at actual input price $10.2 5,000 = $51,000 Flexible production budget = Standard input quantity allowed for actual output at standard input price $10 4,000 = $40,000

Actual input quantity at standard input price $10 5,000 = $50,000

Price Variance $1,000 U Total cost variance $11,000 U ======================

Efficiency Variance $10,000 U

Exhibit 16.10 applies the general model to variable overhead variances. The variable overhead standard rate is derived from a two-stage estimation of (1) costs at various levels of activity, and (2) the relationship between those estimated costs and the basis. The variable overhead price variance could have occurred because (1) actual costs are different from those expected, and (2) the relationship between variable production overhead costs and the basis chosen is not perfect. The variable overhead price variance actually contains some efficiency items as well as price items. Some companies separate those components.

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The variable overhead efficiency variance is not related to the use (or efficiency) of variable overhead. Instead, it is related to efficiency in using the base on which variable overhead is applied. Managers who are responsible for controlling the base will probably be held responsible for the variable overhead efficiency variance as well. ======================

Demonstration Problem 5
(Continued from Demonstration Problem 1) Information about the use of variable overhead at EZ Toys Trucks Division for October follows: Standard costs 0.4 hour per truck @ $5 per hour Trucks produced in October Actual variable overhead cost = = = $2 per truck 10,000 $23,000

Required: Prepare Truck Divisions variable overhead variances for October. Solution: Actual costs = Sum of actual variable overhead costs $23,000 Flexible production budget = Standard input quantity allowed for actual output at standard input price $5 4,000 = $20,000

Actual input quantity at standard input price $5 5,000 = $25,000

Price Variance $2,000 F Total cost variance $3,000 U ======================

Efficiency Variance $5,000 U

Exhibit 16.11 summarizes the variable production cost variances. A summary of this nature is useful for reporting variances to high-level managers. It provides both an overview of variances and their sources.

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Management could want more detailed information about some of the variances by extending each variance branch to show variances by product line, department, or other categories. [Assign Exercises 16-27, 16-28, 16-29, 16-30, 16-31, 16-36, 16-37, 16-38, Problems 16-49, 1650, 16-51, 16-52, 16-53, 16-57, 16-58, 16-59, 16-60, Integrative Case 16-61]

LO6 Compute and use fixed cost variances.


It is usually assumed that fixed costs are unchanged when volume changes within the relevant range, so the amount budgeted for fixed overhead is the same in both the master and flexible budgets. Fixed costs are period costs by nature. When the income statement is prepared using variable costing, there is no absorption of the fixed costs by units of production. All the fixed manufacturing overhead is charged to income in the period incurred. Fixed overhead has no input-output relationships and, therefore, no efficiency variance. Spending (or budget) variance, the price variance for fixed overhead, is the difference between the flexible budget and the actual fixed overhead and is entirely due to changes in the costs that make up fixed overhead. Exhibit 16.12 shows a variance analysis for fixed overhead. That is, Actual Flexible production budget Price (spending) variance (Efficiency variance is not applicable) When companies use full-absorption, standard costing, fixed production costs are unitized and treated as product costs. The fixed manufacturing standard cost is determined before the start of the production period using the following formula from Chapter 7: Standard (or predetermined) = fixed production overhead cost

Budgeted fixed manufacturing overhead . Budgeted activity level

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Production volume variance (also called capacity variance, idle capacity variance, or denominator variance) is the difference between the applied fixed overhead and the budgeted fixed overhead. Production volume variance arises because the volume used to apply fixed overhead differs from the estimated volume used to calculate fixed overhead per unit. Exhibit 16.13 demonstrates the variance analysis for fixed overhead under absorption costing. That is, Actual Price (spending) variance Budgeted Applied

Production volume variance

An alternative way to present fixed overhead variances graphically is shown below (see also Exhibit 16-14). Since fixed overhead is unitized through the calculation of predetermined fixed overhead rate, fixed overhead is applied as if it were variable cost, as seen in the application line. At the budgeted volume, the applied fixed overhead coincides with budgeted fixed overhead, as seen in the budget line. Since actual volume is less than the budgeted volume in this graph, the applied fixed overhead is less than the budgeted fixed overhead; the difference between the two represents production volume variance. The difference between actual and budgeted fixed overhead becomes price (or spending) variance.
Application line Budget Actual Applied Price (spending) variance Production volume variance Budget line

Actual volume

Budgeted volume

The production volume variance applies only to fixed costs as a result of allocating a fixed period cost to units on a predetermined basis. It does not represent resources spent or saved, and is unique to full-absorption costing.

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The benefits of calculating the production volume variance for control purposes are questionable. The price (spending) variance is used for control purposes because it is a measure of difference between actual and budgeted period costs. ======================

Demonstration Problem 6
(Continued from Demonstration Problem 1) Information about the use of fixed overhead at EZ Toys Trucks Division follows: Annual budget data Fixed overhead Direct labor hours Standard fixed overhead rate Standard costs 0.4 hour per truck @ $2 per hour Trucks produced in October Actual variable overhead cost = = = = = = $115,200 57,600 $2 per hour $0.8 per truck 10,000 $9,000

Required: Prepare Truck Divisions fixed overhead variances for October. Solution: Actual costs $9,000 Price Variance $600 F
a

Budgeta $9,600

Applied $2 4,000 = $8,000 Efficiency Variance $1,600 U

$115,200 / 12 months = $9,600 per month. ====================== The method of computing overhead variances described is known as the four-way analysis of overhead variances because it computes the following four variances: price and efficiency for variable overhead, and price and production volume for fixed overhead. Exhibit 16.15 summarizes the four-way analysis of variable and fixed overhead variances.

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The variable overhead efficiency variance measures the efficiency in using the allocation base. The production volume variance occurs only when fixed production cost is unitized. The budgeted fixed overhead might not equal the amount applied to units produced. There is no efficiency variance for fixed production costs. Managers evaluated by variances that include production volume variance do have an incentive to overproduce. This is due to how standard costing is usually practiced. See InAction item for more information. [Assign Exercises 16-32, 16-33, 16-34, 16-35, 16-36, 16-37, 16-38, Problems 16-51, 16-53, 1657, 16-58, 16-59, 16-60, Integrative Case 16-61]

LO7 (Appendix) Understand how to record costs in a standard costing system.


Standard costing is an accounting method that assigns costs to cost objects at predetermined amounts. The entry debiting Work in process inventory at standard cost could be made before actual costs are known. Actual costs are accumulated in accounts such as Accounts payable and Wages payable and are compared with the standard costs allowed for the output produced. The difference between the actual costs assigned to a department and the standard costs of the work done is the variance for the department. Direct materials
Work-in-process inventory Materials price variancea Materials efficiency variance Accounts payable xx xx xx xx

(To record the purchase and use of materials at actual cost and the transfer to work in process at standard cost)
a

Favorable variances should be credited; unfavorable variances should be debited. The variances are debited here for illustration only.

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Direct labor
Work-in-process inventory Direct labor price variance Direct labor efficiency variance Wages payable xx xx xx xx

(To record the purchase and use of direct labor at actual cost and the transfer to work in process at standard cost) Variable manufacturing overhead
Work-in-process inventory Variable overhead applied xx xx

(To record the application of Variable overhead to Work in process on the basis of standard input allowed)
Variable overhead (actual) Miscellaneous payables xx xx

(To record actual Variable overhead costs)


Variable overhead applied Variable overhead price variance Variable overhead efficiency variance Variable overhead (actual) xx xx xx xx

(To record Variable overhead variances and close the applied and actual accounts) Fixed manufacturing overhead
Work-in-process inventory Fixed overhead applied xx xx

(To record the application of Fixed overhead to Work in process on the basis of standard input allowed)
Fixed overhead (actual) Miscellaneous payables xx xx

(To record actual Fixed overhead costs)

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Fixed overhead applied Fixed overhead price variance Fixed overhead production volume variance Fixed overhead (actual)

xx xx xx xx

(To record Fixed overhead variances and close the applied and actual accounts) Transfer to Finished goods inventory
Finished goods inventory Work-in-process inventory xx xx

(To record the transfer to Finished goods inventory at standard cost) Transfer to Cost of goods sold
Accounts receivable Sales revenue xx xx

(To record Sales revenue)


Cost of goods sold Finished goods inventory xx xx

(To record Cost of goods sold at standard cost) Close out variance accounts to Cost of goods sold
Cost of goods sold xx Materials price variance Materials efficiency variance Direct labor price variance Direct labor efficiency variance Variable overhead price variance Variable overhead efficiency variance Fixed overhead price variance Fixed overhead production volume variance

xx xx xx xx xx xx xx xx

(To close the variance accounts to Cost of goods sold) [Assign Exercises 16-30, 16-31, 16-36]

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Matching
A. B. C. D. E. F. Cost variance analysis Efficiency variance Favorable variance Financial budgets Flexible budget Operating budgets G. H. I. J. K. L. Price variance Variance Static budget Standard costing Spending variance Sales activity variance

_____ 1. Budgeted income statement, production budget, budgeted cost of goods sold, and supporting budgets. _____ 2. Budgets of financial resources, including the cash budget and the budgeted balance sheet. _____ 3. Variance that, taken alone, results in an addition to operating profit. _____ 4. Developed in detail for one level of anticipated activity, such as a master budget. _____ 5. The difference between operating profit in the master budget and operating profit in flexible budget that arises because the actual number of units sold is different from the budgeted number. _____ 6. Uses a conceptual model that compares actual input amounts and prices with standard input amounts and prices. _____ 7. The difference between actual costs and budgeted costs arising from changes in the cost of inputs to a production process or other activity. _____ 8. The difference between the flexible budget and the actual fixed overhead and is entirely due to changes in the costs that make up fixed overhead. _____ 9. The difference between planned result and actual outcome. _____ 10. Indicates budgeted revenues, costs, and profits for virtually all feasible levels of activities. _____ 11. An accounting method that assigns costs to cost objects at predetermined amounts. _____ 12. SP (AQ SQ).

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Answers
1. F 2. D 3. C 4. I 5. L 6. A 7. G 8. K 9. H 10. E 11. J 12. B

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Multiple Choice
1. Which of the following statements is incorrect? a. Unfavorable variance occurs when actual costs are lower than budgeted costs. b. The labels favorable and unfavorable should not be considered as evaluations of performance without additional investigation. c. An important part of variance analysis is to understand what might cause a difference between actual and budgeted results. d. Variance = Actual result Budgeted performance. 2. With a planned volume of 15,000 units, the master budget includes variable costs of $450,000 and fixed costs of $350,000. If the actual volume is 12,000 units, the total costs under flexible budget should be a. $490,000. b. $560,000. c. $650,000. d. $710,000. 3. Which of the following is correct regarding sales activity variance? a. Sales activity variance is driven by the volume difference between actual results and flexible budget. b. Variable costs are expected to decrease when volume is higher than planned. c. Sales activity variance is the difference between operating profit in the master budget and operating profit in flexible budget. d. Sales activity variance can be seen on the master budgets profit-volume line. 4. Which of the following statements is correct? a. Marketing and administrative cost variances are treated differently from production cost variances. b. The fixed production cost variance is the difference between flexible budget and master budget costs. c. Variable cost variances are output variances. d. Profit variance analysis shows the causes of differences between budgeted profits and the actual profits earned.

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The following information is for questions 5 8.


Actual results 20,000 units produced and sold Budget data 19,000 units planned

Direct materials: 62,300 units of input purchased and used @ $29 per input unit Direct labor: 51,500 hours used @ $21.5 per hour

$1,806,700

Direct materials: 3 units of input allowed per output unit @ $30 per input unit Direct labor: 2.5 hours of input allowed per output unit @ $20 per hour

$90

1,107,250

50

5. What is the materials price variance? a. $62,3 00 Unfavorable. b. $62,300 Favorable. c. $69,000 Favorable. d. $77,250 Favorable 6. What is the materials total cost variance? a. $7,500 Unfavorable. b. $11,250 Unfavorable. c. $7,500 Favorable. d. $6,700 Unfavorable. 7. What is the labor price variance? a. $77,250 Unfavorable. b. $30,000 Unfavorable. c. $62,300 Favorable. d. $69,000 Unfavorable. 8. What is the labor efficiency variance? a. $77,250 Unfavorable. b. $30,000 Unfavorable. c. $62,300 Favorable. d. $69,000 Unfavorable. 9. Which of the following statements regarding variable overhead variances is correct? a. The variable overhead price variance could have occurred because actual costs are different from those expected. b. The relationship between variable production overhead costs and the basis chosen is perfect. c. The variable overhead price variance usually contains only the efficiency items. d. The variable overhead efficiency variance is related to the use of variable costs.

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10. Which of the following statements regarding fixed overhead is correct? a. Production volume variance is the difference between the actual and applied fixed overhead. b. When the income statement is prepared using variable costing, there is no absorption of the fixed costs by units of production. c. Production volume variance applies only to fixed costs. d. Both b and c are correct. 11. A company purchased and used 10,000 pounds of materials while incurring $2,000 unfavorable price variance. The standard cost for materials is $4.8 per pound. What was the actual price of materials per pound? a. $5. b. $4.9. c. $5.1. d. $5.2. 12. Which of the following statements regarding standard costing system is incorrect? a. The difference between actual costs assigned and the standard costs of the work done determines the variance. b. Favorable variances should be credited. c. The use of standard costs contributes to management control. d. Standard costing system complicates the costing of inventories.

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Answers
1. a 2. d LO1 LO2

$450,000 15,000 units = $30 per unit for variable costs. $30 12,000 units + $350,000 = $710,000. 3. c 4. d 5. b LO3 LO4 LO5 Flexible production budget = Standard input quantity allowed for actual output at standard input price $30 3 20,000 = $1,800,000

Actual costs = $1,806,700

Actual input quantity at standard input price $30 62,300 = $1,869,000 Price Variance $62,300 F Total cost variance $6,700 U

Efficiency Variance $69000 U

6. d 7. a

LO5 LO5 Flexible production budget = Standard input quantity allowed for actual output at standard input price $20 2.5 20,000 = $1,000,000

Actual costs = $1,107,250

Actual input quantity at standard input price $20 51,500 = $1,030,000 Price Variance $77,250 U

Efficiency Variance $30,000 U

8. b 9. a

LO5 LO5

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10. d 11. a

LO6 LO5

$4.8 10,000 + $2,000 = $50,000. $50,000 10,000 = $5. 12. d LO7

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Appendix - Capital Investment Decisions: An Overview

Appendix Capital Investment Decisions: An Overview


Appendix Outline
I. II. III. IV. V. INTRODUCTION ANALYZING CASH FLOWS FOR PRESENT VALUE ANALYSIS Distinguishing between revenues, costs, and cash flows NET PRESENT VALUE Applying present value analysis CAPITAL INVESTMENT ANALYSIS: AN EXAMPLE CATEGORIES OF PROJECT CASH FLOWS A. Investment cash flows B. Periodic operating cash flows C. Cash flows from the depreciation tax shield D. Disinvestment cash flows PREPARING THE NET PRESENT VALUE ANALYSIS USING MICROSOFT EXCEL TO PREPARE THE NET PRESENT VALUE ANALYSIS

VI. VII.

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Appendix - Capital Investment Decisions: An Overview

Key Concepts
Capital investment decisions are the responsibility of managers of investment centers. Specific investments over a certain dollar amount require approval by the board of directors in many companies. Cost accountants estimate the amount and timing of the cash flows used in capital investment decision models to help managers make those decisions. Capital investment models are based on the future cash flows expected from a particular asset investment opportunity. The amount and timing of the cash flows from a capital investment project determine its economic value. Because of the timing of cash flows, any investment project has an opportunity cost for cash committed to it. Time value of money conveys the concept that cash received earlier is worth more than cash received later. The future cash flows associated with a project are adjusted to their present value using a predetermined discount rate to recognize the time value of money. Discount rate is the interest rate used to compute net present value. Net present value (NPV) represents the economic value of a project at a point in time. Net present value = Sum of discounted future cash flows Initial investment. If the net present value of a project is positive, the project will earn a rate of interest higher than its discount rate. The decision models used for capital investments attempt to optimize the economic value to the firm by maximizing the net present value of future cash flows. It is important to distinguish cash flows from revenues and costs when timing difference exists. Capital investment analysis uses cash flows, not revenues and costs as recognized in accrual concept. The present value of cash flows is the amount of future cash flows discounted to their equivalent worth today. The net present value of a project can be computed as

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Appendix - Capital Investment Decisions: An Overview

NPV = Cn d n N

C
n 0

(1 d ) n , where

= Cash to be received or disbursed at the end of time period n, = Appropriate discount rate for the future cash flows, = Time period when the cash flow occurs, and = Life of the investment (in years).

The term (1+d)-n is called a present value factor. Tables of present value factors are at the end of this appendix in Exhibit A.8. Example 1: On the 16th birthday, John was notified by an attorney that he will inherit $150,000 from a rich uncle when he reaches 21 years of age. Assuming a discount rate of 6 percent, what is Johns worth now with respect to the inheritance money? The money (cash inflow) will be vested in 5 years. That is,
Year 0 ? 1 2 3 4 5 $150,000

The present value factor of (1 + 6%)-5 is 0.747. The present value of Johns future inheritance is $150,000 0.747 = $112,050. An annuity is a constant (equal) payment over a period of time. The present value 1 - (1 d )- n factors for an annuity, based on the formula [ ], are shown in Exhibit A.9. d The present value of an annuity can be calculated by summing the present value of the individual payments over the annuity period, or it can be calculated by multiplying the annuity payment by the sum of the present value factors.

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Appendix - Capital Investment Decisions: An Overview

Example 2: Jenny is 71 years old. She bought an insurance policy years ago that pays her $15,000 every year to supplement her income. With a life expectancy of 86 years and an assumed discount rate of 8 percent, what is the remaining value of the annuity now? (The cost of the policy is considered sunk and not relevant for this question.) The timeline below shows the pattern of cash inflows for the next 15 years.
Year 0 ? 1 $15,000 2 $15,000 3 $15,000 4 $15,000 15 $15,000

The present value factor of the annuity, [1 - (1 + 8%)-15] 8%, is 8.559. The present value of Jennys annuity for her expected remaining life is worth $15,000 8.559 = $128,385.

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Appendix - Capital Investment Decisions: An Overview

Example 3: A developer is considering three possible investment opportunities. All three require the same initial investment of $20,000 and will last for 3 years. Project 1 will return $9,000 every year at the end of next three years. Project 2 is expected to generate $12,000 at year 2 and $15,000 at year 3. Finally, Project 3 will return $27,000 at the end of the third year. The developer uses a discount rate of 12 percent. Which projet should the developer choose? Project 1 Cash inflow Cash outflow Net present value
a

$9,000 2.402a

$21,618 (20,000) $1,618

Present value factor of an annuity at 12% for three years.

Project 2 Cash inflow Cash outflow Net present value


b c

$12,000 0.797b + $15,000 0.712c

$20,244 (20,000) $244

Present value factor at 12% for two years. Present value factor at 12% for three years.

Project 3 Cash inflow Cash outflow Net present value


c

$27,000 0.712c

$19,224 (20,000) $(776)

Present value factor at 12% for three years.

Even though the total (undiscounted) cash inflows are the same, $27,000, for the projects under consideration, the timing of the cash flows does make a difference. By receiving cash inflows early and often, Project 1 outperforms the other two in terms of the net present value. Project 2 is less appealing but still acceptable with a positive NPV. A negative NPV, such as that of Project 3, indicates a return less than the discount rate used. Four major categories of cash flows for a project are: (1) Investment cash flows, (2) Periodic operating cash flows,

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Appendix - Capital Investment Decisions: An Overview

(3) Cash flows from the depreciation tax shield, and (4) Disinvestment cash flows. There are three types of investment cash flows: Asset acquisitions, working capital commitments, and investment tax credit, if any. Asset acquisition involves the costs of purchasing and installing an asset, including any resulting gain or loss on disposal. All acquisition costs are listed as cash outflows in the years in which they occur. Installation costs are also considered a cash outflow. The tax effect as a result of the difference between depreciation tax basis and proceeds from the sale of the replaced equipment will be considered a cash inflow (for a loss) or a cash outflow (for a gain). Working capital represents cash, accounts receivable, and other short-term assets required to maintain an activity. The working capital committed to a project normally remains constant over the life of the project, although it is sometimes increased because of inflation. Investment tax credit (ITC) reduces federal income taxes as a result of certain asset purchases. Inverstment tax credi effectively shrinks the cost of making investments by giving compnies a credit against their corporate income taxes equal to a certain percentage of the purchase price. The primary reason for acquiring long-term assets is usually to generate positive periodic operating cash flows as the results of revenue-generating activities and costsaving programs. Periodic operating flows include (1) Periodic cash inflows (+) and outflows (-) before taxes, and (2) Income tax effects of inflows (-) and outflows (+). Costs that do not involve cash (such as depreciation, depletion, and amortization) are excluded, so are financing costs (under the assumption that the financing decision is separate from the asset-acquisition decision). The cost of financing is included in the discount rate.

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Appendix - Capital Investment Decisions: An Overview

Tax shield refers to the reduction in tax payment because of depreciation deducted for tax purposes. It is one of the primary incentives used by tax policy makers to promote investment in long-term assets. The depreciation deduction computed for the tax shield (using accelerated write-offs) is not necessarily the same amount as the depreciation computed for financial reporting purposes (using predominantly straight-line method). ======================

Demonstration Problem 1
Kahn Industry, Inc. decides to add a new machine to its assembly line. The new machine costs $120,000 with a useful life of 6 years and no salvage value. The new machine is expected to bring cash inflows of $80,000 while incurring cash outflows of $50,000 every year. The company uses straight-line method to calculate its depreciation. The tax rate is assumed to be 40 percent. Required: Determine the tax shield of the purchase. Solution: The annual depreciation charge associated with the new machine is $20,000 (= $120,000 6 years).
Change in cash flows without depreciation $80,000 (50,000) $30,000

Cash inflows Cash outflows Before-tax net flows Depreciation Before-tax NI Tax (40%) After-tax NI After-tax net flows

Change in net income $80,000 (50,000) $30,000 (20,000) $10,000 (4,000) $6,000

Change in cash flows $80,000 (50,000) $30,000

(4,000) $26,000

(12,000) $18,000

The tax shield is worth $8,000 (= $20,000 40%, or $12,000 - $4,000) as the result of depreciation deduction. ====================== The faster an assets cost can be written off for tax purposes, the sooner the tax deductions are realized and, therefore, the higher the net present value of the tax shield.

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Appendix - Capital Investment Decisions: An Overview

The depreciation tax shield affects the net present value analysis in two ways: (1) Depreciation tax shield on acquired assets, and (2) Forgone depreciation tax shield on disposed assets. Disinvestment flows are cash flows that take place at the termination of a capital project, including (1) Cash freed from working capital commitment, (2) Salvage value of the long-term assets, (3) Tax consequences for differences between salvage proceeds and the remaining depreciation tax basis of the asset, and (4) Other cash flows, such as employee severance payments and restoration costs. Tax basis is the remaining tax-depreciable book value of an asset for tax purposes. The difference between the book value (tax basis) and the net salvage value can result in a taxable gain or loss. For an asset replacement decision, the forgone salvage value (and related tax effects) from the old assets must be considered. ======================

Demonstration Problem 2
A company wants to expand its operations. One capital investment proposal under consideration is the acquisition of additional equipment. The cost of initial investment is estimated to be $75,000 with useful life of 6 years and the disposal value of $15,000. Straight-line depreciation method will be used for both financial and tax purposes. The expansion will bring in an estimated $38,000 cash every year; the annual operating expenses are around $17,000. At the end of the third year, a one-time tune-up is required for a cost of $8,000. Because of the expansion, working capital in the amount of $14,000 must be committed. The tax rate and the discount rate are 40 percent and 12 percent, respectively. Required: 1. Evaluate the expansion proposal using the net present value analysis. 2. Assume that at the end of the fourth year, because of unforeseen reasons, the equipment is salvaged for $50,000. What are the tax consequences of the disposal? Solution: 1. As soon as the cash flow data have been gathered, they are assembled into the following schedule that shows the cash flows for each year of the projects life. These flows are classified into the four categories discussed earlier.

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Appendix - Capital Investment Decisions: An Overview

(1) (2) (3) (4)

Investment cash flows. Periodic operating cash flows. Cash flows from the depreciation tax shield. Disinvestment cash flows.
Year 0 1 2 3 4 5 6

Investment flows: New equipment Working capital Annual cash flows: Operating cash flowsa Depreciation tax shieldb Disinvestment flows: Return of working capital Proceeds on disposal Total cash flows Present value factor at 12% Present value Net present value
a

$(75,000) (14,000) $12,600 4,000 $12,600 4,000 $7,800 4,000 $12,600 4,000 $12,600 4,000 $12,600 4,000 14,000 15,000 $45,600 0.507 $23,119

$(89,000) 1.0 $(89,000) $(9,455)

$16,600 0.893 $14,824

$16,600 0.797 $13,230

$11,800 0.712 $8,402

$16,600 0.636 $10,558

$16,600 0.567 $9,412

For years 1 through 6 except year 3, the operating cash flows are calculated as ($38,000 - $17,000) (1 40%) = $12,600. For year 3, the operating cash flows are calculated as ($38,000 - $17,000 - $8,000) (1 40%) = $7,800. b The annual depreciation expense is $10,000 (= ($75,000 - $15,000) 6 years). The tax shield represents tax savings as a result of depreciation deduction, calculated as $10,000 40% = $4,000. The negative net present value indicates that the expansion will earn less then the 12 percent used to discount the cash flows, making this proposal less desirable. 2. At the end of the fourth year, the tax basis will be $35,000 (= $75,000 Cost - $10,000 Annual depreciation 4), same as the net book value, since the straight-line method is used for both. The tax payment due to disposal will be $6,000 (= ($50,000 Proceeds from disposal $35,000 Tax basis) 40%). The after-tax cash inflow becomes $44,000 (= $50,000 Proceeds from disposal - $6,000 Tax payment). ====================== Exhibit A.2 contains the analysis for an investment decision.

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Appendix - Capital Investment Decisions: An Overview

All the calculations are available in speadsheet programs such as Microsoft Excel with built-in functions, as shown in Exhibits A.3 A.7.

Matching
A. B. C. D. E. Asset acquisition Discount rate Disinvestment flows Investment tax credit Net present value F. G. H. I J. Present value Tax basis Tax shield Time value of money Working capital

_____ 1. Cash flows that take place at the termination of a capital project. _____ 2. The reduction in tax payment because of depreciation deducted for tax purposes. _____ 3. Cash, accounts receivable, and other short-term assets required to maintain an activity. _____ 4. Reduces federal income taxes as a result of certain asset purchases. _____ 5. Involves the costs of purchasing and installing an asset, including any resulting gain or loss on disposal. _____ 6. The amount of future cash flows discounted to their equivalent worth today.

_____ 7. Conveys the concept that cash received earlier is worth more than cash received later. _____ 8. The interest rate used to compute net present value. _____ 9. The economic value of a project at a point in time. _____ 10. The remaining tax-depreciable book value of an asset for tax purposes.

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Appendix - Capital Investment Decisions: An Overview

Answers
1. C 2. H 3. J 4. D 5. A 6. F 7. I 8. B 9. E 10. G

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