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MANAGEMENT ACCOUNTING - Solutions Manual

TABLE OF CONTENTS

Chapter 1 1-1 1-19


MANAGEMENT ACCOUNTING: AN OVERVIEW
2 Management Accounting and the Business Environment 2-1 2-5
3 Understanding of Financial Statements 3-1 3-10

4 Financial Statements Analysis I 4-1 4-9


5 Financial Statements Analysis II 5-1 5-38
6 Cash Flow Analysis 6-1 6-18
7 Gross Profit Valuation Analysis and Earnings Per Share
Determination 7-1 7-7
8 Cost Concepts and Classifications 8-1 8-17
9 Cost Behavior: Analysis and Use 9-1 9-30
10 Systems Design: Job-Order Costing and Process Costing 10-1 10-16
11 Systems Design: Activity-Based Costing and Management 11-1 11-15
12 Variable Costing 12-1 12-21
13 Cost-Volume-Profit Relationships 13-1 13-37

14 Responsibility Accounting and Transfer Pricing 14-1 14-26


15 Functional and Activity-Based Budgeting 15-1 15-22
16 Standard Costs and Operating Performance Measures 16-1 16-17
17 Application of Quantitative Techniques in Planning, Control and
Decision Making - I 17-1 17-2
18 Application of Quantitative Techniques in Planning, Control and
Decision Making II 18-1 18-7
19 Relevant Costs for Decision Making 19-1 19-33
20 Capital Budgeting Decisions 20-1 20-16
21 Decentralized Operations and Segment Reporting 21-1 21-4
22 Business Planning 22-1 22-6

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Chapter 1 Management Accounting: An Overview

23 Strategic Cost Management; Balanced Scorecard 23-1 23-4


24 Advanced Analysis and Appraisal of Performance: Financial
and Nonfinancial 24-1 24-12
25 Managing Productivity and Marketing Effectiveness 25-1 25-19
26 Executive Performance Measures and Compensation 26-1 26-3
27 Managing Accounting in a Changing Environment 27-1 27-22

CHAPTER 1

MANAGEMENT ACCOUNTING: AN OVERVIEW

I. Questions

1. Use of the word need in the quoted passage is pejorative. It implies an


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

2. a. Historical costs are of limited use in making planning decisions in a


rapidly changing environment. With changing products, processes

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Management Accounting: An Overview Chapter 1

and prices, the historical costs are inadequate approximations of the


opportunity costs of using resources.
Historical costs may, however, be useful for control purposes, as
they provide information about the activities of managers and can be
used as performance measures to evaluate managers.
b. The purpose of accounting systems is to provide information for
planning purposes and control. Although historical costs are not
generally appropriate for planning purposes, additional measures are
costly to make. An accounting system should include additional
measures if the benefits of improved decision making are greater
than the costs of the additional information.
3. Finance and economics textbooks traditionally state that the goal of a
profit organization is to maximize shareholder wealth. Managers are
frequently presumed to act in the best interest of the shareholder,
although recent finance literature recognizes that appropriate incentives
are necessary to align manager interests with shareholder interests. The
goal, however, are not very clear as to how this is achieved. Most
finance textbooks focus on financing decisions and not on the use of
assets and dealing with customers.
Marketings goal of satisfying customers recognizes that customers are
the source of revenues for the organization, and therefore the means
through which shareholder value is increased. However, customer
satisfaction is only valuable insofar as it creates shareholder wealth. The
further goal of marketing is to ensure that customer satisfaction is
maximized without compromising the organizations profitability.

4. Yes. Planning is really much more vital than control; that is, superior
control is fruitless if faulty plans are being implemented. However,
planning and control are so intertwined that it seems artificial to draw
rigid lines of separation between them.

5. Yes. The controller has line authority over the personnel in his own
department but is a staff executive with respect to the other departments.

6. Line authority is exerted downward over subordinates. Staff authority is


the authority to advise but not command others; it is exercised laterally
or upward. Functional authority is the right to command action laterally
and downward with regard to a specific function or specialty.

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7. Cost accounting is the controllers primary means of implementing the


7-point concept of modern controllership. Cost accounting is
intertwined with all seven duties to some extent, but its major focus is on
the first three.

8. Bettina Company

President

VP, Production VP, Finance VP, Sales

Controller Treasurer

Assistant Assistant
Controller Treasurer

Special Cost Tax Internal General System &


Studies Accounting Manager Audit Accounting EDP
Manager Manager Manager Manager Manager

Cost Budget & Performance


Systems Standard Analyst
Analyst Cost Analyst

Cost Payroll Accounts Accounts Billing General


Clerk Clerk Receivable Payable Clerk Ledger
Clerk Clerk Bookkeeper

9. Management accountants contribute to strategic decisions by providing


information about the sources of competitive advantage and by helping
managers identify and build a companys resources and capabilities.

10. In most organizations, management accountants perform multiple roles:


problem solving (comparative analyses for decision making),
scorekeeping (accumulating data and reporting reliable results), and
attention directing (helping managers properly focus their attention).

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Management Accounting: An Overview Chapter 1

11. Three guidelines that help management accountants increase their value
to managers are (a) employ a cost-benefit approach, (b) recognize
behavioral as well as technical considerations, and (c) identify different
costs for different purposes.

12. Management accounting is an integral part of the controllers function in


an organization. In most organizations, the controller reports to the chief
financial officer, who is a key member of the top management team.

13. Management accountants have ethical responsibilities that are related to


competence, confidentiality, integrity, and objectivity.

14. By reporting and interpreting relevant data, the controller exerts a force
or influence that impels management toward making better-informed
decisions.

The controller of one company described the job as a business advisor


tohelp the team develop strategy and focus the team all the way
through recommendations and implementation.

15.
Financial Accounting
Audience: External: shareholders, creditors, tax
authorities
Purpose: Report on past performance to external
parties; basis of contracts with owners and
lenders
Timeliness: Delayed; historical
Restrictions: Regulated; rules driven by generally accepted
accounting principles and government
authorities
Type of Information: Financial measurements only
Nature of Information: Objective, auditable, reliable, consistent,
precise
Scope: Highly aggregate; report on entire
organization

Managerial Accounting

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Audience: Internal: Workers, managers, executives


Purpose: Inform internal decisions made by employees
and managers; feedback and control on
operating performance
Timeliness: Current, future oriented
Restrictions: No regulations; systems and information
determined by management to meet strategic
and operational needs
Type of Information: Financial, plus operational and physical
measurements on processes, technologies,
suppliers customers, and competitors
Nature of Information: More subjective and judgmental; valid,
relevant, accurate
Scope: Disaggregate; inform local decisions and
actions

16. The competitive environment has changed dramatically. Companies


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

17. As measurements are made on operations and, especially, on individuals


and groups, the behavior of the individuals and groups are affected.
People will react to the measurements being made by focusing on the
variables or behavior being measured. In addition, if managers attempt
to introduce or redesign cost and performance measurement systems,
people familiar with the previous system will resist. Management
accountants must understand and anticipate the reactions of individuals
to information and measurements. The design and introduction of new
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Management Accounting: An Overview Chapter 1

measurements and systems must be accompanied with an analysis of the


likely reactions to the innovations.

II. Exercises

Exercise 1

a. (1) Problem solving


b. (3) Attention-directing
c. (1) Problem solving
d. (2) Scorekeeping

Exercise 2

a. (4) Marketing
b. (3) Production
c. (6) Customer service
d. (5) Distribution

Exercise 3

a. (4) Marketing
b. (3) Production
c. (5) Distribution
d. (4) Marketing
e. (5) Distribution
f. (3) Production
g. (1) Research and development
h. (2) Design

III. Problems

Problem 1 (Problem Solving, Scorekeeping, and Attention Directing)

Because the accountants duties are often not sharply defined, some of these
answers might be challenged:
1. Scorekeeping
2. Attention directing
3. Scorekeeping

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4. Problem solving
5. Attention directing
6. Attention directing
7. Problem solving
8. Scorekeeping (depending on the extent of the report) or attention
getting
9. This question is intentionally vague. The give-and-take of the
budgetary process usually encompasses all three functions, but it
emphasizes scorekeeping the least. The main function is attention
directing, but problem solving is also involved.
10. Problem solving

Problem 2 (Management Accounting Information System)

1. Inputs: b, g, i, m
2. Processes: a, d, f, j
3. Outputs: e, k, n
4. System objectives: c, h, l

Problem 3 (Role of Management Accountants)

Planning. The management accountant gains an understanding of the impact


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

Controlling. The management accountant ensures the integrity of financial


information, monitors performance against budgets and goals, and provides
information internally for decision making. Comparing actual performance
against budgeted performance and taking corrective action where necessary
is an example of controlling. Internal auditing is another example.

Evaluating Performance. The management accountant judges and analyzes


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

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Management Accounting: An Overview Chapter 1

Ensuring Accountability of Resources. The management accountant


implements a reporting system closely aligned to organizational goals that
contribute to the measurement of the effective use of resources and
safeguarding of assets. Internal reporting such as comparison of actual to
budget is an example of accountability.

External Reporting. The management accountant prepares reports in


accordance with generally accepted accounting principles and then
disseminates this information to shareholders, creditors, and regulatory tax
agencies. An annual report or a credit application are examples of external
reporting.

Problem 4 (Line Versus Staff)

Jamie Reyes is staff. She is in a support role she prepares reports and
helps explain and interpret them. Her role is to help the line managers more
effectively carry out their responsibilities.

Stephen Santos is a line manager. He has direct responsibility for producing


a garden hose. Clearly, one of the basic objectives for the existence of a
manufacturing firm is to make a product. Thus, Stephen has direct
responsibility for a basic objective and therefore holds a line position.

Problem 5 (Professional Ethics and End-of-Year Games)

Requirement 1
The possible motivations for the snack foods division wanting to play end-
of-year games include:
(a) Management incentives. Yummy Foods may have a division bonus
scheme based on one-year reported division earnings. Efforts to front-
end revenue into the current year or transfer costs into the next year can
increase this bonus.
(b) Promotion opportunities and job security. Top management of Yummy
Foods likely will view those division managers that deliver high reported
earnings growth rates as being the best prospects for promotion.
Division managers who deliver unwelcome surprises may be viewed
as less capable.
(c) Retain division autonomy. If top management of Yummy Foods adopts
a management by exception approach, divisions that report sharp

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reductions in their earnings growth rates may attract a sizable increase in


top management supervision.

Requirement 2
The Standards of Ethical Conduct require management accountants to:
Refrain from either actively or passively subverting the attainment of
the organizations legitimate and ethical objectives, and
Communicate unfavorable as well as favorable information and
professional judgment or opinions.

Several of the end-of-year games clearly are in conflict with these


requirements and should be viewed as unacceptable by Tan:
(a) The fiscal year-end should be closed on midnight of December 31.
Extending the close falsely reports next years sales as this years
sales.
(b) Altering shipping dates is falsification of the accounting reports.
(c) Advertisements run in December should be charged to the current year.
The advertising agency is facilitating falsification of the accounting
records.

The other end-of-year games occur in many organizations and may fall
into the gray to acceptable area. However, much depends on the
circumstances surrounding each one:
(a) If the independent contractor does not do maintenance work in
December, there is no transaction regarding maintenance to record. The
responsibility for ensuring that packaging equipment is well maintained
is that of the plant manager. The division controller probably can do
little more than observe the absence of a December maintenance charge.
(d) In many organizations, sales are heavily concentrated in the final weeks
of the fiscal year-end. If the double bonus is approved by the division
marketing manager, the division controller can do little more than
observe the extra bonus paid in December.
(e) If TV spots are reduced in December, the advertising cost in December
will be reduced. There is no record falsification here.
(g) Much depends on the means of persuading carriers to accept the
merchandise. For example, if an under-the-table payment is involved, it
is clearly unethical. If, however, the carrier receives no extra

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consideration and willingly agrees to accept the assignment, the


transaction appears ethical.

Each of the (a), (d), (e) and (g) end-of-year games may well disadvantage
Yummy Foods in the long run. For example, lack of routine maintenance
may lead to subsequent equipment failure. The divisional controller is well
advised to raise such issues in meetings with the division president.
However, if Yummy Foods has a rigid set of line/staff distinctions, the
division president is the one who bears primary responsibility for justifying
division actions to senior corporate officers.

Requirement 3

If Tan believes that Ryan wants her to engage in unethical behavior, she
should first directly raise her concerns with Ryan. If Ryan is unwilling to
change his request, Tan should discuss her concerns with the Corporate
Controller of Yummy Foods. Tan also may well ask for a transfer from the
snack foods division if she perceives Ryan is unwilling to listen to pressure
brought by the Corporate Controller, CFO, or even President of Yummy
Foods. In the extreme, she may want to resign if the corporate culture of
Yummy Foods is to reward division managers who play end-of-year games
that Tan views as unethical and possibly illegal.

Problem 6
James Torres has come up with a scheme that involves a combination of data
falsification and smoothing! Not only has he made up the revenue numbers,
but also he has had the gall to defer some of them to the next period.
Making up such numbers is clearly illegal. Smoothing, in this example is
also illegal because the numbers are fictitious.

Problem 7
Clearly the vice-president will lose his or her job if you turn him or her in.
Given that this is a major violation of the code of ethics and a violation
patent law, the vice-president could go to jail. Your best course of action is
to check your information and if the vice-president is definitely involved, go
immediately to the VPs superior (who is probably a senior VP or the
company president). The organizations attorneys will take over from there.

Problem 8

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One option is to do nothing and ignore what you saw, however, this may
violate your own code of ethics and your ethical responsibilities under the
organizations code of ethics. Given that you want to do something, it is
probably best to start by talking to employees in your organization whose job
it is to deal with ethical issues. If no such employees exist or are available,
you might start by using a decision model. This model incorporated the
following steps:
1. Determine the Facts What, Who, Where, How
2. Define the Ethical Issue
3. Identify Major Principles, Rule, Values
4. Specify the Alternatives.
5. Compare Values and Alternatives, See if Clear Decision
6. Assess the Consequences.
7. Make Your Decision.

IV. Cases

Case 1 (Financial vs. Managerial Accounting)

Requirement (a)
Other forward looking information desired in addition to the income
statement information are
1. Disclosure of the components of financial performance, i.e., nature
and source of revenues, various activities, transactions, and other
relevant events affecting the company.
2. Nature and function of the components of income and expenses

Requirement (b)
No. GAAP does not allow capitalization of employee training and
advertising costs even if management feels that they increase the value of the
companys brand name. The reasons are uncertainty of the future benefits
that may be derived therefrom and difficulty and reliability of their
measurement.

Requirement (c)

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Management Accounting: An Overview Chapter 1

Detailed information that managers would likely request are analysis of the
significant increases in
1. Sales
2. Cost of sales
3. Payroll
4. Stock and option based compensation
5. Advertising and promotion.

Requirement (d)
Nonmonetary measures:
1. Change in number and profile of customers
2. Share in the market
3. Who, what and how many are the competitors
4. Product lines offered by the entity vs. Product lines of competitors
5. Sales promotion and advertising activities

Requirement (e)
1. Competitors
2. Employees
3. Prospective creditors

Case 2 (You get what you measure!)

Requirement (a)
Increase in sales to new customers to sales
Too much emphasis on this ratio may lead the sales manager to spend more
time developing business with new customers and disregard the needs of
existing customers. It is therefore possible to lose the business of several
key accounts.

Requirement (b)
Decrease in cost of goods sold to sales
This performance measure could create the following problems:
1. Purchasing goods with poor quality at lower cost and selling them
for the same price.

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Chapter 1 Management Accounting: An Overview

2. Indiscriminately increasing selling price to widen the profit margin


without regard to competitors current prices.
3. If the entity is manufacturing its own goods, managers could try to
economize on costs, i.e., buying poorer quality of materials,
employing unskilled workers, etc. thereby causing deterioration of
the quality of the finished products.

In all of the above situations, customer patronage could eventually be


adversely affected.

Requirement (c)
Decrease in selling and administrative expense to sales
Cost-cutting is generally advisable for as long as the quality of goods and
services are not compromised. Likewise, certain cost-saving measures could
demotivate sales people and other employees and could lead to counter-
productive activities.

Case 3 (The Roles of Managers and Management Accountants)

1. Managerial accounting, Financial accounting


2. Planning
3. Directing and motivating
4. Feedback
5. Decentralization
6. Line
7. Staff
8. Controller
9. Budgets
10. Performance report
11. Chief Financial Officer
12. Precision; Nonmonetary data

Case 4 (Ethics in Business)

If cashiers routinely short-changed customers whenever the opportunity


presented itself, most of us would be careful to count our change before
leaving the counter. Imagine what effect this would have on the line at your
favorite fast-food restaurant. How would you like to wait in line while each
and every customer laboriously counts out his or her change? Additionally,

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Management Accounting: An Overview Chapter 1

if you cant trust the cashiers to give honest change, can you trust the cooks
to take the time to follow health precautions such as washing their hands? If
you cant trust anyone at the restaurant would you even want to eat out?

Generally, when we buy goods and services in the free market, we assume
we are buying from people who have a certain level of ethical standards. If
we could not trust people to maintain those standards, we would be reluctant
to buy. The net result of widespread dishonesty would be a shrunken
economy with a lower growth rate and fewer goods and services for sale at a
lower overall level of quality.

Case 5 (Ethics and the Manager)

Requirement 1
Failure to report the obsolete nature of the inventory would violate the
Standards of Ethical Conduct as follows:

Competence
Perform duties in accordance with relevant technical standards.
Prepare complete reports using reliable information.
By failing to write down the value of the obsolete inventory, Perez would not
be preparing a complete report using reliable information. In addition,
generally accepted accounting principles (GAAP) require the write-down of
obsolete inventory.

Integrity
Avoid conflicts of interest.
Refrain from activities that prejudice the ability to perform duties
ethically.
Refrain from subverting the legitimate goals of the organization.
Refrain from discrediting the profession.
Members of the management team, of which Perez is a part, are responsible
for both operations and recording the results of operations. Since the team
will benefit from a bonus, increasing earnings by ignoring the obsolete
inventory is clearly a conflict of interest. Perez would also be concealing
unfavorable information and subverting the goals of the organization.
Furthermore, such behavior is a discredit to the profession.

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Chapter 1 Management Accounting: An Overview

hObjectivity
Communicate information fairly and objectively.
Disclose all relevant information.
Hiding the obsolete inventory impairs the objectivity and relevance of
financial statements.

Requirement 2
As discussed above, the ethical course of action would be for Perez to insist
on writing down the obsolete inventory. This would not, however, be an
easy thing to do. Apart from adversely affecting her own compensation, the
ethical action may anger her colleagues and make her very unpopular.
Taking the ethical action would require considerable courage and self-
assurance.

Case 6 (Preparing an Organization Chart)

Requirement 1
See the organization chart on page 17.

Requirement 2
Line positions would include the university president, academic vice-
president, the deans of the four colleges, and the dean of the law school. In
addition, the department heads (as well as the faculty) would be in line
positions. The reason is that their positions are directly related to the basic
purpose of the university, which is education. (Line positions are shaded on
the organization chart.)

All other positions on the organization chart are staff positions. The reason
is that these positions are indirectly related to the educational process, and
exist only to provide service or support to the line positions.

Requirement 3
All positions would have need for accounting information of some type. For
example, the manager of central purchasing would need to know the level of
current inventories and budgeted allowances in various areas before doing
any purchasing; the vice president for admissions and records would need to
know the status of scholarship funds as students are admitted to the

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university; the dean of the business college would need to know his/her
budget allowances in various areas, as well as information on cost per
student credit hour; and so forth.

Case 7 (Ethics in Business)

Requirement 1
No, Santos did not act in an ethical manner. In complying with the
presidents instructions to omit liabilities from the companys financial
statements he was in direct violation of the IMAs Standards of Ethical
Conduct for Management Accountants. He violated both the Integrity and
Objectivity guidelines on this code of ethical conduct. The fact that the
president ordered the omission of the liabilities is immaterial.

Requirement 2
No, Santos actions cant be justified. In dealing with similar situations, the
Securities and Exchange Commission (SEC) has consistently ruled that
corporate officerscannot escape culpability by asserting that they acted
as good soldiers and cannot rely upon the fact that the violative conduct
may have been condoned or ordered by their corporate superiors. (Quoted
from: Gerald H. Lander, Michael T. Cronin, and Alan Reinstein, In Defense
of the Management Accountant, Management Accounting, May, 1990, p.
55) Thus, Santos not only acted unethically, but he could be held legally
liable if insolvency occurs and litigation is brought against the company by
creditors or others. It is important that students understand this point early
in the course, since it is widely assumed that good soldiers are justified by
the fact that they are just following orders. In the case at hand, Santos
should have resigned rather than become a party to the fraudulent
misrepresentation of the companys financial statements.

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Case 6
Requirement 1

President

Vice
Vice Vice Vice
Academic Vice President,
President, President, President,
President Financial
Auxiliary Admissions & Physical
Services
Services Records Plant
(Controller)

Manager, Manager, Manager,


Manager, Manager, Manager, Manager, Plant
Central University Grounds &
University Computer Accounting & Maintenance
Purchasing Bookstore Custodial
Press Services & Finance
Services

Dean,
Dean, Business Dean, Dean, Dean,
Engineering &
Humanities Fine Arts Law School
Quantitative

(Departments) (Departments) (Departments) (Departments)

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Case 8 (Ethics in Business)

Requirement 1
Andres Romero has an ethical responsibility to take some action in the
matter of PhilChem, Inc. and the dumping of toxic wastes. The Standards of
Ethical Conduct for Management Accountants specifies that management
accountants should not condone the commission of acts by their organization
that violate the standards of ethical conduct. The specific standards that
apply are as follows.
Competence. Management accountants have a responsibility to
perform their professional duties in accordance with relevant laws
and regulations.
Confidentiality. Management accountants must refrain from
disclosing confidential information unless legally obligated to do so.
However, Andres Romero may have a legal responsibility to take
some action.
Integrity. Management accountants have a responsibility to:
- refrain from either actively or passively subverting the
attainment of the organizations legitimate and ethical
objectives.
- communicate favorable as well as unfavorable information and
professional judgments or opinions.
Objectivity. Management accountants must fully disclose all
relevant information that could reasonably be expected to influence
an intended users understanding of the reports, comments, and
recommendations.

Requirement 2
The Standards of Ethical Conduct for Management Accountants indicates
that the first alternative being considered by Andres Romero, seeking the
advice of his boss, is appropriate. To resolve an ethical conflict, the first
step is to discuss the problem with the immediate superior, unless it appears
that this individual is involved in the conflict. In this case, it does not appear
that Romeros boss is involved.

Communication of confidential information to anyone outside the company


is inappropriate unless there is a legal obligation to do so, in which case
Romero should contact the proper authorities.
Contacting a member of the Board of Directors would be an inappropriate

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action at this time. Romero should report the conflict to successively higher
levels within the organization and turn only to the Board of Directors if the
problem is not resolved at lower levels.

Requirement 3
Andres Romero should follow the established policies of the organization
bearing on the resolution of such conflict. If these policies do not resolve
the ethical conflict, Romero should report the problem to successively higher
levels of management up to the Board of Directors until it is satisfactorily
resolved. There is no requirement for Romero to inform his immediate
superior of this action because the superior is involved in the conflict. If the
conflict is not resolved after exhausting all courses of internal review,
Romero may have no other recourse than to resign from the organization and
submit an informative memorandum to an appropriate member of the
organization.
(CMA Unofficial Solution, adapted)

V. Multiple Choice Questions

1. D 11. D 21. B 31. D 41. A 51. B


2. D 12. D 22. B 32. C 42. C 52. B
3. D 13. D 23. A 33. D 43. D 53. A
4. B 14. A 24. A 34. B 44. B 54. C
5. D 15. A 25. B 35. D 45. C 55. D
6. A 16. A 26. C 36. B 46. B 56. C
7. B 17. D 27. B 37. C 47. A 57. C
8. D 18. A 28. D 38. B 48. B 58. C
9. D 19. D 29. B 39. A 49. C 59. A
10. A 20. D 30. C 40. A 50. D 60. B

CHAPTER 2

MANAGEMENT ACCOUNTING
AND THE BUSINESS ENVIRONMENT
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Cost Concepts and Classifications Chapter 8

I. Questions

1. Managerial accounting information often brings to the attention of


managers important issues that need their managerial experience and
skills. In many cases, managerial-accounting information will not
answer the question or solve the problem, but rather make management
aware that the issue or problem exists. In this sense, managerial
accounting sometimes is said to serve an attention-directing role.

2. Non-value-added costs are the costs of activities that can be eliminated


with no deterioration of product quality, performance, or perceived
value.

3. Managers rely on many information systems in addition to managerial-


accounting information. Examples of other information systems include
economic analysis and forecasting, marketing research, legal research
and analysis, and technical information provided by engineers and
production specialists.

4. Becoming the low-cost producer in an industry requires a clear


understanding by management of the costs incurred in its production
process. Reports and analysis of these costs are a primary function of
managerial accounting.

5. Some activities in the value chain of a manufacturer of cotton shirts are


as follows:
(a) Growing and harvesting cotton
(b) Transporting raw materials
(c) Designing shirts
(d) Weaving cotton material
(e) Manufacturing shirts
(f) Transporting shirts to retailers
(g) Advertising cotton shirts
Some activities in the value chain of an airline are as follows:
(a) Making reservations and ticketing
(b) Designing the route network
(c) Scheduling

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Chapter 8 Cost Concepts and Classifications

(d) Purchasing aircraft


(e) Maintaining aircraft
(f) Running airport operations, including handling baggage
(g) Serving food and beverages in flight
(h) Flying passengers and cargo

6. Strategic cost management is the process of understanding and


managing, to the organizations advantage, the cost relationships among
the activities in an organizations value chain.

7. If customers who provide a company with the most profits are attracted,
satisfied, and retained, profits will increase as a result.

8. A value chain is a sequence of business functions whose objective is to


provide a product to a customer or provide an intermediate good or
service in a larger value chain. These business functions include R&D,
design, production, marketing, distribution, and customer service.

An organization can become more effective by focusing on whether each


link in the chain adds value from the customers perspective and furthers
the organizations objectives.

9. Cost: Organizations are under continuous pressure to reduce the


cost of the products or services they sell to their customers.

Quality: Customers are expecting higher levels of quality and are less
tolerant of low quality than in the past.

Time: Time has many components: the time taken to develop and
bring new products to market; the speed at which an
organization responds to customer requests; and the
reliability with which promised delivery dates are met.
Organizations are under pressure to complete activities
faster and to meet promised delivery dates more reliably
than in the past in order to increase customer satisfaction.
Innovation: There is now heightened recognition that a continuing flow
of innovative products or services is a prerequisite for the
ongoing success of most organizations.

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Cost Concepts and Classifications Chapter 8

10. Managers make planning decisions and control decisions. Planning


decisions include deciding on organization goals, predicting results
under various alternative ways of achieving those goals, and then
deciding how to attain the desired goals. Control decisions include
taking actions to implement the planning decisions and deciding on
performance evaluation and feedback that will help future decision
making.

11. Four themes for managers to attain success are customer focus, value-
chain and supply-chain analysis, key success factors, and continuous
improvement and benchmarking.

12. Companies add value through R&D; design of products, services, or


processes; production; marketing; distribution; and customer service.
Managers in all business functions of the value chain are customers of
management accounting information.

13. This phrase means that people will direct their attention to work
primarily on those tasks that management monitors and measures.
Employees may not pay as much attention (or no attention) to tasks that
are not measured. Often management will reward people based on how
well they perform relative to a specific measure. As an example, in a
manufacturing organization, if people are measured and rewarded based
on the number of outputs per hour, regardless of quality, employees will
focus their attention on producing as many units of output as possible. A
negative consequence is that the quality of output may suffer.

14. Some of these new measures are quality, speed to market, cycle time,
flexibility, complexity and productivity.

15. Customer satisfaction is often thought to be a qualitative measure of


performance as one cannot directly observe satisfaction. However,
using attitude surveys and psychological measurements, customer
satisfaction can be measured in quantitative terms. For instance, people
who design surveys often employ attitude scales that ask questions in
which customers respond on a 1 to 5 scale. These values can be summed
and averaged to determine satisfaction scores.

8-23
Chapter 8 Cost Concepts and Classifications

16.
Stakeholders Contribution Requirements
Employees Effort, skills, Rewards, interesting
information jobs, economic
security, proper
treatment
Partners Goods, services, Financial rewards
information commensurate with
the risk taken
Owners Capital Financial rewards
Community Allows the Conformance to laws,
organization to good corporate
operate and does not citizenship and,
oppose its operation perhaps, leadership

17. Competitive benchmarking is an organizations search for, and


implementation of, the best way to do something as practiced in other
organizations.

Continuous improvement is the relentless search to (1) document,


understand, and improve the activities that the organization undertakes
to meet its customers requirement, (2) eliminate processing activities
that do not add product features that customers value, and (3) improve
the performance of activities that increase customer value or satisfaction.

18. A value-added activity is an activity that, if eliminated, would reduce the


products service to the customer in the long run.

An activity that cannot be classified as value-added is a nonvalue-added


activity:
a. Value-added
b. Nonvalue-added
c. Nonvalue-added
d. Value-added
e. Nonvalue-added
f. Nonvalue-added
g. Value-added
h. Value-added

8-24
Cost Concepts and Classifications Chapter 8

i. Nonvalue-added
j. Value-added

19. Just-in-time means making a good or service only when the customer,
internal or external, requires it. Just-in-time requires a product layout
with a continuous flow (no delays) once production starts. It means that
setup costs must be reduced substantially to eliminate the need to
produce in batches, and it means that processing systems must be
reliable. Just-in-time production is based on the elimination of all
nonvalue-added activities to reduce cost and time. It is an approach to
improvement that is continuous and involves employee empowerment
and involvement.

20. Managerial accounting is concerned with providing information to


managers for use within the organization. Financial accounting is con-
cerned with providing information to stockholders, creditors, and others
outside of the organization.

21. A strategy is a game plan that enables a company to attract customers by


distinguishing itself from competitors. The focal point of a companys
strategy should be its target customers.

II. Multiple Choice Questions

11. B 21. A 31. B


12. A 22. B 32. C
13. D 23. C 33. C
14. A 24. D
15. D 25. A
16. A 26. A
17. C 27. B
18. B 28. C
19. D 29. B
20. B 30. A

CHAPTER 3

UNDERSTANDING FINANCIAL STATEMENTS

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Chapter 8 Cost Concepts and Classifications

I. Questions

1. A financial statement is a means of communicating information about an


enterprise in financial (i.e., peso) terms. It represents information that
the accountant believes is a true and fair representation of the financial
activity of the enterprise.

2. Every financial statement relates to time in one way or another. A


statement of financial position, or balance sheet, represent a picture of
the enterprise at a point in time (e.g., the end of a month or year). An
income statement and a statement of cash flows, on the other hand, cover
activity that took place over a period of time (e.g., a month or year).

3. a. Creditors are interested in financial statements to assist them in


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

4. Business transactions affect a companys financial position, and as a


result they change the statement of financial position or balance sheet.
The other financial statements the income statement and the statement
of cash flows are detailed expansions of certain aspects of the
statement of financial position and help explain how the companys
position changed over time.
5. The cost principle indicates that many assets are included in the
financial records, and therefore, in the statement of financial position, at
their original cost to the reporting enterprise. This principle affects
accounting for assets in several ways, one of which is that the amount of

8-26
Cost Concepts and Classifications Chapter 8

most assets is not adjusted periodically for changes in the market value
of the assets. Instead, cost is retained as the basic method of accounting,
regardless of changes in the market value of those assets.

6. The going concern assumption states that in the absence of evidence to


the contrary (i.e., bankruptcy proceedings), an enterprise is expected to
continue to operate in the foreseeable future. This means, for example,
that it will continue to use the assets it has in its financial statements for
the purpose for which they were acquired.

7. The three categories and the information included in each are:


Operating activities Cash provided by and used in revenue and expense
transactions.
Investing activities Cash provided by and used as a result of
investments in assets, such as machinery, equipment, land, and
buildings.
Financial activities Cash provided by and used in debt and equity
financing, such as borrowing and repaying loans, and investments from
and dividends paid to the enterprises owners.

8. Adequate disclosure refers to the requirement that financial statements,


including accompanying notes, must include information necessary for
reasonably informed users of financial statements to understand the
companys financial activities. This requirement is often met, in part, by
the addition of notes to the financial statements. Financial statement
notes include both quantitative and qualitative information that is not
included in the body of the financial statements.

9. A strong income statement is one that has significantly more pesos of


revenue than expenses, resulting in net income that is a relatively high
percentage of the revenue figure. A trend of relatively high income
numbers over time signals a particularly strong income situation.

10. A strong statement of cash flows is one that shows significant amounts
of cash generated from operating activities. This means that the
enterprise is generating cash from its ongoing activities and is not
required to rely on continuous debt and equity financing, or the sale of
its major assets.

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Chapter 8 Cost Concepts and Classifications

11. The purpose of classifications in financial statements is to develop useful


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

12. In classified financial statements, similar items are grouped together to


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

13. In a multiple-step income statement, different categories of expenses are


deducted from revenue in a series of steps, thus resulting in various
subtotals, such as gross profit and operating income. In a single-step
income statement, all expenses are combined and deducted from total
revenue in a single step. Both formats result in the same amount of net
income.

II. Matching Type

1.
1. d 3. a 5. e 7. f 9. c
2. g 4. j 6. h 8. b 10. i

2.
1. d 3. i 5. m 7. h 9. f 11. b 13. e
2. a 4. g 6. c 8. n 10. k 12. j 14. l

3.

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Cost Concepts and Classifications Chapter 8

a. F c. F e. I g. F I. I k. F
b. I d. I f. F h. F j. F l. I

III. Problems

Problem 1 (Preparing a Balance Sheet A Second Problem)

Requirement (a)
SM Farms
Balance Sheet
September 30, 2005

Assets Liabilities and Equity


Cash P 16,710
Liabilities:
Accounts receivable 22,365 Notes payable P530,000
Land 550,000 Accounts payable 77,095
Barns and sheds 78,300 Property taxes payable 9,135
Citrus trees 76,650 Wages payable 1,820
Livestock 120,780 Total liabilities P618,050
Irrigation system 20,125 Equity:
Farm machinery 42,970 Share capital 250,000
Fences & gates 33,570 Retained earnings* 93,420
Total P961,470
Total P961,470

* Total assets, P961,470, minus total liabilities, P618,050, less share capital,
P250,000.

Requirement (b)
The loss of an asset, Barns and Sheds, from a typhoon would cause a
decrease in total assets. When total assets are decreased, the balance sheet
total of liabilities and equity must also decrease. Since there is no change in
liabilities as a result of the destruction of an asset, the decrease on the right-
hand side of the balance sheet must be in the retained earnings account. The
amount of the decrease in Barns and Sheds, in the equity, and in both
balance sheet totals, is P23,800.
Problem 2 (Preparing a Balance Sheet and Cash Flow Statement;
Effects of Business Transactions)

Requirement (a)

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Chapter 8 Cost Concepts and Classifications

The Tasty Bakery


Balance Sheet
August 1, 2005

Assets Liabilities and Equity


Cash P 6,940Liabilities:
Accounts receivable 11,260 Notes payable P 74,900
Supplies 7,000 Accounts payable 16,200
Land 67,000 Salaries payable 8,900
Building 84,000 Total liabilities P100,000
Equipment and fixtures 44,500 Equity:
Share capital 80,000
Retained earnings 40,700
Total P220,700
Total P220,700

Requirement (b)
The Tasty Bakery
Balance Sheet
August 3, 2005

Assets Liabilities and Equity


Cash P 14,490
Liabilities:
Accounts receivable 11,260 Notes payable P 74,900
Supplies 8,250 Accounts payable 7,200
Land 67,000 Salaries payable 8,900
Building 84,000 Total liabilities P 91,000
Equipment and fixtures 51,700 Equity:
Share capital 105,000
Retained earnings 40,700
Total P236,700
Total P236,700

The Tasty Bakery


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

Cash flows from operating

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Cost Concepts and Classifications Chapter 8

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

Cash flows from investing


activities:
None

Cash flows from financing


activities:
Sale of share capital P25,000

Increase in cash P 7,550


Cash balance, August 1, 6,940
2005
Cash balance, August 3, P14,490
2005

Requirement (c)
The Tasty Bakery is in a stronger financial position on August 3 than it was
on August 1.

On August 1, the highly liquid assets (cash and accounts receivable) total
only P18,200, but the company has P25,100 in debts due in the near future
(accounts payable plus salaries payable).

On August 3, after additional infusion of cash from the sale of stock, the
liquid assets total P25,750, and debts due in the near future amount to
P16,100.

Note to Instructor: The analysis of financial position strength in requirement


(c) is based solely upon the balance sheets at August 1 and August 3.
Hopefully, students will raise many legitimate issues regarding necessity of
information about operations, rate at which cash flows into the business, etc.
In this problem, the improvement in financial position results solely from the
sale of share capital.

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Chapter 8 Cost Concepts and Classifications

Problem 3 (Preparing Financial Statements; Effects of Business


Transactions)

Requirement (a)
The First Malt Shop
Balance Sheet
September 30, 2005

Assets Liabilities and Equity


Cash P 7,400Liabilities:
Accounts receivable 1,250 Notes payable* P 70,000
Supplies 3,440 Accounts payable 8,500
Land 55,000 Total liabilities P 78,500
Building 45,500 Equity:
Share capital 50,000
Furniture & fixtures 20,000 Retained earnings 4,090
Total P132,590
Total P132,590

* Total assets, P132,590, less equity, P54,090, less accounts payable, P8,500, equals
notes payable.

Requirement (b)
The First Malt Shop
Balance Sheet
October 6, 2005

Assets Liabilities and Equity


Cash P 29,400
Liabilities:
Accounts receivable 1,250 Notes payable P 70,000
Supplies 4,440 Accounts payable 18,000
Land 55,000 Total liabilities P 88,000
Building 45,500 Equity:
Share capital 80,000
Furniture & fixtures 38,000 Retained earnings 5,590
Total P173,590
Total P173,590

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Cost Concepts and Classifications Chapter 8

The First Malt Shop


Income Statement
For the Period October 1-6, 2005

Revenues P 5,500
Expenses (4,000)
Net income P 1,500

The First Malt Shop


Statement of Cash Flows
For the Period October 1-6, 2005

Cash flows from operating


activities:
Cash received from P5,500
revenues
Cash paid for expenses (4,000)
Cash paid for accounts (8,500)
payable
Cash paid for supplies
(1,000)
Cash used in operating P(8,000)
activities
Cash flows from investing
activities:
None
Cash flows from financing
activities:
Cash received from sale of P30,000
share capital
Increase in cash P
22,000
Cash balance, October 1, 2005 7,400

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Chapter 8 Cost Concepts and Classifications

Cash balance, October 6, 2005 P29,400

Requirement (c)
The First Malt Shop is in a stronger financial position on October 6 than on
September 30. On September 30, the company had highly liquid assets (cash
and accounts receivable) of P8,650, which barely exceeded the P8,500 in
liabilities (accounts payable) due in the near future. On October 6, after the
additional investment of cash by shareholders, the companys cash alone
exceeded its short-term obligations.

Problem 4 (Preparing a Balance Sheet; Discussion of Accounting


Principles)

Requirement (1)
Fil-Cinema Scripts
Balance Sheet
November 30, 2005

Assets Liabilities and Equity


Cash P 3,940Liabilities:
Notes receivable 2,200 Notes payable P 73,500
Accounts receivable 2,450 Accounts payable 32,700
Land 39,000 Total liabilities P106,200
Building 54,320 Equity:
Share capital 5,000
Office furniture* 12,825 Retained earnings 3,535
Total P114,735
Total P114,735

* P8,850 + P6,500 P2,525.

Requirement (2)
(1) The cash in Cruzs personal savings account is not an asset of the
business entity Fil-Cinema Scripts and should not appear in the balance
sheet of the business. The money on deposit in the business bank

8-34
Cost Concepts and Classifications Chapter 8

account (P3,400) and in the company safe (P540) constitute cash owned
by the business. Thus, the cash owned by the business at November 30
totals P3,940.

(2) The years-old IOU does not qualify as a business asset for two reasons.
First, it does not belong to the business entity. Second, it appears to be
uncollectible. A receivable that cannot be collected is not viewed as an
asset, as it represents no future economic benefit.

(3) The total amount to be included in Office furniture for the rug is
P9,400, the total cost, regardless of whether this amount was paid in
cash. Consequently, Office furniture should be increased by P6,500.
The P6,500 liability arising from the purchase of the rug came into
existence prior to the balance sheet date and must be added to the Notes
payable amount.
(4) The computer is no longer owned by Hollywood Scripts and therefore
cannot be included in the assets. To do so would cause an overstatement
of both assets and equity. The Office furniture amount must be
reduced by P2,525.

(5) The P22,400 described as Other assets is not an asset, because there is
no valid legal claim or any reasonable expectation of recovering the
income taxes paid. Also, the payment of income taxes by Cruz was not a
business transaction by Fil-Cinema Scripts. If a refund were obtained
from the government, it would come to Cruz personally, not to the
business entity.

(6) The proper valuation for the land is its historical cost of P39,000, the
amount established by the transaction in which the land was purchased.
Although the land may have a current fair value in excess of its cost, the
offer by the friend to buy the land if Cruz would move the building
appears to be mere conversation rather than solid, verifiable evidence of
the fair value of the land. The cost principle, although less than
perfect, produces far more reliable financial statements than would result
if owners could pull figures out of the air in recording asset values.

(7) The accounts payable should be limited to the debts of the business,
P32,700, and should not include Cruzs personal liabilities.

8-35
Chapter 8 Cost Concepts and Classifications

IV. Multiple Choice Questions

21. D 31. B 21. B 31. B


22. D 32. C 22. C 32. D
23. D 33. D 23. A 33. D
24. B 34. A 24. B 34. D
25. A 35. D 25. A 35. C
26. B a. A 26. D 36. A
27. D 17. A 27. B 37. A
28. C 18. B 28. B 38. C
29. B 19. C 29. D
30. C 20. C 30. C
CHAPTER 4

FINANCIAL STATEMENTS ANALYSIS - I

I. Questions

1. The objective of financial statements analysis is to determine the extent


of a firms success in attaining its financial goals, namely:
a. To earn maximum profit
b. To maintain solvency
c. To attain stability

2. Some of the indications of satisfactory short-term solvency or working


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

3. These tests are:


1. Improvement in the financial position

8-36
Cost Concepts and Classifications Chapter 8

2. Well-balanced financial structure between borrowed funds and


equity
3. Effective employment of borrowed funds and equity
4. Ability to declare satisfactory amount of dividends to
shareholders
5. Ability to withstand adverse business conditions
6. Ability to engage in research and development in an attempt to
provide new products or improve old products, methods or
processes

4. Some indicators of managerial efficiency are:


1. Ability to earn a reasonable return on its investment of borrowed
funds and equity
2. Ability to control operating costs within reasonable limits
3. No overinvestment in fixed assets, receivables and inventories

5. The techniques used in Financial Statement Analysis are:


I. Vertical analysis which shows the relationships of the items in
the same year: also referred to as static measure.
a. Financial ratios
b. Common-size statements

II. Horizontal analysis which shows the changes or tendencies of an


item for 2 or more years; also referred to as dynamic measure.
a. Comparative statements - showing changes in absolute
amount and percentages
b. Trend percentages

III. Use of special reports or statements


a. Statements of Changes in Financial Position
b. Gross Profit / Net Income Variation Analysis

6. Refer to page 133 of the textbook.

7. Horizontal analysis involves the comparison of items on financial


statements between years. Analysis of comparative financial statements

8-37
Chapter 8 Cost Concepts and Classifications

or the increase/decrease method of analysis and trend percentages are the


two techniques that may be applied under horizontal analysis.

Vertical analysis involves the study of items on a single statement for a


single year, such as the analysis of an income statement for some given
year. Common-size statement and financial ratios are techniques used in
vertical analysis.

8. Trends can indicate whether a situation is improving, remaining the


same or deteriorating. They can also give insight to the probable future
course of events in a firm.

9. Trend percentages represent the expression of several years financial


data in percentage form in terms of a base year.

10. Refer to page 133 of the textbook.

11. Observation of trends is useful primarily in determining whether a


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

Some other standards of comparison include comparison with other


similar companies, comparison with industry standards, and comparison
with previous years information. By comparing analytical data for one
company with some independent yardstick, the analyst hopes to
determine how the position of the company in question compares with
some standard of performance.

12. Trend percentages are used to show the increase or decrease in a


financial statement amount over a period of years by comparing the
amount in each year with the base-year amount. A component
percentage is the percentage relationship between some financial amount
and a total of which it is a part.

Measuring the change in sales over a period of several years would call
for use of trend percentages. The sales in the base year are assigned a
weight of 100%. The percentage for each later year is computed by
dividing that years sales by the sales in the base year.

8-38
Cost Concepts and Classifications Chapter 8

13. Expenses (including the cost of goods sold) have been increasing at an
even faster rate than net sales. Thus Premiere is apparently having
difficulty in effectively controlling its expenses.

14. A corporate net income of P1 million would be unreasonably low for a


large corporation, with, say, P100 million in sales, P50 million in assets,
and P40 million in equity. A return of only P1 million for a company of
this size would suggest that the owners could do much better by
investing in insured bank savings accounts or in government bonds
which would be virtually risk-free and would pay a higher return.

On the other hand, a profit of P1 million would be unreasonably high for


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

II. True or False

1. True 3. True 5. False 7. True 9. True


2. False 4. True 6. False 8. False 10. True

III. Problems

Problem 1 (Percentage Changes)

a. Accounts receivable decreased 16% (P24,000 decrease P150,000 =


16% decrease).
b. Marketable securities decreased 100% (P250,000 decrease P250,000 =
100% decrease).
c. A percentage change cannot be calculated because retained earnings
showed a negative amount (a deficit) in the base year and a positive
amount in the following year.
d. A percentage change cannot be calculated because of the zero amount of
notes receivable in 2005, the base year.
e. Notes payable increased 7 % (P60,000 increase P800,000 = 7 %
increase).
f. Cash increased 3% (P2,400 increase P80,000 = 3% increase).
g. Sales increased 10% (P90,000 increase P900,000 = 10% increase).

8-39
Chapter 8 Cost Concepts and Classifications

Problem 2 (Computing and Interpreting Rates of Change)

Requirement (a)
Computation of percentage changes:
1. Net sales increased 10% (P200,000 increase P2,000,000 = 10%
increase).
2. Total expenses increased 11% (P198,000 increase P1,800,000 = 11%
increase).

Requirement (b)
1. Total expenses grew faster than net sales. Net income cannot also have
grown faster than net sales, or the sum of the parts would exceed the size
of the whole.
2. Net income must represent a smaller percentage of net sales in 2006 than
it did in 2005. Again, the reason is that the expenses have grown at a
faster rate than net sales. Thus, total expenses represent a larger
percentage of total sales in 2006 than in 2005, and net income must
represent a smaller percentage.

Problem 3 (Financial Statement Analysis using Comparative Statements


or Increase-Decrease Method)

Requirement 1

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

8-40
Cost Concepts and Classifications Chapter 8

Liabilities and Equity


Notes payable to banks 10,000 54,000 44,000 440.00%
Accounts payable 31,600 55,400 23,800 73.32%
Accrued liabilities 4,200 6,800 2,600 61.90%
Income taxes payable 5,800 7,000 1,200 20.69%
Total current liabilities 51,600 123,200 71,600 138.76%
Share capital 44,600 44,600 0 0.00%
Retained earnings 35,600 70,200 34,600 97.19%
Total equity 80,200 114,800 34,600 43.14%
Total liabilities and equity 131,800 238,000 106,200 80.58%

XYZ Corporation
Income Statement
Years ended December 31
(P thousands)
Change
Peso %
2005 2006
Net sales 266,400 424,000 157,600 59.16%
Cost of goods sold 191,400 314,600 123,200 64.37%
Gross profit 75,000 109,400 34,400 45.87%
Selling, general and administrative
expenses 35,500 58,400 22,900 64.51%
Income before income taxes 39,500 51,000 11,500 29.11%
Income taxes 12,300 16,400 4,100 33.33%
Net income 27,200 34,600 7,400 27.21%

Requirement 2

Short-term financial position


1. Current Current
increased by 62.01% while increased by 138.76%
Assets Liabilities
Unfavorable
2. Quick Current
increased by 62.40% while increased by 138.76%
Assets Liabilities
Unfavorable
3. Net Accounts
increased by 59.16% while increased by 93.06%
Sales Receivable
Unfavorable
4. Cost of Inventories
increased by 64.37% while increased by 58.52%
Goods Sold
Favorable
Leverage

8-41
Chapter 8 Cost Concepts and Classifications

5. Total Total
increased by 80.58% while increased by 138.76%
Assets Liabilities
Unfavorable
6. Total Total
increased by 138.76% while increased by 43.14%
Liabilities Equity
Unfavorable
Profitability
7. Net Cost of
increased by 59.16% while increased by 64.37%
Sales Goods Sold
Unfavorable

8. Net Selling,
Sales increased by 59.16% while General & increased by 64.51%
Administrative
Expenses
Unfavorable
9. Net Net
increased by 59.16% while increased by 27.21%
Sales Income
Unfavorable
10. Net Total
increased by 27.21% while increased by 80.58%
Income Assets
Unfavorable

Problem 4 (Trend Percentages)

Requirement (1)
The trend percentages are:
Year 5 Year 4 Year 3 Year 2 Year 1
Sales 125.0 120.0 110.0 105.0 100.0

Cash 80.0 90.0 105.0 110.0 100.0


Accounts receivable 140.0 124.0 108.0 104.0 100.0
Inventory 112.0 110.0 102.0 108.0 100.0
Total current assets 118.8 113.1 104.1 106.9 100.0

Current liabilities 130.0 106.0 108.0 110.0 100.0

Requirement (2)
Sales: The sales are increasing at a steady rate, with a particularly
strong gain in Year 4.

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Cost Concepts and Classifications Chapter 8

Assets: Cash declined from Year 3 through Year 5. This may have
been due to the growth in both inventories and accounts
receivable. In particular, the accounts receivable grew far
faster than sales in Year 5. The decline in cash may reflect
delays in collecting receivables. This is a matter for
management to investigate further.

Liabilities: The current liabilities jumped up in Year 5. This was probably


due to the buildup in accounts receivable in that the company
doesnt have the cash needed to pay bills as they come due.

Problem 5 (Use of Trend Percentages)

a. 1. An unfavorable tendency could be observed in Receivables in


relation to Net Sales from 2003 2005 because receivables had been
increasing at a much faster rate than Net Sales. This could indicate
inefficiency in the collection of receivables or simply poor company
credit policy. The situation however, improved in 2006 and 2007
when sales started to move up at a faster rate than accounts
receivable. This would indicate improvement in the credit and
collection policy or more cash sales were being generated.
2. Unfavorable tendency in inventory persisted from 2003 to 2007
because it had been going up at a much faster rate than Net Sales. If
this continues, the company will end up with over-investment in
inventory because the buying rate is faster than the selling price.
3. Favorable tendencies could be noted in Fixed Assets in relation to
Net Sales because inspite of the minimal additions to fixed assets
made by the company from 2003 through 2007, sales had been
increasing at a very encouraging rate.
4. Net Income had likewise been increasing at a much faster rate than
net sales. This is favorable because this would indicate that the
company had been successfully controlling the increases in Cost of
Sales and Operating Expenses.
b. Review computations of the Trend Percentages. It will be noted that the
Trend Percentages in Total Noncurrent Liabilities and Equity from 2005

8-43
Chapter 8 Cost Concepts and Classifications

to 2007 were interchanged. Correction should be made first before


interpretation is done.
1. The upward tendency in current assets had been accompanied by an
upward trend in current liabilities. It could be noted that current
assets had been moving up at a much faster rate than current
liabilities. This is favorable because the margin of safety of the
short-term creditors is widened.
2. Favorable tendencies could also be observed in noncurrent assets
which had been increasing and which increases had been
accompanied by downward trend in noncurrent liabilities. This
would mean better security on the part of creditors and stronger
financial position.
3. There is an unfavorable tendency in Net Sales in relation to non-
current assets. Sales had not been increasing at the same rate as the
increases in fixed assets. This could indicate that more investments
are made in noncurrent assets without considering whether or not
they could sell the additional units of product they are producing.
c. The unfavorable trend in net income could be attributed to the following
tendencies:
1. Higher rates of increases in cost of sales as compared to sales.
2. Higher rates of increases in selling, general and administrative
expenses in relation to net sales.
3. Higher rates of increases in other financial expenses than the rates of
increases in net sales

IV. Multiple Choice Questions

31. D 36. A, C, D
32. A 37. B*
33. A 38. D
34. B
35. D
36. C
37. C
38. A

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Cost Concepts and Classifications Chapter 8

39. D
40. C

* (P400,000 P160,000) P160,000 = 150%

CHAPTER 5

FINANCIAL STATEMENTS ANALYSIS - II

I. Questions

1. By looking at trends, an analyst hopes to get some idea of whether a


situation is improving, remaining the same, or deteriorating. Such
analyses can provide insight into what is likely to happen in the future.
Rather than looking at trends, an analyst may compare one company to
another or to industry averages using common-size financial statements.

2. Ratios highlight relationships, movements, and trends that are very


difficult to perceive looking at the raw underlying data standing alone.
Also, ratios make financial data easier to grasp by putting the data into
perspective. As to the limitation in the use of ratios, refer to page 129.

3. Price-earnings ratios are determined by how investors see a firms future


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

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Chapter 8 Cost Concepts and Classifications

4. A managers financing responsibilities relate to the acquisition of assets


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

5. Financial leverage, as the term is used in business practice, means


obtaining funds from investment sources that require a fixed annual rate
of return, in the hope of enhancing the well-being of the ordinary
shareholders. If the assets in which these funds are invested earn at a
rate greater that the return required by the suppliers of the funds, then
leverage is positive in the sense that the excess accrues to the benefit of
the ordinary shareholders. If the return on assets is less than the return
required by the suppliers of the funds, then leverage is negative in the
sense that part of the earnings from the assets provided by the ordinary
shareholders will have to go to make up the deficiency.

6. How a shareholder would feel would depend in large part on the stability
of the firm and its industry. If the firm is in an industry that experiences
wide fluctuations in earnings, then shareholders might be very pleased
that no interest-paying debt exists in the firms capital structure. In hard
times, interest payments might be very difficult to meet, or earnings
might be so poor that negative leverage would result.

7. No, the stock is not necessarily overpriced. Book value represents the
cumulative effects on the balance sheet of past activities evaluated using
historical prices. The market value of the stock reflects investors
beliefs about the companys future earning prospects. For most
companies market value exceeds book value because investors anticipate
future growth in earnings.

8. A company in a rapidly growing technological industry probably would


have many opportunities to invest its earnings at a high rate of return;
thus, one would expect it to have a low dividend payout ratio.

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Cost Concepts and Classifications Chapter 8

9. It is more difficult to obtain positive financial leverage from preference


shares than from long-term debt due to the fact that interest on long-term
debt is tax deductible, whereas dividends paid on preference shares are
not tax deductible.

10. The current ratio would probably be highest during January, when both
current assets and current liabilities are at a minimum. During peak
operating periods, current liabilities generally include short-term
borrowings that are used to temporarily finance inventories and
receivables. As the peak periods end, these short-term borrowings are
paid off, thereby enhancing the current ratio.

11. A 2-to-1 current ratio might not be adequate for several reasons. First,
the composition of the current assets may be heavily weighted toward
slow-turning inventory, or the inventory may consist of large amounts of
obsolete goods. Second, the receivables may be large and of doubtful
collectibility, or the receivables may be turning very slowly due to poor
collection procedures.

12. Expenses (including the cost of goods sold) have been increasing at an
even faster rate than net sales. Thus Sunday is apparently having
difficulty in effectively controlling its expenses.

13. If the companys earnings are very low, they may become almost
insignificant in relation to stock price. While this means that the p/e
ratio becomes very high, it does not necessarily mean that investors are
optimistic. In fact, they may be valuing the company at its liquidation
value rather than a value based upon expected future earnings.

14. From the viewpoint of the companys shareholders, this situation


represents a favorable use of leverage. It is probable that little interest, if
any, is paid for the use of funds supplied by current creditors, and only
11% interest is being paid to long-term bondholders. Together these two
sources supply 40% of the total assets. Since the firm earns an average
return of 16% on all assets, the amount by which the return on 40% of
the assets exceeds the fixed-interest requirements on liabilities will
accrue to the residual equity holders the ordinary shareholders
raising the return on equity.

15. The length of operating cycle of the two companies cannot be


determined from the fact the one companys current ratio is higher. The

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Chapter 8 Cost Concepts and Classifications

operating cycle depends on the relationships between receivables and


sales, and between inventories and cost of goods sold. The company
with the higher current ratio might have either small amounts of
receivables and inventories, or large sales and cost of sales, either of
which would tend to produce a relatively short operating cycle.

16. The investor is calculating the rate of return by dividing the dividend by
the purchase price of the investment (P5 P50 = 10%). A more
meaningful figure for rate of return on investment is determined by
relating dividends to current market price, since the investor at the
present time is faced with the alternative of selling the stock for P100
and investing the proceeds elsewhere or keeping the investment. A
decision to retain the stock constitutes, in effect, a decision to continue
to invest P100 in it, at a return of 5%. It is true that in a historical sense
the investor is earning 10% on the original investment, but this is
interesting history rather than useful decision-making information.
17. A corporate net income of P1 million would be unreasonably low for a
large corporation, with, say, P100 million in sales, P50 million in assets,
and P40 million in equity. A return of only P1 million for a company of
this size would suggest that the owners could do much better by
investing in insured bank savings accounts or in government bonds
which would be virtually risk-free and would pay a higher return.
On the other hand, a profit of P1 million would be unreasonably high for
a corporation which had sales of only P5 million, assets of, say, P3
million, and equity of perhaps one-half million pesos. In other words,
the net income of a corporation must be judged in relation to the scale of
operations and the amount invested.

II. True or False

1. True 3. True 5. True 7. True 9. False


2. True 4. False 6. True 8. True 10. False

III. Problems

Problem 1 (Common Size Income Statements)

Common size income statements for 2005 and 2006:


2006 2005

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Cost Concepts and Classifications Chapter 8

Sales .................................................. 100% 100%


Cost of goods sold ............................ 66 67
Gross profit ....................................... 34% 33%
Operating expenses ........................... 28 29
Net income ........................................ 6% 4%

The changes from 2005 to 2006 are all favorable. Sales increased and the
gross profit per peso of sales also increased. These two factors led to a
substantial increase in gross profit. Although operating expenses increased
in peso amount, the operating expenses per peso of sales decreased from 29
cents to 28 cents. The combination of these three favorable factors caused
net income to rise from 4 cents to 6 cents out of each peso of sales.

Problem 2 (Measures of Liquidity)

Requirement (a)

Current assets:
Cash P 47,600
Marketable securities 175,040
Accounts receivable 230,540
Inventory 179,600
Unexpired insurance 4,500
Total current assets P637,280
Current liabilities:
Notes payable P 70,000
Accounts payable 125,430
Salaries payable 7,570
Income taxes payable 14,600
Unearned revenue 10,000
Total current liabilities P227,600

Requirement (b)

The current ratio is 2.8 to 1. It is computed by dividing the current assets of


P637,280 by the current liabilities of P227,600. The amount of working
capital is P409,680, computed by subtracting the current liabilities of
P227,600 from the current assets of P637,280.

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Chapter 8 Cost Concepts and Classifications

The company appears to be in a strong position as to short-run debt-paying


ability. It has almost three pesos of current assets for each peso of current
liabilities. Even if some losses should be sustained in the sale of the
merchandise on hand or in the collection of the accounts receivable, it
appears probable that the company would still be able to pay its debts as they
fall due in the near future. Of course, additional information, such as the
credit terms on the accounts receivable, would be helpful in a careful
evaluation of the companys current position.

Problem 3 (Common-Size Income Statement)

Requirement 1
2006 2005
Sales 100.0 % 100.0 %
Less cost of goods sold .........................................................................................................
63.2 60.0
Gross margin .........................................................................................................................
36.8 40.0
Selling expenses ....................................................................................................................
18.0 17.5
Administrative expenses .......................................................................................................
13.6 14.6
Total expenses .......................................................................................................................
31.6 32.1
Net operating income ............................................................................................................
5.2 7.9
Interest expense.....................................................................................................................
1.4 1.0
Net income before taxes........................................................................................................
3.8 % 6.9 %

Requirement 2

The companys major problem seems to be the increase in cost of goods


sold, which increased from 60.0% of sales in 2005 to 63.2% of sales in 2006.
This suggests that the company is not passing the increases in costs of its
products on to its customers. As a result, cost of goods sold as a percentage
of sales has increased and gross margin has decreased. Selling expenses and
interest expense have both increased slightly during the year, which suggests
that costs generally are going up in the company. The only exception is the
administrative expenses, which have decreased from 14.6% of sales in 2005
to 13.6% of sales in 2006. This probably is a result of the companys efforts
to reduce administrative expenses during the year.

Problem 4 (Comparing Operating Results with Average Performance in


the Industry)

Requirement (a)
Ms. Freeze,Inc. Industry Average

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Cost Concepts and Classifications Chapter 8

Sales (net) 100% 100%


Cost of goods sold 49 57
Gross profit on sales 51% 43%
Operating expenses:
Selling 21% 16%
General and administrative 17 20
Total operating expenses 38% 36%
Operating income 13% 7%
Income taxes 6 3
Net income 7% 4%
Requirement (b)

Ms. Freezes operating results are significantly better than the average
performance within the industry. As a percentage of sales revenue, Ms.
Freezes operating income and net income after nearly twice the average for
the industry. As a percentage of total assets, Ms. Freezes profits amount to
an impressive 23% as compared to 14% for the industry.
The key to Ms. Freezes success seems to be its ability to earn a relatively
high rate of gross profit. Ms. Freezes exceptional gross profit rate (51%)
probably results from a combination of factors, such as an ability to
command a premium price for the companys products and production
efficiencies which lead to lower manufacturing costs.
As a percentage of sales, Ms. Freezes selling expenses are five points higher
than the industry average (21% compared to 16%). However, these higher
expenses may explain Ms. Freezes ability to command a premium price for
its products. Since the companys gross profit rate exceeds the industry
average by 8 percentage points, the higher-than-average selling costs may be
part of a successful marketing strategy. The companys general and
administrative expenses are significantly lower than the industry average,
which indicates that Ms. Freezes management is able to control expenses
effectively.

Problem 5 (Common-Size Statements)

Requirement 1

The income statement in common-size form would be:


2006 2005
Sales ......................................................... 100.0% 100.0%

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Chapter 8 Cost Concepts and Classifications

Less cost of goods sold ............................ 65.0 60.0


Gross margin ............................................ 35.0 40.0
Less operating expenses .......................... 26.3 30.4
Net operating income ............................... 8.7 9.6
Less interest expense ............................... 1.2 1.6
Net income before taxes .......................... 7.5 8.0
Less income taxes (30%) ......................... 2.3 2.4
Net income ............................................... 5.3% 5.6%

The balance sheet in common-size form would be:

2006 2005
Current assets:
Cash ................................................... 2.0% 5.1%
Accounts receivable, net ................... 15.0 10.1
Inventory ........................................... 30.1 15.2
Prepaid expenses ............................... 1.0 1.3
Total current assets ..................... 48.1 31.6
Plant and equipment ................................ 51.9 68.4
Total assets .............................................. 100.0% 100.0%
Liabilities:
Current liabilities............................... 25.1% 12.7%
Bonds payable, 12% .......................... 20.1 25.3
Total liabilities ............................ 45.1 38.0
Equity:
Preference shares, 8%, P10 par ......... 15.0 19.0
Ordinary shares, P5 par ..................... 10.0 12.7
Retained earnings .............................. 29.8 30.4
Total equity ................................. 54.9 62.0
Total liabilities and equity ....................... 100.0% 100.0%

Note: Columns do not total down in all cases due to rounding differences.

Requirement 2

The companys cost of goods sold has increased from 60 percent of sales in
2005 to 65 percent of sales in 2006. This appears to be the major reason the
companys profits showed so little increase between the two years. Some
benefits were realized from the companys cost-cutting efforts, as evidenced

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Cost Concepts and Classifications Chapter 8

by the fact that operating expenses were only 26.3 percent of sales in 2006 as
compared to 30.4 percent in 2005. Unfortunately, this reduction in operating
expenses was not enough to offset the increase in cost of goods sold. As a
result, the companys net income declined from 5.6 percent of sales in 2005
to 5.3 percent of sales in 2006.

Problem 6 (Solvency of Alabang Supermarket)

Requirement (a)
(Pesos in
Millions)
Current assets:
Cash P 74.8
Receivables 152.7
Merchandise inventories 1,191.8
Prepaid expenses 95.5
Total current assets P1,514.8

Quick assets:
Cash P 74.8
Receivables 152.7
Total quick assets P 227.5

Requirement (b)

(1) Current ratio:


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

(2) Quick ratio:


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

(3) Working capital:


Current assets (Req. a) P1,514.8
Less: Current liabilities P1,939.0
Working capital P(424.2)

Requirement (c)

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Chapter 8 Cost Concepts and Classifications

No. It is difficult to draw conclusions from the above ratios. Alabang


Supermarkets current ratio and quick ratio are well below safe levels,
according to traditional rules of thumb. On the other hand, some large
companies with steady ash flows are able to operate successfully with
current ratios lower than Alabang Supermarkets.
Requirement (d)

Due to characteristics of the industry, supermarkets tend to have smaller


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

Requirement (e)

In evaluating Alabang Supermarkets liquidity, it would be useful to review


the companys financial position in prior years, statements of cash flows, and
the financial ratios of other supermarket chains. One might also ascertain
the companys credit rating from an agency such as Dun & Bradstreet.

Note to Instructor: Prior to the year in which the data for this problem was
collected, Alabang Supermarket had reported a negative retained earnings
balance in its balance sheet for several consecutive periods. The fact that
Alabang Supermarket has only recently removed the deficit from its
financial statements is also worrisome.

Problem 7 (Balance Sheet Measures of Liquidity and Credit Risk)

Requirement (a)

(1) Quick assets:


Cash P 47,524
Marketable securities (short-term) 55,926
Accounts receivable 23,553

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Cost Concepts and Classifications Chapter 8

Total quick assets P127,003

(2) Current assets:


Cash P 47,524
Marketable securities (short-term) 55,926
Accounts receivable 23,553
Inventories 32,210
Prepaid expenses 5,736
Total current assets P164,949

(3) Current liabilities:


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

Requirement (b)

(1) Quick ratio:


Quick assets (Req. a) P127,003
Current liabilities (Req. a) P 55,306
Quick ratio (P127,003 P55,306) 2.3 to 1

(2) Current ratio:


Current assets (Req. a) P164,949
Current liabilities (Req. a) P 55,306
Current ratio (P164,949 P55,306) 3.0 to 1

(3) Working capital:


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

(4) Debt ratio:

8-55
Chapter 8 Cost Concepts and Classifications

Total liabilities (given) P 81,630


Total assets (given) P353,816
Debt ratio (P81,630 P353,816) 23.1%

Requirement (c)

(1) From the viewpoint of short-term creditors, Bonbon Sweets appear


highly liquid. Its quick and current ratios are well above normal rules of
thumb, and the companys cash and marketable securities alone are
almost twice its current liabilities.

(2) Long-term creditors also have little to worry about. Not only is the
company highly liquid, but creditors claims amount to only 23.1% of
total assets. If Bonbon Sweets were to go out of business and liquidate
its assets, it would have to raise only 23 cents from every peso of assets
for creditors to emerge intact.

(3) From the viewpoint of shareholders, Bonbon Sweets appears overly


liquid. Current assets generally do not generate high rates of return.
Thus, the companys relatively large holdings of current assets dilutes its
return on total assets. This should be of concern to shareholders. If
Bonbon Sweets is unable to invest its highly liquid assets more
productively in its business, shareholders probably would like to see the
money distributed as dividends.

Problem 8 (Selected Financial Measures for Short-term Creditors)

Requirement 1

Current assets (P80,000 + P460,000 + P750,000 +


P10,000) ...............................................................................................................
P1,300,000
Current liabilities (P1,300,000 2.5) ......................................................................
520,000
Working capital ........................................................................................................
P 780,000

Requirement 2
Cash + Marketable securities + Accounts receivable
Acid-test ratio =
Current liabilities
P80,000 + P0 + P460,000
Acid-test ratio
Requirement 3 = = 1.04 to 1 (rounded)
P520,000

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Cost Concepts and Classifications Chapter 8

a. Working capital would not be affected:

Current assets (P1,300,000 P100,000) ..................................................................


P1,200,000
Current liabilities (P520,000 P100,000) ...............................................................
420,000
Working capital ........................................................................................................
P 780,000

b. The current ratio would rise:


Current assets
Current ratio =
Current liabilities
P1,200,000
Current rate = = 2.9 to 1 (rounded)
P420,000

Problem 9 (Selected Financial Ratios)

1. Gross margin percentage:


Gross margin P840,000
= = 40%
Sales P2,100,000

2. Current ratio:
Current assets P490,000
= = 2.45 to 1
Current liabilities P200,000

3. Acid-test ratio:
Quick assets P181,000
= = 0.91 to 1 (rounded)
Current liabilities P200,000

4. Accounts receivable turnover:

Sales P2,100,000
= = 14 times
Average accounts receivables P150,000

365 days
= 26.1 days (rounded)
14 times

5. Inventory turnover:

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Chapter 8 Cost Concepts and Classifications

Cost of goods sold P1,260,000


= = 4.5 times
Average inventory P280,000

365 days
= 81.1 days to turn (rounded)
4.5 times
6. Debt-to-equity ratio:
Total liabilities P500,000
= = 0.63 to 1 (rounded)
Total equity P800,000

7. Times interest earned:

Earnings before interest


and income taxes P180,000
= = 6.0 times
Interest expense P30,000

8. Book value per share:


Equity P800,000
= = P40 per share
Ordinary shares outstanding 20,000 shares*
* P100,000 total par value P5 par value per share = 20,000 shares

Problem 10 (Selected Financial Ratios for Ordinary Shareholders)

1. Earnings per share:

Net income to ordinary shares P105,000


= = P5.25 per share
Average ordinary shares 20,000 shares
outstanding

2. Dividend payout ratio:


Dividends paid per share P3.15
= = 60%
Earnings per share P5.25

3. Dividend yield ratio:


Dividends paid per share P3.15
= = 5%
Market price per share P63.00
4. Price-earnings ratio:

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Cost Concepts and Classifications Chapter 8

Market price per share P63.00


= = 12.0
Earnings per share P5.25

Problem 11 (Selected Financial Ratios for Ordinary Shareholders)

1. Return on total assets:

Return on Net income + [Interest expense x (1 Tax rate)]


=
total assets Average total assets

P105,000 + [P30,000 x (1 0.30)]


=
(P1,100,000 + P1,300,000)
P126,000
= = 10.5%
P1,200,000

2. Return on ordinary shareholders equity:

Return on ordinary Net income preference dividends


=
shareholders equity Average ordinary shareholders equity
P105,000
=
(P725,000 + P800,000)
P105,000
= = 13.8% (rounded)
P762,500

3. Financial leverage was positive, since the rate of return to the ordinary
shareholders (13.8%) was greater than the rate of return on total assets
(10.5%). This positive leverage is traceable in part to the companys
current liabilities, which may carry no interest cost, and to the bonds
payable, which have an after-tax interest cost of only 7%.

10% interest rate (1 0.30) = 7% after-tax cost.

Problem 12 (Selected Financial Measures for Short-Term Creditors)

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Chapter 8 Cost Concepts and Classifications

Requirement (1)

Current assets
(P80,000 + P460,000 + P750,000 + P10,000) ..................................... P1,300,000
Current liabilities (P1,300,000 2.5)...................................................... 520,000
Working capital .......................................................................................
P 780,000

Requirement (2)

Cash + Marketable securities


Acid-test + Accounts receivable + Short-term notes
=
ratio Current liabilities

P80,000 + P0 + P460,000 + P0
= = 1.04 (rounded)
P520,000

Requirement (3)

a. Working capital would not be affected by a P100,000 payment on


accounts payable:

Current assets (P1,300,000 P100,000) ................................ P1,200,000


Current liabilities (P520,000 P100,000) ............................. 420,000
Working capital ......................................................................
P 780,000

b. The current ratio would increase if the company makes a P100,000


payment on accounts payable:
Current assets
Current ratio =
Current liabilities
P1,200,000
= = 2.9 (rounded)
P420,000

Problem 13 (Effects of Transactions on Various Financial Ratios)

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Cost Concepts and Classifications Chapter 8

1. Decrease Sale of inventory at a profit will be reflected in an increase


in retained earnings, which is part of shareholders equity.
An increase in shareholders equity will result in a
decrease in the ratio of assets provided by creditors as
compared to assets provided by owners.
2. No effect Purchasing land for cash has no effect on earnings or on
the number of ordinary shares outstanding. One asset is
exchanged for another.
3. Increase A sale of inventory on account will increase the quick
assets (cash, accounts receivable, marketable securities)
but have no effect on the current liabilities. For this
reason, the acid-test ratio will increase.
4. No effect Payments on account reduce cash and accounts payable by
equal amounts; thus, the net amount of working capital is
not affected.
5. Decrease When a customer pays a bill, the accounts receivable
balance is reduced. This increases the accounts receivable
turnover, which in turn decreases the average collection
period.
6. Decrease Declaring a cash dividend will increase current liabilities,
but have no effect on current assets. Therefore, the current
ratio will decrease.
7. Increase Payment of a previously declared cash dividend will
reduce both current assets and current liabilities by the
same amount. An equal reduction in both current assets
and current liabilities will always result in an increase in
the current ratio, so long as the current assets exceed the
current liabilities.
8. No effect Book value per share is not affected by the current market
price of the companys stock.

9. Decrease The dividend yield ratio is obtained by dividing the

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Chapter 8 Cost Concepts and Classifications

dividend per share by the market price per share. If the


dividend per share remains unchanged and the market
price goes up, then the yield will decrease.
10. Increase Selling property for a profit would increase net income
and therefore the return on total assets would increase.
11. Increase A write-off of inventory will reduce the inventory
balance, thereby increasing the turnover in relation to a
given level of cost of goods sold.
12. Increase Since the companys assets earn at a rate that is higher
than the rate paid on the bonds, leverage is positive,
increasing the return to the ordinary shareholders.
13. No effect Changes in the market price of a stock have no direct
effect on the dividends paid or on the earnings per share
and therefore have no effect on this ratio.
14. Decrease A decrease in net income would mean less income
available to cover interest payments. Therefore, the
times-interest-earned ratio would decrease.
15. No effect Write-off of an uncollectible account against the
Allowance for Bad Debts will have no effect on total
current assets. For this reason, the current ratio will
remain unchanged.
16. Decrease A purchase of inventory on account will increase current
liabilities, but will not increase the quick assets (cash,
accounts receivable, marketable securities). Therefore,
the ratio of quick assets to current liabilities will
decrease.
17. Increase The price-earnings ratio is obtained by dividing the
market price per share by the earnings per share. If the
earnings per share remains unchanged, and the market
price goes up, then the price-earnings ratio will increase.
18. Decrease Payments to creditors will reduce the total liabilities of a
company, thereby decreasing the ratio of total debt to
total equity.

Problem 14 (Interpretation of Financial Ratios)

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Cost Concepts and Classifications Chapter 8

a. The market price is going down. The dividends paid per share over the
three-year period are unchanged, but the dividend yield is going up.
Therefore, the market price per share of stock must be decreasing.

b. The earnings per share is increasing. Again, the dividends paid per share
have remained constant. However, the dividend payout ratio is
decreasing. In order for the dividend payout ratio to be decreasing, the
earnings per share must be increasing.

c. The price-earnings ratio is going down. If the market price of the stock is
going down [see part (a) above], and the earnings per share are going up
[see part (b) above], then the price-earnings ratio must be decreasing.

d. In Year 1, leverage was negative because in that year the return on total
assets exceeded the return on ordinary equity. In Year 2 and in Year 3,
leverage was positive because in those years the return on ordinary
equity exceeded the return on total assets employed.

e. It is becoming more difficult for the company to pay its bills as they
come due. Although the current ratio has improved over the three years,
the acid-test ratio is down. Also note that the accounts receivable and
inventory are both turning more slowly, indicating that an increasing
portion of the current assets is being made up of those items, from which
bills cannot be paid.

f. Customers are paying their bills more slowly in Year 3 than in Year 1.
This is evidenced by the decline in accounts receivable turnover.

g. Accounts receivable is increasing. This is evidenced both by a slowdown


in turnover and in an increase in total sales.

h. The level of inventory undoubtedly is increasing. Notice that the


inventory turnover is decreasing. Even if sales (and cost of goods sold)
just remained constant, this would be evidence of a larger average
inventory on hand. However, sales are not constant but rather are
increasing. With sales increasing (and undoubtedly cost of goods sold
also increasing), the average level of inventory must be increasing as
well in order to service the larger volume of sales.

IV. Cases

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Chapter 8 Cost Concepts and Classifications

Case 1 (Common-Size Statements and Financial Ratios for Creditors)

Requirement 1

This Year Last Year


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

b. Current assets (a) .....................................................................................................


P2,060,000 P1,470,000
Current liabilities (b) ...............................................................................................
P1,100,000 P600,000
Current ratio (a) (b) ..............................................................................................
1.87 to 1 2.45 to 1

c. Quick assets (a)........................................................................................................


P740,000 P650,000
Current liabilities (b) ...............................................................................................
P1,100,000 P600,000
Acid-test ratio (a) (b) ............................................................................................
0.67 to 1 1.08 to 1

d. Sales on account (a) .................................................................................................


P7,000,000 P6,000,000
Average receivables (b) ...........................................................................................
P525,000 P375,000
Turnover of receivables (a) (b).............................................................................
13.3 times 16.0 times

Average age of receivables:


365 turnover .........................................................................................................
27.4 days 22.8 days

e. Cost of goods sold (a) ..............................................................................................


P5,400,000 P4,800,000
Average inventory (b) ..............................................................................................
P1,050,000 P760,000
Inventory turnover (a) (b) .....................................................................................
5.1 times 6.3 times

Turnover in days: 365 turnover ............................................................................


71.6 days 57.9 days
f. Total liabilities (a) ...................................................................................................
P1,850,000 P1,350,000
Equity (b) .................................................................................................................
P2,150,000 P1,950,000
Debt-to-equity ratio (a) (b) ...................................................................................
0.86 to 1 0.69 to 1

g. Net income before interest and taxes (a) .................................................................


P630,000 P490,000
Interest expense (b)..................................................................................................
P90,000 P90,000
Times interest earned (a) (b) ................................................................................
7.0 times 5.4 times
Requirement 2

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Cost Concepts and Classifications Chapter 8

a. METRO BUILDING SUPPLY


Common-Size Balance Sheets

This Year Last Year


Current assets:
Cash ......................................................................................................................
2.3 % 6.1 %
Marketable securities ...........................................................................................
0.0 1.5
Accounts receivable, net ......................................................................................
16.3 12.1
Inventory ..............................................................................................................
32.5 24.2
Prepaid expenses ..................................................................................................
0.5 0.6
Total current assets ...................................................................................................
51.5 44.5
Plant and equipment, net ..........................................................................................
48.5 55.5
Total assets ...............................................................................................................
100.0 % 100.0 %

Liabilities:
Current liabilities .................................................................................................
27.5 % 18.2 %
Bonds payable, 12% .............................................................................................
18.8 22.7
Total liabilities .........................................................................................................
46.3 40.9
Equity:
Preference shares, P50 par, 8% ............................................................................
5.0 6.1
Ordinary shares, P10 par ......................................................................................
12.5 15.2
Retained earnings .................................................................................................
36.3 37.9
Total equity ..............................................................................................................
53.8 59.1
Total liabilities and equity........................................................................................
100.0 % 100.0 %

Note: Columns do not total down in all cases due to rounding.

b. METRO BUILDING SUPPLY


Common-Size Income Statements

This Year Last Year


Sales .........................................................................................................................
100.0 % 100.0 %
Less cost of goods sold ............................................................................................
77.1 80.0
Gross margin ............................................................................................................
22.9 20.0
Less operating expenses ...........................................................................................
13.9 11.8
Net operating income ...............................................................................................
9.0 8.2
Less interest expense ................................................................................................
1.3 1.5
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Chapter 8 Cost Concepts and Classifications

Net income before taxes ...........................................................................................


7.7 6.7
Less income taxes.....................................................................................................
3.1 2.7
Net income ...............................................................................................................
4.6 % 4.0 %

Requirement 3

The following points can be made from the analytical work in parts (1) and
(2) above:

The company has improved its profit margin from last year. This is
attributable to an increase in gross margin, which is offset somewhat by an
increase in operating expenses. In both years the companys net income as a
percentage of sales equals or exceeds the industry average of 4%.

Although the companys working capital has increased, its current position
actually has deteriorated significantly since last year. Both the current ratio
and the acid-test ratio are well below the industry average, and both are
trending downward. (This shows the importance of not just looking at the
working capital in assessing the financial strength of a company.) Given the
present trend, it soon will be impossible for the company to pay its bills as
they come due.

The drain on the cash account seems to be a result mostly of a large buildup
in accounts receivable and inventory. This is evident both from the
common-size balance sheet and from the financial ratios. Notice that the
average age of the receivables has increased by 5 days since last year, and
that it is now 9 days over the industry average. Many of the companys
customers are not taking their discounts, since the average collection period
is 27 days and collection terms are 2/10, n/30. This suggests financial
weakness on the part of these customers, or sales to customers who are poor
credit risks. Perhaps the company has been too aggressive in expanding its
sales.

The inventory turned only 5 times this year as compared to over 6 times last
year. It takes three weeks longer for the company to turn its inventory than
the average for the industry (71 days as compared to 50 days for the
industry). This suggests that inventory stocks are higher than they need to be.

In the authors opinion, the loan should be approved on the condition that the

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Cost Concepts and Classifications Chapter 8

company take immediate steps to get its accounts receivable and inventory
back under control. This would mean more rigorous checks of
creditworthiness before sales are made and perhaps paring out of slow
paying customers. It would also mean a sharp reduction of inventory levels
to a more manageable size. If these steps are taken, it appears that sufficient
funds could be generated to repay the loan in a reasonable period of time.

Case 2 (Financial Ratios for Ordinary Shareholders)

Requirement 1

a. This Year Last Year


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

b. Ordinary dividend per share (a)* .............................................................................


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

c. Ordinary dividend per share (a) ...............................................................................


P2.16 P1.20
Earnings per share (b) ..............................................................................................
P6.16 P4.48
Dividend payout ratio (a) (b) ................................................................................
35.1% 26.8%

d. Market price per share (a) ........................................................................................


P45.00 P36.00
Earnings per share (b) ..............................................................................................
P6.16 P4.48
Price-earnings ratio (a) (b) ....................................................................................
7.3 8.0

Investors regard Metro Building Supply less favorably than other firms
in the industry. This is evidenced by the fact that they are willing to pay
only 7.3 times current earnings for a share of the companys stock, as
compared to 9 times current earnings for the average of all stocks in the
industry. If investors were willing to pay 9 times current earnings for
Metro Building Supplys stock, then it would be selling for about P55
per share (9 P6.16), rather than for only P45 per share.
e. This Year Last Year

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Chapter 8 Cost Concepts and Classifications

Equity .......................................................................................................................
P2,150,000 P1,950,000
Less preference shares .............................................................................................
200,000 200,000
Ordinary equity (a)...................................................................................................
P1,950,000 P1,750,000

Number of ordinary shares (b) .................................................................................


50,000 50,000
Book value per share (a) (b) .................................................................................
P39.00 P35.00

A market price in excess of book value does not mean that the price of a
stock is too high. Market value is an indication of investors perceptions
of future earnings and/or dividends, whereas book value is a result of
already completed transactions and is geared to the past.

Requirement 2

a. This Year Last Year


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

Average total assets (b) ............................................................................................


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

b. This Year Last Year


Net income ...............................................................................................................
P 324,000 P 240,000
Less preference dividends ........................................................................................
16,000 16,000
Net income remaining for ordinary
shareholders (a) ....................................................................................................
P 308,000 P 224,000

Average total equity* ...............................................................................................


P2,050,000 P1,868,000
Less average preference shares ................................................................................
200,000 200,000
Average ordinary equity (b) .....................................................................................
P1,850,000 P1,668,000
*1/2(P2,150,000 + P1,950,000); 1/2(P1,950,000 + P1,786,000).

Return on ordinary equity (a) (b) ..........................................................................


16.6% 13.4%

c. Financial leverage is positive in both years, since the return on ordinary


equity is greater than the return on total assets. This positive financial

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Cost Concepts and Classifications Chapter 8

leverage is due to three factors: the preference shares, which has a


dividend of only 8%; the bonds, which have an after-tax interest cost of
only 7.2% [12% interest rate (1 0.40) = 7.2%]; and the accounts
payable, which may bear no interest cost.

Requirement 3

We would recommend keeping the stock. The stocks downside risk seems
small, since it is selling for only 7.3 times current earnings as compared to 9
times earnings for the average firm in the industry. In addition, its earnings
are strong and trending upward, and its return on ordinary equity (16.6%) is
extremely good. Its return on total assets (10.4%) compares favorably with
that of the industry.

The risk, of course, is whether the company can get its cash problem under
control. Conceivably, the cash problem could worsen, leading to an eventual
reduction in profits through inability to operate, a reduction in dividends,
and a precipitous drop in the market price of the companys stock. This does
not seem likely, however, since the company can easily control its cash
problem through more careful management of accounts receivable and
inventory. If this problem is brought under control, the price of the stock
could rise sharply over the next few years, making it an excellent investment.

Case 3 (Comprehensive Ratio Analysis)

Requirement 1
This Year Last Year
a. Net income ...............................................................................................................
P 280,000 P 168,000
Add after-tax cost of interest:
P120,000 (1 0.30)...........................................................................................
84,000
P100,000 (1 0.30)...........................................................................................
70,000
Total (a) ....................................................................................................................
P 364,000 P 238,000

Average total assets (b) ............................................................................................


P5,330,000 P4,640,000
Return on total assets (a) (b) .................................................................................
6.8% 5.1%

b. Net income ...............................................................................................................


P 280,000 P 168,000
Less preference dividends ........................................................................................
48,000 48,000

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Chapter 8 Cost Concepts and Classifications

Net income remaining for ordinary (a) ....................................................................


P 232,000 P 120,000

Average total equity .................................................................................................


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

Return on ordinary equity (a) (b) ..........................................................................


9.2% 4.9%

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

Requirement 2

This Year Last Year


a. Net income remaining for ordinary (a) ....................................................................
P 232,000 P 120,000
Average number of ordinary shares (b) ....................................................................
50,000 50,000
Earnings per share (a) (b)......................................................................................
P4.64 P2.40

b. Ordinary dividend per share (a) ...............................................................................


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

c. Ordinary dividend per share (a) ...............................................................................


P1.44 P0.72
Earnings per share (b) ..............................................................................................
P4.64 P2.40
Dividend payout ratio (a) (b) ................................................................................
31.0% 30.0%

d. Market price per share (a) .............................................................................................


P36.00 P20.00
Earnings per share (b) ...................................................................................................
P4.64 P2.40
Price-earnings ratio (a) (b).........................................................................................
7.8 8.3

Notice from the data given in the problem that the average P/E ratio for
companies in Helixs industry is 10. Since Helix Company presently has
a P/E ratio of only 7.8, investors appear to regard it less well than they
do other companies in the industry. That is, investors are willing to pay
only 7.8 times current earnings for a share of Helix Companys stock, as
compared to 10 times current earnings for a share of stock for the
average company in the industry.

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Cost Concepts and Classifications Chapter 8

e. Equity .......................................................................................................................
P3,200,000 P3,040,000
Less preference shares .............................................................................................
600,000 600,000
Ordinary equity (a) ...................................................................................................
P2,600,000 P2,440,000

Number of ordinary shares (b) .................................................................................


50,000 50,000
Book value per share (a) (b) .................................................................................
P52.00 P48.80

Note that the book value of Helix Companys stock is greater than the
market value for both years. This does not necessarily indicate that the
stock is selling at a bargain price. Market value is an indication of
investors perceptions of future earnings and/or dividends, whereas book
value is a result of already completed transactions and is geared to the
past.

f. Gross margin (a) .......................................................................................................


P1,050,000 P860,000
Sales (b) ...................................................................................................................
P5,250,000 P4,160,000
Gross margin percentage (a) (b) ...........................................................................
20.0% 20.7%

Requirement 3
This Year Last Year
a. Current assets ...........................................................................................................
P2,600,000 P1,980,000
Current liabilities .....................................................................................................
1,300,000 920,000
Working capital ........................................................................................................
P1,300,000 P1,060,000

b. Current assets (a) .....................................................................................................


P2,600,000 P1,980,000
Current liabilities (b) ................................................................................................
P1,300,000 P920,000
Current ratio (a) (b)...............................................................................................
2.0 to 1 2.15 to 1

c. Quick assets (a) ........................................................................................................


P1,220,000 P1,120,000
Current liabilities (b) ................................................................................................
P1,300,000 P920,000
Acid-test ratio (a) (b) ............................................................................................
0.94 to 1 1.22 to 1

d. Sales on account (a) .................................................................................................


P5,250,000 P4,160,000
Average receivables (b) ............................................................................................
P750,000 P560,000
Accounts receivable turnover (a) (b) ....................................................................
7.0 times 7.4 times
Average age of receivables,
365 turnover ......................................................................................................
52 days 49 days
e. Cost of goods sold (a) ..............................................................................................
P4,200,000 P3,300,000
Average inventory (b) ..............................................................................................
P1,050,000 P720,000

8-71
Chapter 8 Cost Concepts and Classifications

Inventory turnover (a) (b) .....................................................................................


4.0 times 4.6 times
Number of days to turn inventory,
365 days turnover (rounded) .............................................................................
91 days 79 days

f. Total liabilities (a) ....................................................................................................


P2,500,000 P1,920,000
Equity (b) .................................................................................................................
P3,200,000 P3,040,000
Debt-to-equity ratio (a) (b) ...................................................................................
0.78 to 1 0.63 to 1

g. Net income before interest and taxes (a) .................................................................


P520,000 P340,000
Interest expense (b) ..................................................................................................
P120,000 P100,000
Times interest earned (a) (b) .................................................................................
4.3 times 3.4 times

Requirement 4

As stated by Meri Ramos, both net income and sales are up from last year.
The return on total assets has improved from 5.1% last year to 6.8% this
year, and the return on ordinary equity is up to 9.2% from 4.9% the year
before. But this appears to be the only bright spot in the companys operating
picture. Virtually all other ratios are below the industry average, and, more
important, they are trending downward. The deterioration in the gross
margin percentage, while not large, is worrisome. Sales and inventories have
increased substantially, which should ordinarily result in an improvement in
the gross margin percentage as fixed costs are spread over more units.
However, the gross margin percentage has declined.

Notice particularly that the average age of receivables has lengthened to 52


daysabout three weeks over the industry averageand that the inventory
turnover is 50% longer than the industry average. One wonders if the
increase in sales was obtained at least in part by extending credit to high-risk
customers. Also notice that the debt-to-equity ratio is rising rapidly. If the
P1,000,000 loan is granted, the ratio will rise further to 1.09 to 1.

In the authors opinion, what the company needs is more equitynot more
debt. Therefore, the loan should not be approved. The company should be
encouraged to make another issue of ordinary stock in order to provide a
broader equity base on which to operate.

Case 4 (Statement Reconstruction Using Ratios)

Bulacan Company

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Cost Concepts and Classifications Chapter 8

Income Statement
For the Year Ended December 31, 2005

Sales P140,800
Less: Cost of Sales (4) 84,480
Gross Profit P 56,320
Less: Expenses 46,320
Net Income (1) P 10,000

Bulacan Company
Balance Sheet
December 31, 2005

Assets

Current Assets:
Cash P 27,720
Accounts Receivable (5) 28,160
Merchandise Inventory (3) 21,120
Total Current Assets (2) P 77,000
Fixed Assets (8) 55,000
Total Assets P132,000

Liabilities and Equity

Current Liabilities:
Accounts Payable (2) P 44,000
Equity:
Share Capital (issued 20,000 shares) (6) P40,000
Retained Earnings 48,000 88,000
Total Liabilities and Equity P132,000

Supporting Computations:
Net Income
(1) Earnings Per Share =
Ordinary Shares Outstanding
X
P0.50 =
20,000

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Chapter 8 Cost Concepts and Classifications

X (Net Income) = P10,000

(2) Current Assets Pxx 1.75


Current Liabilities xx 1
Working Capital P33,000 0.75

Current Liabilities = P33,000 0.75

= P44,000

Current Assets
(3) Current Ratio =
Current Liabilities
X
1.27 =
44,000
X (Current Assets) = P77,000

Quick Assets
Quick Ratio =
Current Liabilities

X
1.27 =
44,000
X (Current Assets) = P55,880

Current Assets P77,000


Quick Assets 55,800
Inventory P21,120

Cost of Sales
(4) Inventory turnover = Ave. Inventory
X
4 =
P21,120
X (Cost of Sales) = P84,480

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Cost Concepts and Classifications Chapter 8

Quick Assets
(5) Average age of outstanding =
Current Liabilities
Accounts Receivable
365
= 73 days (Average age of
5
receivables)
Net Sales
Average Receivables = 5

P140,800
X = 5

X (Receivables) = P28,160

Another Method:
P140,800
365 = 73 days = P28,160 Accounts receivable

(6) Earnings for the year as a percentage of Share Capital


P10,000
= 25%
Share Capital
Share Capital = P40,000

(7) Current Fixed Current Liabilities +


Assets + Assets = Equity

P77,000 + 0.625X = P44,000 + X

0.375X = P33,000

X = P88,000 Equity
(8) Fixed Assets to Equity
Fixed Assets
= 0.625
Equity
X
= 0.625
P140,800

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Chapter 8 Cost Concepts and Classifications

X (Fixed Assets) = P55,000

Case 5 (Ethics and the Manager)

Requirement 1

The loan officer stipulated that the current ratio prior to obtaining the loan
must be higher than 2.0, the acid-test ratio must be higher than 1.0, and the
interest on the loan must be no more than four times net operating income.
These ratios are computed below:
Current assets
Current ratio =
Current liabilities
P290,000
Current rate = = 1.8 (rounded)
P164,000
Cash + Marketable securities + Accounts receivable
Acid-test ratio =
Current liabilities
P70,000 + P0 + P50,000
Acid-test ratio = = 0.70 (rounded)
P164,000
Net operating income P20,000
= = 5.0
Interest on the loan P80,000 x 0.10 x (6/12)

The company would fail to qualify for the loan because both its current ratio
and its acid-test ratio are too low.

Requirement 2

By reclassifying the P45 thousand net book value of the old machine as
inventory, the current ratio would improve, but there would be no effect on
the acid-test ratio. This happens because inventory is considered to be a
current asset but is not included in the numerator when computing the acid-
test ratio.
Current assets
Current ratio =
Current liabilities
P290,000 + P45,000
Current rate = = 2.0 (rounded)
P164,000

Cash + Marketable securities + Current receivables


Acid-test ratio =
Current liabilities
P70,000 + 8-76
P0 + P50,000
Acid-test ratio = = 0.70 (rounded)
P164,000
Cost Concepts and Classifications Chapter 8

Even if this tactic had succeeded in qualifying the company for the loan, we
strongly advise against it. Inventories are assets the company has acquired
for the sole purpose of selling them to outsiders in the normal course of
business. Used production equipment is not considered to be inventory
even if there is a clear intention to sell it in the near future. Since the loan
officer would not expect used equipment to be included in inventories, doing
so would be intentionally misleading.

Nevertheless, the old equipment is an asset that could be turned into cash. If
this were done, the company would immediately qualify for the loan since
the P45 thousand in cash would be included in the numerator in both the
current ratio and in the acid-test ratio.

Current assets
Current ratio =
Current liabilities
P290,000 + P45,000
Current rate = = 2.0 (rounded)
P164,000

Cash + Marketable securities + Current receivables


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

Case 6 (Financial Ratios for Ordinary Shareholders)


[pesos in thousands]
Requirement (1)

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Chapter 8 Cost Concepts and Classifications

Calculation of the gross margin percentage:


Gross margin
Gross margin percentage =
Sales
P23,000
= = 34.8%
P66,000
Requirement (2)

Calculation of the earnings per share:


Net income Preference dividends
Earnings per share =
Average number of ordinary shares outstanding
P1,980 P60
= = P3.20 per share
600 shares
Requirement (3)

Calculation of the price-earnings ratio:


Market price per share
Price-earnings ratio =
Earnings per share
P26
= = 8.1
P3.20
Requirement (4)

Calculation of the dividend payout ratio:


Dividends per share
Dividend payout ratio =
Earnings per share
P0.75
= = 23.4%
P3.20

Requirement (5)

Calculation of the dividend yield ratio:


Dividends per share
Dividend yield ratio =
Market price per share
P0.75
= = 2.9%
P26.00
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Cost Concepts and Classifications Chapter 8

Requirement (6)

Calculation of the return on total assets:

Net income + [Interest expense x (1 Tax rate)]


Return on total assets =
Average total assets
P1,980 + [P800 x (1 0.40)]
= = 3.7%
(P65,810 + P68,480) / 2
Requirement (7)

Calculation of the return on ordinary shareholders equity:

Beginning balance, shareholders equity (a) P39,610


Ending balance, shareholders equity (b) 41,080
Average shareholders equity [(a) + (b)]/2 40,345
Average preference shares 1,000
Average ordinary shareholders equity P39,345
Return on ordinary Net income Preference dividends
=
shareholders equity Average ordinary shareholders equity
P1,980 P60
= = 4.9%
P39,345
Requirement (8)

Calculation of the book value per share:


Book value Total shareholders equity Preference shares
=
per share Number of ordinary shares outstanding
P41,080 P1,000
= = P66.80 per share
Case 7 (Financial Ratios for Short-Term
600 shares Creditors)

Requirement (1)

Calculation of working capital:

Working capital = Current assets Current liabilities


= P22,680 P19,400 = P3,280
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Chapter 8 Cost Concepts and Classifications

Requirement (2)

Calculation of the current ratio:


Current assets
Current ratio =
Current liabilities
P22,680
= = 1.17
P19,400

Requirement (3)

Calculation of the acid-test ratio:


Cash + Marketable securities
+ Accounts receivable + Short-term notes
Acid-test ratio =
Current liabilities
P1,080 + P0 + P9,000 + P0
Acid-test ratio = = 0.52
P19,400

Requirement (4)

Calculation of accounts receivable turnover:

Accounts receivable Sales on account


= Average accounts receivable balance
turnover
P66,000
Acid-test ratio = = 8.5
(P6,500 + P9,000) / 2

Requirement (5)

Calculation of the average collection period:

Average collection 365 days


= Accounts receivable turnover
period
365 days
Acid-test ratio = = 42.9 days
8.5
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Cost Concepts and Classifications Chapter 8

Requirement (6)

Calculation of inventory turnover:

Inventory Cost of goods sold


= Average inventory balance
turnover
P43,000
Acid-test ratio = = 3.8
(P10,600 + P12,000) / 2
Requirement (7)

Calculation of the average sale period:

Average sale 365 days


= Inventory turnover
period
365 days
Acid-test ratio = = 96.1 days
3.8
Case 8 (Financial Ratios for Long-Term Creditors)

Requirement (1)

Calculation of the times interest earned ratio:

Times interest Earnings before interest expense


= and income taxes
earned ratio
Inventory expense
P4,100
Acid-test ratio = = 5.1
P800

Requirement (2)

Calculation of the debt-to-equity ratio:

Debt-to-equity Total liabilities


= Shareholders equity
ratio
P27,400
Acid-test ratio = = 0.67
P41,080

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Chapter 8 Cost Concepts and Classifications

V. Multiple Choice Questions

41. A 39. C 34. B 41. C 41. C


42. C 40. A 35. D 42. D
43. D 41. C 36. A 43. C
44. B 42. B 37. C 44. A
45. A 43. D 38. A 45. A
46. D 44. B 39. C 46. C
47. C 45. A 40. D 47. A
48. D 46. C 41. A 48. A
49. A 47. A 42. D 49. C
50. B 48. C 43. A 50. C

CHAPTER 6

CASH FLOW ANALYSIS

I. Questions

1. Purposes of the Statement of Cash Flows


a. To predict future cash flows
b. To evaluate management decisions
c. To determine the ability to pay dividends to shareholders and
interest and principal to creditors
d. To show the relationship of net income to changes in the
businesss cash.

2. Comparative balance sheets present the financial position of the


enterprise at two points in time. The income statement for the period
between the two balance sheets describes how the income-producing
activities affected the financial position. Because cash flows from
operating activities may differ substantially from net income, and
because numerous other financing and investing activities have an
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Cost Concepts and Classifications Chapter 8

impact on financial position, the statement of cash flows is necessary.


The statement emphasizes changes in the cash balances that result from
changes in assets, liabilities and equity accounts caused by operating,
investing and financing activities.

3. The most important source of cash for many successful companies is


from operating activities. A large positive operating cash flow is a good
sign because it means funds have been internally generated with no fixed
obligations or commitment to return such to anybody.

4. It is possible for cash to decrease during a year when income is high


because cash may be used not only for operating activities but also for
investing and financing activities.

5. Transactions involving accounts payable are not considered to be


financing activities because such transactions are used to obtain goods
and services rather than to obtain cash. Furthermore, purchases of goods
and services relate to a companys day-to-day operating activities.

6. The loss is added back to net income to avoid double counting since the
entire proceeds from the sale (net book value minus loss on sale) will
appear as a cash inflow from investing activities.

7. Three categories of transactions that may result in increases in cash are


a. Operating activities
b. Investing activities (e.g., sale of investments or other assets).
c. Financing activities (e.g., borrowing or sale of shares).

These activities are sources of cash when cash is increased as a result of


the particular activity.

8. Three categories of transactions that may result in decreases in cash are


a. Operating activities
b. Investing activities (e.g., purchase of investments or other assets).
c. Financing activities (e.g., repayment of debt or retirement of shares).

These activities are uses of cash when cash is decreased as a result of the
particular activity.

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Chapter 8 Cost Concepts and Classifications

9. Noncash transactions do not provide or consume cash even though they


may result in significant changes in financial position. Examples are the
issuance of share capital for plant assets and the conversion of debt or
preference shares into ordinary shares. Such transactions are not
presented in the body of the statement of cash flows but rather disclosed
in a separate schedule as financing or investing activities.

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

Net loss P(100,000)


Add: Expenses not requiring cash depreciation
and amortization 125,000
Net cash provided by operating activities P 25,000

11. The change in cash is the difference between cash at the beginning and
end of the accounting period. The net amount of cash provided by or
used in operating, investing and financing activities must equal this
change in cash. For example, if cash increased by P150,000 during the
year, total sources from operating, investing, and financing activities
must exceed total uses by P150,000. Also, if cash decreased by P25,000
during the year, total uses of cash must exceed total sources by P25,000.

12. (a) The use of cash does not occur until the cash dividend is actually
paid in the next period. The declaration of the dividend does affect
financial position, however, and should be disclosed as a noncash
financing activity in a separate schedule accompanying the statement
of cash flows.
(b) Because the dividend was declared and paid in the same accounting
period, it appears in the statement of cash flows as a cash decrease in
the financing activities category.

13. Disagree. The refunding of 10% debt by the 8% debt represents a


significant financing activity, even though the net impact of the
exchange on the balance sheet or on the amount of cash is not material.

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Cost Concepts and Classifications Chapter 8

The issuance of 8% bonds and the retirement of 10% bonds should be


reported as noncash financing transactions in a schedule accompanying
the statement of cash flows.

14. The net income figure includes P150,000 as an expense. Only P112,500
of this amount resulted in a decrease in cash, because P37,500 represents
an increase in the deferred income tax liability account. In determining
cash provided by operating activities, the amount of income tax paid is
P112,500 (direct method). Alternatively, under the indirect method,
P37,500 must be added to net income to determine cash flows from
operating activities.

15. The loss is omitted when listing expenses requiring cash payment (direct
approach) or added back to net income (indirect approach) in
determining cash provided by operating activities. This eliminates the
impact of the transaction from cash provided by operating activities.
Then, the proceeds from the sale are included as a source of cash in the
investing activities category of the statement of cash flows. Any tax
effects of the transaction are included in the tax expense figure and
remain a part of cash flows from operating activities.

16. (1) Operating activities: Transactions that affect current assets, current
liabilities, or net income.
(2) Investing activities: Transactions that involve the acquisition or
disposition of noncurrent assets.
(3) Financing activities: Transactions (other than the payment of
interest) involving borrowing from creditors, and any transactions
(involving the owners of a company.

17. Interest is included as an operating activity since it is part of net income.


Financing activities are narrowly defined to include only the principal
amount borrowed or repaid.

18. Since the entire proceeds from a sale of an asset (including any gain)
appear as a cash inflow from investing activities, the gain must be
deducted from net income to avoid double counting.

19. The direct method reconstructs the income statement on a cash basis by
restating revenues and expenses in terms of cash inflows and outflows.

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Chapter 8 Cost Concepts and Classifications

The indirect method starts with net income and adjusts it to a cash basis
to determine the cash provided by operating activities.

20. An increase in the Accounts Receivable account must be deducted from


net income under the indirect method because this is an increase in a
noncash asset.

21. A decrease in the Accounts Payable account must be added to cost of


goods sold under the direct method. The cost of goods sold is increased
by the amount of the decrease in accounts payable. Because the cost of
goods sold is increased, the net cash flow provided by operating
activities is decreased. The effect of a decrease in a liability is a decrease
in cash.

22. A sale of equipment for cash would be classified as an investing activity.


Any transaction involving the acquisition or disposition of noncurrent
assets is classified as an investing activity.

II. Exercises

Exercise 1

Net income .....................................................................................................................


P84,000
Adjustments to convert net income to a cash basis:
Depreciation charges for the year ..............................................................................
P50,000
Increase in accounts receivable .................................................................................
(60,000)
Increase in inventory..................................................................................................
(77,000)
Decrease in prepaid expenses ....................................................................................
2,000
Increase in accounts payable .....................................................................................
30,000
Decrease in accrued liabilities ...................................................................................
(4,000)
Increase in deferred income taxes ..............................................................................
6,000 (53,000)
Net cash provided by operating activities ......................................................................P31,000

Exercise 2

Sales..................................................................................................
P1,000,000
Adjustments to a cash basis:
60,000
Less increase in accounts receivable ........................................ P940,000
Cost of goods sold ............................................................................
580,000
Adjustments to a cash basis:

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Cost Concepts and Classifications Chapter 8

Plus increase in inventory .........................................................


+ 77,000
30,000
Less increase in accounts payable ............................................ 627,000
Selling and administrative expenses.................................................
300,000
Adjustments to a cash basis:

Less decrease in prepaid expenses ...........................................
2,000
Plus decrease in accrued liabilities ...........................................
+ 4,000
50,000
Less depreciation charges ......................................................... 252,000
Income taxes .....................................................................................
36,000
Adjustments to a cash basis:

Less increase in deferred income taxes .................................... 6,000 30,000
Net cash provided by operating activities ........................................ P 31,000

Note that the P31,000 agrees with the cash provided by operating activities
figure under the indirect method in the previous exercise.

Exercise 3

Item Amount Add Deduct


Accounts Receivable ........................................
P70,000 decrease X
Accrued Interest Receivable ............................ P6,000 increase X
Inventory ..........................................................
P110,000 increase X
Prepaid Expenses .............................................
P3,000 decrease X
Accounts Payable .............................................
P40,000 decrease X
Accrued Liabilities ...........................................
P9,000 increase X
Deferred Income Taxes Liability ..................... P15,000 increase X
Sale of equipment ............................................
P8,000 gain X
Sale of long-term investments.......................... P12,000 loss X

Exercise 4

Requirement (1)

Net income .................................................................................................. P75


Adjustments to convert net income to a cash basis:
Depreciation charges ...............................................................................
P40
Decrease in accounts receivable ............................................................. 10
Increase in inventory ...............................................................................
(30)

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Chapter 8 Cost Concepts and Classifications

Decrease in prepaid expenses .................................................................5


Increase in accounts payable...................................................................
20
Decrease in accrued liabilities ................................................................
(10)
Increase in taxes payable ........................................................................
10
Increase in deferred taxes .......................................................................
5
Loss on sale of long-term investments.................................................... 5
Gain on sale of land ................................................................................
(40) 15
Net cash provided by operating activities ................................................... P90

Requirement (2)

Swan Company
Statement of Cash Flows

Operating activities:
Net cash provided by operating activities (see above) .........................................
P 90

Investing activities:
Proceeds from sale of long-term investments ......................................................
P 45
Proceeds from sale of land ...................................................................................
70
Additions to long-term investments .....................................................................
(20)
Additions to plant & equipment ...........................................................................
(150)
Net cash used for investing activities ...................................................................
(55)

Financing activities:
Decrease in bonds payable ...................................................................................
(20)
Increase in ordinary shares ...................................................................................
40
Cash dividends .....................................................................................................
(35)
Net cash used by financing activities ................................................................... (15)

Net increase in cash (net cash flow) ....................................................................20


Cash balance, beginning.......................................................................................
100
Cash balance, ending............................................................................................
P120

While not a requirement, a worksheet may be helpful.

Change Source Cash Adjust- Adjusted Classification

8-88
Cost Concepts and Classifications Chapter 8

or Flow ments Effect


Use? Effect
Assets (except cash and cash equivalents)
Current assets:
Accounts receivable ................................................. 10 Source +10 +10 Operating
Inventory ................................................................... +30 Use 30 30 Operating
Prepaid expenses..................................................... 5 Source +5 +5 Operating
Noncurrent assets:
Long-term investments ............................................. 30 Source +30 50 20 Investing

Plant and equipment ................................................ +150 Use 150 150 Investing
Land ......................................................................... 30 Source +30 30 0 Investing

Liabilities, Contra assets, and Shareholders Equity


Contra assets:
Accumulated depreciation ........................................ +40 Source +40 +40 Operating
Current liabilities:
Accounts payable ..................................................... +20 Source +20 +20 Operating
Accrued liabilities ..................................................... 10 Use 10 10 Operating
Taxes payable .......................................................... +10 Source +10 +10 Operating
Noncurrent liabilities:
Bonds payable.......................................................... 20 Use 20 20 Financing
Deferred income taxes ............................................. +5 Source +5 +5 Operating
Shareholders equity:
Ordinary shares ........................................................ +40 Source +40 +40 Financing
Retained earnings:
Net income .......................................................... +75 Source +75 +75 Operating
Dividends ............................................................ 35 Use 35 35 Financing

Additional entries
Proceeds from sale of investments ............................... +45 +45 Investing
Loss on sale of investments .......................................... +5 +5 Operating
Proceeds from sale of land ............................................ +70 +70 Investing
Gain on sale of land....................................................... 40 40 Operating
Total +20 0 +20

Exercise 5

Sales............................................................................................
P600
Adjustments to a cash basis:
Decrease in accounts receivable .........................................+10 P610
Cost of goods sold ......................................................................250
Adjustments to a cash basis:
Increase in inventory...........................................................+30
Increase in accounts payable ..............................................20 260

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Chapter 8 Cost Concepts and Classifications

Selling and administrative expenses...........................................280


Adjustments to a cash basis:
Decrease in prepaid expenses ............................................. 5
Decrease in accrued liabilities ............................................+10
Depreciation charges ..........................................................40 245
Income taxes ............................................................................... 30
Adjustments to a cash basis:
Increase in taxes payable ....................................................10
Increase in deferred taxes ................................................... 5 15
Net cash provided by operating activities .................................. P 90
Exercise 6

Requirements (1) and (2)

Stephenie Company
Statement of Cash Flows
For the Year Ended December 31, 2008

Operating activities:
Net income...............................................................................................
P 56
Adjustments to convert net income to cash basis:
Depreciation charges .......................................................................
25
Increase in accounts receivable .......................................................(80)
Decrease in inventory ......................................................................
35
Increase in prepaid expenses ........................................................... (2)
Increase in accounts payable ...........................................................75
Decrease in accrued liabilities .........................................................
(10)
Gain on sale of investments .............................................................(5)
Loss on sale of equipment ............................................................... 2
Increase in deferred income taxes ................................................... 8 48
Net cash provided by operating activities ............................................... 104

Investing activities:
Proceeds from sale of long-term investments..........................................
12
Proceeds from sale of equipment ............................................................
18
Additions to plant and equipment ...........................................................
(110)
Net cash used for investing activities ...................................................... (80)

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Cost Concepts and Classifications Chapter 8

Financing activities:
Increase in bonds payable ........................................................................
25
Decrease in ordinary shares .....................................................................
(40)
Cash dividends.........................................................................................
(16)
Net cash used for financing activities ..................................................... (31)

Net decrease in cash ................................................................................ (7)


Cash balance, January 1, 2008 ................................................................ 11
Cash balance, December 31, 2008 .......................................................... P 4

While not a requirement, a worksheet may be helpful.


Source Cash
or Flow Adjust- Adjusted Classi-
Change Use? Effect ments Effect fication
Assets (except cash and cash equivalents)
Current assets:
Accounts receivable ................................................. +80 Use 80 80 Operating
Inventory ................................................................... 35 Source +35 +35 Operating
Prepaid expenses..................................................... +2 Use 2 2 Operating
Noncurrent assets:
Plant and equipment ................................................ +80 Use 80 30 110 Investing
Long-term investments ............................................. 7 Source +7 7 0 Investing

Liabilities, Contra assets, and Shareholders Equity


Contra assets:
Accumulated depreciation ........................................ +15 Source +15 +10 +25 Operating
Current liabilities:
Accounts payable ..................................................... +75 Source +75 +75 Operating
Accrued liabilities ..................................................... 10 Use 10 10 Operating
Noncurrent liabilities:
Bonds payable.......................................................... +25 Source +25 +25 Financing
Deferred income taxes ............................................. +8 Source +8 +8 Operating
Shareholders equity:
Ordinary shares ........................................................ 40 Use 40 40 Financing
Retained earnings:
Net income .......................................................... +56 Source +56 +56 Operating
Dividends ............................................................ 16 Use 16 16 Financing

Additional entries
Proceeds from sale of equipment ................................... +18 +18 Investing
Loss on sale of equipment.............................................. +2 +2 Operating
Proceeds from sale of long-term investments ................ +12 +12 Investing
Gain on sale of long-term investments ........................... 5 5 Operating

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Chapter 8 Cost Concepts and Classifications

Total 7 0 7

II. Problems

Problem 1

Transaction Operating Investing Financing Source Use


1. Short-term investment
securities were
purchased .................... X X
2. Equipment was
purchased .................... X X
3. Accounts payable
increased ..................... X X
4. Deferred taxes
decreased..................... X X
5. Long-term bonds were
issued .......................... X X
6. Ordinary shares were
sold.............................. X X
7. Interest was paid to
long-term creditors ...... X X
8. A long-term mortgage
was entirely paid off .... X X
9. A cash dividend was
declared and paid ........ X X
10. Inventories decreased ... X X
11. Accounts receivable
increased ....................... X X
12. Depreciation charges
totaled P200,000 for the
year ............................... X X

Problem 2 (Analysis of Cash Flow Transactions)

Requirement (a)

The eight items should be presented in the statement of cash flows as


follows:
1. Net income is the basis for the calculation of cash flows from operating
activities by starting with that number and adjusting for noncash revenue
and expense transactions (indirect method) or by computing by the direct

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Cost Concepts and Classifications Chapter 8

method the positive cash flows from revenues, less the negative cash
flows from expenses. The cash flows from the transaction giving rise to
the extraordinary loss is reclassified as an investing activity.
2. The acquisition of intangibles is a negative cash flow from investing
activities. The amortization is a noncash expense in determining cash
flows from operating activities.
3. The payment of a cash dividend is a negative cash flow that is presented
in the financing activities section of the statement.
4. The purchase of treasury share is a negative cash flow in the financing
activities section of the statement.
5. The depreciation expense recognized during the year is a noncash
expense in determining cash flows from operating activities.
6. The conversion of convertible bonds into ordinary shares is a noncash
financing activity that requires disclosure in a separate schedule.
7. The changes in plant asset accounts land, equipment, and building
represent activities whose cash flow effects are presented in the
investing activities section of the statement.
8. The increase in working capital also represents the change in cash
because all other current assets and current liabilities remained constant.
The net of all cash flows from operating, investing and financing
activities must reconcile with the change in cash in the statement of cash
flows.

Requirement (b)

1. Net cash provided by operating activities


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

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Chapter 8 Cost Concepts and Classifications

P(159,000)
3. Net cash used in financing activities
Purchase of treasury shares P(31,000)
Payment of dividends (12,500)
P(43,500)
Computations:
Depreciation expense
Change in accumulated depreciation account P35,000
Accumulated depreciation on fully depreciated
assets disposed 11,250
P46,250
Purchase of land
Change in land account P (50,000)
Cost of land sold in condemnation proceedings 180,000
P130,000

Problem 3 (Cash Flow from Operating Activities)

Cash received from customers:


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

Problem 4 (Cash Flow from Operating Activities)

Cash received from customers (1) P5,237,000


Cash paid for expenses:
Cost of goods sold P3,150,000
Selling 246,000
Salaries and wages (2) 394,400
Interest (3) 65,200
Miscellaneous operating 5,000
Incomes taxes (4) 335,000 4,195,600

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Cost Concepts and Classifications Chapter 8

Net cash provided by operating activities P1,041,400


Computations:
1. Revenue from sales P5,432,000
Less: Note receivable (120,000)
Land (75,000)
P5,237,000

2. Salaries and wages expense P 400,000


Less: Increase in accrued salaries and wages
(P45,600 P40,000) (5,600)
P 394,400

3. Interest expense P 72,000


Less: Discount amortization (6,800)
P 65,200

4. Income tax expense P 445,000


Less: Deferred portion (110,000)
P 335,000

Problem 5 (Statement of Cash Flows Preparation Indirect)

Green Tea Company


Statement of Cash Flows
For the Year Ended December 31, 2005

Cash flows from operating


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

*
Increase in retained earnings (P20,000 P13,000) P7,000
Dividends declared 1,500
Net income P8,500

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Chapter 8 Cost Concepts and Classifications

Net cash provided by operating P7,500


activities

Cash flows from financing activities


Dividends paid (1,500)
Retirement of long-term liabilities (1,000)
Net cash used in financing (2,500)
activities
Net increase in cash P 5,000
Cash, January 1, 2005 10,000
Cash, December 31, 2005 P15,000

Problem 6 (Cash Flow Statement Preparation Direct)

Requirement (a)

Hundred Acre Company


Statement of Cash Flows
For the Year Ended December 31, 2005

Cash flows from operating


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

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Cost Concepts and Classifications Chapter 8

Reconciliation of net income to net cash


provided by operating activities:
Net income P15,000
Adjustments to reconcile net income to
net cash provided by operating
activities:
Depreciation expense 24,500*
Amortization expense 1,000
Increase in accounts receivable (33,000)
Decrease in accrued expenses (500)
Net cash provided by operating activities P 7,000

Computations:
Cash received from customers:
Revenues P107,000
Deduct: Increase in accounts receivable
(P78,000 P45,000) 33,000
P 74,000
Cash paid for expenses:
Expenses P 92,000
Add: Decrease in accrued expenses
(P7,500 P7,000) 500
Deduct: Depreciation expense
(P33,600 P27,100 + P18,000) (24,500)
Amortization (1,000)
P 67,000
Cash from sale of equipment:
Cost P 27,500
Deduct: Accumulated depreciation (18,000)
Cash received on sale at book value P 9,500
Cash paid to acquire equipment:
Increase in property, plant and equipment
(P118,100 P92,600) P 25,500
Cost of machinery sold 27,500

*
Net increase during 2005 (P33,600 P27,100) P 6,500
Accumulated depreciation on assets sold 18,000
Depreciation expense for 2005 P24,500

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Chapter 8 Cost Concepts and Classifications

P 53,000
Cash received on sale of shares:
Increase in ordinary shares amount
(P100,000 P75,000) P 25,000
Increase in additional paid-in capital account
(P55,000 P40,000) 15,000
P 40,000
Cash dividends:
Increase in retained earnings (P21,000 P14,500) P 6,500
Net income (P107,000 P92,000) (15,000)
P 8,500

Requirement (b)

The reconciliation of net income to net cash provided by or used in operating


activities is required to be disclosed in order to show more clearly the
relationship and emphasize the differences between the two. Users of
financial statements are often not as aware of the accrual concepts, which
determine net income, as are preparers of those statements. The
reconciliation of net income to net cash flows from operating activities
clearly demonstrates that the two are different and details those events and
transactions that account for the difference.

Problem 7 (Interpretation of Cash Flow Statement)

Requirement (a)

The two companies are similar in the following respects:


1. Overall size.
2. Industry in which they operate.
3. Current ratio (2.4 to 1).
4. Overall peso amounts of cash provided and used:

Range, 2002-2005
Cash Cash Used
Provided
Ebony P125,000 P115,000
Company P168,000 P170,000
Ivory P135,000 P125,000

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Cost Concepts and Classifications Chapter 8

Company P160,000 P165,000

5. Net increase in working capital is identical for each year, 2002


2005.

Requirement (b)

The two companies are dissimilar in the makeup of the sources of cash, as
indicated in the following analysis:

Sources of Cash in Percentages


2002 2003 2004
Ebony Ivory Ebony Ivory Ebony I
Cash
provided:
Operations 80 37 77 21 70 (
Long-term debt 8 56 -- 10 --
Share capital -- -- 16 52 --
Asset disposition 12 7 7 17 30
100 100 100 100 100 1

Ebony Company has relied much more heavily on operations to provide cash
and to a very limited extent on debt and equity financing and asset
disposition. On the other hand, Ivory Company has not been able to provide
cash from operations and has been required to rely on the alternatives of debt
and equity financing and asset disposition.

Requirement (c)

Ebony Company is in a considerably stronger position (as determined by the


data given) and thus should be considered the better investment and credit
risk. The following points are significant:
1. Ebony Company has provided 70%-80% of its cash via operating
activities, supplementing with other means to maintain a current
ratio at the industry average. Ebony has not had to rely consistently
on any alternative source of funding.
2. Ivory Company has apparently been forced to rely continuously on
debt financing except in 2005, perhaps because of the inability to
obtain such financing. The year 2004 is particularly weak for Ivory,
with operations resulting in a P60,000 reduction in cash. The ability

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Chapter 8 Cost Concepts and Classifications

of Ivory to sustain its present financial position (i.e., current ratio,


etc.) is questionable in light of its history.

III. Multiple Choice Questions

1. D 4. D 7. C 10. B
2. C 5. B 8. B 11. A
3. D 6. D 9. A 12. D

CHAPTER 7

GROSS PROFIT VARIATION ANALYSIS AND


EARNINGS PER SHARE DETERMINATION

I. Problems

Problem I

The Dawn Mining Company


Gross Profit Variation Analysis
For 2006

Increase in Sales:
Quantity Factor [(24,000) x P8] P(192,000)
Price Factor (105,000 x P3) 315,000
Quantity/Price Factor [(24,000) x P3] (72,000) P 51,000
Less: Increase (decrease) in Cost of Sales:
Quantity Factor [(24,000) x P9] P(216,000)
Cost Factor [105,000 x (P.50)] (52,500)
Quantity/Cost Factor [(24,000) x (P.50)] 12,000 (256,500)
Increase in Gross Profit P 307,500

Problem II

1. Selling Price Factor


Sales in 2006 P210,000

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Cost Concepts and Classifications Chapter 8

Less: Sales in 2006 at 2005 prices


(P210,000 105%) 200,000
Favorable P 10,000

2. Cost Factor
Cost of Sales in 2006 P164,000
Less: Cost of Sales in 2006 at 2005 costs 176,000
Favorable P(12,000)

3. Quantity Factor
Increase in Sales
Sales in 2006 at 2005 prices P200,000
Less: Sales in 2005 150,000
Favorable P 50,000
Less: Increase in Cost of Sales
Cost of Sales in 2006 at 2005 costs
(P132,000 x 133-1/3%) P176,000
Less: Cost of Sales in 2005 132,000
Unfavorable P 44,000
Net favorable quantity factor 6,000*
Increase in Gross Profit P 28,000

* This may also be obtained using the following presentation:


Quantity Factor:
Sales in 2006 at 2005 prices P200,000
Less: Sales in 2005 150,000
Increase in Sales P 50,000
Multiplied by: Ave. Gross Profit rate in 2005 12%
Net favorable variance P 6,000

Problem III
Requirement A:
Tony Corporation
Statement Accounting for Gross Profit Variation
For 2006

Increase (Decrease) in Sales accounted for as follows:


Price Factor

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Chapter 8 Cost Concepts and Classifications

Sales this year P210,210


Less: Sales this year at last years prices 269,500
Favorable (Unfavorable) P(59,290)
Quantity Factor
Sales this year at last years
prices (P210,210 78%) P269,500
Less: Sales last year 192,500
Favorable (Unfavorable) P 77,000
Net Increase (decrease) in sales P 17,710
Increase (decrease) in Cost of Sales accounted for as follows:

Cost Factor
Cost of Sales this year P 165,400
Less: Cost of Sales this year at last
years costs 161,700
(Favorable) Unfavorable P 3,700

Quantity Factor
Cost of Sales this year at last years
costs (115,500 x 140%) P 161,700
Less: Cost of Sales last year 115,500
(Favorable) Unfavorable P 46,200

Net increase (decrease) in Cost of Sales P 49,900


Net increase (decrease) in Gross Profit P (32,190)

Gross Profit, this year P 44,810


Gross Profit, last year 77,000
Increase (Decrease) in Gross Profit P(32,190)

Requirement B:

(1) Change in Quantity = P 77,000 = 40% increase


P192,500

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


P161,700

Problem IV

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Cost Concepts and Classifications Chapter 8

Quantity Factor
1. Decrease in Sales due to decrease in the number
of customers [(1,000) x 18 MCF x P2.50)] P(45,000)
2. Increase in Sales due to increase in consumption
rate per customer (26,000 x 2 MCF x P2.50) 130,000
Net Increase P 85,000

Price Factor
3. Decrease in Sales due to the decrease in rate per
MCF [P(.05) x 520,000] (26,000)
Increase in operating revenues P 59,000

Supporting Computations:
Average Consumption:
(a) 2006 = 520,000 26,000 = 20 MCF/customer
2005 = 486,000 27,000 = 18 MCF/customer
Increase in Consumption
per customer 2 MCF/customer

(b) 27,000 - 26,000 = 1,000 decrease in number of customers

(c) Price 2006 P2.45


2005 2.50
Decrease in rate or
price per MCF sold P(.05)

Problem V

XYZ Corporation
Gross Profit Variation Analysis
For 2006

Price Factor
Sales in 2006 P 1,750
Less: Sales in 2006 at 2005 prices
A (25 x P10) P 250

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Chapter 8 Cost Concepts and Classifications

B (75 x P20) 1,500 1,750


Increase (decrease) in gross profit P -

Cost Factor:
Cost of sales in 2006 P 875
Less: Cost of sales in 2006 at 2005 costs:
A (25 X P5) P 125
B (75 x P10) 750 875
Increase (decrease) in gross profit P -

Quantity Factor:
Increase (decrease) in total quantity
Multiplied by: Average gross profit
per unit in 2005 (P750 100) P 7.50
Increase (decrease) in gross profit P -

Sales Mix Factor:


Average gross profit per unit in 2006 at
2005 prices P8.75 *
Less: Average gross profit per unit in 2005 7.50
Increase (decrease) P1.25
Multiplied by: Total quantity in 2006 100
Increase (decrease) in gross profit P125.00
Increase in Gross Profit P125.00

* Sales in 2006 at 2005 prices P1,750


Less: Cost of sales in 2006 at 2005 prices 875
Gross profit in 2006 at 2005 prices P 875

Average Gross Profit on 2006 at 2005 prices:

P875 = P8.75
100 (volume in 2006)

Problem VI (Computation of Weighted Average Number of Ordinary


Shares)

Number of Shares
Adjustment
for 25%

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Cost Concepts and Classifications Chapter 8

stock As Weighted
Date Unadjusted dividend Adjusted Multiplier Shares
1/1/2006 16,000 4,000 20,000 12/12 20,000
2/15/2006 3,200 800 4,000 10.5/12 3,500
4/1/2006 (3,000) (750) (3,750) 9/12 (2,812)
6/1/2006 1,400 350 1,750 7/12 1,020
9/1/2006 6,400 1,600 8,000 4/12 2,667
12/1/2006 6,000 (6,000) - - -
Total 30,000 - 30,000 24,375

Problem VII (Computation of Basic EPS and Diluted EPS)

1. Basic EPS = P 90,000


100,000

= P0.90

2. Diluted EPS = P90,000 + (10% x P500,000 x 65%)


P500,000
100,000 + x 100
P1,000
P90,000 + P32,500
= 150,000

= P0.82 (rounded off)

Problem VIII

Requirements (1) and (2)

Explanation Earnings Shares = Per Share


Basic earnings and shares P122,000 a
33,333 b
= P3.66 Basic
Stock option share increment 293c
Tentative DEPS1 amounts P122,000 33,626 = P3.63 DEPS1
10% bond interest expense savingse 13,300d
Increment in shares 4,400d
Tentative DEPS2 amounts P135,300 38,026 = P3.56 DEPS2
7.5% preference dividend savingse 28,500d
Increment in shares 9,310d
P163,800 47,336 = P3.46 DEPS3

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Chapter 8 Cost Concepts and Classifications

5.8% bonds 21,924 6,264


Diluted earnings and shares P185,724 53,600 = P3.465 Diluted

a
P122,000 = P150,500 (net income) - P28,500 (preference dividends)

b
Weighted average shares: 25,000 x 1.20 = 30,000 x 7/12 = 17,500
32,000 x 1.20 = 38,400 x 4/12 = 12,800
38,400 - 2,000 = 36,400 x 1/12 = 3,033
Weighted average shares 33,333

c
Increment due to stock options:

Issued 4,000
4,000 x ( P33 + P5 )
Reacquired = (3,707)
P41
Increment in shares 293

d
Impact on diluted earnings per share and ranking:
Impact Ranking

[(0.10 x P200,000) P1,000] x 0.7 P13,300


10% bonds: = 4,400 P3.02 5
200 x 22

(0.058 x P540,000) x 0.7 P21,924


5.8% bonds: 540 x 11.6 = 6,264 P3.50 3

(0.075 x P380,000) P28,500


7.5% preference: 3,800 x 2.45 = 9,310 P3.06 2

e
Dilutive effect on diluted earnings per share:
10% bonds: P3.02 impact < P3.63 (DEPS1), therefore dilutive
7.5% preference: P3.06 impact < P3.56 (DEPS2), therefore dilutive
5.8% bonds: P3.50 impact > P3.46 (DEPS3), therefore exclude from EPS

Requirement 3

Fuego Company would report basic earnings per share of P3.66 and diluted
earnings per share of P3.46 on its 2005 income statement.

II. Multiple Choice Questions

1. B 5. A 9. A 13. A 17. A 21. C

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Cost Concepts and Classifications Chapter 8

2. B 6. B 10. A 14. D 18. B 22. A


3. C 7. B 11. D * 15. C 19. C 23. B
4. D 8. B 12. C 16. A 20. D

* Supporting computation for no. 11:


P3,500,000 + (P800,000 x 65%)
Diluted EPS for 12/31/2006 =
400,000 + 25,000 + 225,000
P4,020,000
= or P6.18
650,000
CHAPTER 8

COST CONCEPTS AND CLASSIFICATIONS

I. Questions

1. The phrase different costs for different purposes refers to the fact that
the word cost can have different meanings depending on the context in
which it is used. Cost data that are classified and recorded in a
particular way for one purpose may be inappropriate for another use.

2. Fixed costs remain constant in total across changes in activity, whereas


variable costs change in proportion to the level of activity.

3. Examples of direct costs of the food and beverage department in a hotel


include the money spent on the food and beverages served, the wages of
table service personnel, and the costs of entertainment in the dining
room and lounge. Examples of indirect costs of the food and beverage
department include allocations of the costs of advertising for the entire
hotel, of the costs of the grounds and maintenance department, and of
the hotel general managers salary.

4. The cost of idle time is treated as manufacturing overhead because it is a


normal cost of the manufacturing operation that should be spread out
among all of the manufactured products. The alternative to this
treatment would be to charge the cost of idle time to a particular job that
happens to be in process when the idle time occurs. Idle time often
results from a random event, such as a power outage. Charging the cost

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Chapter 8 Cost Concepts and Classifications

of the idle time resulting from such a random event to only the job that
happened to be in process at the time would overstate the cost of that
job.

5. a. Uncontrollable cost
b. Controllable cost
c. Uncontrollable cost

6. Product costs are costs that are associated with manufactured goods until
the time period during which the products are sold, when the product
costs become expenses. Period costs are expensed during the time
period in which they are incurred.

7. The most important difference between a manufacturing firm and a


service industry firm, with regard to the classification of costs, is that the
goods produced by a manufacturing firm are inventoried, whereas the
services produced by a service industry firm are consumed as they are
produced. Thus, the costs incurred in manufacturing products are
treated as product costs until the period during which the goods are sold.
Most of the costs incurred in a service industry firm to produce services
are operating expenses that are treated as period costs.

8. Product costs are also called inventoriable costs because they are
assigned to manufactured goods that are inventoried until a later period,
when the products are sold. The product costs remain in the finished
goods inventory account until the time period when the goods are sold.

9. A sunk cost is a cost that was incurred in the past and cannot be altered
by any current or future decision. A differential cost is the difference in
a cost item under two decision alternatives.

10. a. Direct cost


b. Direct cost
c. Indirect cost
d. Indirect cost

11. The two properties of a relevant cost are:


1. it differs between the decision options
2. it will be incurred in the future

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Cost Concepts and Classifications Chapter 8

12. The three types of product costs are:


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

13. The three types of manufacturing inventories are:


1. materials inventory the store of materials used in the
manufacturing process or in providing the service.
2. work in process inventory accounts for all costs put into the
manufacturing of products that are started but not complete at the
financial statement date.
3. finished goods inventory the cost of goods that are ready for sale.

14. Direct materials include the materials in the product and a reasonable
allowance for scrap and defective units, while indirect materials are
materials used in manufacturing that are not physically part of the
finished product.

15. The income statement of a manufacturing company differs from the


income statement of a merchandising company in the cost of goods sold
section. A merchandising company sells finished goods that it has
purchased from a supplier. These goods are listed as purchases in the
cost of goods sold section. Since a manufacturing company produces its
goods rather than buying them from a supplier, it lists cost of goods
manufactured in place of purchases. Also, the manufacturing
company identifies its inventory in this section as Finished Goods
inventory, rather than as Merchandise Inventory.

16. Yes, costs such as salaries and depreciation can end up as part of assets
on the balance sheet if these are manufacturing costs. Manufacturing
costs are inventoried until the associated finished goods are sold. Thus,
if some units are still in inventory, such costs may be part of either Work
in Process inventory or Finished Goods inventory at the end of a period.

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Chapter 8 Cost Concepts and Classifications

17. No. A variable cost is a cost that varies, in total, in direct proportion to
changes in the level of activity. A variable cost is constant per unit of
product. A fixed cost is fixed in total, but the average cost per unit
changes with the level of activity.

18. Manufacturing overhead is an indirect cost since these costs cannot be


easily and conveniently traced to particular units of products.

19.
Direct labor cost (34 hours P15 per hour).......................... P510
Manufacturing overhead cost (6 hours P15 per hour) ....... 90
Total wages earned ................................................................ P600

20.
Direct labor cost (45 hours P14 per hour)......................... P630
Manufacturing overhead cost (5 hours P7 per hour) ........ 35
Total wages earned .............................. P665

II. Exercises

Exercise 1 (Schedule of Cost of Goods Manufactured and Sold; Income


Statement)

Requirement 1

Amazing Aluminum Company


Schedule of Cost of Goods Manufactured
For the Year Ended December 31, 2005

Direct material:
Raw-material inventory, January 1 .................. P 60,000
Add: Purchases of raw material ...................... 250,000
Raw material available for use ......................... P310,000
Deduct: Raw-material inventory, 70,000
December 31 ..............................................
Raw material used ............................................ P240,000
Direct labor ............................................................. 400,000
Manufacturing overhead:
Indirect material ............................................... P 10,000
Indirect labor .................................................... 25,000
Depreciation on plant and equipment .............. 100,000
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Cost Concepts and Classifications Chapter 8

Utilities ............................................................ 25,000


Other ................................................................ 30,000
Total manufacturing overhead ......................... 190,000
Total manufacturing costs ...................................... P830,000
Add: Work-in-process inventory, January 1 ......... 120,000
Subtotal................................................................... P950,000
Deduct: Work-in-process inventory, 115,000
December 1 ......................................................
Cost of goods manufactured ................................... P835,000

Requirement 2

Amazing Aluminum Company


Schedule of Cost of Goods Sold
For the Year Ended December 31, 2005

Finished goods inventory, January 1 ........................................ P150,000


Add: Cost of goods manufactured ........................................... 835,000
Cost of goods available for sale ............................................... P985,000
Deduct: Finished goods inventory, December 31 ................... 165,000
Cost of goods sold .................................................................... P820,000

Requirement 3

Amazing Aluminum Company


Income Statement
For the Year Ended December 31, 2005

Sales revenue ............................................................................ P1,105,000


Less: Cost of goods sold.......................................................... 820,000
Gross margin ............................................................................ P 285,000
Selling and administrative expenses ........................................ 110,000
Income before taxes .................................................................. P 175,000
Income tax expense .................................................................. 70,000
Net income ............................................................................... P 105,000

Exercise 2

Fixed (F) Period (P)


Cost Item Variable (V) Product (R)

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Chapter 8 Cost Concepts and Classifications

a. Transportation-in costs on materials


purchased V R
b. Assembly-line workers wages V R
c. Property taxes on work in process
inventories V R
d. Salaries of top executives in the F P
company
e. Overtime premium for assembly workers V R
f. Sales commissions V P
g. Sales personnel office rental F P
h. Production supervisory salaries F R
i. Controllers office supplies F P
Fixed (F) Period (P)
Cost Item Variable (V) Product (R)
j. Executive office heat and air F P
conditioning
k. Executive office security personnel F P
l. Supplies used in assembly work V R
m. Factory heat and air conditioning F R
n. Power to operate factory equipment V R
o. Depreciation on furniture for sales staff F P
p. Varnish used for finishing product V R
q. Marketing personnel health insurance F P
r. Packaging materials for finished product V R
s. Salary of the quality control manager
who checks work on the assembly line F R
t. Assembly-line workers dental insurance F R

Exercise 3 (Cost Classifications; Manufacturer)

1. a, d, g, i
2. a, d, g, j
3. b, f
4. b, d, g, k
5. a, d, g, k
6. a, d, g, j
7. b, c, f
8. b, d, g, k

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Cost Concepts and Classifications Chapter 8

9. b, c and d*, e and f and g*, k*


* The building is used for several purposes.
10. b, c, f
11. b, c, h
12. b, c, f
13. b, c, e
14. b, c and d, e and f and g, k

The building that the furnace heats is used for several purposes.
15. b, d, g, k

Exercise 4 (Economic Characteristics of Costs)

1. marginal cost
2. sunk cost
3. average cost
4. opportunity cost
5. differential cost
6. out-of-pocket cost

Exercise 5 (Cost Classifications; Hotel)

1. a, c, e, k
2. b, d, e, k
3. d, e, i
4. d, e, i
5. a, d, e, k
6. a, d, e, k
7. d, e, k
8. b, d, e, k

Unless the dishwasher has been used improperly.
9. h
10. a, d, e*, j
* The hotel general manager may have some control over the total space
allocated to the kitchen.

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Chapter 8 Cost Concepts and Classifications

11. i
12. j
13. a, c, e
14. e, k

Exercise 6

Pickup Truck Output

3,000 trucks 6,000 trucks 9,000 trucks


Variable production costs P 29,640,000 P 59,280,000 P 88,920,000
Fixed production costs 39,200,000 39,200,000 39,200,000
Variable selling costs 4,500,000 9,000,000 13,500,000
Fixed selling costs 13,660,000 13,660,000 13,660,000
Total costs P 87,000,000 P121,140,000 P155,280,000

Selling price per truck 46,000 40,100 35,900

Unit cost 29,000 20,190 17,253

Profit per truck 17,000 19,910 18,647

Exercise 7

(see next page)

Exercise 8

1. The wages of employees who build the sailboats: direct labor cost.
2. The cost of advertising in the local newspapers: marketing and selling
cost.
3. The cost of an aluminum mast installed in a sailboat: direct materials
cost.
4. The wages of the assembly shops supervisor: manufacturing overhead
cost.
5. Rent on the boathouse: a combination of manufacturing overhead,
administrative, and marketing and selling cost. The rent would most
likely be prorated on the basis of the amount of space occupied by

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Cost Concepts and Classifications Chapter 8

manufacturing, administrative, and marketing operations.


6. The wages of the companys bookkeeper: administrative cost.
7. Sales commissions paid to the companys salespeople: marketing and
selling cost.
8. Depreciation on power tools: manufacturing overhead cost.

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Cost Concepts and Classifications Chapter 8

Exercise 7

Period Product Cost


Variable Fixed (Selling and Direct Direct Manufacturing Sunk Opportunity
Cost Cost Administrative) Materials Labor Overhead Cost Cost
Cost
1. Wood used
in a table
X X
(P200 per
table)
2. Labor cost
to
assemble a X X
table (P80
per table)
3. Salary of
the factory
supervisor X X
(P76,000
per year)
4. Cost of
electricity
to produce
tables (P4 X X
per
machine-
hour)
5.
Depr
eciation of
machines
used to X X X*
produce
tables
(P20,000
per year)

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Cost Concepts and Classifications Chapter 8
6. Salary of
the
company
X X
president
(P200,000
per year)
7. Advertising
expense
X X
(P500,000
per year)
8.
Com
missions
paid to
X X
salesperso
ns (P60
per table
sold)
9. Rental
income
forgone on X1
factory
space

* This is a sunk cost because the outlay for the equipment was made in a previous period.
1 This is an opportunity cost because it represents the potential benefit that is lost or sacrificed as a result of using the factory space to produce tables.
Opportunity cost is a special category of cost that is not ordinarily recorded in an organizations accounting books. To avoid possible confusion with other
costs, we will not attempt to classify this cost in any other way except as an opportunity cost.

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Chapter 8 Cost Concepts and Classifications

Exercise 9

Direct Indirect
Cost Cost Object Cost Cost
1. The salary of the head chef The hotels restaurant X
2. The salary of the head chef A particular restaurant X
customer
3. Room cleaning supplies A particular hotel guest X
4. Flowers for the reception desk A particular hotel guest X
5. The wages of the doorman A particular hotel guest X
6. Room cleaning supplies The housecleaning X
department
7. Fire insurance on the hotel The hotels gym X
building
8. Towels used in the gym The hotels gym X

Note: The room cleaning supplies would most likely be considered an


indirect cost of a particular hotel guest because it would not be practical to
djkeep track of exactly how much of each cleaning supply was used in the
guests room.

III. Problems

Problem 1

The relevant costs for this decision are the differential costs. These are:

Opportunity cost or lost wages (take home)


[P1,500 x 70% x 12 months] ........ P12,600
Tuition .................................................... 2,200
Books and supplies ................................. 300
Total differential costs ..................... P15,100

Room and board, clothing, car, and incidentals are not relevant because these
are presumed to be the same whether or not Francis goes to school. The
possibility of part-time work, summer jobs, or scholarship assistance could
be considered as reductions to the cost of school. If students are familiar
with the time value of money, then they should recognize that the analysis
calls for a comparison of the present value of the differential after-tax cash
inflows with the present value of differential costs of getting the education
(including the opportunity costs of lost income).

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Cost Concepts and Classifications Chapter 8

Problem 2

Requirement (a)

Only the differential outlay costs need be considered. The travel and other
variable expenses of P22 per hour would be the relevant costs. Any amount
received in excess would be a differential, positive return to Pat.

Requirement (b)

The opportunity cost of the hours given up would be considered in this


situation. Unless Pat receives more than the P100 normal consulting rate,
the contract would not be beneficial.

Requirement (c)

In this situation Pat would have to consider the present value of the contract
and compare that to the present value of the existing consulting business.
The final rate may be more or less than the normal P100 rate depending on
the outcome of Pats analysis.

Problem 3

Utilities for the bakery 2,100


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

Problem 4

Administrative costs 1,000

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Rent for administration offices 17,200


Advertising 1,900
Office managers salary 13,000
Total period costs in pesos 33,100

Problem 5

Requirement (a)

Sunk costs not shown could include lost book value on traded assets,
depreciation estimates for new investment, and interest costs on capital
needed during facilities construction.

Requirement (b)

The client might be used to differential cost as a decision tool, and believes
(correctly) that use of differential analyses has several advantages --- it is
quicker, requires less data, and tends to give a better focus to the decision.
The banker might suspect the client of hiding some material data in order to
make the proposal more acceptable to the financing agency.

Problem 6

Requirement (1)

EH Corporation
Schedule of Cost of Goods Manufactured
For the Year Ended December 31

Direct materials:
Raw materials, inventory, January 1 P
45,000
Add: Purchases of raw materials
375,000
Raw materials available for use 420,000
Deduct: Raw materials inventory,
December 31 30,000
Raw materials used in production P
390,000
Direct labor 75,000

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Cost Concepts and Classifications Chapter 8

Manufacturing overhead:
Utilities, factory 18,000
Depreciation, factory 81,000
Insurance, factory 20,000
Supplies, factory 7,500
Indirect labor 150,000
Maintenance, factory
43,500
Total manufacturing overhead cost
320,000
Total manufacturing cost 785,000
Add: Work in process inventory, January
1 90,000
875,000
Deduct: Work in process inventory,
December 31 50,000
Cost of goods manufactured P825,000

Requirement (2)

The cost of goods sold would be computed as follows:

Finished goods inventory, January 1 P130,000


Add: Cost of goods manufactured
825,000
Goods available for sale 955,000
Deduct: Finished goods inventory, December 31
105,000
Cost of goods sold P850,000

Requirement (3)

EH Corporation
Income Statement
For the Year Ended December 31

Sales P1,250,000
Cost of goods sold (above) 850,000
Gross margin 400,000
Selling and administrative expenses:

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Chapter 8 Cost Concepts and Classifications

Selling expenses P
70,000
Administrative expenses
135,000 205,000
Net operating income P
195,000

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Cost Concepts and Classifications Chapter 8

Problem 7

Note to the Instructor: Some of the answers below are debatable.

Adminis- Manufacturing
Variable or Selling trative (Product) Cost
Cost Item Fixed Cost Cost Direct Indirect
1. Depreciation, executive jet ........................................................................... F X
2. Costs of shipping finished goods to customers ............................................ V X
3. Wood used in manufacturing furniture ......................................................... V X
4. Sales managers salary.................................................................................. F X
5. Electricity used in manufacturing furniture .................................................. V X
6. Secretary to the company president .............................................................. F X
7. Aerosol attachment placed on a spray can produced by the company ......... V X
8. Billing costs .................................................................................................. V X*
9. Packing supplies for shipping products overseas ......................................... V X
10. Sand used in manufacturing concrete ........................................................... V X
11. Supervisors salary, factory .......................................................................... F X
12. Executive life insurance ............................................................................... F X
13. Sales commissions ........................................................................................ V X
14. Fringe benefits, assembly line workers ........................................................ V X**
15. Advertising costs .......................................................................................... F X
16. Property taxes on finished goods warehouses .............................................. F X
17. Lubricants for production equipment ........................................................... V X
*Could be an administrative cost.
**Could be an indirect cost.

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Cost Concepts and Classifications Chapter 8
Problem 8
Requirement (1)
Period
(Selling
Product Cost and
Variable Fixed Direct Direct Mfg. Admin.) Opportunity Sunk
Name of the Cost Cost Cost Materials Labor Overhead Cost Cost Cost
Lings present salary of P400,000 per
month ........................................................................... X
Rent on the garage, P15,000 per month ............................ X X
Rent of production equipment, P50,000 per
month ........................................................................... X X
Materials for producing flyswatters, at
P30.00 each ..................................................................
X X
Labor cost of producing flyswatters, at
P50.00 each ..................................................................
X X
Rent of room for a sales office, P7,500 per
month ........................................................................... X X
Answering device attachment, P2,000 per
month ........................................................................... X X
Interest lost on savings account, P100,000
per year......................................................................... X
Advertising cost, P40,000 per month ................................ X X
Sales commission, at P10.00 per flyswatter ...................... X X
Legal and filing fees, P60,000 .......................................... X

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Requirement (2)

The P60,000 legal and filing fees are not a differential cost. These legal and
filing fees have already been paid and are a sunk cost. Thus, the cost will not
differ depending on whether Ling decides to produce flyswatters or to stay
with the consulting firm. All other costs listed above are differential costs
since they will be incurred only if Ling leaves the consulting firm and
produces the flyswatters.

Problem 9

Requirement (1)

Ms. Rios first action was to direct that discretionary expenditures be


delayed until the first of the new year. Providing that these discretionary
expenditures can be delayed without hampering operations, this is a good
business decision. By delaying expenditures, the company can keep its cash
a bit longer and thereby earn a bit more interest. There is nothing unethical
about such an action. The second action was to ask that the order for the
parts be cancelled. Since the clerks order was a mistake, there is nothing
unethical about this action either.

The third action was to ask the accounting department to delay recognition
of the delivery until the bill is paid in January. This action is dubious.
Asking the accounting department to ignore transactions strikes at the heart
of the integrity of the accounting system. If the accounting system cannot be
trusted, it is very difficult to run a business or obtain funds from outsiders.
However, in Ms. Rios defense, the purchase of the raw materials really
shouldnt be recorded as an expense. He has been placed in an extremely
awkward position because the companys accounting policy is flawed.

Requirement (2)

The companys accounting policy with respect to raw materials is incorrect.


Raw materials should be recorded as an asset when delivered rather than as
an expense. If the correct accounting policy were followed, there would be
no reason for Ms. Rio to ask the accounting department to delay recognition
of the delivery of the raw materials. This flawed accounting policy creates
incentives for managers to delay deliveries of raw materials until after the
end of the fiscal year. This could lead to raw materials shortages and poor

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relations with suppliers who would like to record their sales before the end
of the year.

The companys manage-by-the-numbers approach does not foster ethical


behaviorparticularly when managers are told to do anything so long as
you hit the target profits for the year. Such no excuses pressure from the
top too often leads to unethical behavior when managers have difficulty
meeting target profits.

IV. Multiple Choice Questions

1. B 7. C 13. D 19. A 25. C


2. D 8. D 14. D 20. A* 26. B
3. B 9. C 15. B 21. B 27. B
4. A 10. C 16. A 22. B 28. A **
5. C 11. A 17. C 23. C 29. A
6. D 12. C 18. C 24. C 30. B

* Controllable costs are those costs that can be influenced by a specified


manager within a given time period.
** The answer assumes absorption costing method is used.

Supporting Computations
14. P60 + P10 + P18 + P4 = P92 16. P60 + P10 + P18 + P32 = P120
15. P32 + P16 = P48 17. P4 + P16 = P20

CHAPTER 9

COST BEHAVIOR: ANALYSIS AND USE

I. Questions

1. a. Variable cost: A variable cost is one that remains constant on a per


unit basis, but which changes in total in direct relationship to
changes in volume.

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b. Fixed cost: A fixed cost is one that remains constant in total


amount, but which changes, if expressed on a per unit basis,
inversely with changes in volume.
c. Mixed cost: A mixed cost is a cost that contains both variable and
fixed cost elements.

2. a. Unit fixed costs will decrease as volume increases.


b. Unit variable costs will remain constant as volume increases.
c. Total fixed costs will remain constant as volume increases.
d. Total variable costs will increase as volume increases.

3. a. Cost behavior: Cost behavior can be defined as the way in which


costs change or respond to changes in some underlying activity, such
as sales volume, production volume, or orders processed.
b. Relevant range: The relevant range can be defined as that range of
activity within which assumptions relative to variable and fixed cost
behavior are valid.

4. Although the accountant recognizes that many costs are not linear in
relationship to volume at some points, he concentrates on their behavior
within narrow bands of activity known as the relevant range. The
relevant range can be defined as that range of activity within which
assumptions as relative to variable and fixed cost behavior are valid.
Generally, within this range an assumption of strict linearity can be used
with insignificant loss of accuracy.
5. The high-low method, the scattergraph method, and the least-squares
regression method are used to analyze mixed costs. The least-squares
regression method is generally considered to be most accurate, since it
derives the fixed and variable elements of a mixed cost by means of
statistical analysis. The scattergraph method derives these elements by
visual inspection only, and the high-low method utilizes only two points
in doing a cost analysis, making it the least accurate of the three
methods.

6. The fixed cost element is represented by the point where the regression
line intersects the vertical axis on the graph. The variable cost per unit
is represented by the slope of the line.

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7. The two assumptions are:


1. A linear cost function usually approximates cost behavior within the
relevant range of the cost driver.
2. Changes in the total costs of a cost object are traceable to variations
or changes in a single cost driver.

8. No. High correlation merely implies that the two variables move
together in the data examined. Without economic plausibility for a
relationship, it is less likely that a high level of correlation observed in
one set of data will be found similarly in another set of data.

9. Refer to page 312 of the textbook.

10. The relevant range is the range of the cost driver in which a specific
relationship between cost and cost driver is valid. This concept enables
the use of linear cost functions when examining CVP relationships as
long as the volume levels are within that relevant range.

11. A unit cost is computed by dividing some amount of total costs (the
numerator) by the related number of units (the denominator). In many
cases, the numerator will include a fixed cost that will not change
despite changes in the denominator. It is erroneous in those cases to
multiply the unit cost by activity or volume change to predict changes in
total costs at different activity or volume levels.

12. Cost estimation is the process of developing a well-defined relationship


between a cost object and its cost driver for the purpose of predicting the
cost. The cost predictions are used in each of the management
functions:
Strategic Management: Cost estimation is used to predict costs of
alternative activities, predict financial impacts of alternative strategic
choices, and to predict the costs of alternative implementation strategies.
Planning and Decision Making: Cost estimation is used to predict costs
so that management can determine the desirability of alternative options
and to budget expenditures, profits, and cash flows.
Management and Operational Control: Cost estimation is used to
develop cost standards, as a basis for evaluating performance.

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Cost-Volume-Profit Relationships Chapter 13

Product and Service Costing: Cost estimation is used to allocate costs to


products and services or to charge users for jointly incurred costs.

13. The five methods of cost estimation are:


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

14. Implementation problems with cost estimation include:


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

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Chapter 13 Cost-Volume-Profit Relationships

e. dependent variables and cost drivers may be affected by trend or


seasonality.
f. when extreme observations (outliers) are used the reliability of the
results will be diminished.
g. when there is a shift in the data, as, for example, a new product is
introduced or when there is a work stoppage, the data will be
unreliable for future estimates.

15. The dependent variable is the cost object of interest in the cost
estimation. An important issue in selecting a dependent variable is the
level of aggregation in the variable. For example, the company, plant, or
department may all be possible levels of data for the cost object. The
choice of aggregation level depends on the objectives for the cost
estimation, data availability, reliability, and cost/benefit considerations.
If a key objective is accuracy, then a detailed level of analysis is often
preferred. The detail cost estimates can then be aggregated if desired.

16. Nonlinear cost relationships are cost relationships that are not
adequately explained by a single linear relationship for the cost driver(s).
In accounting data, a common type of nonlinear relationship is trend and
seasonality. For a trend example, if sales increase by 8% each year, the
plot of the data for sales with not be linear with the driver, the number of
years. Similarly, sales which fluctuate according to a seasonal pattern
will have a nonlinear behavior. A different type of nonlinearity is where
the cost driver and the dependent variable have an inherently nonlinear
relationship. For example, payroll costs as a dependent variable
estimated by hours worked and wage rates is nonlinear, since the
relationship is multiplicative and therefore not the additive linear model
assumed in regression analysis.

17. The advantages of using regression analysis include that it:


a. provides an estimation model with best fit (least squared error) to the
data
b. provides measures of goodness of fit and of the reliability of the
model which can be used to assess the usefulness of the specific
model, in contrast to the other estimation methods which provide no
means of self-evaluation
c. can incorporate multiple independent variables

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Cost-Volume-Profit Relationships Chapter 13

d. can be adapted to handle non-linear relationships in the data,


including trends, shifts and other discontinuities, seasonality, etc.
e. results in a model that is unique for a given set of data

18. High correlation exists when the changes in two variables occur
together. It is a measure of the degree of association between the two
variables. Because correlation is determined from a sample of values,
there is no assurance that it measures or describes a cause and effect
relationship between the variables.

19. An activity base is a measure of whatever causes the incurrence of a


variable cost. Examples of activity bases include units produced, units
sold, letters typed, beds in a hospital, meals served in a cafe, service
calls made, etc.

20. (a) Variable cost: A variable cost remains constant on a per unit basis,
but increases or decreases in total in direct relation to changes in
activity.
(b) Mixed cost: A mixed cost is a cost that contains both variable and
fixed cost elements.
(c) Step-variable cost: A step-variable cost is a cost that is incurred in
large chunks, and which increases or decreases only in response to
fairly wide changes in activity.

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Chapter 13 Cost-Volume-Profit Relationships

Mixed Cost

Variable Cost

Cost

Step-Variable Cost

Activity

21. The linear assumption is reasonably valid providing that the cost formula
is used only within the relevant range.

22. A discretionary fixed cost has a fairly short planning horizonusually a


year. Such costs arise from annual decisions by management to spend on
certain fixed cost items, such as advertising, research, and management
development. A committed fixed cost has a long planning horizon
generally many years. Such costs relate to a companys investment in
facilities, equipment, and basic organization. Once such costs have been
incurred, they are locked in for many years.

23. a. Committed d. Committed


b. Discretionary e. Committed
c. Discretionary f. Discretionary

24. The high-low method uses only two points to determine a cost formula.
These two points are likely to be less than typical since they represent
extremes of activity.

25. The term least-squares regression means that the sum of the squares of
the deviations from the plotted points on a graph to the regression line is
smaller than could be obtained from any other line that could be fitted to
the data.

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Cost-Volume-Profit Relationships Chapter 13

26. Ordinary single least-squares regression analysis is used when a variable


cost is a function of only a single factor. If a cost is a function of more
than one factor, multiple regression analysis should be used to analyze
the behavior of the cost.

II. Exercises

Exercise 1 (Cost Classification)

1. b
2. f
3. e
4. i
5. e
6. h
7. l
8. a
9. j
10. k
11. c or d
12. g

Exercise 2 (Cost Estimation; High-Low Method)

Requirement (1)

Cost equation using square fee as the cost driver:

Variable costs:

P4,700 P2,800
= P1.134
4,050 2,375

Fixed costs:

P4,700 = Fixed Cost + P1.134 x 4,050


Fixed Cost = P107

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

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Chapter 13 Cost-Volume-Profit Relationships

There are two choices for the High-Low points when using openings for the
cost driver. At 11 openings there is a cost of P2,800 and at 10 openings
there is a cost of P2,875.

Cost equation using 11 openings as the cost driver:

Variable costs:

P4,700 P2,800
= P237.50
19 11

Fixed costs:

P4,700 = Fixed Cost + P237.50 x 19


Fixed Cost = P187.50

Equation Two: Total Cost = P187.50 + P237.50 x openings

Cost equation using 10 openings as the cost driver:

Variable costs:

P4,700 P2,875
= P202.78
19 10

Fixed costs:

P4,700 = Fixed Cost + P202.78 x 19


Fixed Cost = P847.18

Equation Three: Total Cost = P847.18 + P202.78 x openings

Predicted total cost for a 3,200 square foot house with 14 openings using
equation one:

P107 + P1.134 x 3,200 = P3,735.80

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Cost-Volume-Profit Relationships Chapter 13

Predicted total cost for a 3,200 square foot house with 14 openings using
equation two:

P187.50 + P237.50 x 14 = P3,512.50

Predicted total cost for a 3,200 square foot house with 14 openings using
equation three:

P847.18 + P202.78 x 14 = P3,686.10

There is no simple method to determine which prediction is best when using


the High-Low method. In contrast, regression provides quantitative
measures (R-squared, standard error, t-values,) to help asses which
regression equation is best.

Predicted cost for a 2,400 square foot house with 8 openings, using equation
one:

P107 + P1.134 x 2,400 = P2,828.60

We cannot predict with equation 2 or equation 3 since 8 openings are outside


the relevant range, the range for which the high-low equation was developed.

Requirement 2

Figure 9-A shows that the relationship between costs and square feet is
relatively linear without outliers, while Figure 9-B shows a similar result for
the relationship between costs and number of openings. From this
perspective, both variables are good cost drivers.

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Chapter 13 Cost-Volume-Profit Relationships

Figure 9-A

P5,000
P4,500

P4,000

P3,500

P3,000
Cost

P2,500
P2,000
P1,500
P1,000

P500
P0
2,375

2,450

2,600

2,600

2,650

2,700

2,800

2,850

3,010

3,550

3,700

4,050
Square Feet

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Cost-Volume-Profit Relationships Chapter 13

Figure 9-B

Cost versus No. of Openings

P5,000
P4,500
P4,000
P3,500
P3,000
Cost

P2,500
P2,000
P1,500
P1,000
P500
P0
10 11 11 12 12 13 13 13 15 16 16 19
Num ber of Openings

Exercise 3 (Cost Estimation; Account Classification)

Requirement 1

Fixed Costs:
Rent P10,250
Depreciation 400
Insurance 750
Advertising 650
Utilities 1,250
Mr. Blacks salary 18,500
Total P31,800
Variable Costs:
Wages P17,800
CD Expense 66,750
Shopping Bags 180
Total P84,730

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Chapter 13 Cost-Volume-Profit Relationships

Variable Costs Per Unit = P84,730 / 8,900


= P95.20

Cost Function Equation: y = P31,800 + P95.20 x (CDs sold)

Requirement 2

New Sales = 8,900 x 1.25


= 11,125 units
= round to 11,130

Total Costs = P31,800 + P95.20 x (11,130)


= P137,760

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


= P123.80

Add P1 profit per disc: P123.80 + P10 = P133.80

Requirement 3

Adjusted New Sales = 8,900 x 11.50


= 10,240 units

Revenue = P133.80 x (10,240)


= P137,010

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


= P129,280

Cost Per Disc = P129,280 / 10,240 = P126.30

Profit Per Disk = P133.80 P126.30


= P7.50

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Cost-Volume-Profit Relationships Chapter 13

Exercise 4 (Cost Estimation Using Graphs; Service)

Requirement 1

Sales and Advertising Expense

P160,000
P140,000
P120,000
P100,000
Sales

P80,000
P60,000
P40,000
P20,000
P0
P2,500

P3,000

P3,500

P4,000

P4,500

P5,000

P5,500
Advertising Expense

Requirement 2
There seems to be a positive linear relationship for the data between P2,500
and P4,000 of advertising expense. Llanes analysis is correct within this
relevant range but not outside of it. Notice that the relationship between
advertising expense and sales changes at P4,000 of expense.

Exercise 5 (Fixed and Variable Cost Behavior)

Requirement (1)
Cups of Coffee Served
in a Week
1,800 1,900 2,000
Fixed cost .................................................................................................................
P11,000 P11,000 P11,000
Variable cost ............................................................................................................
4,680 4,940 5,200
Total cost .................................................................................................................
P15,680 P15,940 P16,200
Cost per cup of coffee served * ...............................................................................
P8.71 P8.39 P8.10
* Total cost cups of coffee served in a week

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Chapter 13 Cost-Volume-Profit Relationships

Requirement (2)

The average cost of a cup of coffee declines as the number of cups of coffee
served increases because the fixed cost is spread over more cups of coffee.

Exercise 6 (Scattergraph Analysis)

Requirement (1)

The completed scattergraph is presented below:

16,000

14,000

12,000

10,000
Total Cost

8,000

6,000

4,000

2,000

0
0 2,000 4,000 6,000 8,000 10,000
Units Processed

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Cost-Volume-Profit Relationships Chapter 13

Requirement (2)
(Students answers will vary considerably due to the inherent imprecision
and subjectivity of the quick-and-dirty scattergraph method of estimating
variable and fixed costs.)
The approximate monthly fixed cost is P6,000the point where the straight
line intersects the cost axis.
The variable cost per unit processed can be estimated as follows using the
8,000-unit level of activity, which falls on the straight line:
Total cost at the 8,000-unit level of activity ............................................ P14,000
Less fixed costs .......................................................................................6,000
Variable costs at the 8,000-unit level of activity ..................................... P 8,000
P8,000 8,000 units = P1 per unit.
Observe from the scattergraph that if the company used the high-low method
to determine the slope of the line, the line would be too steep. This would
result in underestimating the fixed cost and overestimating the variable cost
per unit.

Exercise 7 (High-Low Method)


Requirement (1)
Electrical
Month Occupancy-Days Costs
High activity level (August) ................... 3,608 P8,111
Low activity level (October) .................. 186 1,712
Change .................................................... 3,422 P6,399
Variable cost = Change in cost Change in activity
= P6,399 3,422 occupancy-days
= P1.87 per occupancy-day
Total cost (August) ............................................................................................
P8,111
Variable cost element
(P1.87 per occupancy-day 3,608 occupancy-days) .................................... 6,747
Fixed cost element .............................................................................................
P1,364

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Chapter 13 Cost-Volume-Profit Relationships

Requirement (2)

Electrical costs may reflect seasonal factors other than just the variation in
occupancy days. For example, common areas such as the reception area must
be lighted for longer periods during the winter. This will result in seasonal
effects on the fixed electrical costs.

Additionally, fixed costs will be affected by how many days are in a month.
In other words, costs like the costs of lighting common areas are variable
with respect to the number of days in the month, but are fixed with respect to
how many rooms are occupied during the month.

Other, less systematic, factors may also affect electrical costs such as the
frugality of individual guests. Some guests will turn off lights when they
leave a room. Others will not.

Exercise 8 (Least-Squares Regression)

The least-squares regression estimates of fixed and variable costs can be


computed using any of a variety of statistical and mathematical software
packages or even by hand.

Month Rental Car Wash


Returns Costs
January ......................... 2,310 P10,113
February ....................... 2,453 P12,691
March ........................... 2,641 P10,905
April ............................. 2,874 P12,949
May............................... 3,540 P15,334
June .............................. 4,861 P21,455
July ............................... 5,432 P21,270
August .......................... 5,268 P19,930
September ..................... 4,628 P21,860
October ......................... 3,720 P18,383
November ..................... 2,106 P 9,830
December ..................... 2,495 P11,081

Intercept P2,296
Slope P3.74
RSQ 0.92

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Cost-Volume-Profit Relationships Chapter 13

The intercept provides the estimate of the fixed cost element, P2,296 per
month, and the slope provides the estimate of the variable cost element,
P3.74 per rental return. Expressed as an equation, the relation between car
wash costs and rental returns is
Y = P2,296 + P3.74X
where X is the number of rental returns.

Note that the R2 is 0.92, which is quite high, and indicates a strong linear
relationship between car wash costs and rental returns.

While not a requirement of the exercise, it is always a good to plot the data
on a scattergraph. The scattergraph can help spot nonlinearities or other
problems with the data. In this case, the regression line (shown below) is a
reasonably good approximation to the relationship between car wash costs
and rental returns.

Php25,000

Php20,000
Car Wash Costs

Php15,000

Php10,000

Php5,000

Php0
0 1,000 2,000 3,000 4,000 5,000 6,000
Rental Returns

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Chapter 13 Cost-Volume-Profit Relationships

III. Problems

Problem 1

Requirement (a) Miles Total Annual


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

* 120,000 miles x P0.116 = P13,920.


80,000 miles x P0.136 = P10,880.
Variable cost per mile:
Change in cost, P3,040
Change in activity,40,000 = P0.076 per mile.
Fixed cost per year:
Total cost at 120,000 miles ................................... P13,920
Less variable cost element: 120,000 x P0.076 ..... 9,120
Fixed cost per year ............................................. P 4,800
Requirement (b)
Y = P4,800 + P0.076X
Requirement (c)

Fixed cost..................................................................... P 4,800


Variable cost: 100,000 miles x P0.076 ....................... 7,600
Total annual cost ................................................... P12,400

Problem 2

Requirement 1

Cost of goods sold ...................................................... Variable


Shipping expense ....................................................... Mixed
Advertising expense ................................................... Fixed
Salaries and commissions .......................................... Mixed
Insurance expense ...................................................... Fixed
Depreciation expense ................................................. Fixed

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Requirement 2

Analysis of the mixed expenses:


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

Variable cost element:


Change in cost
= Variable rate
Change in activity
P12,000
Shipping expense: = P8 per unit.
1,500 units

P36,000
Salaries and comm. expense: 1,500 units = P24 per unit.

Fixed cost element:


Shipping Salaries and
Expense Comm. Expense
Cost at high level of activity ............... P56,000 P143,000
Less variable cost element:
4,500 units x P8 ............................ 36,000
4,500 units x P24 .......................... 108,000
Fixed cost element .............................. P20,000 P 35,000

The cost elements are:


Shipping expense: P20,000 per month plus P8 per unit or Y =
P20,000 + P8X.
Salaries and comm. expense: P35,000 per month plus P24 per unit or
Y = P35,000 + P24X.

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Requirement 3
LILY COMPANY
Income Statement
For the Month Ended June 30

Sales in units................................................... 4,500


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

Problem 3
Requirement 1

Number of Total Cost


Year Leagues (X) (Y) XY X2
2004 5 P13,000 P 65,000 25
2005 2 7,000 14,000 4
2006 4 10,500 42,000 16
2007 6 14,000 84,000 36
2008 3 10,000 30,000 9
20 P54,500 P235,000 90

n (XY) - (X) (Y)


b =
n (X2) - (X)2
5 (235,000) - (20) (54,500)
=
5 (90) - (20)2
= 1,700

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a = (Y) - b(X)
n
(54,500) - 1,700 (20)
=
5
= P4,100

Therefore, the variable cost per league is P1,700 and the fixed cost
is P4,100 per year.

Requirement 2

Y = P4,100 + P1,700X

Requirement 3

The expected value total would be:


Fixed cost .............................................................. P 4,100
Variable cost (7 leagues x P1,700) ....................... 11,900
Total cost .......................................................... P16,000

The problem with using the cost formula from (2) to derive this total cost
figure is that an activity level of 7 sections lies outside the relevant range
from which the cost formula was derived. [The relevant range is represented
by a solid line on the graph in requirement 4 below.]

Although an activity figure may lie outside the relevant range, managers will
often use the cost formula anyway to compute expected total cost as we have
done above. The reason is that the cost formula frequently is the only basis
that the manager has to go on. Using the cost formula as the starting point
should not present a problem so long as the manager is alert for any unusual
problems that the higher activity level might bring about.

Requirement 4
P16,000 Y

P14,000

P12,000

P10,000
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P8,000

P6,000

P4,000

P2,000
X
P-
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Chapter 13 Cost-Volume-Profit Relationships

Problem 4 (Regression Analysis, Service Company)

Requirement 1

Figure 9-C plots the relationship between labor-hours and overhead costs
and shows the regression line.

y = P48,271 + P3.93 X

Economic plausibility. Labor-hours appears to be an economically plausible


driver of overhead cost for a catering company. Overhead costs such as
scheduling, hiring and training of workers, and managing the workforce are
largely incurred to support labor.

Goodness of fit. The vertical differences between actual and predicted costs
are extremely small, indicating a very good fit. The good fit indicates a
strong relationship between the labor-hour cost driver and overhead costs.

Slope of regression line. The regression line has a reasonably steep slope
from left to right. The positive slope indicates that, on average, overhead
costs increase as labor-hours increase.

Requirement 2

The regression analysis indicates that, within the relevant range of 2,500 to
7,500 labor-hours, the variable cost per person for a cocktail party equals:
Food and beverages P15.00
Labor (0.5 hrs. x P10 per hour) 5.00
Variable overhead (0.5 hrs. x P3.93 per labor-hour) 1.97

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Total variable cost per person P21.97

Requirement 3

To earn a positive contribution margin, the minimum bid for a 200-person


cocktail party would be any amount greater than P4,394. This amount is
calculated by multiplying the variable cost per person of P21.97 by the 200
people. At a price above the variable costs of P4,394, Bobby Gonzales will
be earning a contribution margin toward coverage of his fixed costs.

Of course, Bobby Gonzales will consider other factors in developing his bid
including (a) an analysis of the competition vigorous competition will limit
Gonzales ability to obtain a higher price (b) a determination of whether or
not his bid will set a precedent for lower prices overall, the prices Bobby
Gonzales charges should generate enough contribution to cover fixed costs
and earn a reasonable profit, and (c) a judgment of how representative past
historical data (used in the regression analysis) is about future costs.

Figure 9-C
Regression Line of Labor-Hours on Overhead Costs for Bobby Gonzales
Catering Company

P90,000

P80,000

P70,000
Overhead Costs

P60,000

P50,000

P40,000

P30,000

P20,000

P10,000

P0
0 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000
Cost Driver: Labor-Hours

Problem 5 (Linear Cost Approximation)

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Requirement 1
Difference in cost
Slope coefficient (b) =
Difference in labor-hours
P529,000 P400,000
= = P43.00
7,000 4,000

Constant (a) = P529,000 P43.00 (7,000)


= P228,000

Cost function = P228,000 + P43.00 (professional labor-hours)

The linear cost function is plotted in Figure 9-D.

No, the constant component of the cost function does not represent the fixed
overhead cost of the ABS Group. The relevant range of professional labor-
hours is from 3,000 to 8,000. The constant component provides the best
available starting point for a straight line that approximates how a cost
behaves within the 3,000 to 8,000 relevant range.

Requirement 2

A comparison at various levels of professional labor-hours follows. The


linear cost function is based on formula of P228,000 per month plus P43.00
per professional labor-hours.

Total overhead cost behavior:

Month 1 Month 2 Month 3 Month 4 Month 5


Actual total
overhead P340,000 P400,000 P435,000 P477,000 P529,000
costs
Linear 357,000 400,000 443,000 486,000 529,000
approximat
ion
Actual minus
linear P(17,000) P 0 P (8,000) P (9,000) P 0
approximat
ion
Professional 3,000 4,000 5,000 6,000 7,000
labor-hours

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The data are shown in Figure 9-D. The linear cost function overstates costs
by P8,000 at the 5,000-hour level and understates costs by P15,000 at the
8,000-hour level.

Requirement 3
Based on
Linear
Based on Cost
Actual Function
Contribution before deducting
incremental overhead P38,000 P38,000
Incremental overhead 35,000 43,000
Contribution after incremental P 3,000 P
overhead (5,000)

The total contribution margin actually forgone is P3,000.

Figure 9-D
Linear Cost Function Plot of Professional Labor-Hours
on Total Overhead Costs for ABS Consulting Group

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Chapter 13 Cost-Volume-Profit Relationships

P700,000

P600,000
Total Overhead Costs

P500,000

P400,000

P300,000

P200,000

P100,000

P0
0 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000
Professional Labor-Hours Billed

Problem 6 (Cost Behavior)

The variable cost per hour can be computed as follows:

P20,000 / 5,000 hours = P4 per hour

Therefore, the missing amounts are as follows:

Hours of Operating Time


5,000 6,000 7,000
Total
costs:
Variab
le costs
(@ P4
per hour) P 20,000 P24,000 P28,000
Fixed
costs 168,000 168,000 168,000
Total costs P188,000 P192,000 P196,000

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Hours of Operating Time


5,000 6,000 7,000
Cost per
hour:
Variab
le cost P4.00 P4.00 P4.00
Fixed
cost 33.60 28.00 24.00
Total cost
per hour P37.60 P32.00 P28.00

Observe that the total variable costs increase in proportion to the number of
hours of operating time, but that these costs remain constant at P4 if
expressed on a per hour basis.

In contrast, the total fixed costs do not change with changes in the level of
activity. They remain constant at P168,000 within the relevant range. With
increases in activity, however, the fixed cost per hour decreases, dropping
from P33.60 per hour when the boats are operated 5,000 hours a period to
only P21.00 per hour when the boats are operated 8,000 hours a period.
Because of this troublesome aspect of fixed costs, they are most easily (and
most safely) dealt with on a total basis, rather than on a unit basis, in cost
analysis work.

Problem 7 (High-Low Method)

Requirement (1)

The first step in the high-low method is to identify the periods of the lowest
and highest activity. Those periods are November (1,100 patients admitted)
and June (1,900 patients admitted).

The second step is to compute the variable cost per unit using those two data
points:

Number of Admitting
Month Patients Department
Admitted Costs

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High activity level 1,900 P15,200


(June)
Low activity level 1,100 12,800
(November)
Change 800 P 2,400

Change in cost
Variable cost =
Change in activity
P240,000
=
800 patients admitted

= P3 per patient admitted

The third step is to compute the fixed cost element by deducting the variable
cost element from the total cost at either the high or low activity. In the
computation below, the high point of activity is used:
Fixed cost element = Total cost Variable cost element
= P15,200 (P3 per patient admitted
x 1,900 patients admitted)
= P9,500
Requirement (2)
The cost formula is Y = P9,500 + P3X.
Problem 8 (Scattergraph Analysis; Selection of an Activity Base)
Requirement (1)
The completed scattergraph for the number of units produced as the activity
base is presented below:

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Cost-Volume-Profit Relationships Chapter 13

5,000

4,500

4,000
Janitorial Labor Cost 3,500

3,000

2,500

2,000

1,500

1,000

500

0
0 20 40 60 80 100 120 140
Units Produced

Requirement (2)

The completed scattergraph for the number of workdays as the activity base
is presented below:

5,000

4,500

4,000

3,500
Janitorial Labor Cost

3,000

2,500

2,000

1,500

1,000

500

0
0 2 4 6 8 10 12 14 16 18 20 22 24
Number of Janitorial Workdays

Requirement (3)

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The number of workdays should be used as the activity base rather than the
number of units produced. There are several reasons for this. First, the
scattergraphs reveal that there is a much stronger relationship (i.e., higher
correlation) between janitorial costs and number of workdays than between
janitorial costs and number of units produced. Second, from the description
of the janitorial costs, one would expect that variations in those costs have
little to do with the number of units produced. Two janitors each work an
eight-hour shiftapparently irrespective of the number of units produced or
how busy the company is. Variations in the janitorial labor costs apparently
occur because of the number of workdays in the month and the number of
days the janitors call in sick. Third, for planning purposes, the company is
likely to be able to predict the number of working days in the month with
much greater accuracy than the number of units that will be produced.

Note that the scattergraph in part (1) seems to suggest that the janitorial
labor costs are variable with respect to the number of units produced. This is
false. Janitorial labor costs do vary, but the number of units produced isnt
the cause of the variation. However, since the number of units produced
tends to go up and down with the number of workdays and since the
janitorial labor costs are driven by the number of workdays, it appears on
the scattergraph that the number of units drives the janitorial labor costs to
some extent. Analysts must be careful not to fall into this trap of using the
wrong measure of activity as the activity base just because it appears there is
some relationship between cost and the measure of activity. Careful thought
and analysis should go into the selection of the activity base.

IV. Multiple Choice Questions

1. A 11. C* 21. C 31. D 41. B


2. D 12. C* 22. D 32. B 42. D
3. B 13. C 23. C 33. A 43. C
4. A 14. A 24. A 34. B
5. B 15. D 25. D 35. A
6. B 16. C 26. B 36. D
7. C 17. D 27. D 37. B
8. D 18. B 28. B 38. C
9. C 19. C 29. A 39. B
10. A 20. C 30. D 40. D

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Cost-Volume-Profit Relationships Chapter 13

* Supporting Computations:
11. (10,000 x 2) (P3,000 x 2) P5,000 = P9,000
12. [(P20 + P3 + P6) x 2,000 units] + (P10 x 1,000 units) = P68,000

CHAPTER 10

SYSTEMS DESIGN: JOB-ORDER COSTING AND


PROCESS COSTING

I. Questions
1. Job-order costing is used in those manufacturing situations where there
are many different products produced each period. Each product or job
is different from all others and requires separate costing. Process
costing is used in those manufacturing situations where a single,
homogeneous product, such as cement, bricks, or gasoline, is produced
for long periods at a time.
2. The job cost sheet is used in accumulating all costs assignable to a
particular job. These costs would include direct materials cost traceable
to the job, and manufacturing overhead cost allocable to the job. When
a job is completed, the job cost sheet is used to compute the cost per
completed unit. The job cost sheet is then used as a control document
for: (1) determining how many units have been sold and determining the
cost of these units; and (2) determining how many units are still in
inventory at the end of a period and determining the cost of these units
on the balance sheet.
3. Many production costs cannot be traced directly to a particular product
or job, but rather are incurred as a result of overall production activities.
Therefore, in order to be assigned to products, such costs must be
allocated to the products in some manner. Examples of such costs would
include utilities, maintenance on machines, and depreciation of the
factory building. These costs are indirect production costs.

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4. A firm will not know its actual manufacturing overhead costs until after
a period is over. Thus, if actual costs were used to cost products, it
would be necessary either (1) to wait until the period was over to add
overhead costs to jobs, or (2) to simply add overhead cost to jobs as the
overhead cost was incurred day by day. If the manager waits until after
the period is over to add overhead cost to jobs, then cost data will not be
available during the period. If the manager simply adds overhead cost
to jobs as the overhead cost is incurred, then unit costs may fluctuate
from month to month. This is because overhead cost tends to be
incurred somewhat evenly from month to month (due to the presence of
fixed costs), whereas production activity often fluctuates. For these
reasons, most firms use predetermined overhead rates, based on
estimates of overhead cost and production activity, to apply overhead
cost to jobs.
5. An allocation base should act as a cost driver in the incurrence of the
overhead cost; that is, the base should cause the overhead cost. If the
allocation base does not really cause the overhead, then costs will be
incorrectly attributed to products and jobs and their costs will be
distorted.
6. A process costing system is appropriate in those situations where a
homogeneous product is produced on a continuous basis.
7. In a process costing system, costs are accumulated by department.
8. First, the activity performed in a department must be performed
uniformly on all units moving through it. Second, the output of the
department must be homogeneous.
9. The reason cost accumulation is simpler is that costs only need to be
identified by department - not by separate job. Usually there will be
only a few departments in a company, whereas there can be hundreds or
even thousands of jobs in a job-order costing system.
10. A quantity schedule shows the physical flow of units through a
department during a period. It serves several purposes. First, it provides
the manager with information relative to activity in his or her department
and also shows the manager the stage of completion of any in-process
units. Second, it serves as an essential guide in computing the
equivalent units and in preparing the other parts of the production report.

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11. By definition, manufacturing overhead consists of costs that cannot be


practically traced to products or jobs. Therefore, if these costs are to be
assigned to products or jobs, they must be allocated rather than traced.
12. Assigning manufacturing overhead costs to jobs does not ensure a profit.
The units produced may not be sold and if they are sold, they may not be
sold at prices sufficient to cover all costs. It is a myth that assigning
costs to products or jobs ensures that those costs will be recovered.
Costs are recovered only by selling to customersnot by allocating
costs.
13. (a) Job-order costing and process costing have the same basic
purposesto assign materials, labor, and overhead cost to products
and to provide a mechanism for computing unit product costs.
(b) Both systems use the same basic manufacturing accounts.
(c) Costs flow through the accounts in basically the same way in both
systems.
14. The company will want to distinguish between the costs of the metals
used to make the medallions, but the medals are otherwise identical and
go through the same production processes. Thus, operation costing is
ideally suited for the companys needs.

II. Exercises

Exercise 1 (Process Costing and Job Order Costing)

a. Job-order costing f. Process costing


b. Process costing g. Process costing
c. Process costing * h. Job-order costing
d. Job-order costing i. Job-order costing
e. Job-order costing j. Job-order costing
* Some of the listed companies might use either a process costing or a job-
order costing system, depending on how operations are carried out and
how homogeneous the final product is. For example, a plywood
manufacturer might use job-order costing if plywoods are constructed of
different woods or come in markedly different sizes.

Exercise 2 (Applying Overhead with Various Bases)

Requirement 1
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Chapter 13 Cost-Volume-Profit Relationships

Predetermined overhead rates:

Company X:

Predetermined Estimated total manufacturing overhead cost


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

Predetermined Estimated total manufacturing overhead cost


=
overhead rate Estimated total amount of the allocation base
P270,000
= = P3.00 per MH
90,000 DLHs
Company Z:

Predetermined Estimated total manufacturing overhead cost


=
overhead rate Estimated total amount of the allocation base
P384,000
= = 160% of materials cost
P240,000 materials cost
Requirement 2

Actual overhead costs incurred......................................... P420,000


Overhead cost applied to Work in Process: ......................
58,000* actual hours P7.20 per hour ...................... 417,600
Underapplied overhead cost ............................................. P 2,400

* 7,000 hours + 30,000 hours + 21,000 hours = 58,000 hours

Exercise 3 (Departmental Overhead Rates)

Requirement 1

Milling Department:

Predetermined Estimated total manufacturing overhead cost


=
overhead rate Estimated total amount of the allocation base
P510,000
= = P8.50 per machine-hour
60,000 machine-hours
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Assembly Department:

Predetermined Estimated total manufacturing overhead cost


=
overhead rate Estimated total amount of the allocation base
P800,000
= = 125% of direct labor cost
P640,000 direct labor cost
Requirement 2
Overhead Applied
Milling Department: 90 MHs P8.50 per MH P765
Assembly Department: P160 125% 200
Total overhead cost applied P965

Requirement 3

Yes; if some jobs required a large amount of machine time and little labor
cost, they would be charged substantially less overhead cost if a plantwide
rate based on direct labor cost were being used. It appears, for example, that
this would be true of job 123 which required considerable machine time to
complete, but required only a small amount of labor cost.

Exercise 4 (Process Costing Journal Entries)

Work in ProcessMixing .......................................................................................


330,000
Raw Materials Inventory..................................................................................
330,000

Work in ProcessMixing .......................................................................................


260,000
Work in ProcessBaking .......................................................................................
120,000
Wages Payable .................................................................................................
380,000

Work in ProcessMixing .......................................................................................


190,000
Work in ProcessBaking .......................................................................................
90,000
Manufacturing Overhead .................................................................................
280,000

Work in ProcessBaking .......................................................................................


760,000
Work in ProcessMixing ...............................................................................
760,000

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Finished Goods ........................................................................................................


980,000
Work in ProcessBaking................................................................................
980,000

Exercise 5 (Quantity Schedule, Equivalent Units, and Cost per


Equivalent Unit Weighted Average Method)

Requirement 1

Weighted-Average Method
Quantity
Schedule
Gallons to be accounted for:
Work in process, May 1 (materials 80%
complete, labor and overhead 75%
complete) ....................................................................................................................................
80,000
Started into production ....................................................................................................................
760,000
Total gallons accounted for ..................................................................................................................
840,000

Equivalent Units
Materials Labor Overhead
Gallons accounted for as follows:
Transferred to the next department............... 790,000 790,000 790,000 790,000
Work in process, May 31 (materials 60%
complete, labor and overhead 20%
complete) ................................................. 50,000 30,000 10,000 10,000
Total gallons accounted for ............................... 840,000 820,000 800,000 800,000

Requirement 2

Total Costs Materials Labor Overhead Whole Unit


Cost to be accounted for:
Work in process, May 1 ............................................
P 146,600 P 68,600 P 30,000 P 48,000
Cost added during the month ....................................
1,869,200 907,200 370,000 592,000
Total cost to be accounted for (a) ...................................
P2,015,800 P975,800 P400,000 P640,000

Equivalent units (b) ........................................................ 820,000 800,000 800,000
Cost per equivalent unit (a) (b) ................................... P1.19 + P0.50 + P0.80 = P2.49

Exercise 6 (Quantity Schedule, Equivalent Units, and Cost per


Equivalent Unit FIFO Method)

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Requirement 1

FIFO Method
Quantity
Schedule
Gallons to be accounted for:
Work in process, May 1 (materials 80%
complete, labor and overhead 75%
complete) ....................................................................................................................................
80,000
Started into production ....................................................................................................................
760,000
Total gallons accounted for ..................................................................................................................
840,000

Equivalent Units
Materials Labor Overhead
Gallons accounted for as follows:
Transferred to the next department:
From the beginning inventory ................. 80,000 16,000* 20,000* 20,000*
Started and completed this month**........ 710,000 710,000 710,000 710,000
Work in process, May 31 (materials 60%
complete, labor and overhead 20%
complete) ................................................. 50,000 30,000 10,000 10,000
Total gallons accounted for ............................... 840,000 756,000 740,000 740,000

* Work required to complete the beginning inventory.


** 760,000 gallons started 50,000 gallons in ending work in process = 710,000 gallons
started and completed.

Requirement 2

Total Costs Materials Labor Overhead Whole Unit


Cost to be accounted for:
Work in process, May 31 ..........................................
P 146,600
Cost added during the month (a)...............................
1,869,200 P907,200 P370,000 P592,000
Total cost to be accounted for ........................................
P2,015,800
Equivalent units (b) ........................................................ 756,000 740,000 740,000
Cost per equivalent unit (a) (b) ................................... P1.20 + P0.50 + P0.80 = P2.50

Exercise 7

Requirement (1)

The direct materials and direct labor costs listed in the exercise would have
been recorded on four different documents: the materials requisition form for

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Job KC123, the time ticket for Kristine, the time ticket for Clarisse, and the
job cost sheet for Job KC123.

Requirement (2)

The costs for Job KC123 would have been recorded as follows:

Materials requisition form:


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

Time ticket for Kristine


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

Time ticket for Clarisse


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

Job Cost Sheet for Job KC123


Direct materials .............. P8,960.00
Direct labor:
Kristine ..................... 390.00
Clarisse ..................... 315.00
P9,665.00

Exercise 8

The predetermined overhead rate is computed as follows:

Estimated total manufacturing overhead .....................................P586,000


Estimated total direct labor hours (DLHs) ............................... 40,000 DLHs
= Predetermined overhead rate .................................................... P14.65 per DLH

Exercise 9

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Weighted-Average Method
Materials Labor Overhead Total
Work in process, May 1 ................................ P 14,550 P23,620 P118,100
Cost added during May .................................88,350 14,330 71,650
Total cost (a) .................................................
P102,900 P37,950 P189,750

Equivalent units of
production (b) ........................................... 1,200 1,100 1,100
Cost per equivalent unit
(a) (b) .....................................................P85.75 P34.50 P172.50 P292.75

Exercise 10

FIFO Method
Materials Conversion
To complete beginning work in process:
Materials: 400 units x (100% 75%) .............................................................
100
Conversion: 400 units x (100% 25%) .......................................................... 300
Units started and completed during the period
(42,600 units started 500 units in ending
inventory) ........................................................................................................
42,100 42,100
Ending work in process
Materials: 500 units x 80% complete ..............................................................
400
Conversion: 500 units x 30% complete .......................................................... 150
Equivalent units of production ...............................................................................
42,600 42,550

III. Problems

Problem 1

Requirement 1

a. Raw Materials Inventory .............................................. 210,000


Accounts Payable ..................................................... 210,000

b. Work in Process ........................................................... 178,000


Manufacturing Overhead ............................................. 12,000
Raw Materials Inventory .......................................... 190,000

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c. Work in Process ........................................................... 90,000


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

d. Manufacturing Overhead ............................................. 40,000


Accumulated Depreciation ....................................... 40,000

e. Manufacturing Overhead ............................................. 70,000


Accounts Payable ..................................................... 70,000

f. Work in Process ........................................................... 240,000


Manufacturing Overhead.......................................... 240,000
30,000 MH x P8 per MH = P240,000.

g. Finished Goods............................................................. 520,000


Work in Process ....................................................... 520,000

h. Cost of Goods Sold ...................................................... 480,000


Finished Goods ......................................................... 480,000

Accounts Receivable .................................................... 600,000


Sales ......................................................................... 600,000
P480,000 1.25 = P600,000

Requirement 2

Manufacturing Overhead Work in Process


(b) 12,000 240,000(f) Bal. 42,000 510,000(g)
(c) 110,000 (b) 178,000
(d) 40,000 (c) 90,000
(e) 70,000 (f) 240,000
8,000 Bal. 30,000
(Overapplied
overhea
d)
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Problem 2

Requirement 1

The costing problem does, indeed, lie with manufacturing overhead cost, as
suggested. Since manufacturing overhead is mostly fixed, the cost per unit
increases as the level of production decreases. The problem can be solved
by use of predetermined overhead rates, which should be based on expected
activity for the entire year. Many students will use units of product in
computing the predetermined overhead rate, as follows:
Estimated manufacturing overhead cost, P840,000 = P4.20 per unit.
Estimated units to be produced, 200,000

The predetermined overhead rate could also be set on the basis of either
direct labor cost or direct materials cost. The computations are:
Estimated manufacturing overhead cost, P840,000 350% of direct
=
Estimated direct labor cost, P240,000 labor cost

Estimated manufacturing overhead cost, P840,000 140% of direct


Estimated direct materials cost, P600,000 = materials cost

Requirement 2

Using a predetermined overhead rate, the unit costs would be:


Quarter
First Second Third Fourth
Direct materials ................... P240,000 P120,000 P 60,000 P180,000
Direct labor ......................... 96,000 48,000 24,000 72,000
Manufacturing overhead:
Applied at P4.20 per
units; 350% of direct
labor cost, or 140% of
direct materials cost ......... 336,000 168,000 84,000 252,000
Total cost ...................... P672,000 P336,000 P168,000 P504,000
Number of units
produced........................... 80,000 40,000 20,000 60,000
Estimated cost per unit........ P8.40 P8.40 P8.40 P8.40
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Problem 3

Weighted-Average Method
Quantity
Schedule
Pounds to be accounted for:
Work in process, May 1
(all materials, 55% labor and
overhead added last month) .......... 30,000
Started into production during
May .............................................. 480,000
Total pounds ........................... 510,000

Equivalent Units
Labor &
Materials Overhead
Pounds accounted for as follows:
Transferred to Department 2 ............ 490,000* 490,000 490,000
Work in process, May 31
(all materials, 90% labor and
overhead added this month) .......... 20,000 20,000 18,000
Total pounds ........................... 510,000 510,000 508,000
* 30,000 + 480,000 - 20,000 = 490,000.
Problem 4 (Weighted-Average Method; Interpreting a Production
Report)

Requirement 1

Weighted-Average Method

The equivalent units for the month would be:

Quantity Equivalent Units


Schedule Materials Conversion
Units accounted for as follows:
Transferred to next department ... 190,000 190,000 190,000
Work in process, April 30
(75% materials, 60%
conversion cost added this
month) ...................................... 40,000 30,000 24,000

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Total units and equivalent units


of production ............................ 230,000 220,000 214,000

Requirement 2

Total Cost Materials Conversion Whole Unit


Work in process, April 1 ... P 98,000 P 67,800 P 30,200
Cost added during the
month 827,000 579,000 248,000
Total cost (a) .................. P925,000 P646,800 P278,200

Equivalent units of
production (b) .............. 220,000 214,000
Cost per EU (a) (b) ....... P2.94 + =
P P
1 4
. .
3 2
0 4

Requirement 3

Total units transferred ....................................................... 190,000


Less units in the beginning inventory ............................... 30,000
Units started and completed during April ......................... 160,000

Requirement 4

No, the manager should not be rewarded for good cost control. The reason
for the Mixing Departments low unit cost for April is traceable to the fact
that costs of the prior month have been averaged in with Aprils costs in
computing the lower, P2.94 per unit figure. This is a major criticism of the
weighted-average method in that the figures computed for product costing
purposes cant be used to evaluate cost control or measure performance for
the current period.

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Problem 5 (Preparation of Production Report from Analysis of Work in


Process T-account Weighted-Average Method)

Requirement 1

Weighted-Average Method

Quantity Schedule and Equivalent Units

Quantity
Schedule
Pounds to be accounted for:
Work in process, May 1
(materials all complete, labor
and overhead 4/5 complete) ..... 35,000
Started into production ................ 280,000
Total pounds to be accounted for .... 315,000

Equivalent Units (EU)


Labor &
Materials Overhead
Pounds accounted for as follows:
Transferred to Blending* ............ 270,000 270,000 270,000
Work in process, May 31
(materials all complete, labor
and overhead 2/3 complete) ..... 45,000 45,000 30,000
Total pounds accounted for ............. 315,000 315,000 300,000
* 35,000 + 280,000 45,000 = 270,000.

Cost per Equivalent Unit Labor & Whole


Total Materials Ov Unit
er
he
ad
Cost to be accounted for:
Work in process, May 1 .... P 63,700 P 43,400 P 20,300
Cost added during the

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month 587,300 397,600 189,700


Total cost to be
accounted for (a) ......... P651,000 P441,000 P210,000

Equivalent units (b) ......... 315,000 300,000


Cost per equivalent unit
(a) (b) P1.40 + =
P P
0 2
. .
7 1
0 0

Cost Reconciliation

Total Equivalent Units (EU)


Cost Materials Conversion
Cost accounted for as follows:
Transferred to Blending:
270,000 pounds x P2.10
per pound.............................. P567,000 270,000 270,000
Work in process, May 31:
Materials, at P1.40 per EU ...... 63,000 45,000
Labor and overhead, at P0.70
per EU ................................... 21,000 30,000
Total work in process, May 31 .... 84,000
Total costs accounted for ................. P651,000

Requirement 2

In computing unit costs, the weighted-average method mixes costs of the


prior period with current period costs. Thus, under the weighted-average
method, unit costs are influenced to some extent by what happened in a prior
period. This problem becomes particularly significant when attempting to
measure performance in the current period. Good (or bad) cost control in the
current period might be concealed to some degree by the costs that have
been brought forward in the beginning inventory.

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IV. Multiple Choice Questions

1. D 6. D 11. A 16. A
2. D 7. A 12. D 17. D
3. D 8. C 13. B 18. A
4. C 9. C 14. D 19. C
5. D 10. B 15. C 20. D

CHAPTER 11

SYSTEMS DESIGN: ACTIVITY-BASED COSTING


AND MANAGEMENT

I. Questions
1. The three levels available are: Level 1, in which a company uses a
plantwide overhead rate; Level 2, in which a company uses departmental
overhead rates; and Level 3, in which a company uses activity-based
costing.
2. New approaches to costing are needed because events of the last few
decades have made drastic changes in many organizations. Automation
has greatly decreased the amount of direct labor required to manufacture
products; product diversity has increased in that companies are
manufacturing a wider range of products and these products differ
substantially in volume, lot size, and complexity of design; and total
overhead cost has increased to the point in some companies that a
correlation no longer exists between it and direct labor.
3. The departmental approach to assigning overhead cost to products relies
solely on volume as an assignment base. Where diversity exists between
products (that is, where products differ in terms of number of units
produced, lot size, or complexity of production), volume alone is not
adequate for overhead costing. Overhead costing based on volume will

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systematically overcost high-volume products and undercost low-volume


products.
4. Process value analysis (PVA) is a systematic approach to gaining an
understanding of the steps associated with a product or service. It
identifies all resource-consuming activities involved in the production
process and labels these activities as being either value-added or non-
value-added. Thus, it is the beginning point in designing an activity-
based costing system since management must know what activities are
involved with each product before activity centers can be designated and
cost drivers established. Also, PVA helps management to eliminate any
non-value-added activities and thereby streamline operations and
minimize costs.
5. The four general levels of activities are:
1. Unit-level activities, which are performed each time a unit is
produced.
2. Batch-level activities, which are performed each time a batch of
goods is handled or processed.
3. Product-level activities, which are performed as needed to support
specific products.
4. Facility-level activities, which simply sustain a facilitys general
manufacturing process.
6. First, activity-based costing increases the number of cost pools used to
accumulate overhead costs. Second, it changes the base used to assign
overhead costs to products. And third, it changes a managers
perception of many overhead costs in that costs that were formerly
thought to be indirect (such as depreciation or machine setup) are
identified with specific activities and thereby are recognized as being
traceable to individual products.
7. The two chief limitations are: First, the portion of overhead costs that
relate to facility-level activities are still usually allocated to products on
some arbitrary basis, such as machine-hours or direct labor-hours.
Critics of activity-based costing argue that facility-level activities
account for the bulk of all overhead costs in some companies. Second,
high measurement costs are involved in operating an activity-based
costing system. That is, the system requires the tracking of large
amounts of detail and the completion of many separate computations in
order to determine the cost of a unit or product.

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8. Yes, activity-based costing can be used in service organizations. It has


been successfully implemented, for example, in railroads, hospitals,
banks and data service companies.
9. A resource driver is a measure of the quality of resources consumed by
an activity.
10. An activity driver is a measure of frequency and intensity of demands
placed on activities by cost objects.
11. Two-stage allocation is a procedure that first assigns a firms resource
costs, namely factory overhead cost, to cost pools, and then to cost
objects.

12. Two major advantages of ABM are:


a. ABM measures the effectiveness of the key business processes and
activities, and identifies how they can be improved to reduce costs
and improve the customer value.
b. ABM improves the management focus by allocating resources to key
value-added activities, key customers, key products, and continuous
improvement methods to maintain the firms competitive advantage.
13. When direct labor is used as an allocation base for overhead, it is
implicitly assumed that overhead cost is directly proportional to direct
labor. When cost systems were originally developed in the 1800s, this
assumption may have been reasonably accurate. However, direct labor
has declined in importance over the years while overhead has been
increasing. This suggests that there is no longer a direct link between the
level of direct labor and overhead. Indeed, when a company automates,
direct labor is replaced by machines; a decrease in direct labor is
accompanied by an increase in overhead. This violates the assumption
that overhead cost is directly proportional to direct labor. Overhead cost
appears to be driven by factors such as product diversity and complexity
as well as by volume, for which direct labor has served as a convenient
measure.
14. Employees may resist activity-based costing because it changes the
rules of the game. ABC changes some of the key measures, such as
product costs, used in making decisions and may affect how individuals
are evaluated. Without top management support, employees may have
little interest in making these changes. In addition, if top managers

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continue to make decisions based on the numbers generated by the


traditional costing system, subordinates will quickly conclude that the
activity-based costing system can be ignored.
15. Unit-level activities are performed for each unit that is produced. Batch-
level activities are performed for each batch regardless of how many
units are in the batch. Product-level activities must be carried out to
support a product regardless of how many batches are run or units
produced. Customer-level activities must be carried out to support
customers regardless of what products or services they buy.
Organization-sustaining activities are carried out regardless of the
companys precise product mix or mix of customers.
16. Organization-sustaining costs, customer-level costs, and the costs of idle
capacity should not be assigned to products. These costs represent
resources that are not consumed by the products.

II. True or False

1. True 3. False 5. False 7. True


2. True 4. True 6. False 8. True

III. Exercises

Exercise 1
Examples of Examples of
Activity Traceable Cost
Activity Classification Costs Drivers
a. Materials are moved Batch-level Labor cost; Number of
from the receiving depreciation receipts;
dock to product pounds
of equipment;
flow lines by a handled
space cost
material-handling
crew
b. Direct labor workers Unit-level Direct labor Direct labor-
assemble various cost; indirect hours
products labor cost;
labor benefits
c. Ongoing training is Facility-level* Space cost; Hours of
provided to all training costs; training time;

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employees in the administration number trained


company costs
d. A product is Product-level Space cost; Hours of
designed by a supplies used; design time;
specialized design depreciation of number of
team design engineering
equipment change orders
e. Equipment setups Batch-level Labor cost; Number of
are performed on a supplies used; setups; hours
regular basis depreciation of or setup time
equipment
f. Numerical control Unit-level Power; Machine-
(NC) machines are supplies used; hours; number
used to cut and maintenance; of units
shape materials depreciation
* Personnel administration and training costs might be traceable in part to the
facility-level and in part to other activity centers at the unit-level, product-
level, and batch-level.

Exercise 2

1. plantwide overhead rate 6. Batch-level


2. volume 7. Product-level
3. two stage, stage, stage 8. Facility-level
4. Process value analysis 9. high-volume, low-volume, low-volume
5. Unit-level 10. activity centers

Exercise 3

a. Various individuals manage the parts


inventories. Product-level
b. A clerk in the factory issues purchase orders for
a job. Batch-level
c. The personnel department trains new production Organization-
workers. sustaining
d. The factorys general manager meets with other
department heads such as marketing to Organization-
coordinate plans. sustaining
e. Direct labor workers assemble products. Unit-level

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f. Engineers design new products. Product-level


g. The materials storekeeper issues raw materials to
be used in jobs. Batch-level
h. The maintenance department performs periodic
preventative maintenance on general-use Organization-
equipment. sustaining

Note: Some of these classifications are debatable and may depend on the
specific circumstances found in particular companies.

Exercise 4

Sales (P1,650 per standard model glider 10 standard


model gliders + P2,300 per custom designed glider 2
custom designed gliders) .....................................................................................
P21,100
Costs:
Direct materials (P462 per standard model glider 10
standard model gliders + P576 per custom
designed glider 2 custom designed gliders) ..................................................
P5,772
Direct labor (P19 per direct labor-hour 28.5 direct
labor-hours per standard model glider 10 standard
model gliders + P19 per direct labor-hour 32 direct
labor-hours per custom designed glider 2 custom
designed gliders)..............................................................................................
6,631
Supporting manufacturing (P18 per direct labor-hour
28.5 direct labor-hours per standard model glider
10 standard model gliders + P18 per direct labor-hour
32 direct labor-hours per custom designed glider
2 custom designed gliders) ..............................................................................
6,282
Order processing (P192 per order 3 orders) .....................................................576
Custom designing (P261 per custom design 2 custom
designs)............................................................................................................
522
Customer service (P426 per customer
1 customer) ......................................................................................................
426 20,209
Customer margin ......................................................................................................
P 891

Exercise 5

Requirement 1

The predetermined overhead rate is computed as follows:

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Predetermined P290,000
= = P5.80 per DLH
overhead rate 50,000 DLHs

The unit product costs under the companys traditional costing system are
computed as follows:
Special Regular
Direct materials ...............................................................................................................
P60.00 P45.00
Direct labor .....................................................................................................................
9.60 7.20
Manufacturing overhead (0.8 DLH P5.80 per DLH;
0.6 DLH P5.80 per DLH) .......................................................................................
4.64 3.48
Unit product cost .............................................................................................................
P74.24 P55.68
Requirement 2

The activity rates are computed as follows:

(a)
Estimated (b)
Overhead Total (a) (b)
Activities Cost Expected Activity Activity Rate
Supporting direct labor ...............................
P150,000 50,000 DLHs P3 per DLH
Batch setups ................................................
P60,000 250 setups P240 per setup
Safety testing...............................................
P80,000 100 tests P800 per test

Manufacturing overhead is assigned to the two products as follows:

Special Product:
(a) (b) (a) (b)
Activity Cost Pool Activity Rate Activity ABC Cost
Supporting direct labor ...................................................... P3 per DLH 8,000 DLHs P24,000
Batch setups .......................................................................
P240 per setup 200 setups 48,000
Safety testing......................................................................
P800 per test 80 tests 64,000
Total P136,000

Regular Product:
(a) (b) (a) (b)
Activity Cost Pool Activity Rate Activity ABC Cost
Supporting direct labor ...................................................... P3 per DLH 42,000 DLHs P126,000
Batch setups .......................................................................
P240 per setup 50 setups 12,000
Safety testing......................................................................
P800 per test 20 tests 16,000
Total P154,000

Activity-based costing unit product costs are computed as follows:

Special Regular

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Direct materials ..................................................................................................


P60.00 P45.00
Direct labor ........................................................................................................
9.60 7.20
Manufacturing overhead (P136,000 10,000 units; P154,000
70,000 units)..................................................................................................
13.60 2.20
Unit product cost ................................................................................................
P83.20 P54.40

IV. Problems

Problem 1

Cost Pool Cost Driver Cost


Systems Rate Consumption Assignment
Traditional cost system 350% P10,000 P35,000
ABC system
Labor 10% P10,000 P 1,000
Machining P25/hour 800 hours 20,000
Setup P10/hour 100 hours 1,000
Production order P100/order 12 orders 1,200
Material handling P20/requisition 5 requisitions 100
Parts administration P40/part 18 parts 720
P24,020
Problem 2

Requirement 1

(a)
Total overhead = P200,000 + P32,000 + P100,000 + P120,000
= P452,000

Overhead rate = P452,000 / 50,000 direct labor hours


= P9.04 per direct labor hour

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


= P9,040

(b) Total cost of proposed job:


Direct materials P 6,000
Direct labor 10,000
Overhead applied 9,040
Total cost P25,040

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(c) Companys bid = Full manufacturing cost x 120% = P25,040 x 120%


= P30,048

Requirement 2

(a) Maintenance : P200,000 / 20,000 = P10 per machine hour


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

Overhead assigned to proposed job:


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

(b) Total cost of proposed project:


Direct materials P 6,000
Direct labor 10,000
Overhead applied 5,620
Total cost P21,620

(c) Companys bid = Full manufacturing cost x 120% = P21,620 x 120%


= P25,944

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


Direct materials P6,000
Direct labor 10,000
Overhead assigned:
Maintenance (P10 x 500) P5,000
Material handling (P20 x 12) 240
Setups (P40 x 2) 80
Inspections (P30 x 10) 300
Total overhead assigned to job 5,620
Total cost P21,620

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Markup 120%
Bid price P25,944

Problem 3 (Activity-Based Costing)

Requirement 1

The first-stage allocation of costs to the activity cost pools appears below:

Activity Cost Pools


Assembling Processing Supporting
Units Orders Customers Other Total
Manufacturing
overhead P250,000 P175,000 P25,000 P50,000 P500,000
Selling and
administrative
overhead 30,000 135,000 75,000 60,000 300,000
Total cost P280,000 P310,000 P100,000 P110,000 P800,000

Requirement 2

The activity rates for the cost pools are:

(a) (b) (a) (b)


Total Cost Total Activity Activity Rate
Assembling units P280,000 1,000 units P280 per unit
Processing orders P310,000 250 orders P1,240 per order
Supporting customers P100,000 100 customers P1,000 per customer

Requirement 3

The overhead cost attributable to Lucky Sale would be computed as follows:

(a) (b) (a) x (b)


Activity Cost Pools Activity Rate Activity ABC Cost
Assembling units P280 per unit 80 units P22,400
Processing orders P1,240 per order 4 orders P4,960
Supporting customers P1,000 per customer 1 customer P1,000

Requirement 4

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The customer margin can be computed as follows:

Sales (P595 per unit x 80 units) P47,600


Costs:
Direct materials (P180 per unit x 80 units) P14,400
Direct labor (P50 per unit x 80 units) 4,000
Unit-related overhead (above) 22,400
Order-related overhead (above) 4,960
Customer-related overhead (above) 1,000 46,760
Customer margin P 840

Problem 4 (Activity-Based Costing as an Alternative to Traditional


Product Costing)

Requirement 1

a. When direct labor-hours are used to apply overhead cost to products, the
companys predetermined overhead rate would be:
Predetermined Manufacturing overhead cost
=
overhead rate Direct labor hours

P1,480,000
= = P74 per DLH
20,000 DLHs

b. Model
HY5 AS2
Direct materials ......................................................................
P35.00 P25.00
Direct labor:
P20 per hour 0.2 DLH, 0.4 DLH .................................... 4.00 8.00
Manufacturing overhead:
P74 per hour 0.2 DLH, 0.4 DLH .................................... 14.80 29.60
Total unit product cost ...........................................................
P53.80 P62.60

Requirement 2

a. Predetermined overhead rates for the activity cost pools:

(a) (b) (a) (b)


Activity Cost Pool Estimated Estimated Activity Rate

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Total Cost Total Activity


Machine setups ................ P180,000 250 setups P720 per setup
Special milling ................ P300,000 1,000 MHs P300 per MH
General factory ................
P1,000,000 20,000 DLHs P50 per DLH

The overhead applied to each product can be determined as follows:

Model HY5
(a) (a) (b)
Predetermined (b) Overhead
Activity Cost Pool Overhead Rate Activity Applied
Machine setups .....................................................................................
P720 per setup 150 setups P108,000
Special milling .....................................................................................
P300 per MH 1,000 MHs 300,000
General factory .....................................................................................
P50 per DLH 4,000 DLHs 200,000
Total manufacturing overhead cost (a) ................................................. P608,000
Number of units produced (b) .............................................................. 20,000
Overhead cost per unit (a) (b) ........................................................... P30.40

Model AS2
(a) (a) (b)
Predetermined (b) Overhead
Activity Cost Pool Overhead Rate Activity Applied
Machine setups .....................................................................................
P720 per setup 100 setups P 72,000
Special milling .....................................................................................
P300 per MH 0 MHs 0
General factory .....................................................................................
P50 per DLH 16,000 DLHs 800,000
Total manufacturing overhead cost (a) ................................................. P872,000
Number of units produced (b) .............................................................. 40,000
Overhead cost per unit (a) (b) ........................................................... P21.80

b. The unit product cost of each model under activity-based costing would
be computed as follows:
Model
HY5 AS2
Direct materials .........................................................................................................
P35.00 P25.00
Direct labor (P20 per DLH 0.2 DLH; P20 per DLH 04.DLH) ............................ 4.00 8.00
Manufacturing overhead (above) ...............................................................................
30.40 21.80
Total unit product cost ...............................................................................................
P69.40 P54.80

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Comparing these unit cost figures with the unit costs in Part 1(b), we find
that the unit product cost for Model HY5 has increased from P53.80 to
P69.40, and the unit product cost for Model AS2 has decreased from
P62.60 to P54.80.

Requirement 3

It is especially important to note that, even under activity-based costing, 68%


of the companys overhead costs continue to be applied to products on the
basis of direct labor-hours:
Machine setups (number of setups) ............................P 180,000 12 %
Special milling (machine-hours) ................................ 300,000 20
General factory (direct labor-hours) ........................... 1,000,000 68
Total overhead cost ....................................................P1,480,000 100 %

Thus, the shift in overhead cost from the high-volume product (Model AS2)
to the low-volume product (Model HY5) occurred as a result of reassigning
only 32% of the companys overhead costs.

The increase in unit product cost for Model HY5 can be explained as
follows: First, where possible, overhead costs have been traced to the
products rather than being lumped together and spread uniformly over
production. Therefore, the special milling costs, which are traceable to
Model HY5, have all been assigned to Model HY5 and none assigned to
Model AS2 under the activity-based costing approach. It is common in
industry to have some products that require special handling or special
milling of some type. This is especially true in modern factories that produce
a variety of products. Activity-based costing provides a vehicle for assigning
these costs to the appropriate products.

Second, the costs associated with the batch-level activity (machine setups)
have also been assigned to the specific products to which they relate. These
costs have been assigned according to the number of setups completed for
each product. However, since a batch-level activity is involved, another
factor affecting unit costs comes into play. That factor is batch size. Some
products are produced in large batches and some are produced in small
batches. The smaller the batch, the higher the cost per unit of the batch
activity. In the case at hand, the data can be analyzed as shown below.

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Model HY5:
Cost to complete one setup [see 2(a)]........................................ P720 (a)
Number of units processed per setup
(20,000 units 150 setups).................................................... 133.33 (b)
Setup cost per unit (a) (b) ....................................................... P5.40
Model AS2:
Cost to complete one setup (above) ........................................... P720 (a)
Number of units processed per setup
(40,000 units 100 setups).................................................... 400 (b)
Setup cost per unit (a) (b) ....................................................... P1.80

Thus, the cost per unit for setups is three times as great for Model HY5, the
low-volume product, as it is for Model AS2, the high-volume product. Such
differences in cost are obscured when direct labor-hours (or any other
volume measure) is used as the basis for applying overhead cost to
products.

In sum, overhead cost has shifted from the high-volume product to the low-
volume product as a result of more appropriately assigning some costs to
the products on the basis of the activities involved, rather than on the basis
of direct labor-hours.

V. Multiple Choice Questions

1. A 11. B 21. D
2. D 12. D 22. A
3. C 13. C 23. B
4. B 14. A 24. A
5. A 15. C 25. B
6. D 16. D 26. D
7. A 17. D 27. B
8. B 18. C 28. C
9. D 19. B 29. A
10. C 20. A 30. C

CHAPTER 12

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VARIABLE COSTING

I. Questions
1. The variable costing technique does not consider fixed costs as
unimportant or irrelevant, but it maintains that the distinction between
behaviors of different costs is crucial for certain decisions.

2. The central issue in variable costing is what is the proper timing for
release of fixed manufacturing overhead as expense: at the time of
incurrence, or at the time the finished units to which the fixed overhead
relates are sold.

3. Direct costing would be more accurately called variable or marginal


costing because in substance it is the inventory costing method which
applies only variable production costs to product; fixed factory overhead
is not assigned to product.

4. Marketing and administrative costs are treated as period costs under both
variable costing and absorption costing methods of product costing.

5. Under absorption costing, as a company manufactures units of product,


the fixed manufacturing overhead costs of the period are added to the
units, along with direct materials, direct labor, and variable
manufacturing overhead. If some of these units are not sold by the end
of the period, then they are carried into the next period as inventory.
The fixed manufacturing overhead cost attached to the units in ending
inventory follow the units into the next period as part of their inventory
cost. When the units carried over as inventory are finally sold, the fixed
manufacturing overhead cost that has been carried over with the units is
included as part of that periods cost of goods sold.

6. Many accountants and managers believe absorption costing does a better


job of matching costs with revenues than variable costing. They argue
that all manufacturing costs must be assigned to products to properly
match the costs of producing units of product with the revenues from the
units when they are sold. They believe that the fixed costs of
depreciation, taxes, insurance, supervisory salaries, and so on, are just as
essential to manufacturing products as are the variable costs.

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7. If fixed manufacturing overhead cost is released from inventory, then


inventory levels must have decreased and therefore production must
have been less than sales.

8. Under absorption costing it is possible to increase net operating income


without increasing sales by increasing the level of production. If
production exceeds sales, units of product are added to inventory. These
units carry a portion of the current periods fixed manufacturing
overhead costs into the inventory account, thereby reducing the current
periods reported expenses and causing net operating income to rise.

9. Generally speaking, variable costing cannot be used externally for


financial reporting purposes nor can it be used for tax purposes.

10. If production exceeds sales, absorption costing will show higher net
operating income than variable costing. The reason is that inventories
will increase and therefore part of the fixed manufacturing overhead cost
of the current period will be deferred in inventory to the next period
under absorption costing. By contrast, all of the fixed manufacturing
overhead cost of the current period will be charged immediately against
revenues as a period cost under variable costing.

11. Absorption and variable costing differ in how they handle fixed
manufacturing overhead. Under absorption costing, fixed manufacturing
overhead is treated as a product cost and hence is an asset until products
are sold. Under variable costing, fixed manufacturing overhead is treated
as a period cost and is expensed on the current periods income
statement.

12. Advocates of variable costing argue that fixed manufacturing costs are
not really the cost of any particular unit of product. If a unit is made or
not, the total fixed manufacturing costs will be exactly the same.
Therefore, how can one say that these costs are part of the costs of the
products? These costs are incurred to have the capacity to make products
during a particular period and should be charged against that period as
period costs according to the matching principle.

II. Exercises

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Exercise 1 (Variable and Absorption Costing Unit Product Costs and


Income Statements)

Requirement 1

a. The unit product cost under absorption costing would be:


Direct materials .......................................................................... P18
Direct labor ................................................................................. 7
Variable manufacturing overhead ............................................... 2
Total variable manufacturing costs ............................................. 27
Fixed manufacturing overhead (P160,000 20,000 units) ........ 8
Unit product cost ........................................................................ P35

b. The absorption costing income statement:


Sales (16,000 units P50 per unit) ....................... P800,000
Less cost of goods sold:
Beginning inventory .......................................... P 0
Add cost of goods manufactured
(20,000 units P35 per unit) ......................... 700,000
Goods available for sale .................................... 700,000
Less ending inventory
(4,000 units P35 per unit) ........................... 140,000 560,000
Gross margin.......................................................... 240,000
Less selling and administrative expenses .............. 190,000 *
Net operating income ............................................ P 50,000
*(16,000 units P5 per unit) + P110,000 = P190,000.

Requirement 2

a. The unit product cost under variable costing would be:


Direct materials ............................................................................... P18
Direct labor ...................................................................................... 7
Variable manufacturing overhead .................................................... 2
Unit product cost ............................................................................. P27

b. The variable costing income statement:


Sales (16,000 units P50 per unit) ..................... P800,000

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Less variable expenses:


Variable cost of goods sold:
Beginning inventory .................................... P 0
Add variable manufacturing costs
(20,000 units P27 per unit) ................... 540,000
Goods available for sale .............................. 540,000
Less ending inventory
(4,000 units P27 per unit) ..................... 108,000
Variable cost of goods sold .............................. 432,000 *
Variable selling expense
(16,000 units P5 per unit) ......................... 80,000 512,000
Contribution margin ............................................ 288,000
Less fixed expenses:
Fixed manufacturing overhead ........................ 160,000
Fixed selling and administrative ...................... 110,000 270,000
Net operating income .......................................... P 18,000
* The variable cost of goods sold could be computed more simply as:
16,000 units P27 per unit = P432,000.

Exercise 2 (Variable and Absorption Costing Unit Product Costs)

Requirement 1

Sales (40,000 units P33.75 per unit) .................................... P1,350,000


Less variable expenses:
Variable cost of goods sold
(40,000 units P16 per unit*) .........................................
P640,000
Variable selling and administrative expenses
(40,000 units P3 per unit) .............................................
120,000 760,000
Contribution margin ................................................................ 590,000
Less fixed expenses:
Fixed manufacturing overhead ............................................ 250,000
Fixed selling and administrative expenses .......................... 300,000 550,000
Net operating income .............................................................. P 40,000

* Direct materials ........................................................................................................


P10
Direct labor...............................................................................................................
4
Variable manufacturing overhead ............................................................................
2

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Total variable manufacturing cost ............................................................................


P16

Requirement 2

The difference in net operating income can be explained by the P50,000 in


fixed manufacturing overhead deferred in inventory under the absorption
costing method:
Variable costing net operating income ........................................ P40,000
Add: Fixed manufacturing overhead cost
deferred in inventory under absorption
costing: 10,000 units P5 per unit in
fixed manufacturing overhead cost .......................................... 50,000
Absorption costing net operating income .................................... P90,000

Exercise 3 (Variable Costing Unit Product Cost and Income Statement;


Break-even)

Requirement 1

Under variable costing, only the variable manufacturing costs are included in
product costs.

Direct materials ............................................................................ P 600


Direct labor .................................................................................. 300
Variable manufacturing overhead ................................................ 100
Unit product cost ......................................................................... P1,000

Note that selling and administrative expenses are not treated as product
costs; that is, they are not included in the costs that are inventoried. These
expenses are always treated as period costs and are charged against the
current periods revenue.

Requirement 2

The variable costing income statement appears below:


Sales ........................................................................ P18,000,000
Less variable expenses:

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Variable cost of goods sold:


Beginning inventory...................................... P 0
Add variable manufacturing costs
(10,000 units P1,000 per unit) ................ 10,000,000
Goods available for sale ................................ 10,000,000
Less ending inventory (1,000 units P1,000
per unit) ................................................... 1,000,000
Variable cost of goods sold* ............................... 9,000,000
Variable selling and administrative (9,000 units
P200 per unit) ................................................. 1,800,000 10,800,000
Contribution margin................................................ 7,200,000
Less fixed expenses:
Fixed manufacturing overhead ............................... 3,000,000
Fixed selling and administrative ............................. 4,500,000 7,500,000
Net operating loss ................................................... P (300,000)

* The variable cost of goods sold could be computed more simply as: 9,000 units
sold P1,000 per unit = P9,000,000.

Requirement 3

The break-even point in units sold can be computed using the contribution
margin per unit as follows:
Selling price per unit................................................................................................
P2,000
Variable cost per unit ...............................................................................................
1,200
Contribution margin per unit ...................................................................................
P 800
Fixed expenses
Exercise 4 (Absorption
Break-even unitCosting
sales Unit
= Product Cost and Income Statement)
Unit contribution margin
P7,500,000
=
Requirement 1 P800 per unit
= 9,375 units
Under absorption costing, all manufacturing costs (variable and fixed) are
included in product costs.

Direct materials ................................................................. P 600


Direct labor ........................................................................ 300
Variable manufacturing overhead ...................................... 100

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Fixed manufacturing overhead


(P3,000,000 10,000 units) .......................................... 300
Unit product cost ............................................................... P1,300

Requirement 2

The absorption costing income statement appears below:

Sales (9,000 units P2,000 per unit) ................................... P18,000,000


Cost of goods sold:
Beginning inventory .........................................................P 0
Add cost of goods manufactured
(10,000 units P1,300 per unit) ................................... 13,000,000
Goods available for sale ...................................................
13,000,000
Less ending inventory
(1,000 units P1,300 per unit) ..................................... 1,300,000 11,700,000
Gross margin ........................................................................ 6,300,000
Selling and administrative expenses:
Variable selling and administrative (9,000
units P200 per unit) ...................................................1,800,000
Fixed selling and administrative ...................................... 4,500,000 6,300,000
Net operating income ........................................................... P 0

Note: The company apparently has exactly zero net operating income even
though its sales are below the break-even point computed in Exercise 3. This
occurs because P300,000 of fixed manufacturing overhead has been deferred
in inventory and does not appear on the income statement prepared using
absorption costing.
Exercise 5 (Variable Costing Income Statement; Explanation of Difference in Net

Operating Income)

Requirement 1

2,000 units P60 per unit fixed manufacturing overhead = P120,000

Requirement 2

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The variable costing income statement appears below:

Sales............................................................................... P4,000,000
Variable expenses:
Variable cost of goods sold:
Beginning inventory ..............................................P 0
Add variable manufacturing costs
(10,000 units P310 per unit) ........................3,100,000
Goods available for sale ........................................3,100,000
Less ending inventory
(2,000 units P310 per unit) ............................. 620,000
Variable cost of goods sold* ......................................2,480,000
Variable selling and administrative
(8,000 units P20 per unit) ................................... 160,000 2,640,000
Contribution margin ...................................................... 1,360,000
Fixed expenses:
Fixed manufacturing overhead .................................. 600,000
Fixed selling and administrative ................................ 400,000 1,000,000
Net operating income .................................................... P 360,000

* The variable cost of goods sold could be computed more simply as: 8,000
units sold P310 per unit = P2,480,000.

The difference in net operating income between variable and absorption


costing can be explained by the deferral of fixed manufacturing overhead
cost in inventory that has taken place under the absorption costing approach.
Note from part (1) that P120,000 of fixed manufacturing overhead cost has
been deferred in inventory to the next period. Thus, net operating income
under the absorption costing approach is P120,000 higher than it is under
variable costing.
Exercise 6 (Evaluating Absorption and Variable Costing as Alternative
Costing Methods)

Requirement 1

a. By assumption, the unit selling price, unit variable costs, and total fixed
costs are constant from year to year. Consequently, variable costing net
operating income will vary with sales. If sales increase, variable costing
net operating income will increase. If sales decrease, variable costing net

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operating income will decrease. If sales are constant, variable costing net
operating income will be constant. Because variable costing net
operating income was P16,847 each year, unit sales must have been the
same in each year.

The same is not true of absorption costing net operating income. Sales
and absorption costing net operating income do not necessarily move in
the same direction because changes in inventories also affect absorption
costing net operating income.

b. When variable costing net operating income exceeds absorption costing


net operating income, sales exceeds production. Inventories shrink and
fixed manufacturing overhead costs are released from inventories. In
contrast, when variable costing net operating income is less than
absorption costing net operating income, production exceeds sales.
Inventories grow and fixed manufacturing overhead costs are deferred in
inventories. The year-by-year effects are shown below.

Year 1 Year 2 Year 3


Variable costing NOI Variable costing NOI < Variable costing NOI
= Absorption costing Absorption costing > Absorption costing
NOI NOI NOI
Production = Sales Production > Sales Production < Sales
Inventories remain the
same Inventories grow Inventories shrink

Requirement 2

a. As discussed in part (1 a) above, unit sales and variable costing net


operating income move in the same direction when unit selling prices
and the cost structure are constant. Because variable costing net
operating income declined, unit sales must have also declined. This is
true even though the absorption costing net operating income increased.
How can that be? By manipulating production (and inventories) it may
be possible to maintain or increase the level of absorption costing net
operating income even though unit sales decline. However, eventually
inventories will grow to be so large that they cannot be ignored.

b. As stated in part (1 b) above, when variable costing net operating income


is less than absorption costing net operating income, production exceeds

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Cost-Volume-Profit Relationships Chapter 13

sales. Inventories grow and fixed manufacturing overhead costs are


deferred in inventories. The year-by-year effects are shown below.

Year 1 Year 2 Year 3


Variable costing NOI = Variable costing NOI < Variable costing NOI
Absorption costing Absorption costing < Absorption costing
NOI NOI NOI
Production = Sales Production > Sales Production > Sales
Inventories remain the
same Inventories grow Inventories grow

Requirement 3

Variable costing appears to provide a much better picture of economic reality


than absorption costing in the examples above. In the first case, absorption
costing net operating income fluctuates wildly even though unit sales are the
same each year and unit selling prices, unit variable costs, and total fixed
costs remain the same. In the second case, absorption costing net operating
income increases from year to year even though unit sales decline.
Absorption costing is much more subject to manipulation than variable
costing. Simply by changing production levels (and thereby deferring or
releasing costs from inventory) absorption costing net operating income can
be manipulated upward or downward.

Note: This exercise is based on the following data:

Common data:
Annual fixed manufacturing costs ............................... P153,153
Contribution margin per unit ...................................... P35,000
Annual fixed SGA costs ............................................... P180,000

Part 1:
Year 1 Year 2 Year 3
Beginning inventory ............................................................. 1 1 2
Production ............................................................................ 10 11 9
Sales ..................................................................................... 10 10 10
Ending .................................................................................. 1 2 1

Variable costing net operating income .................................


P16,847 P16,847 P16,847

Fixed manufacturing overhead in beginning P15,315 P15,315 P27,846

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inventory* .....................................................................
Fixed manufacturing overhead in ending inventory ............ P15,315 P27,846 P17,017
Absorption costing net operating income............................. P16,847 P29,378 P6,018

* Fixed manufacturing overhead in beginning inventory is assumed in both parts 1 and 2


for Year 1. A FIFO inventory flow assumption is used.

Part 2:
Year 1 Year 2 Year 3
Beginning inventory .................................................. 1 1 4
Production ................................................................. 10 12 20
Sales .......................................................................... 10 9 8
Ending ....................................................................... 1 4 16

Variable costing net operating income (loss) ............P16,847 (P18,153) (P53,153)

Fixed manufacturing overhead in beginning


inventory* ..........................................................P15,315 P15,315 P51,051
Fixed manufacturing overhead in ending
inventory ............................................................P15,315 P51,051 P122,522
Absorption costing net operating income..................P16,847 P17,583 P18,318

* Fixed manufacturing overhead in beginning inventory is assumed in both parts 1 and 2


for Year 1. A FIFO inventory flow assumption is used.
III. Problems

Problem 1

Requirement 1: Variable Costing Method

Romero Parts, Inc.


Income Statement - Manufacturing
For the Year Ended December 31, 2005

Sales P20,700,000
Less: Variable Cost of Sales
Inventory, Jan. 1 P1,155,000
Current Production 7,700,000
Total Available for Sale P8,855,000
Inventory, Dec. 31 805,000 8,050,000
Contribution Margin P12,650,000
Less Fixed Costs and Expenses 6,000,000

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Net Income P 6,650,000

Requirement 2: Absorption Costing Method

Romero Parts, Inc.


Income Statement - Manufacturing
For the Year Ending December 31, 2006

Sales P26,100,000
Less Cost of goods sold:
Inventory, Jan. 1 P 1,380,000
Current Production 16,100,000
Total Available for Sale P17,480,000
Inventory, Dec. 31 747,500
Cost of Sales - Standard P16,732,500
Favorable Capacity Variance 900,000 15,832,500
Income from Manufacturing P10,267,500

Requirement 3: Variable Costing Method

Romero Parts, Inc.


Income Statement - Manufacturing
For the Year Ending December 31, 2006

Sales P26,100,000
Less Variable Cost of Sales:
Inventory, Jan. 1 P 805,000
Production 9,800,000
Total Available for Sale P10,605,000
Inventory, Dec. 31 455,000 10,150,000
Contribution Margin - Manufacturing P15,950,000
Less Fixed Cost 5,400,000
Income from Manufacturing P10,550,000

Reconciliation

Net Income, absorption costing P10,267,500

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Add Fixed Factory Overhead Inventory, 1/1 575,000


Total P10,842,500
Less Fixed Factory Overhead Inventory, 12/31 292,500
Net Income, direct costing P10,550,000

Problem 2

Requirement 1

Honey Company
Income Statement - Direct Costing
For the Year Ended December 31, 2005

Sales P280,000
Less Variable Cost of Sales:
Finished Goods Inventory, 1/1 P 4,000
Current Production 120,000
Total Available for Sale P124,000
Finished Goods Inventory, 12/31 12,000
Variable Cost of Sale - Standard P112,000
Unfavorable Variance 5,000 117,000

Contribution Margin - Manufacturing P163,000


Less Variable Marketing Expenses 28,000
Contribution Margin - Final P135,000
Less Fixed Costs and Expenses:
Fixed Factory Overhead P 54,000
Fixed Marketing and
Administrative Expenses 20,000 74,000
Net Income P 61,000

Requirement 2

Honey Company
Income Statement - Absorption Costing
For the Year Ended December 31, 2005

Sales P280,000
Less: Cost of Sales
Finished goods inventory, Jan. 1 (1,000 x P5.50) P 5,500

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Current production costs


Variable (30,000 x P4.00) P120,000
Fixed (30,000 x P1.50) 45,000 165,000
P170,500
Less: Finished goods inventory, Dec. 31
(3,000 x P5.50) 16,500
Cost of Sales - at Standard P154,000
Add (Deduct) Variance
Unfavorable variable manufacturing
costs variances 5,000
Underapplied fixed factory overhead
(6,000 x P1.50) 9,000
Cost of Sales - Actual P168,000
Gross Profit P112,000
Less: Selling and administrative expenses
Variable 28,000
Fixed 20,000
P 48,000
Net Income P 64,000

Problem 3 (Variable Costing Income Statement; Reconciliation)

Requirement 1

The unit product cost under the variable costing approach would be
computed as follows:
Direct materials ........................................................................................................
P 8
Direct labor...............................................................................................................
10
Variable manufacturing overhead ............................................................................
2
Unit product cost ......................................................................................................
P20

With this figure, the variable costing income statements can be prepared:
Year 1 Year 2
Sales .........................................................................................................................
P1,000,000 P1,500,000
Less variable expenses:
Variable cost of goods sold @ P20 per unit.........................................................
400,000 600,000
Variable selling and administrative
@ P3 per unit ...................................................................................................
60,000 90,000

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Total variable expenses............................................................................................


460,000 690,000
Contribution margin.................................................................................................
540,000 810,000
Less fixed expenses:
Fixed manufacturing overhead ............................................................................
350,000 350,000
Fixed selling and administrative ..........................................................................
250,000 250,000
Total fixed expenses ................................................................................................
600,000 600,000
Net operating income (loss) .....................................................................................
P (60,000) P 210,000

Requirement 2

Variable costing net operating income (loss) ..............P (60,000) P 210,000


Add: Fixed manufacturing overhead cost
deferred in inventory under absorption costing
(5,000 units P14 per unit) .................................... 70,000
Deduct: Fixed manufacturing overhead cost
released from inventory under absorption
costing (5,000 units P14 per unit) ....................... (70,000)
Absorption costing net operating income ....................P 10,000 P 140,000

Problem 4 (Prepare and Interpret Statements; Changes in Both Sales


and Production; JIT)

Requirement 1

Year 1 Year 2 Year 3


Sales P1,000,000 P 800,000 P1,000,000
Less variable expenses:
Variable cost of goods sold
@ P4 per unit ...............................................................................................................
200,000 160,000 200,000
Variable selling and administrative
@ P2 per unit ...............................................................................................................
100,000 80,000 100,000
Total variable expenses .........................................................................................................
300,000 240,000 300,000
Contribution margin ..............................................................................................................
700,000 560,000 700,000
Less fixed expenses:
Fixed manufacturing overhead.......................................................................................
600,000 600,000 600,000
Fixed selling and administrative ....................................................................................
70,000 70,000 70,000
Total fixed expenses..............................................................................................................
670,000 670,000 670,000
Net operating income (loss) ..................................................................................................
P 30,000 P(110,000) P 30,000

Requirement 2

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a.
Year 1 Year 2 Year 3
Variable manufacturing cost ....................................................................................
P 4 P 4 P 4
Fixed manufacturing cost:
P600,000 50,000 units ......................................................................................
12
P600,000 60,000 units ......................................................................................
10
P600,000 40,000 units ......................................................................................
15
Unit product cost .....................................................................................................
P16 P14 P19

b.
Variable costing net operating income
(loss) ...................................................................................................................
P30,000 P(110,000) P 30,000
Add (Deduct): Fixed manufacturing
overhead cost deferred in inventory
from Year 2 to Year 3 under
absorption costing (20,000 units
P10 per unit) .......................................................................................................
200,000 (200,000)
Add: Fixed manufacturing overhead
cost deferred in inventory from Year
3 to the future under absorption
costing (10,000 units P15 per
unit) .....................................................................................................................
150,000
Absorption costing net operating
income (loss) .......................................................................................................
P30,000 P 90,000 P(20,000)

Requirement 3

Production went up sharply in Year 2 thereby reducing the unit product cost,
as shown in (2a). This reduction in cost, combined with the large amount of
fixed manufacturing overhead cost deferred in inventory for the year, more
than offset the loss of revenue. The net result is that the companys net
operating income rose even though sales were down.

Requirement 4

The fixed manufacturing overhead cost deferred in inventory from Year 2


was charged against Year 3 operations, as shown in the reconciliation in (2b).
This added charge against Year 3 operations was offset somewhat by the fact

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that part of Year 3s fixed manufacturing overhead costs was deferred in


inventory to future years [again see (2b)]. Overall, the added costs charged
against Year 3 were greater than the costs deferred to future years, so the
company reported less income for the year even though the same number of
units was sold as in Year 1.

Requirement 5

a. Several things would have been different if the company had been using
JIT inventory methods. First, in each year production would have been
geared to sales so that little or no inventory of finished goods would
have been built up in either Year 2 or Year 3. Second, unit product costs
probably would have been the same in all three years, since these costs
would have been established on the basis of expected sales (50,000
units) for each year. Third, since only 40,000 units were sold in Year 2,
the company would have produced only that number of units and
therefore would have had some underapplied overhead cost for the year.
(See the discussion on underapplied overhead in the following
paragraph.)

b. If JIT had been in use, the net operating income under absorption costing
would have been the same as under variable costing in all three years.
The reason is that with production geared to sales, there would have
been no ending inventory on hand, and therefore there would have been
no fixed manufacturing overhead costs deferred in inventory to other
years. Assuming that the company expected to sell 50,000 units in each
year and that unit product costs were set on the basis of that level of
expected activity, the income statements under absorption costing would
have appeared as follows:
Year 1 Year 2 Year 3
Sales ......................................................................................................................................
P1,000,000 P 800,000 P1,000,000
Less cost of goods sold:
Cost of goods manufactured @ P16 per unit .........................................................................
800,000 640,000 * 800,000
Add underapplied overhead ..................................................................................................
120,000 **
Cost of goods sold .................................................................................................................
800,000 760,000 800,000
Gross margin .........................................................................................................................
200,000 40,000 200,000
Selling and administrative expenses ......................................................................................
170,000 150,000 170,000
Net operating income (loss) ..................................................................................................
P 30,000 P(110,000) P 30,000

* 40,000 units P16 per unit = P640,000.

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** 10,000 units not produced P12 per unit fixed manufacturing overhead cost =
P120,000 fixed manufacturing overhead cost not applied to products.

Problem 5 (Contrasting Variable and Absorption Costing)

Requirement 1 (a)

Under absorption costing, all manufacturing costs, variable and fixed, are
included in unit product costs:

Year 1 Year 2
Direct materials P11 P11
Direct labor 6 6
Variable manufacturing overhead 3 3
Fixed manufacturing overhead
(P120,000 10,000 units) 12
(P120,000 6,000 units) 20
Unit product cost P32 P40

Requirement 1 (b)

The absorption costing income statements follow:

Year 1 Year 2
Sales (8,000
units x P50
per unit) P400,000 P400,000
Cost of goods
sold:
Beginning P P
inventory 0 64,000
Add cost of
goods
manufactur
ed (10,000 320,000 240,000

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units x P32
per unit;
6,000 units
x P40 per
unit)
Goods
available for
sale 320,000 304,000
Less ending
inventory
(2,000 units
x P32 per
unit; 0 units
x P40 per
unit) 64,000 256,000 0 304,000
Gross margin 144,000 96,000
Selling and
administrativ
e expenses
(8,000 units
x P4 per unit
+ P70,000) 102,000 102,000
Net operating P
income 42,000 P (6,000)
Requirement 2 (a)

Under variable costing, only the variable manufacturing costs are included in
unit product costs:

Year 1 Year 2
Direct materials P11 P11
Direct labor 6 6

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Variable manufacturing overhead 3 3


Unit product cost P20 P20

Requirement 2 (b)

The variable costing income statements follow. Notice that the variable cost
of goods sold is computed in a simpler, more direct manner than in the
examples provided earlier. On a variable costing income statement, this
simple approach or the more complex approach illustrated earlier is
acceptable for computing the cost of goods sold.

Year 1 Year 2
Sales (8,000
units x P50
per unit) P400,000 P400,000
Variable
expenses:
Variable cost
of goods sold
(8,000 units
x P20 per
unit) P160,000 P160,000
Variable
selling and
administrati
ve (8,000
units x P4
per unit) 32,000 192,000 32,000 192,000
Contribution
margin 208,000 208,000
Fixed
expenses:
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Chapter 13 Cost-Volume-Profit Relationships

Fixed
manufacturin
g overhead 120,000 120,000
Fixed selling
and
administrati
ve expenses 70,000 190,000 70,000 190,000
Net operating P P
income 18,000 18,000
Requirement 3

The reconciliation of the variable and absorption costing net operating


incomes follows:
Year 1 Year 2
Variable costing net operating income P18,000 P18,000
Add fixed manufacturing overhead costs
deferred in inventory under absorption
costing (2,000 units x P12 per unit) 24,000
Deduct fixed manufacturing overhead
costs released from inventory under
absorption costing (2,000 units x P12
per unit) (24,000)
Absorption costing net operating income P42,000 P(6,000)

Problem 6 (Variable Costing Income Statement; Reconciliation)

Requirement 1

Sales (40,000 units P33.75 per unit) .......................................... P1,350,000


Variable expenses:
Variable cost of goods sold
(40,000 units P16 per unit*) ..............................................
P640,000
Variable selling and administrative expenses
(40,000 units P3 per unit) ..................................................
120,000 760,000
Contribution margin ...................................................................... 590,000

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Cost-Volume-Profit Relationships Chapter 13

Fixed expenses:
Fixed manufacturing overhead..................................................
250,000
Fixed selling and administrative expenses ................................
300,000 550,000
Net operating income .................................................................... P 40,000

* Direct materials......................................................... P10


Direct labor ............................................................... 4
Variable manufacturing overhead ............................. 2
Total variable manufacturing cost ............................ P16

Requirement 2

The difference in net operating income can be explained by the P50,000 in


fixed manufacturing overhead deferred in inventory under the absorption
costing method:

Variable costing net operating income .................................................................


P40,000
Add: Fixed manufacturing overhead cost deferred in
inventory under absorption costing: 10,000 units P5 per
unit in fixed manufacturing overhead cost .......................................................
50,000
Absorption costing net operating income .............................................................
P90,000

IV. Multiple Choice Questions

1. D 11. B
2. B 12. A
3. B 13. C
4. B 14. D
5. B 15. B
6. C 16. A
7. A 17. C
8. B 18. C
9. A 19. B
10. A 20. C

CHAPTER 13
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Chapter 13 Cost-Volume-Profit Relationships

COST-VOLUME-PROFIT RELATIONSHIPS

I. Questions
1. The total contribution margin is the excess of total revenue over total
variable costs. The unit contribution margin is the excess of the unit
price over the unit variable costs.
2. Total contribution margin:
Selling price - manufacturing variable costs expensed -
nonmanufacturing variable costs expensed = Total contribution margin.
Gross margin:
Selling price - variable manufacturing costs expensed - fixed
manufacturing costs expensed = Gross margin.
3. A company operating at break-even is probably not covering costs
which are not recorded in the accounting records. An example of such a
cost is the opportunity cost of owner-invested capital. In some small
businesses, owner-managers may not take a salary as large as the
opportunity cost of forgone alternative employment. Hence, the
opportunity cost of owner labor may be excluded.
4. In the short-run, without considering asset replacement, net operating
cash flows would be expected to exceed net income, because the latter
includes depreciation expense, while the former does not. Thus, the
cash basis break-even would be lower than the accrual break-even if
asset replacement is ignored. However, if asset replacement costs are
taken into account, (i.e., on a cradle to grave basis), the long-run net
cash flows equal long-run accrual net income, and the long-run break-
even points are the same.
5. Both unit price and unit variable costs are expressed on a per product
basis, as:
= (P1 - V1) X1 + (P2 - V2) X2 + + (Pn - Vn) Xn - F,
for all products 1 to n where:
= operating profit,
P = average unit selling price,

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Cost-Volume-Profit Relationships Chapter 13

V = average unit variable cost,


X = quantity of units,
F = total fixed costs for the period.
6. If the relative proportions of products (i.e., the product mix) is not
held constant, products may be substituted for each other. Thus, there
may be almost an infinite number of ways to achieve a target operating
profit. As shown from the multiple product profit equation, there are
several unknowns for one equation:
= (P1 - V1) X1 + (P2 - V2) X2 + + (Pn - Vn) Xn - F,
for all products 1 to n.
7. A constant product mix is assumed to simplify the analysis. Otherwise,
there may be no unique solution.
8. Operating leverage measures the impact on net operating income of a
given percentage change in sales. The degree of operating leverage at a
given level of sales is computed by dividing the contribution margin at
that level of sales by the net operating income.
9. Three approaches to break-even analysis are (a) the equation method, (b)
the contribution margin method, and (c) the graphical method. In the
equation method, the equation is: Sales = Variable expenses + Fixed
expenses + Profits, where profits are zero at the break-even point. The
equation is solved to determine the break-even point in units or peso
sales.
10. The margin of safety is the excess of budgeted (or actual) sales over the
break-even volume of sales. It states the amount by which sales can
drop before losses begin to be incurred.
11. The sales mix is the relative proportions in which a companys products
are sold. The usual assumption in cost-volume-profit analysis is that the
sales mix will not change.
12. A higher break-even point and a lower net operating income could result
if the sales mix shifted from high contribution margin products to low
contribution margin products. Such a shift would cause the average
contribution margin ratio in the company to decline, resulting in less
total contribution margin for a given amount of sales. Thus, net
operating income would decline. With a lower contribution margin
ratio, the break-even point would be higher since it would require more
sales to cover the same amount of fixed costs.

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Chapter 13 Cost-Volume-Profit Relationships

13. The contribution margin (CM) ratio is the ratio of the total contribution
margin to total sales revenue. It can be used in a variety of ways. For
example, the change in total contribution margin from a given change in
total sales revenue can be estimated by multiplying the change in total
sales revenue by the CM ratio. If fixed costs do not change, then a peso
increase in contribution margin will result in a peso increase in net
operating income. The CM ratio can also be used in break-even analysis.
Therefore, knowledge of a products CM ratio is extremely helpful in
forecasting contribution margin and net operating income.
14. Incremental analysis focuses on the changes in revenues and costs that
will result from a particular action.
15. All other things equal, Company B, with its higher fixed costs and lower
variable costs, will have a higher contribution margin ratio than
Company A. Therefore, it will tend to realize a larger increase in
contribution margin and in profits when sales increase.
16. (a) If the selling price decreased, then the total revenue line would rise
less steeply, and the break-even point would occur at a higher unit
volume. (b) If the fixed cost increased, then both the fixed cost line and
the total cost line would shift upward and the break-even point would
occur at a higher unit volume. (c) If the variable cost increased, then the
total cost line would rise more steeply and the break-even point would
occur at a higher unit volume.

II. Exercises

Exercise 1 (Using a Contribution Format Income Statement)

Requirement 1
Total Per Unit
Sales (30,000 units 1.15 = 34,500 units) ..............................................................
P172,500 P5.00
Less variable expenses ............................................................................................
103,500 3.00
Contribution margin ................................................................................................
69,000 P2.00
Less fixed expenses .................................................................................................
50,000
Net operating income ..............................................................................................
P 19,000

Requirement 2

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Cost-Volume-Profit Relationships Chapter 13

Sales (30,000 units 1.20 = 36,000 units) ..............................................................


P162,000 P4.50
Less variable expenses ............................................................................................
108,000 3.00
Contribution margin ................................................................................................
54,000 P1.50
Less fixed expenses .................................................................................................
50,000
Net operating income ..............................................................................................
P 4,000

Requirement 3

Sales (30,000 units 0.95 = 28,500 units) ..............................................................


P156,750 P5.50
Less variable expenses ............................................................................................
85,500 3.00
Contribution margin ................................................................................................
71,250 P2.50
Less fixed expenses (P50,000 + P10,000)...............................................................
60,000
Net operating income ..............................................................................................
P 11,250

Requirement 4

Sales (30,000 units 0.90 = 27,000 units) ..............................................................


P151,200 P5.60
Less variable expenses ............................................................................................
86,400 3.20
Contribution margin ................................................................................................
64,800 P2.40
Less fixed expenses .................................................................................................
50,000
Net operating income ..............................................................................................
P 14,800

Exercise 2 (Break-even Analysis and CVP Graphing)

Requirement 1

The contribution margin per person would be:

Price per ticket .........................................................................................................


P30
Less variable expenses:
Dinner ..................................................................................................................
P7
Favors and program .............................................................................................
3 10
Contribution margin per person .............................................................................. P20

The fixed expenses of the Extravaganza total P8,000; therefore, the break-
even point would be computed as follows:

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Chapter 13 Cost-Volume-Profit Relationships

Sales = Variable expenses + Fixed expense + Profits

P30Q = P10Q + P8,000 + P0


P20Q = P8,000
Q = P8,000 P20 per person
Q = 400 persons; or, at P30 per person, P12,000

Alternative solution:
Break-even Fixed expenses
point =
Unit contribution margin
in unit sales
P8,000
=
P20 per person
= 400 persons

or, at P30 per person, P12,000.

Requirement 2

Variable cost per person (P7 + P3) ..........................................................................


P10
Fixed cost per person (P8,000 250 persons).........................................................
32
Ticket price per person to break even ......................................................................
P42

Requirement 3

Cost-volume-profit graph:

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Cost-Volume-Profit Relationships Chapter 13

P22,000

P20,000

P18,000

P16,000 Total Sales

P14,000
Break-even point: 400 persons,
P12,000 or P12,000 in sales
Pesos

P10,000

P8,000 Total Expenses

P6,000 Fixed Expenses

P4,000

P2,000

P0
0 100 200 300 400 500 600
Number of Persons

Exercise 3 (Break-even and Target Profit Analysis)

Requirement 1

Sales = Variable expenses + Fixed expenses + Profits


P900Q = P630Q + P1,350,000 + P0
P270Q = P1,350,000
Q = P1,350,000 P270 per lantern
Q = 5,000 lanterns, or at P900 per lantern, P4,500,000 in sales

Alternative solution:
Break-even Fixed expenses
point =
Unit contribution margin
in unit sales
P1,350,000
=
P270 per lantern

=
13-2135,000 lanterns
Chapter 13 Cost-Volume-Profit Relationships

or at P900 per lantern, P4,500,000 in sales

Requirement 2

An increase in the variable expenses as a percentage of the selling price


would result in a higher break-even point. The reason is that if variable
expenses increase as a percentage of sales, then the contribution margin will
decrease as a percentage of sales. A lower CM ratio would mean that more
lanterns would have to be sold to generate enough contribution margin to
cover the fixed costs.

Requirement 3
Present: Proposed:
8,000 Lanterns 10,000 Lanterns*
Total Per Unit Total Per Unit
Sales ...............................................................................................................................
P7,200,000 P900 P8,100,000 P810 **
Less variable expenses ...................................................................................................
5,040,000 630 6,300,000 630
Contribution margin .......................................................................................................
2,160,000 P270 1,800,000 P180
Less fixed expenses ........................................................................................................
1,350,000 1,350,000
Net operating income .....................................................................................................
P 810,000 P 450,000

* 8,000 lanterns 1.25 = 10,000 lanterns


** P900 per lantern 0.9 = P810 per lantern

As shown above, a 25% increase in volume is not enough to offset a 10%


reduction in the selling price; thus, net operating income decreases.

Requirement 4

Sales = Variable expenses + Fixed expenses + Profits


P810Q = P630Q + P1,350,000 + P720,000
P180Q = P2,070,000
Q = P2,070,000 P180 per lantern
Q = 11,500 lanterns

Alternative solution:
Unit sales to Fixed expenses + Target profit
attain target profit =
Unit contribution margin
13-214
P1,350,000 + P720,000
=
P180 per lantern
= 11,500 lanterns
Cost-Volume-Profit Relationships Chapter 13

Exercise 4 (Operating Leverage)

Requirement 1

Sales (30,000 doors) ................................................................................................


P18,000,000 P600
Less variable expenses .............................................................................................
12,600,000 420
Contribution margin.................................................................................................
5,400,000 P180
Less fixed expenses .................................................................................................
4,500,000
Net operating income ...............................................................................................
P 900,000
Degree of Contribution margin
operating =
Net operating income
leverage
P5,400,000
=
P900,000

= 6
Requirement 2

a. Sales of 37,500 doors represents an increase of 7,500 doors, or 25%,


over present sales of 30,000 doors. Since the degree of operating
leverage is 6, net operating income should increase by 6 times as much,
or by 150% (6 25%).
b. Expected total peso net operating income for the next year is:
Present net operating income...................................................................................
P 900,000
Expected increase in net operating income next year
(150% P900,000) ..............................................................................................
1,350,000
Total expected net operating income.......................................................................
P2,250,000

Exercise 5 (Multiproduct Break-even Analysis)

Requirement 1
Model E700 Model J1500 Total Company
Amount % Amount % Amount %
Sales P700,000 100 P300,000 100 P1,000,000 100

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Chapter 13 Cost-Volume-Profit Relationships

Less variable expenses ..........................................................................................................


280,000 40 90,000 30 370,000 37
Contribution margin ..............................................................................................................
P420,000 60 P210,000 70 630,000 63 *
Less fixed expenses...............................................................................................................
598,500
Net operating income ............................................................................................................
P 31,500

* 630,000 P1,000,000 = 63%.

Requirement 2

The break-even point for the company as a whole would be:


Break-even point Fixed expenses
in total peso sales =
Overall CM ratio
P598,500
=
0.63
= P950,000 in sales
Requirement 3

The additional contribution margin from the additional sales can be


computed as follows:
P50,000 63% CM ratio = P31,500

Assuming no change in fixed expenses, all of this additional contribution


margin should drop to the bottom line as increased net operating income.

This answer assumes no change in selling prices, variable costs per unit,
fixed expenses, or sales mix.
Exercise 6 (Break-even Analysis; Target Profit; Margin of Safety)

Requirement 1

Sales = Variable expenses + Fixed expenses + Profits


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

Alternatively:

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Cost-Volume-Profit Relationships Chapter 13

Break-even Fixed expenses


point =
Unit contribution margin
in unit sales
P150,000
=
P12 per unit
= 12,500 units
or, at P40 per unit, P500,000.

Requirement 2

The contribution margin at the break-even point is P150,000 since at that


point it must equal the fixed expenses.

Requirement 3
Unit sales to Fixed expenses + Target profit
attain target profit =
Unit contribution margin
P150,000 + P18,000
=
P12 per unit

= 14,000 units

Total Unit
Sales (14,000 units P40 per unit) .........................................................................
P560,000 P40
Less variable expenses
(14,000 units P28 per unit) ...............................................................................
392,000 28
Contribution margin
(14,000 units P12 per unit) ...............................................................................
168,000 P12
Less fixed expenses .................................................................................................
150,000
Net operating income ...............................................................................................
P 18,000

Requirement 4

Margin of safety in peso terms:

Margin of safety in pesos = Total sales Break-even sales

= P600,000 P500,000 = P100,000

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Chapter 13 Cost-Volume-Profit Relationships

Margin of safety in percentage terms:


Margin of safety Margin of safety in pesos
percentage =
Total sales
P100,000
=
P600,000

= 16.7% (rounded)

Requirement 5

The CM ratio is 30%.

Expected total contribution margin: P680,000 30% ............................................


P204,000
Present total contribution margin: P600,000 30% ...............................................
180,000
Increased contribution margin .................................................................................
P 24,000

Alternative solution:

P80,000 incremental sales 30% CM ratio = P24,000

Since in this case the companys fixed expenses will not change, monthly net
operating income will increase by the amount of the increased contribution
margin, P24,000.

Exercise 7 (Changes in Variable Costs, Fixed Costs, Selling Price, and


Volume)

Requirement (1)

The following table shows the effect of the proposed change in monthly
advertising budget:
Sales With
Additional
Current Advertising
Sales Budget Difference
Sales ............................................. P225,000 P240,000 P15,000

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Cost-Volume-Profit Relationships Chapter 13

Variable expenses ........................ 135,000 144,000 9,000


Contribution margin ..................... 90,000 96,000 6,000
Fixed expenses ............................. 75,000 83,000 8,000
Net operating income ................... P 15,000 P 13,000 P(2,000)

Assuming that there are no other important factors to be considered, the


increase in the advertising budget should not be approved since it would lead
to a decrease in net operating income of P2,000.

Alternative Solution 1

Expected total contribution margin:


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

Alternative Solution 2

Incremental contribution margin:


P15,000 40% CM ratio............................................. P 6,000
Less incremental advertising expense .............................. 8,000
Change in net operating income ....................................... P(2,000)

Requirement (2)

The P3 increase in variable costs will cause the unit contribution margin to
decrease from P30 to P27 with the following impact on net operating
income:
Expected total contribution margin with the higher-quality
components:
3,450 units P27 per unit ................................................................P93,150
Present total contribution margin:
3,000 units P30 per unit ................................................................ 90,000
Change in total contribution margin ....................................................P 3,150

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Chapter 13 Cost-Volume-Profit Relationships

Assuming no change in fixed costs and all other factors remain the same, the
higher-quality components should be used.

Exercise 8 (Compute the Margin of Safety)

Requirement (1)

To compute the margin of safety, we must first compute the break-even unit
sales.

Sales = Variable expenses + Fixed expenses + Profits


P25Q = P15Q + P8,500 + P0
P10Q = P8,500
Q = P8,500 P10 per unit
Q = 850 units

Sales (at the budgeted volume of 1,000 units) ................................. P25,000


Break-even sales (at 850 units) ........................................................ 21,250
Margin of safety (in pesos)............................................................... P 3,750

Requirement (2)

The margin of safety as a percentage of sales is as follows:

Margin of safety (in pesos)...................................................... P3,750


Sales ..................................................................................... P25,000
Margin of safety as a percentage of sales ................................ 15.0%
Exercise 9 (Compute and Use the Degree of Operating Leverage)

Requirement (1)

The companys degree of operating leverage would be computed as follows:

Contribution margin .................................. P36,000


Net operating income ............................. P12,000
Degree of operating leverage .................... 3.0

Requirement (2)

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Cost-Volume-Profit Relationships Chapter 13

A 10% increase in sales should result in a 30% increase in net operating


income, computed as follows:

Degree of operating leverage ........................................................................3.0


Percent increase in sales ............................................................................
10%
Estimated percent increase in net operating income ..................................... 30%

Requirement (3)

The new income statement reflecting the change in sales would be:

Percent of
Amount Sales
Sales ............................................. P132,000 100%
Variable expenses ......................... 92,400 70%
Contribution margin ..................... 39,600 30%
Fixed expenses ............................. 24,000
Net operating income ................... P 15,600

Net operating income reflecting change in sales ....................................... P15,600


Original net operating income ....................................................................
P12,000
Percent change in net operating income ....................................................30%

Exercise 10 (Compute the Break-Even Point for a Multiproduct


Company)

Requirement (1)

The overall contribution margin ratio can be computed as follows:


Total contribution margin
Overall CM ratio =
Total sales
P120,000
=
P150,000

= 80%
Requirement (2)

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Chapter 13 Cost-Volume-Profit Relationships

The overall break-even point in sales pesos can be computed as follows:


Total fixed expenses
Overall break-even =
Overall CM ratio
P90,000
=
80%

= P112,500
Requirement (3)

To construct the required income statement, we must first determine the


relative sales mix for the two products:

Ping Pong Total


Original peso sales ....................... P100,000 P50,000 P150,000
Percent of total ............................. 67% 33% 100%
Sales at break-even ....................... P75,000 P37,500 P112,500

Ping Pong Total


Sales ............................................. P75,000 P37,500 P112,500
Variable expenses* ...................... 18,750 3,750 22,500
Contribution margin ..................... P56,250 P33,750 90,000
Fixed expenses ............................. 90,000
Net operating income ................... P 0

*Ping variable expenses: (P75,000/P100,000) P25,000 = P18,750


Pong variable expenses: (P37,500/P50,000) P5,000 = P3,750

Exercise 11 (Break-Even and Target Profit Analysis)

Requirement (1)

Variable expenses: P60 (100% 40%) = P36.

Requirement (2)

a. Selling price ............................................... P60 100%


Variable expenses ...................................... 36 60%
Contribution margin ................................... P24 40%

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Cost-Volume-Profit Relationships Chapter 13

Let Q = Break-even point in units.


Sales = Variable expenses + Fixed expenses + Profits
P60Q = P36Q + P360,000 + P0
P24Q = P360,000
Q = P360,000 P24 per unit
Q = 15,000 units
In sales pesos: 15,000 units P60 per unit = P900,000
Alternative solution:
Let X = Break-even point in sales pesos.
X = 0.60X + P360,000 + P0
0.40X = P360,000
X = P360,000 0.40
X = P900,000
In units: P900,000 P60 per unit = 15,000 units
b. P60Q = P36Q + P360,000 + P90,000
P24Q = P450,000
Q = P450,000 P24 per unit
Q = 18,750 units

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


Alternative solution:

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


0.40X = P450,000
X = P450,000 0.40
X = P1,125,000

In units: P1,125,000 P60 per unit = 18,750 units

c. The companys new cost/revenue relationships will be:

Selling price .................................................................. P60 100%


Variable expenses (P36 P3) ....................................... 33 55%
Contribution margin ...................................................... P27 45%

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Chapter 13 Cost-Volume-Profit Relationships

P60Q = P33Q + P360,000 + P0


P27Q = P360,000
Q = P360,000 P27 per unit
Q = 13,333 units (rounded).

In sales pesos: 13,333 units P60 per unit = P800,000 (rounded)

Alternative solution:

X = 0.55X + P360,000 + P0
0.45X = P360,000
X = P360,000 0.45
X = P800,000

In units: P800,000 P60 per unit = 13,333 units (rounded)

Requirement (3)
Break-even point Fixed expenses
a. in unit sales =
Unit contribution margin
= P360,000 P24 per unit = 15,000 units

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

Alternative solution:
Break-even point Fixed expenses
in sales pesos =
CM ratio
= P360,000 0.40 = P900,000
In units: P900,000 P60 per unit = 15,000 units

Unit sales to Fixed expenses + Target profit


b. =
attain target profit Unit contribution margin
= (P360,000 + P90,000) P24 per unit

= 18,750 units

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Cost-Volume-Profit Relationships Chapter 13

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

Alternative solution:
Peso sales to Fixed expenses + Target profit
attain target profit =
CM ratio
= (P360,000 + P90,000) 0.40

= P1,125,000

In units: P1,125,000 P60 per unit = 18,750 units

c. Break-even point Fixed expenses


in unit sales =
Unit contribution margin
= P360,000 P27 per unit

= 13,333 units (rounded)


In sales pesos: 13,333 units P60 per unit = P800,000 (rounded)

Alternative solution:
Break-even point Fixed expenses
in sales pesos =
CM ratio
= P360,000 0.45

= P800,000

In units: P800,000 P60 per unit = 13,333 (rounded)

Exercise 12 (Operating Leverage)

Requirement (1)

Sales (30,000 doors) ............................... P1,800,000 P60

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Chapter 13 Cost-Volume-Profit Relationships

Variable expenses ................................... 1,260,000 42


Contribution margin ............................... 540,000 P18
Fixed expenses ....................................... 450,000
Net operating income ............................. P 90,000
Degree of Contribution margin
operating =
Net operating income
leverage
= P540,000 P90,000 = 6

Requirement (2)

a. Sales of 37,500 doors represents an increase of 7,500 doors, or 25%,


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

Present net operating income ................................................................


P 90,000
Expected increase in net operating income next year
(150% P90,000) .............................................................................
135,000
Total expected net operating income ....................................................
P225,000

III. Problems

Problem 1 (CVP Relationships)

Requirement 1
Contribution margin P15
CM ratio = = = 25%
Selling price P60
Variable expense P45
Variable expense ratio = = = 75%
Selling price P60

Requirement 2

Sales = Variable expenses + Fixed expenses + Profits


P60Q = P45Q + P240,000 + P0
P15Q = P240,000
Q = P240,000 P15 per unit

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Cost-Volume-Profit Relationships Chapter 13

Q = 16,000 units, or at P60 per unit, P960,000

Alternative solution:

X = 0.75X + P240,000 + P0
0.25X = P240,000
X = P240,000 0.25
X = P960,000; or at P60 per unit, 16,000 units

Requirement 3

Increase in sales ................................................... P400,000


Multiply by the CM ratio ..................................... x 25%
Expected increase in contribution margin ........... P100,000

Since the fixed expenses are not expected to change, net operating income
will increase by the entire P100,000 increase in contribution margin
computed above.

Requirement 4

Sales = Variable expenses + Fixed expenses + Profits


P60Q = P45Q + P240,000 + P90,000
P15Q = P330,000
Q = P330,000 P15 per unit
Q = 22,000 units

Contribution margin method:


Fixed expenses + Target profit P240,000 + P90,000
= = 22,000 units
Contribution margin per unit P15 per unit

Requirement 5

Margin of safety in pesos = Total sales Break-even sales

= P1,200,000 P960,000 = P240,000

Margin of safety Margin of safety in pesos P240,000


=
percentage =
Total sales P1,200,000 = 20%
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Chapter 13 Cost-Volume-Profit Relationships

Requirement 6
Contribution margin P300,000
a. Degree of operating leverage = = 5
Net operating P60,000
=
income
b. Expected increase in sales .......................................... 8%
Degree of operating leverage ...................................... x 5
Expected increase in net operating income ................ 40%

c. If sales increase by 8%, then 21,600 units (20,000 x 1.08 = 21,600) will
be sold next year. The new income statement will be as follows:
Percent of
Total Per Unit Sales
Sales (21,600 units) ............... P1,296,000 P60 100%
Less variable expenses ........... 972,000 45 75%
Contribution margin ............... 324,000 P15 25%
Less fixed expenses................ 240,000
Net operating income ............. P 84,000

Thus, the P84,000 expected net operating income for next year
represents a 40% increase over the P60,000 net operating income earned
during the current year:
P84,000 P60,000 P24,000
= = 40% increase
P60,000 P60,000
Note from the income statement above that the increase in sales from
20,000 to 21,600 units has resulted in increases in both total sales and
total variable expenses. It is a common error to overlook the increase in
variable expense when preparing a projected income statement.

Requirement 7

a. A 20% increase in sales would result in 24,000 units being sold next
year: 20,000 units x 1.20 = 24,000 units.
Percent of
Total Per Unit Sales

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Cost-Volume-Profit Relationships Chapter 13

Sales (24,000 units) ............... P1,440,000 P60 100%


Less variable expenses ........... 1,152,000 48* 80%
Contribution margin ............... 288,000 P12 20%
Less fixed expenses................ 210,000
Net operating income ............. P 78,000

* P45 + P3 = P48; P48 P60 = 80%.



P240,000 P30,000 = P210,000.

Note that the change in per unit variable expenses results in a change in
both the per unit contribution margin and the CM ratio.

b. Break-even point Fixed expenses


in unit sales =
Contribution margin per unit
P210,000
=
P12 per unit
= 17,500 units
Break-even
c. Yes, based on these point Fixedshould
data the changes expenses
be made. The changes will
peso sales net =operating
increase theincompanys CMincome
ratio from the present P60,000
to P78,000 per year. Although the changes will also result in a higher
P210,000
break-even point (17,500 units= as compared to the present 16,000 units),
0.20
the companys margin of safety will actually be wider than before:
= P1,050,000
Margin of safety in pesos = Total sales Break-even sales
= P1,440,000 P1,050,000 = P390,000

As shown in requirement (5) above, the companys present margin of


safety is only P240,000. Thus, several benefits will result from the
proposed changes.

Problem 2 (Basics of CVP Analysis; Cost Structure)

Requirement 1
The CM ratio is 30%.
Total Per Unit Percentage
Sales (13,500 units) .................................................................................................
P270,000 P20 100 %
Less variable expenses .............................................................................................
189,000 14 70

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Chapter 13 Cost-Volume-Profit Relationships

Contribution margin.................................................................................................
P 81,000 P 6 30 %

The break-even point is:


Sales = Variable expenses + Fixed expenses + Profits
P20Q = P14Q + P90,000 + P0
P 6Q = P90,000
Q = P90,000 P6 per unit
Q = 15,000 units
15,000 units P20 per unit = P300,000 in sales

Alternative solution:
Break-even point Fixed expenses
in unit sales =
Contribution margin per unit
P90,000
=
P6 per unit
= 15,000 units
Break-even point Fixed expenses
in sales pesos = CM ratio
P90,000
=
0.30
= P300,000 in sales
Requirement 2

Incremental contribution margin:


P70,000 increased sales 30% CM ratio ............................................................
P21,000
Less increased fixed costs:
Increased advertising cost ....................................................................................
8,000
Increase in monthly net operating income ...............................................................
P13,000

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Cost-Volume-Profit Relationships Chapter 13

Since the company presently has a loss of P9,000 per month, if the changes
are adopted, the loss will turn into a profit of P4,000 per month.

Requirement 3

Sales (27,000 units P18 per unit*) .......................................................................


P486,000
Less variable expenses
(27,000 units P14 per unit) ...............................................................................
378,000
Contribution margin.................................................................................................
108,000
Less fixed expenses (P90,000 + P35,000) ...............................................................
125,000
Net operating loss ....................................................................................................
P(17,000)

*P20 (P20 0.10) = P18

Requirement 4

Sales = Variable expenses + Fixed expenses + Profits


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

* P14.00 + P0.60 = P14.60.

Alternative solution:

Unit sales to Fixed expenses + Target profit


attain target profit =
CM per unit
P90,000 + P4,500
=
P5.40 per unit**

= 17,500 units

** P6.00 P0.60 = P5.40.

Requirement 5

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Chapter 13 Cost-Volume-Profit Relationships

a. The new CM ratio would be:


Per Unit Percentage
Sales .........................................................................................................................
P20 100 %
Less variable expenses .............................................................................................
7 35
Contribution margin .................................................................................................
P13 65 %

The new break-even point would be:


Break-even point Fixed expenses
in unit sales =
Contribution margin per unit
P208,000
=
P13 per unit
= 16,000 units

Break-even point Fixed expenses


in sales pesos = CM ratio
P208,000
=
0.65
= P320,000 in sales
b. Comparative income statements follow:

Not Automated Automated


Total Per Unit % Total Per Unit %
Sales (20,000 units) ..............................................................................................................
P400,000 P20 100 P400,000 P20 100
Less variable expenses ..........................................................................................................
280,000 14 70 140,000 7 35
Contribution margin ..............................................................................................................
120,000 P 6 30 260,000 P13 65
Less fixed expenses ..............................................................................................................
90,000 208,000
Net operating income ............................................................................................................
P 30,000 P 52,000

c. Whether or not one would recommend that the company automate its
operations depends on how much risk he or she is willing to take, and
depends heavily on prospects for future sales. The proposed changes
would increase the companys fixed costs and its break-even point.
However, the changes would also increase the companys CM ratio
(from 30% to 65%). The higher CM ratio means that once the break-

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Cost-Volume-Profit Relationships Chapter 13

even point is reached, profits will increase more rapidly than at present.
If 20,000 units are sold next month, for example, the higher CM ratio
will generate P22,000 more in profits than if no changes are made.

The greatest risk of automating is that future sales may drop back down
to present levels (only 13,500 units per month), and as a result, losses
will be even larger than at present due to the companys greater fixed
costs. (Note the problem states that sales are erratic from month to
month.) In sum, the proposed changes will help the company if sales
continue to trend upward in future months; the changes will hurt the
company if sales drop back down to or near present levels.

Note to the Instructor: Although it is not asked for in the problem, if


time permits you may want to compute the point of indifference between
the two alternatives in terms of units sold; i.e., the point where profits
will be the same under either alternative. At this point, total revenue
will be the same; hence, we include only costs in our equation:

Let Q = Point of indifference in units sold


P14Q + P90,000 = P7Q + P208,000
P7Q = P118,000
Q = P118,000 P7 per unit
Q = 16,857 units (rounded)

If more than 16,857 units are sold, the proposed plan will yield the greatest
profit; if less than 16,857 units are sold, the present plan will yield the
greatest profit (or the least loss).

Problem 3 (Sales Mix; Multiproduct Break-even Analysis)

Requirement 1

Products
Sinks Mirrors Vanities Total
Percentage of total sales .......................................................................................................................
32% 40% 28% 100%
Sales ....................................................................................................................................................
P160,000 100 % P200,000 100 % P140,000 100 % P500,000 100 %
Less variable expenses .........................................................................................................................
48,000 30 160,000 80 77,000 55 285,000 57
Contribution margin .............................................................................................................................
P112,000 70 % P 40,000 20 % P 63,000 45 % 215,000 43 %*
Less fixed expenses ..............................................................................................................................
223,600
Net operating income (loss) .................................................................................................................
P ( 8,600)

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Chapter 13 Cost-Volume-Profit Relationships

* P215,000 P500,000 = 43%.

Requirement 2
Break-even sales:
Break-even point Fixed expenses
in total peso sales =
CM ratio
P223,600
=
Requirement 3 0.43

Memo to the president: = P520,000 in sales


Although the company met its sales budget of P500,000 for the month, the
mix of products sold changed substantially from that budgeted. This is the
reason the budgeted net operating income was not met, and the reason the
break-even sales were greater than budgeted. The companys sales mix was
planned at 48% Sinks, 20% Mirrors, and 32% Vanities. The actual sales mix
was 32% Sinks, 40% Mirrors, and 28% Vanities.

As shown by these data, sales shifted away from Sinks, which provides our
greatest contribution per peso of sales, and shifted strongly toward Mirrors,
which provides our least contribution per peso of sales. Consequently,
although the company met its budgeted level of sales, these sales provided
considerably less contribution margin than we had planned, with a resulting
decrease in net operating income. Notice from the attached statements that
the companys overall CM ratio was only 43%, as compared to a planned
CM ratio of 52%. This also explains why the break-even point was higher
than planned. With less average contribution margin per peso of sales, a
greater level of sales had to be achieved to provide sufficient contribution
margin to cover fixed costs.

Problem 4 (Basic CVP Analysis)

Requirement 1

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Cost-Volume-Profit Relationships Chapter 13

The CM ratio is 60%:


Selling price .............................................................................................................
P150 100 %
Less variable expenses .............................................................................................
60 40
Contribution margin.................................................................................................
P 90 60 %
Requirement 2
Break-even point Fixed expenses
in total sales =
CM ratio
pesos
P1,800,000
=
0.60
= P3,000,000 in sales
Requirement 3

P450,000 increased sales 60% CM ratio = P270,000 increased contribution


margin. Since fixed costs will not change, net operating income should also
increase by P270,000.

Requirement 4
Contribution margin P2,160,000
a. Degree of operating leverage = = 6
Net operating P360,000
=
income
b. 6 15% = 90% increase in net operating income.

Requirement 5
Last Year: Proposed:
28,000 units 42,000 units*
Total Per Unit Total Per Unit
Sales ......................................................................................................................................
P4,200,000 P150.00 P5,670,000 P135.00 **
Less variable expenses ..........................................................................................................
1,680,000 60.00 2,520,000 60.00
Contribution margin ..............................................................................................................
2,520,000 P 90.00 3,150,000 P 75.00
Less fixed expenses ...............................................................................................................
1,800,000 2,500,000
Net operating income ............................................................................................................
P 720,000 P 650,000

* 28,000 units 1.5 = 42,000 units


** P150 per unit 0.90 = P135.00 per unit

No, the changes should not be made.

Requirement 6

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Chapter 13 Cost-Volume-Profit Relationships

Expected total contribution margin:


28,000 units 200% P70 per unit* ..................................................................
P3,920,000
Present total contribution margin:
28,000 units P90 per unit ..................................................................................
2,520,000
Incremental contribution margin, and the amount by which
advertising can be increased with net operating income
remaining unchanged ...........................................................................................
P1,400,000

* P150 (P60 + P20) = P70

Problem 5 (Break-Even and Target Profit Analysis)

Requirement 1

The contribution margin per patch would be:

Selling price .............................................................................................................


P30
Less variable expenses:
Purchase cost of the patches ................................................................................
P15
Commissions to the student salespersons ............................................................6 21
Contribution margin ................................................................................................
P 9

Since there are no fixed costs, the number of unit sales needed to yield the
desired P7,200 in profits can be obtained by dividing the target profit by the
unit contribution margin:
Target profit P7,200
= = 800 patches
Unit contribution margin P9 per patch
800 patches x P30 per patch = P24,000 in total sales

Requirement 2

Since an order has been placed, there is now a fixed cost associated with
the purchase price of the patches (i.e., the patches cant be returned). For
example, an order of 200 patches requires a fixed cost (investment) of
P3,000 (200 patches P15 per patch = P3,000). The variable costs drop to
only P6 per patch, and the new contribution margin per patch becomes:

Selling price .............................................................................................................


P30

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Cost-Volume-Profit Relationships Chapter 13

Less variable expenses (commissions only) ............................................................ 6


Contribution margin ................................................................................................
P24

Since the fixed cost of P3,000 must be recovered before Ms. Morales
shows any profit, the break-even computation would be:
Break-even Fixed expenses
point =
Unit contribution margin
in unit sales
P3,000
= = 125 patches
P24 per patch

125 patches x P30 per patch = P3,750 in total sales

If a quantity other than 200 patches were ordered, the answer would change
accordingly.

Problem 6

Requirement 1: Break-even chart


TR
600,000

500,000

TC
400,000
(P)
Break-even
300,000 point

200,000

FC
100,000

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5,000 10,000 15,000 20,000 25,000 30,000
(units)
Chapter 13 Cost-Volume-Profit Relationships

Requirement 2: Profit-volume graph

250,000

P 200,000
R
O
F 150,000
I
T
100,000

Break-even
50,000
point

0
5,000 10,000 15,000 20,000 25,000 30,000

50,000

100,000
L
O 150,000
S
S 13-238
200,000

250,000
Cost-Volume-Profit Relationships Chapter 13

Problem 7 (Sales Mix; Break-Even Analysis; Margin of Safety)

Requirement (1)
a. Hun Yun Total
Pesos % P % Euros %
Sales ..............................................
P80,000 100 P48,000 100 P128,000 100
Variable expenses ......................... 48,000 60 9,600 20 57,600 45
Contribution margin ...................... P32,000 40 P38,400 80 70,400 55
Fixed expenses .............................. 66,000
Net operating income .................... P 4,400

b. Break-even sales = Fixed expenses CM ratio


= P66,000 0.55 = P120,000

Margin of safety
= Actual sales Break-even sales
in pesos
= P128,000 P120,000

= P8,000

Margin of safety Margin of safety in pesos Actual sales


percentage =
= P8,000 P128,000

= 6.25%

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Chapter 13 Cost-Volume-Profit Relationships

Requirement (2)

a. Hun Yun HY143 Total


Pesos % Pesos % Pesos % Pesos %
Sales P80,000 100 P48,000 100 P32,000 100 P160,000 100
Variable expenses 48,000 60 9,600 20 2,4000 75 81,600 51
Contribution margin P32,000 40 P38,400 80 P 8,000 25 78,400 49
Fixed expenses 66,000
Net operating income P 12,400

b. Break-even sales = Fixed expenses CM ratio


= P66,000 0.49 = P134,700 (rounded)

Margin of safety
= Actual sales Break-even sales
in pesos
= P160,000 P134,700

= P25,300

Margin of safety Margin of safety in pesos Actual sales


percentage =
= P25,300 P160,000

= 15.81%
Requirement (3)

The reason for the increase in the break-even point can be traced to the
decrease in the companys average contribution margin ratio when the third
product is added. Note from the income statements above that this ratio
drops from 55% to 49% with the addition of the third product. This product,
called HY143, has a CM ratio of only 25%, which causes the average
contribution margin ratio to fall.

This problem shows the somewhat tenuous nature of break-even analysis


when more than one product is involved. The manager must be very careful
of his or her assumptions regarding sales mix when making decisions such as

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Cost-Volume-Profit Relationships Chapter 13

adding or deleting products.

It should be pointed out to the president that even though the break-even
point is higher with the addition of the third product, the companys margin
of safety is also greater. Notice that the margin of safety increases from
P8,000 to P25,300 or from 6.25% to 15.81%. Thus, the addition of the new
product shifts the company much further from its break-even point, even
though the break-even point is higher.

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Chapter 13 Cost-Volume-Profit Relationships

Problem 8 (Break-Even Analysis with Step Fixed Costs)

Requirement (1)

The total annual fixed cost of the Pediatric Ward can be computed as follows:

Annual Supervising Total Other Fixed Total Fixed


Patient-Days Aides Nurses Nurses Personnel Cost Cost
@ P360,000 @ P580,000 @ P760,000
10,000-12,000 P2,520,000 P8,700,000 P2,280,000 P13,500,000 P27,400,000 P40,900,000
12,001-13,750 P2,880,000 P8,700,000 P2,280,000 P13,860,000 P27,400,000 P41,260,000
13,751-16,500 P3,240,000 P9,280,000 P3,040,000 P15,560,000 P27,400,000 P42,960,000
16,501-18,250 P3,600,000 P9,280,000 P3,040,000 P15,920,000 P27,400,000 P43,320,000
18,251-20,750 P3,600,000 P9,860,000 P3,800,000 P17,260,000 P27,400,000 P44,660,000
20,751-23,000 P3,960,000 P10,440,000 P3,800,000 P18,200,000 P27,400,000 P45,600,000

Requirement (2)

The break-even can be computed for each range of activity by dividing the total fixed cost for that range of activity by the contribution
margin per patient-day, which is P3,000 (=P4,800 revenue P1,800 variable cost).

(a) (b)
Annual Total Fixed Contribution Break-Even Within Relevant
Patient-Days Cost Margin (a) (b) Range?
10,000-12,000 P40,900,000 P3,000 13,633 No
12,001-13,750 P41,260,000 P3,000 13,753 No
13,751-16,500 P42,960,000 P3,000 14,320 Yes
16,501-18,250 P43,320,000 P3,000 14,440 No
18,251-20,750 P44,660,000 P3,000 14,887 No
20,751-23,000 P45,600,000 P3,000 15,200 No

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Cost-Volume-Profit Relationships Chapter 13

While a break-even can be computed for each range of activity (i.e., relevant range), all but one of these break-evens is bogus. For example,
within the range of 10,000 to 12,000 patient-days, the computed break-even is 13,633 (rounded) patient-days. However, this level of activity
is outside this relevant range. To serve 13,633 patient-days, the fixed costs would have to be increased from P40,900,000 to P41,260,000 by
adding one more aide. The only break-even that occurs within its own relevant range is 14,320. This is the only legitimate break-even.

Requirement (3)

The level of activity required to earn a profit of P7,200,000 can be computed as follows:

Activity to
(a) (b) Attain Target
Annual Total Fixed Total Fixed Cost + Contribution Profit Within Relevant
Patient-Days Cost Target Profit Target Profit Margin (a) (b) Range?
10,000-12,000 P40,900,000 P7,200,000 P48,100,000 P3,000 16,033 No
12,001-13,750 P41,260,000 P7,200,000 P48,460,000 P3,000 16,153 No
13,751-16,500 P42,960,000 P7,200,000 P50,160,000 P3,000 16,720 No
16,501-18,250 P43,320,000 P7,200,000 P50,520,000 P3,000 16,840 Yes
18,251-20,750 P44,660,000 P7,200,000 P51,860,000 P3,000 17,287 No
20,751-23,000 P45,600,000 P7,200,000 P52,800,000 P3,000 17,600 No

In this case, the only solution that is within the appropriate relevant range is 16,840 patient-days.

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MANAGEMENT ACCOUNTING - Solutions Manual

IV. Multiple Choice Questions

1. B 6. B 11. B 16. D 21. A 26. A


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

CHAPTER 14

RESPONSIBILITY ACCOUNTING AND


TRANSFER PRICING

I. Questions
1. Cost centers are evaluated by means of performance reports. Profit
centers are evaluated by means of contribution income statements
(including cost center performance reports), in terms of meeting sales
and cost objectives. Investment centers are evaluated by means of the
rate of return which they are able to generate on invested assets.
2. Overall profitability can be improved (1) by increasing sales, (2) by
reducing expenses, or (3) by reducing assets.
3. ROI may lead to dysfunctional decisions in that divisional managers may
reject otherwise profitable investment opportunities simply because they
would reduce the divisions overall ROI figure. The residual income
approach overcomes this problem by establishing a minimum rate of
return which the company wants to earn on its operating assets, thereby
motivating the manager to accept all investment opportunities promising
a return in excess of this minimum figure.
4. A cost center manager has control over cost, but not revenue or
investment funds. A profit center manager, by contrast, has control over
both cost and revenue. An investment center manager has control over
cost and revenue and investment funds.

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Application of Quantitative Techniques in Planning, Control and Decision Making II Chapter 18

5. The term transfer price means the price charged for a transfer of goods
or services between units of the same organization, such as two
departments or divisions. Transfer prices are needed for performance
evaluation purposes.
6. The use of market price for transfer purposes will create the actual
conditions under which the transferring and receiving units would be
operating if they were completely separate, autonomous companies. It is
generally felt that the creation of such conditions provides managerial
incentive, and leads to greater overall efficiency in operations.
7. Negotiated transfer prices should be used (1) when the volume involved
is large enough to justify quantity discounts, (2) when selling and/or
administrative expenses are less on intracompany sales, (3) when idle
capacity exists, and (4) when no clear-cut market price exists (such as a
sister division being the only supplier of a good or service).
8. Suboptimization can result if transfer prices are set in a way that benefits
a particular division, but works to the disadvantage of the company as a
whole. An example would be a transfer between divisions when no
transfers should be made (e.g., where a better overall contribution
margin could be generated by selling at an intermediate stage, rather
than transferring to the next division). Suboptimization can also result if
transfer pricing is so inflexible that one division buys from the outside
when there is substantial idle capacity to produce the item internally. If
divisional managers are given full autonomy in setting, accepting, and
rejecting transfer prices, then either of these situations can be created,
through selfishness, desire to look good, pettiness, or bickering.

II. Exercises

Exercise 1 (Evaluation of a Profit Center)

No. Although Department 3 does not cover all of the cost allocated to it. It
contributes P21,000 to the total operations over and above its direct costs.
Without Department 3, the company would earn P21,000 less as compared
with the original over-all income of P47,000.

Department
1 2 4 Total
Revenue P132,000 P168,000 P98,000 P398,000
Direct cost of department 82,000 108,000 61,000 251,000

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Chapter 18 Application of Quantitative Techniques in Planning, Control and Decision Making - II

Contribution of the
department P 50,000 P 60,000 P37,000 P147,000
Allocated cost 121,000
Net income P 26,000

With the discontinuance of Department 3, the revenue and direct cost of the
department are eliminated, but there is no reduction in the total allocated
cost.

Exercise 2 (Evaluation of an Investment Center)

Requirement 1
ROI RI
Operating assets P400,000 P400,000
Operating income P100,000 P100,000
ROI (P100,000 P400,000) 25%
Minimum required income
(16% x P400,000) P64,000
RI (P100,000 - P64,000) P36,000

Requirement 2

The manager of the Cling Division would not accept this project under the
ROI approach since the division is already earning 25%. Accepting this
project would reduce the present divisional performance, as shown below:
Present New Project Overall
Operating assets P400,000 P60,000 P460,000
Operating income P100,000 P12,000* P112,000
ROI 25% 20% 24.35%
* P60,000 x 20% = P12,000

Under the RI approach, on the other hand, the manager would accept this
project since the new project provides a higher return than the minimum
required rate of return (20 percent vs. 16 percent). The new project would
increase the overall divisional residual income, as shown below:
Present New Project Overall
Operating assets P400,000 P60,000 P460,000

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Application of Quantitative Techniques in Planning, Control and Decision Making II Chapter 18

Operating income P100,000 P12,000 P112,000


Minimum required
return at 16% 64,000 9,600* 73,600
RI P 36,000 P 2,400 P 38,400
* P60,000 x 16% = P9,600

Exercise 3 (ROI, Comparison of Three Divisions)

Requirement 1

Division X Division Y Division Z


ROI: P10,000 P12,600 P 28,800
= 25% = 18% = 16%
P40,000 P70,000 P180,000

Requirement 2

Division X would reject this investment opportunity since the addition


would lower the present divisional ROI. Divisions Y and Z would accept it
because they would look better in terms of their divisional ROI.

Exercise 4 (ROI, RI, Comparisons of Two Divisions)

Requirement 1

Net Operating income X Sales = ROI


Sales Average Operating Assets

P630,000 P9,000,000
Division A : X = ROI
P9,000,000 P3,000,000

7% X 3 = 21%

P1,800,000 P20,000,000
Division B : X = ROI
P20,000,000 P10,000,000

9% X 2 = 18%

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Chapter 18 Application of Quantitative Techniques in Planning, Control and Decision Making - II

Requirement 2

Division A Division B
Average operating assets (a) ........ P3,000,000 P10,000,000
Net operating income ................... P 630,000 P 1,800,000
Minimum required return on average
operating assets - 16% x (a) .... 480,000 1,600,000
Residual income........................... P 150,000 P 200,000

Requirement 3

No, Division B is simply larger than Division A and for this reason one
would expect that it would have a greater amount of residual income. As
stated in the text, residual income cant be used to compare the performance
of divisions of different sizes. Larger divisions will almost always look
better, not necessarily because of better management but because of the
larger peso figures involved. In fact, in the case above, Division B does not
appear to be as well managed as Division A. Note from Part (2) that
Division B has only an 18 percent ROI as compared to 21 percent for
Division A.

Exercise 5 (Evaluation of a Cost Center)

(1) Controllable Costs by supervisor of Department 10 are as follows:


a. Supplies, Department 10
b. Repairs and Maintenance, Department 10
c. Labor Cost, Department 10

(2) Direct Costs of Department 10 are


a. Salary, supervisor of Department 10
b. Supplies, Department 10
c. Repairs and Maintenance, Department 10
d. Labor Cost, Department 10

(3) Costs allocated to Factory Department are:


a. Factory, heat and light
b. Depreciation, factory
c. Factory insurance
d. Salary of factory superintendent

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(4) Costs which do not pertain to factory operations are:


a. Sales salaries and commissions
b. General office salaries

Exercise 6 (Evaluating New Investments Using Return on Investment


(ROI) and Residual Income)

Requirement 1

Computation of ROI

Division A:
P300,000 P6,000,000
ROI = x = 5% x 4 = 20%
P6,000,000 P1,500,000

Division B:
P900,000 P10,000,000
ROI = x = 9% x 2 = 18%
P10,000,000 P5,000,000

Division C:

P180,000 P8,000,000
ROI = x = 2.25% x 4 = 9%
P8,000,000 P2,000,000

Requirement 2

Division A Division B Division C


Average operating assets .......................................................................................................
P1,500,000 P5,000,000 P2,000,000
Required rate of return ..........................................................................................................
15% 18% 12%
Required operating income ...................................................................................................
P 225,000 P 900,000 P 240,000
Actual operating income .......................................................................................................
P 300,000 P 900,000 P 180,000
Required operating income (above) ......................................................................................
225,000 900,000 240,000
Residual income ....................................................................................................................
P 75,000 P 0 P (60,000)

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Requirement 3

a. and b. Division A Division B Division C


Return on investment (ROI) ....................................................................................
20% 18% 9%
Therefore, if the division is
presented with an investment
opportunity yielding 17%, it
probably would ....................................................................................................
Reject Reject Accept
Minimum required return for
computing residual income ..................................................................................
15% 18% 12%
Therefore, if the division is
presented with an investment
opportunity yielding 17%, it
probably would ....................................................................................................
Accept Reject Accept

If performance is being measured by ROI, both Division A and Division B


probably would reject the 17% investment opportunity. The reason is that
these companies are presently earning a return greater than 17%; thus, the
new investment would reduce the overall rate of return and place the
divisional managers in a less favorable light. Division C probably would
accept the 17% investment opportunity, since its acceptance would increase
the Divisions overall rate of return.

If performance is being measured by residual income, both Division A and


Division C probably would accept the 17% investment opportunity. The
17% rate of return promised by the new investment is greater than their
required rates of return of 15% and 12%, respectively, and would therefore
add to the total amount of their residual income. Division B would reject the
opportunity, since the 17% return on the new investment is less than Bs
18% required rate of return.

Exercise 7 (Transfer Pricing from Viewpoint of the Entire Company)

Requirement 1
Division A Division B Total Company
Sales P3,500,000 1 P2,400,000 2 P5,200,000 3
Less expenses:
Added by the division .......................................................................................................
2,600,000 1,200,000 3,800,000

Transfer price paid ............................................................................................................
700,000

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Total expenses .......................................................................................................................


2,600,000 1,900,000 3,800,000
Net operating income ............................................................................................................
P 900,000 P 500,000 P1,400,000
1
20,000 units P175 per unit = P3,500,000.
2
4,000 units P600 per unit = P2,400,000.
3
Division A outside sales (16,000 units P175 per unit) .......................................................
P2,800,000
Division B outside sales (4,000 units P600 per unit).........................................................
2,400,000
Total outside sales.................................................................................................................
P5,200,000

Observe that the P700,000 in intracompany sales has been eliminated.


Requirement 2

Division A should transfer the 1,000 additional units to Division B. Note


that Division Bs processing adds P425 to each units selling price (Bs P600
selling price, less As P175 selling price = P425 increase), but it adds only
P300 in cost. Therefore, each tube transferred to Division B ultimately
yields P125 more in contribution margin (P425 P300 = P125) to the
company than can be obtained from selling to outside customers. Thus, the
company as a whole will be better off if Division A transfers the 1,000
additional tubes to Division B.

Exercise 8 (Transfer Pricing Situations)

Requirement 1

The lowest acceptable transfer price from the perspective of the selling
division is given by the following formula:
Total contribution margin
Variable on lost sales
Transfer price cost per unit
+
Number of units transferred
.
There is no idle capacity, so each of the 20,000 units transferred from
Division X to Division Y reduces sales to outsiders by one unit. The
contribution margin per unit on outside sales is P20 (= P50 P30).
P20 x 20,000
Transfer price (P30 P2) +
20,000
Transfer price = P28 + P20 = P48

The buying division, Division Y, can purchase a similar unit from an outside
supplier for P47. Therefore, Division Y would be unwilling to pay more

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than P47 per unit.

Transfer price Cost of buying from outside supplier = P47

The requirements of the two divisions are incompatible and no transfer will
take place.

Requirement 2

In this case, Division X has enough idle capacity to satisfy Division Ys


demand. Therefore, there are no lost sales and the lowest acceptable price as
far as the selling division is concerned is the variable cost of P20 per unit.
P0
Transfer price P20 +
20,000
= P20

The buying division, Division Y, can purchase a similar unit from an outside
supplier for P34. Therefore, Division Y would be unwilling to pay more
than P34 per unit.

Transfer price Cost of buying from outside supplier = P34

In this case, the requirements of the two divisions are compatible and a
transfer will hopefully take place at a transfer price within the range:

P20 Transfer price P34

Exercise 9 (Transfer Pricing: Decision Making)

Requirement 1

Division As purchase decision from the overall firm perspective:

Purchase costs from outside 10,000 x P150 = P1,500,000


Less: Savings of Divisions Bs variable costs 10,000 x P140 = 1,400,000
Net Cost (Benefit) for A to buy outside P 100,000

Assuming Division B has no outside sales, Division A should buy inside


from Division B for the benefit of the entire firm.

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Requirement 2

As above, but in addition, if Division A buys outside, Division B saves an


additional P200,000.

Purchase costs from outside 10,000 x P150 = P1,500,000


Less: Savings in variable costs 10,000 x P140 = 1,400,000
Less: Savings of B material assignment 200,000
Net Cost (Benefit) for A to buy outside P (100,000)

The additional savings in Division B means that now Division A should buy
outside.

Requirement 3

Assuming the outside price drops from P150 to P130:

Purchase costs from outside 10,000 x P130 = P1,300,000


Less: Savings in variable costs 10,000 x P140 = 1,400,000
Net Cost (Benefit) for A to buy outside P (100,000)

Division A should buy outside.

Exercise 10 (Compute the Return on Investment (ROI))

Requirement (1)

Net operating income


Margin = Sales
P5,400,000
= P18,000,000 = 30%

Requirement (2)

Sales
Turnover = Average operating assets
P18,000,000
= 18-253 = 0.5
P36,000,000
Chapter 18 Application of Quantitative Techniques in Planning, Control and Decision Making - II

Requirement (3)

ROI = Margin x Turnover


= 30% x 0.5 = 15%

Exercise 11 (Residual Income)

Average operating assets (a) ............................................. P2,200,000


Net operating income ....................................................... P400,000
Minimum required return: 16% (a) ............................... 352,000
Residual income ............................................................... P 48,000

III. Problems

Problem 1 (Evaluation of Profit Centers)

Requirement (a)

Jadlow Manufacturing Corporation


Income Statement
For the Year Ended December 31, 2005

Total Product S Product T


Sales P5,100,000 P2,700,000 P2,400,000
Less: Variable Costs 3,330,000 1,890,000 1,440,000
Contribution Margin P1,770,000 P 810,000 P 960,000
Less: Controllable fixed
expenses 501,000 66,000 435,000
Contribution to the recovery
of non-controllable fixed
expenses P1,269,000 P 744,000 P 525,000

Requirement (b)

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The complaint of the manager of Product T is justified on the ground that his
product line shows a positive contribution margin and therefore, contributes
to the recovery of non-controllable fixed expenses. This observation is, of
course, made under the assumption that the preceding years figures (which
are not given) were less favorable than the current year.

Problem 2 (Evaluation of Profit Centers)

Requirement 1
Product
A B C
Incremental sales P71,000 P46,000 P117,000
Less: Incremental costs 42,000 15,000 96,000
Net income P29,000 P31,000 P 21,000

Product B seems to offer the best profit potential.

Requirement 2
The sunk costs are:
Depreciation of equipment P 6,400
Operating cost of the equipment 4,600
Total P11,000

Requirement 3
Opportunity cost of selling Product B is
From Product A P29,000
From Product C 21,000
Total P50,000

Problem 3 (Evaluation of Performance)

Ranjie Tool Company


Performance Report
For the Year 2005

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Budgeted Labor Hours 4,000


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

Problem 4 (Evaluation of Performance)

Requirement 1

Performance Report for the Production Manager


Actual Flexible Variance
Cost Budget Cost (U) or (F)
Controllable costs:
Direct material P24,000 P20,000 P4,000 (U)
Direct labor 48,000 50,000 2,000 (F)
Supplies 4,000 6,000 2,000 (F)
Maintenance 3,000 4,000 1,000 (F)
Total P79,000 P80,000 P1,000 (F)

The cost of raw materials rose significantly, possibly because of (1) deficient
machinery due to the cutback in maintenance expenditures and/or (2) to the
lower labor cost, possibly due to the use of less-skilled workers. Supplies
decreased, indicating possible inadequacies for next periods production run.

Requirement 2

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Performance Report for the Vice President


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

Problem 5 (Target Sales Price; Return on Investment)

Requirement 1

Return on investment = Operating income / Investment


20% = X / P800,000
Target Operating Income = P160,000

Target revenues, calculated as follows:

Fixed overhead P200,000


Variable costs 1,500,000 x P300 450,000
Desired operating income 160,000
Revenues P810,000

The selling price per units is P540 = P810,000 / 1,500

Requirement 2

Data are in thousands.

Units 1,500 2,000 1,000


Revenues P810 P1,080 P540

Variable costs 450 600 300


Fixed costs 200 200 200
Total costs 650 800 500
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Chapter 18 Application of Quantitative Techniques in Planning, Control and Decision Making - II

Operating income P160 P280 P 40


Return on 20% 35% 5%
investment
= P160 / = P280 / = P40 /
P800 P800 P800

Note how the change in income follows the change in revenues, as predicted
by operating leverage. Operating leverage multiplied times the percentage
change in sales gives the percentage change in income. Thus, the greater the
operating leverage ratio, the larger the effect on income and ROI of a given
percentage change in sales. This exercise provides an opportunity to review
the relationship between volume and profit. See the illustration below:

Operating leverage = contribution margin / operating income


= (P810 P450) / P160 = 2.25

% change in income = operating leverage x % change in revenues


= 2.25 x 33.33% = 75%

% change in income
If volume goes to 2,000 units: (P280 P160) / P160 = 75%
If volume goes to 1,000 units: (P160 P40) / P160 = 75%

% change in ROI
If volume goes to 2,000 units: (35% - 20%) / 20% = 75%
If volume goes to 1,000 units: (20% - 5%) / 20% = 75%

Problem 6 (Contrasting Return on Investment (ROI) and Residual


Income)

Requirement 1

ROI computations:

Net operating income Sales


ROI = x
Sales Average operating assets

Pasig: P630,000 P9,000,000


x = 7% x 3 = 21%
P9,000,000 P3,000,000

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P1,800,000 P20,000,000
Quezon: x = 9% x 2 = 18%
P20,000,000 P10,000,000

Requirement 2
Pasig Quezon
Average operating assets (a) ....................................................................................
P3,000,000 P10,000,000
Net operating income ...............................................................................................
P 630,000 P 1,800,000
Minimum required return on average
operating assets16% (a) ................................................................................
480,000 P 1,600,000
Residual income.......................................................................................................
P 150,000 P 200,000

Requirement 3

No, the Quezon Division is simply larger than the Pasig Division and for this
reason one would expect that it would have a greater amount of residual
income. Residual income cant be used to compare the performance of
divisions of different sizes. Larger divisions will almost always look better,
not necessarily because of better management but because of the larger peso
figures involved. In fact, in the case above, Quezon does not appear to be as
well managed as Pasig. Note from Part (1) that Quezon has only an 18%
ROI as compared to 21% for Pasig.

Problem 7 (Transfer Pricing)

Requirement 1

Since the Valve Division has idle capacity, it does not have to give up any
outside sales to take on the Pump Divisions business. Applying the formula
for the lowest acceptable transfer price from the viewpoint of the selling
division, we get:
Total contribution margin
Variable on lost sales
Transfer price cost per unit +
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Number of units transferred
Chapter 18 Application of Quantitative Techniques in Planning, Control and Decision Making - II

P0
Transfer price P16 +
10,000
= P16

The Pump Division would be unwilling to pay more than P29, the price it is
currently paying an outside supplier for its valves. Therefore, the transfer
price must fall within the range:

P16 Transfer price P29

Requirement 2

Since the Valve Division is selling all of the valves that it can produce on the
outside market, it would have to give up some of these outside sales to take
on the Pump Divisions business. Thus, the Valve Division has an
opportunity cost, which is the total contribution margin on lost sales:
Total contribution margin
Variable on lost sales
Transfer price cost per unit
+
Number of units transferred

(P30 P16) x 10,000


Transfer price P16 +
10,000

= P16 + P14 = P30

Since the Pump Division can purchase valves from an outside supplier at
only P29 per unit, no transfers will be made between the two divisions.

Requirement 3

Applying the formula for the lowest acceptable price from the viewpoint of
the selling division, we get:

Total contribution margin


Variable on lost sales
Transfer price cost per unit
+
Number of units transferred

(P30 P16) x 10,000


Transfer price (P16 P3) +
10,000

= P1318-260
+ P14 = P27
Application of Quantitative Techniques in Planning, Control and Decision Making II Chapter 18

In this case, the transfer price must fall within the range:

P27 Transfer price P29

Problem 8 (Transfer Pricing)

To produce the 20,000 special valves, the Valve Division will have to give
up sales of 30,000 regular valves to outside customers. Applying the
formula for the lowest acceptable price from the viewpoint of the selling
division, we get:
Total contribution margin
Variable on lost sales
Transfer price cost per unit
+
Number of units transferred

(P30 P16) x 30,000


Transfer price P20 +
20,000

= P20 + P21 = P41

Problem 9 (Effects of Changes in Sales, Expenses, and Assets in ROI)

1. Net operating income


Margin = Sales
P800,000
= P8,000,000 = 10%

2. Sales
Turnover = Average operating assets
P8,000,000
= P3,200,000 = 2.5

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3.
ROI = Margin x Turnover
= 10% x 2.5 = 25%

Problem 10 (Transfer Pricing Basics)

Requirement (1)

a. The lowest acceptable transfer price from the perspective of the selling
division, the Electrical Division, is given by the following formula:

Total contribution margin


Variable cost + on lost sales
Transfer price =
per unit Number of units transferred

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

Transfer price = P21 + P0 = P21


10,000
b. The Motor Division can buy a similar transformer from an outside
supplier for P38. Therefore, the Motor Division would be unwilling to
pay more than P38 per transformer.
Transfer price: Cost from buying from outside supplier = P38

c. Combining the requirements of both the selling division and the buying
division, the acceptable range of transfer prices in this situation is:
P21 : Transfer price : P38

Assuming that the managers understand their own businesses and that
they are cooperative, they should be able to agree on a transfer price
within this range and the transfer should take place.

d. From the standpoint of the entire company, the transfer should take
place. The cost of the transformers transferred is only P21 and the
company saves the P38 cost of the transformers purchased from the

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Application of Quantitative Techniques in Planning, Control and Decision Making II Chapter 18

outside supplier.

Requirement (2)

a. Each of the 10,000 units transferred to the Motor Division must displace
a sale to an outsider at a price of P40. Therefore, the selling division
would demand a transfer price of at least P40. This can also be computed
using the formula for the lowest acceptable transfer price as follows:

Transfer price = P21 + (P40 P21) x 10,000


10,000
= P21 + (P40 P21) = P40
b. As before, the Motor Division would be unwilling to pay more than P38
per transformer.

c. The requirements of the selling and buying divisions in this instance are
incompatible. The selling division must have a price of at least P40
whereas the buying division will not pay more than P38. An agreement
to transfer the transformers is extremely unlikely.

d. From the standpoint of the entire company, the transfer should not take
place. By transferring a transformer internally, the company gives up
revenue of P40 and saves P38, for a loss of P2.

Problem 11 (Transfer Pricing with an Outside Market)

Requirement (1)

The lowest acceptable transfer price from the perspective of the selling
division is given by the following formula:
Total contribution margin
Variable cost + on lost sales
Transfer price =
per unit Number of units transferred

The Tuner Division has no idle capacity, so transfers from the Tuner
Division to the Assembly Division would cut directly into normal sales of
tuners to outsiders. The costs are the same whether a tuner is transferred
internally or sold to outsiders, so the only relevant cost is the lost revenue of
P200 per tuner that could be sold to outsiders. This is confirmed below:

Transfer price = P110 + (P200 P110) x 30,000


30,000
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= P110 + (P200 P110) = P200
Chapter 18 Application of Quantitative Techniques in Planning, Control and Decision Making - II

Therefore, the Tuner Division will refuse to transfer at a price less than P200
per tuner.

The Assembly Division can buy tuners from an outside supplier for P200,
less a 10% quantity discount of P20, or P180 per tuner. Therefore, the
Division would be unwilling to pay more than P180 per tuner.

Transfer price : Cost of buying from outside supplier = P180


The requirements of the two divisions are incompatible. The Assembly
Division wont pay more than P180 and the Tuner Division will not accept
less than P200. Thus, there can be no mutually agreeable transfer price and
no transfer will take place.

Requirement (2)

The price being paid to the outside supplier, net of the quantity discount, is
only P180. If the Tuner Division meets this price, then profits in the Tuner
Division and in the company as a whole will drop by P600,000 per year:

Lost revenue per tuner ....................................................... P200


Outside suppliers price ..................................................... P180
Loss in contribution margin per tuner ............................... P20
Number of tuners per year ................................................. 30,000
Total loss in profits ............................................................ P600,000

Profits in the Assembly Division will remain unchanged, since it will be


paying the same price internally as it is now paying externally.

Requirement (3)

The Tuner Division has idle capacity, so transfers from the Tuner Division
to the Assembly Division do not cut into normal sales of tuners to outsiders.
In this case, the minimum price as far as the Assembly Division is concerned
is the variable cost per tuner of P11. This is confirmed in the following
calculation:
Transfer price = P110 + P0 = P110
30,000
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The Assembly Division can buy tuners from an outside supplier for P180
each and would be unwilling to pay more than that in an internal transfer. If
the managers understand their own businesses and are cooperative, they
should agree to a transfer and should settle on a transfer price within the
range:

P110 : Transfer price : P180

Requirement (4)

Yes, P160 is a bona fide outside price. Even though P160 is less than the
Tuner Divisions P170 full cost per unit, it is within the range given in Part
3 and therefore will provide some contribution to the Tuner Division.

If the Tuner Division does not meet the P160 price, it will lose P1,500,000 in
potential profits:

Price per tuner.................................................. P160


Variable costs ................................................... 110
Contribution margin per tuner ......................... P 50

30,000 tuners P50 per tuner = P1,500,000 potential increased profits

This P1,500,000 in potential profits applies to the Tuner Division and to the
company as a whole.

Requirement (5)

No, the Assembly Division should probably be free to go outside and get the
best price it can. Even though this would result in lower profits for the
company as a whole, the buying division should probably not be forced to
purchase inside if better prices are available outside.

Requirement (6)

The Tuner Division will have an increase in profits:

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Selling price ..................................................... P200


Variable costs ................................................... 110
Contribution margin per tuner ......................... P 90

30,000 tuners P90 per tuner = P2,700,000 increased profits

The Assembly Division will have a decrease in profits:

Inside purchase price ....................................... P200


Outside purchase price .................................... 160
Increased cost per tuner ................................... P 40

30,000 tuners P40 per tuner = P1,200,000 decreased profits

The company as a whole will have an increase in profits:

Increased contribution margin in the Tuner Division...........................................


P 90
Decreased contribution margin in the Assembly Division ................................... 40
Increased contribution margin per tuner ..............................................................
P 50

30,000 tuners P50 per tuner = P1,500,000 increased profits

So long as the selling division has idle capacity and the transfer price is
greater than the selling divisions variable costs, profits in the company as a
whole will increase if internal transfers are made. However, there is a
question of fairness as to how these profits should be split between the
selling and buying divisions. The inflexibility of management in this
situation damages the profits of the Assembly Division and greatly enhances
the profits of the Tuner Division.

Problem 12 (Transfer Pricing; Divisional Performance)

Requirement (1)

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The Electronics Division is presently operating at capacity; therefore, any


sales of the KK8 circuit board to the Clock Division will require that the
Electronics Division give up an equal number of sales to outside customers.
Using the transfer pricing formula, we get a minimum transfer price of:
Total contribution margin
Variable cost + on lost sales
Transfer price =
per unit Number of units transferred
Transfer price = P82.50 + (P125.00 P82.50)
Transfer price = P82.50 + P42.50
Transfer price = P125.00
Thus, the Electronics Division should not supply the circuit board to the
Clock Division for P90 each. The Electronics Division must give up
revenues of P125.00 on each circuit board that it sells internally. Since
management performance in the Electronics Division is measured by ROI
and dollar profits, selling the circuit boards to the Clock Division for P9
would adversely affect these performance measurements.

Requirement (2)

The key is to realize that the P100 in fixed overhead and administrative costs
contained in the Clock Divisions P697.50 cost per timing device is not
relevant. There is no indication that winning this contract would actually
affect any of the fixed costs. If these costs would be incurred regardless of
whether or not the Clock Division gets the oven timing device contract, they
should be ignored when determining the effects of the contract on the
companys profits. Another key is that the variable cost of the Electronics
Division is not relevant either. Whether the circuit boards are used in the
timing devices or sold to outsiders, the production costs of the circuit boards
would be the same. The only difference between the two alternatives is the
revenue on outside sales that is given up when the circuit boards are
transferred within the company.

Selling price of the timing devices ................................................................ P700.00


Less:
The cost of the circuit boards used in the timing devices
(i.e. the lost revenue from sale of circuit boards to
outsiders) ...............................................................................................
P125.00
Variable costs of the Clock Division excluding the circuit 507.50 632.50

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board (P300.00 + P207.50)....................................................................


Net positive effect on the companys profit ..................................................
P 67.50

Therefore, the company as a whole would be better off by P67.50 for each
timing device that is sold to the oven manufacturer.

Requirement (3)

As shown in part (1) above, the Electronics Division would insist on a


transfer price of at least P125.00 for the circuit board. Would the Clock
Division make any money at this price? Again, the fixed costs are not
relevant in this decision since they would not be affected. Once this is
realized, it is evident that the Clock Division would be ahead by P67.50 per
timing device if it accepts the P125.00 transfer price.

Selling price of the timing devices ............................................................... P700.00


Less:
Purchased parts (from outside vendors) ...................................................
P300.00
Circuit board KK8 (assumed transfer price) ............................................
125.00
Other variable costs ..................................................................................
207.50 632.50
Clock Division contribution margin ............................................................. P 67.50

In fact, since the contribution margin is P62.50, any transfer price within the
range of P125.00 to P192.50 (= P125.00 + P67.50) will improve the profits
of both divisions. So yes, the managers should be able to agree on a transfer
price.

Requirement (4)

It is in the best interests of the company and of the divisions to come to an


agreement concerning the transfer price. As demonstrated in part (3) above,
any transfer price within the range P125.00 to P192.50 would improve the
profits of both divisions. What happens if the two managers do not come to
an agreement?

In this case, top management knows that there should be a transfer and could
step in and force a transfer at some price within the acceptable range.
However, such an action, if done on a frequent basis, would undermine the
autonomy of the managers and turn decentralization into a sham.

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Our advice to top management would be to ask the two managers to meet to
discuss the transfer pricing decision. Top management should not dictate a
course of action or what is to happen in the meeting, but should carefully
observe what happens in the meeting. If there is no agreement, it is important
to know why. There are at least three possible reasons. First, the managers
may have better information than the top managers and refuse to transfer for
very good reasons. Second, the managers may be uncooperative and
unwilling to deal with each other even if it results in lower profits for the
company and for themselves. Third, the managers may not be able to
correctly analyze the situation and may not understand what is actually in
their own best interests. For example, the manager of the Clock Division
may believe that the fixed overhead and administrative cost of P100 per
timing device really does have to be covered in order to avoid a loss.
If the refusal to come to an agreement is the result of uncooperative attitudes
or an inability to correctly analyze the situation, top management can take
some positive steps that are completely consistent with decentralization. If
the problem is uncooperative attitudes, there are many training companies
that would be happy to put on a short course in team building for the
company. If the problem is that the managers are unable to correctly analyze
the alternatives, they can be sent to executive training courses that
emphasize economics and managerial accounting.

IV. Multiple Choice Questions

1. C 11. E 21. C 31. B


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

CHAPTER 15

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FUNCTIONAL AND ACTIVITY-BASED BUDGETING

I. Questions
1. No. Planning and control are different, although related, concepts.
Planning involves developing objectives and formulating steps to
achieve those objectives. Control, by contrast, involves the means by
which management ensures that the objectives set down at the planning
stage are attained.
2. Budgets have a dual purpose, for planning and for following up the
implementation of the plan. The great benefits from budgeting lie in the
quick investigation of deviations and in the subsequent corrective action.
Budgets should not be prepared in the first place if they are ignored,
buried in files, or improperly interpreted.
3. Two major features of a budgetary program are (1) the accounting
techniques which developed it and (2) the human factors which
administer it. The human factors are far more important. The success of
a budgetary system depends upon its acceptance by the company
members who are affected by the budget. Without a thoroughly
educated and cooperative management group at all levels of
responsibility, budgets are a drain on the funds of the business and are a
hindrance instead of help to efficient operations.
4. Manufacturing overhead costs are budgeted at normal operating
capacity, and the costs are applied to the products using a predetermined
rate. The predetermined rate is computed by dividing a factor that can
be identified with both the products and the overhead into the overhead
budgeted at the normal operating capacity. Budgets may also be used in
costing products in a standard cost accounting system.
5. The production division operates to produce the products that are sold.
Production and sales must be coordinated. Products must be
manufactured so that they will be available to meet sales delivery dates.
Activity of the production division will depend upon the sales that can
be made. Also, the sales division is limited by the capabilities of the
production department in manufacturing products. Successful
operations depend upon a coordination of sales and production.

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6. Labor hour required for production can be translated into labor pesos by
multiplying the number of hours budgeted by the appropriate labor rates.
The rates to be used will depend upon the rates established for job
classifications and the policy with respect to premium pay for overtime
or shift differences.
7. A long-range plan for the acquisition of plant assets is broken down and
entered in the current budget as the plan unfolds. The portion of the plan
which is to be executed in the next year is included in the budget for that
year.
8. A budget period is not limited to any particular unit of time. At a
minimum, a budget should cover at least one operating cycle. For
example, a budget should not cover a period when purchasing activity is
high and omit the period when sales volume and cash collection are
relatively high. The budget period should encompass the entire cycle
extending from the purchasing operation to the subsequent sale of the
products and the realization of the sales in cash. Ordinarily, a budget of
operations is prepared for a year which in turn is divided into quarters
and months. Long-term budgets, such as budgets for projects or capital
investments, may extend five to ten years or more into the future.
9. A rolling budget or a progressive budget or sometimes called continuous
budget, is a budget which is prepared throughout the year. As one
month elapses, a budget is prepared for one more month in the future.
At any one time for example, the company will have a budget for one
year into the future, when July of one year is over, a budget for the
following July will be added at the other end of the budget. This process
of adding a new month as a month expires is continuous.
10. Variances that are revealed by a comparison of actual results with a
budget are investigated if it appears that an investigation is warranted.
The investigation may show that stricter control measures are needed or
that some weaknesses in the operation should be corrected. It may also
reveal that the budget plan should be revised. The comparison is one
step in the control and direction of business operations.
11. A comparison of actual results with a budget can contribute information
that can be applied in the preparation of better budgets in the future.
Subsequent investigation of variances provides management with a
better knowledge of operations. This knowledge can be applied in the
preparation of more realistic budgets for subsequent fiscal periods.

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12. A self-imposed budget is one in which persons with responsibility over


cost control prepare their own budgets, i.e., the budget is not imposed
from above. The major advantages are: (1) the views and judgments of
persons from all levels of an organization are represented in the final
budget document; (2) budget estimates generally are more accurate and
reliable, since they are prepared by those who are closest to the
problems; (3) managers generally are more motivated to meet budgets
which they have participated in setting; (4) self-imposed budgets reduce
the amount of upward blaming resulting from inability to meet budget
goals. One caution must be exercised in the use of self-imposed budgets.
The budgets prepared by lower-level managers should be carefully
reviewed to prevent too much slack.
13. No, although this is clearly one of the purposes of the cash budget. The
principal purpose is to provide information on probable cash needs
during the budget period, so that bank loans and other sources of
financing can be anticipated and arranged well in advance of the actual
time of need.
14. Zero-based budgeting requires that managers start at zero levels every
year and justify all costs as if all programs were being proposed for the
first time. In traditional budgeting, by contrast, budget data are usually
generated on an incremental basis, with last years budget being the
starting point.
15. A budget is a detailed quantitative plan for the acquisition and use of
financial and other resources over a given time period. Budgetary control
involves the use of budgets to control the actual activities of a firm.
16. 1. Budgets communicate managements plans throughout the
organization.
2. Budgets force managers to think about and plan for the future.
3. The budgeting process provides a means of allocating resources to
those parts of the organization where they can be used most
effectively.
4. The budgeting process can uncover potential bottlenecks before they
occur.
5. Budgets coordinate the activities of the entire organization by
integrating the plans of its various parts. Budgeting helps to ensure
that everyone in the organization is pulling in the same direction.
6. Budgets define goals and objectives that can serve as benchmarks
for evaluating subsequent performance.

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17. A master budget represents a summary of all of managements plans and


goals for the future, and outlines the way in which these plans are to be
accomplished. The master budget is composed of a number of smaller,
specific budgets encompassing sales, production, raw materials, direct
labor, manufacturing overhead, selling and administrative expenses, and
inventories. The master budget generally also contains a budgeted
income statement, budgeted balance sheet, and cash budget.
18. The flow of budgeting information moves in two directionsupward
and downward. The initial flow should be from the bottom of the
organization upward. Each person having responsibility over revenues or
costs should prepare the budget data against which his or her subsequent
performance will be measured. As the budget data are communicated
upward, higher-level managers should review the budgets for
consistency with the overall goals of the organization and the plans of
other units in the organization. Any issues should be resolved in
discussions between the individuals who prepared the budgets and their
managers.

All levels of an organization should participate in the budgeting


processnot just top management or the accounting department.
Generally, the lower levels will be more familiar with detailed, day-to-
day operating data, and for this reason will have primary responsibility
for developing the specifics in the budget. Top levels of management
should have a better perspective concerning the companys strategy.
19. Budgeting can assist a company forecast its workforce staffing needs
through direct labor and other budgets. By careful planning through the
budget process, a company can often smooth out its activities and avoid
erratic hiring and laying off employees.

II. Matching Type

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

III. Exercises

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Exercises 1 (Schedule of Expected Cash Collections)

Requirement 1

July August September Total


May sales:
P430,000 10% .........................................................................................................
P 43,000 P 43,000
June sales:
P540,000 70%, 10% ...............................................................................................
378,000 P54,000 432,000
July sales:
P600,000 20%,
70%, 10% ...............................................................................................................
120,000 420,000 P 60,000 600,000
August sales:
P900,000 20%, 70% ...............................................................................................
180,000 630,000 810,000
September sales:
P500,000 20% .........................................................................................................
100,000 100,000
Total cash collections .....................................................................................................
P541,000 P654,000 P790,000 P1,985,000

Notice that even though sales peak in August, cash collections peak in
September. This occurs because the bulk of the companys customers pay in
the month following sale. The lag in collections that this creates is even
more pronounced in some companies. Indeed, it is not unusual for a
company to have the least cash available in the months when sales are
greatest.

Requirement 2

Accounts receivable at September 30:

From August sales: P900,000 10%.......................................................................


P 90,000
From September sales: P500,000 (70% + 10%) ..................................................
400,000
Total accounts receivable ........................................................................................
P490,000

Exercise 2 (Production Budget)

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July August September Quarter


Budgeted sales in units ..........................................................................................................
30,000 45,000 60,000 135,000
Add desired ending inventory* .............................................................................................
4,500 6,000 5,000 5,000
Total needs ............................................................................................................................
34,500 51,000 65,000 140,000
Less beginning inventory ......................................................................................................
3,000 4,500 6,000 3,000
Required production..............................................................................................................
31,500 46,500 59,000 137,000
* 10% of the following months sales

Exercise 3 (Materials Purchase Budget)

Quarter Year 2 Year 3


First Second Third Fourth First
Required production of calculators ......................................................................................................
60,000 90,000 150,000 100,000 80,000
Number of chips per calculator ............................................................................................................
3 3 3 3 3
Total production needschips.............................................................................................................
180,000 270,000 450,000 300,000 240,000

Year 2
First Second Third Fourth Year
Production needschips .....................................................................................................................
180,000 270,000 450,000 300,000 1,200,000
Add desired ending inventory
chips ................................................................................................................................................
54,000 90,000 60,000 48,000 48,000
Total needschips ...............................................................................................................................
234,000 360,000 510,000 348,000 1,248,000
Less beginning inventorychips .........................................................................................................
36,000 54,000 90,000 60,000 36,000
Required purchaseschips ..................................................................................................................
198,000 306,000 420,000 288,000 1,212,000
Cost of purchases at P2 per chip ..........................................................................................................
P396,000 P612,000 P840,000 P576,000 P2,424,000

Exercise 4 (Direct Labor Budget)

Requirement 1

Assuming that the direct labor workforce is adjusted each quarter, the direct
labor budget would be:
1st 2nd 3rd 4th
Quarter Quarter Quarter Quarter Year
Units to be produced ............................................................................................................
5,000 4,400 4,500 4,900 18,800
Direct labor time per unit (hours) .........................................................................................
0.40 0.40 0.40 0.40 0.40
Total direct labor hours needed ............................................................................................
2,000 1,760 1,800 1,960 7,520
Direct labor cost per hour .....................................................................................................
P11.00 P11.00 P11.00 P11.00 P11.00
Total direct labor cost ..........................................................................................................
P 22,000 P 19,360 P 19,800 P 21,560 P 82,720

Requirement 2

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Assuming that the direct labor workforce is not adjusted each quarter and
that overtime wages are paid, the direct labor budget would be:

1st 2nd 3rd 4th


Quarter Quarter Quarter Quarter Year
Units to be produced ............................................................................................................................
5,000 4,400 4,500 4,900 18,800
Direct labor time per unit (hours) ........................................................................................................
0.40 0.40 0.40 0.40 0.40
Total direct labor hours needed............................................................................................................
2,000 1,760 1,800 1,960 7,520
Regular hours paid ...............................................................................................................................
1,800 1,800 1,800 1,800 7,200
Overtime hours paid .............................................................................................................................
200 - - 160 360
Wages for regular hours
(@ P11.00 per hour) .......................................................................................................................
P19,800 P19,800 P19,800 P19,800 P79,200
Overtime wages
(@ P11.00 per hour 1.5) ..............................................................................................................
3,300 - - 2,640 5,940
Total direct labor cost ..........................................................................................................................
P23,100 P19,800 P19,800 P22,440 P85,140

Exercise 5 (Manufacturing Overhead Budget)

Requirement 1

Kiko Corporation
Manufacturing Overhead Budget

1st 2nd 3rd 4th


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

Requirement 2

Total budgeted manufacturing overhead for the year (a) ................................................................................


P175,700
Total budgeted direct labor-hours for the year (b) ..........................................................................................
20,400
Predetermined overhead rate for the year (a) (b) .........................................................................................
P 8.61

Exercise 6 (Selling and Administrative Budget)

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Helene Company
Selling and Administrative Expense Budget

1st 2nd 3rd 4th


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

Exercise 7 (Cash Budget Analysis)

Quarter (000 omitted)


1 2 3 4 Year
Cash balance, beginning ........................................................................................................
P 9 * P 5 P 5 P 5 P 9
Add collections from customers ............................................................................................
76 90 125 * 100 391 *
Total cash available ...............................................................................................................
85 * 95 130 105 400
Less disbursements:
Purchase of inventory .......................................................................................................
40 * 58 * 36 32 * 166
Operating expenses ...........................................................................................................
36 42 * 54 * 48 180 *
Equipment purchases ........................................................................................................
10 * 8 * 8 * 10 36 *
Dividends ..........................................................................................................................
2 * 2 * 2 * 2 * 8
Total disbursements ...............................................................................................................
88 110 * 100 92 390
Excess (deficiency) of cash
available over disbursements ............................................................................................
(3) * (15) 30 * 13 10

Financing:
20 *
Borrowings .......................................................................................................................
8 28

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Repayments (including interest)........................................................................................


0 0 (25) (7) * (32)
Total financing ......................................................................................................................
8 20 (25) (7) (4)
Cash balance, ending .............................................................................................................
P5 P 5 P 5 P 6 P 6

*Given.

IV. Problems

Problem 1 (Schedule of Expected Cash Collections and Disbursements)

Requirement 1

September cash sales ................................................................................................


P 7,400
September collections on account:
July sales: P20,000 18%....................................................................................
3,600
August sales: P30,000 70% ...............................................................................
21,000
September sales: P40,000 10% .........................................................................
4,000
Total cash collections ...............................................................................................
P36,000

Requirement 2

Payments to suppliers:
August purchases (accounts payable)...................................................................
P16,000
September purchases: P25,000 20% .................................................................
5,000
Total cash payments .................................................................................................
P21,000

Requirement 3

COOKIE PRODUCTS
Cash Budget
For the Month of September

Cash balance, September 1.......................................................................................


P 9,000
Add cash receipts:
Collections from customers ..................................................................................
36,000
Total cash available before current financing ..........................................................
45,000
Less disbursements:
Payments to suppliers for inventory .....................................................................
P21,000
Selling and administrative expenses.....................................................................
9,000 *

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Equipment purchases ............................................................................................


18,000
Dividends paid ......................................................................................................
3,000
Total disbursements ..................................................................................................
51,000
Excess (deficiency) of cash available over
disbursements .......................................................................................................
(6,000)
Financing:
Borrowings ...........................................................................................................
11,000
Repayments ..........................................................................................................
0
Interest ..................................................................................................................
0
Total financing..........................................................................................................
11,000
Cash balance, September 30.....................................................................................
P 5,000
* P13,000 P4,000 = P9,000.

Problem 2 (Production and Purchases Budget)

Requirement 1

Production budget:
July August September October
Budgeted sales (units) ...........................................................................................................
40,000 50,000 70,000 35,000
Add desired ending inventory ...............................................................................................
20,000 26,000 15,500 11,000
Total needs ............................................................................................................................
60,000 76,000 85,500 46,000
Less beginning inventory ......................................................................................................
17,000 20,000 26,000 15,500
Required production .............................................................................................................
43,000 56,000 59,500 30,500

Requirement 2

During July and August the company is building inventories in anticipation


of peak sales in September. Therefore, production exceeds sales during
these months. In September and October inventories are being reduced in
anticipation of a decrease in sales during the last months of the year.
Therefore, production is less than sales during these months to cut back on
inventory levels.

Requirement 3

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Raw materials purchases budget:


Third
July August September Quarter
Required production (units) ..................................................................................................
43,000 56,000 59,500 158,500
Material P214 needed per unit ..............................................................................................
3 lbs. 3 lbs. 3 lbs. 3 lbs.
Production needs (lbs.) ..........................................................................................................
129,000 168,000 178,500 475,500
Add desired ending inventory (lbs.) ......................................................................................
84,000 89,250 45,750 * 45,750
Total Material P214 needs.....................................................................................................
213,000 257,250 224,250 521,250
Less beginning inventory (lbs.) .............................................................................................
64,500 84,000 89,250 64,500
Material P214 purchases (lbs.) ..............................................................................................
148,500 173,250 135,000 456,750

* 30,500 units (October production) 3 lbs. per unit= 91,500 lbs.; 91,500 lbs.
0.5 = 45,750 lbs.

As shown in requirement (1), production is greatest in September. However,


as shown in the raw material purchases budget, the purchases of materials is
greatest a month earlier because materials must be on hand to support the
heavy production scheduled for September.

Problem 3 (Cash Budget; Income Statement; Balance Sheet)

Requirement 1

Schedule of cash receipts:

Cash salesJune .....................................................................................................


P 60,000
Collections on accounts receivable:
May 31 balance ....................................................................................................
72,000
June (50% 190,000) ..........................................................................................
95,000
Total cash receipts ...................................................................................................
P227,000

Schedule of cash payments for purchases:

May 31 accounts payable balance ...........................................................................


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

PICTURE THIS, INC.


Cash Budget

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For the Month of June

Cash balance, beginning ..........................................................................................


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

Requirement 2

PICTURE THIS, INC.


Budgeted Income Statement
For the Month of June

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

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PICTURE THIS, INC.


Budgeted Balance Sheet
June 30

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

Liabilities and Equity


Accounts payable (60% 200,000) .........................................................................
P120,000
Note payable .............................................................................................................
18,000
Share capital .............................................................................................................
420,000
Retained earnings (P85,000 + P6,500) .....................................................................
91,500
Total liabilities and equity ........................................................................................
P649,500

Problem 4 (Sales, Production and Materials Purchases Budget)

Requirement 1

Nikko Manufacturing Company


Sales Budget
For the year ending December 31, 2005

Units Amount
First quarter 16,000 P 480,000
Second quarter 20,000 600,000
Third quarter 22,000 660,000
Fourth quarter 22,000 660,000
Total 80,000 P2,400,000

Requirement 2

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Nikko Manufacturing Company


Statement of Production Required
For 2005

Quarter
1st 2nd 3rd 4th Total
Units to be sold 16,000 20,000 22,000 22,000 80,000
Add: Desired ending inventory (20%) 4,000 4,400 4,400 5,000 5,000
Total units required 20,000 24,400 26,400 27,000 85,000
Less: Beginning inventory 3,000 4,000 4,400 4,400 3,000
Units to be produced 17,000 20,400 22,000 22,600 82,000

Requirement 3

Nikko Manufacturing Company


Statement of Raw Materials Purchase Requirements
For 2005

Quarter
1st 2nd 3rd 4th Total
Units required for production 51,000 61,200 66,000 67,800 246,000
Add: Desired ending inventory 12,240 13,200 13,560 15,000 15,000
Total units 63,240 74,400 79,560 82,800 261,000
Less: Beginning inventory 12,500 12,240 13,200 13,560 12,500
Raw Materials to be Purchased 50,740 62,160 66,360 69,240 248,500

Problem 5 (Schedule of Expected Cash Collections; Cash Budget)

Requirement 1

Schedule of expected cash collections:

Month
April May June Quarter
From accounts receivable .........................................................................................
P141,000 P 7,200 P148,200
From April sales:
20% 200,000 .....................................................................................................
40,000 40,000
75% 200,000 .....................................................................................................
150,000 150,000
4% 200,000 .......................................................................................................
P 8,000 8,000

From May sales:


20% 300,000 .....................................................................................................
60,000 60,000

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75% 300,000 .....................................................................................................


225,000 225,000
From June sales:
20% 250,000 .....................................................................................................
50,000 50,000
Total cash collections ...............................................................................................
P181,000 P217,200 P283,000 P681,200

Requirement 2

Cash budget:

Month
April May June Quarter
Cash balance, beginning ...........................................................................................
P 26,000 P 27,000 P 20,200 P 26,000
Add receipts:
Collections from
customers ..........................................................................................................
181,000 217,200 283,000 681,200
Total available ..........................................................................................................
207,000 244,200 303,200 707,200
Less disbursements:
Merchandise purchases ........................................................................................
108,000 120,000 180,000 408,000
Payroll ..................................................................................................................
9,000 9,000 8,000 26,000
Lease payments ....................................................................................................
15,000 15,000 15,000 45,000
Advertising ...........................................................................................................
70,000 80,000 60,000 210,000

Equipment purchases ............................................................................................
8,000 8,000
Total disbursements ..................................................................................................
210,000 224,000 263,000 697,000
Excess (deficiency) of
receipts over
disbursements .......................................................................................................
(3,000) 20,200 40,200 10,200
Financing:

Borrowings ...........................................................................................................
30,000 30,000

Repayments ..........................................................................................................
(30,000) (30,000)

Interest ..................................................................................................................
(1,200) (1,200)
30,000
Total financing..........................................................................................................
(31,200) (1,200)
Cash balance, ending P 27,000 P 20,200 P 9,000 P 9,000

Requirement 3

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If the company needs a minimum cash balance of P20,000 to start each


month, the loan cannot be repaid in full by June 30. If the loan is repaid in
full, the cash balance will drop to only P9,000 on June 30, as shown above.
Some portion of the loan balance will have to be carried over to July, at
which time the cash inflow should be sufficient to complete repayment.

Problem 6 (Flexible Budget)

Summer Machine Company


Flexible Overhead Budget
Department 1

Capacity
100% 90% 80% 70% 60%
Machine Hours 200,000 180,000 160,000 140,000 120,000
Variable Overhead P1,300,000 P1,170,000 P1,040,000 P 910,000 P 780,000
Fixed Overhead 300,000 300,000 300,000 300,000 300,000
Total P1,600,000 P1,470,000 P1,340,000 P1,210,000 P1,080,000

Manufacturing Overhead rate per machine hour P8.00

Summer Machine Company


Flexible Overhead Budget
Department 2

Capacity
100% 90% 80% 70% 60%
Direct Labor Hours 200,000 180,000 160,000 140,000 120,000
Machine Hours 400,000 360,000 320,000 280,000 240,000
Variable Overhead P1,400,000 P1,260,000 P1,120,000 P 980,000 P 840,000
Fixed Overhead 500,000 500,000 500,000 500,000 500,000
Total P1,900,000 P1,760,000 P1,620,000 P1,480,000 P1,340,000

Manufacturing Overhead rate per machine hour P4.75

Problem 7 (Cash Budget with Supporting Schedules)

1. Collections on sales: July August Sept. Quarter


Cash sales ......................................................
P 8,000 P14,000 P10,000 P 32,000
Credit sales:
May: P30,000 80% 20% .....................
4,800 4,800
June: P36,000 80% 70%,
20% ........................................................
20,160 5,760 25,920

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July: P40,000 80% 10%,


70%, 20% ..............................................
3,200 22,400 6,400 32,000
Aug.: P70,000 80% 10%,
70% ........................................................ 5,600 39,200 44,800
Sept.: P50,000 80% 10% .................... 4,000 4,000
Total cash collections ....................................
P36,160 P47,760 P59,600 P143,520

2. a. Merchandise purchases budget:


July August Sept. Oct.
Budgeted cost of goods sold.........................
P24,000 P42,000 P30,000 P27,000
Add desired ending inventory* ....................
31,500 22,500 20,250
Total needs ...................................................
55,500 64,500 50,250
Less beginning inventory .............................
18,000 31,500 22,500
Required inventory purchases ......................
P37,500 P33,000 P27,750

*75% of the next months budgeted cost of goods sold.

b. Schedule of expected cash disbursements for merchandise purchases:


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

July
August Sept. Quarter
P P P
Cash balance, beginning ............................8,000 8,410 8,020 P 8,000
Add collections from sales ........................
36,160 47,760 59,600 143,520

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Total cash available ...............................


44,160 56,170 67,620 151,520
Less disbursements:
For inventory purchases ........................
30,450 35,250 30,375 96,075
For selling expenses ..............................7,200 11,700 8,500 27,400
For administrative expenses ..................3,600 5,200 4,100 12,900
For land..................................................4,500 0 0 4,500
For dividends ......................................... 0 0 1,000 1,000
Total disbursements ...................................
45,750 52,150 43,975 141,875
Excess (deficiency) of cash available
over disbursements ................................(1,590) 4,020 23,645 9,645
Financing:
Borrowings ............................................
10,000 4,000 14,000
Repayment ............................................. 0 0 (14,000) (14,000)
Interest ................................................... 0 0 (380) (380)
Total financing...........................................
10,000 4,000 (14,380) (380)
P P P
Cash balance, ending .................................8,410 8,020 9,265 P 9,265

* P10,000 1% 3 = P300
P4,000 1% 2 = 80
P380

V. Multiple Choice Questions

1. B 11. C 21. C
2. B 12. B 22. C
3. C 13. C 23. D
4. E 14. B 24. C
5. C 15. D 25. C
6. C 16. C 26. C
7. D 17. A 27. D
8. C 18. B 28. A
9. A 19. E 29. C

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10. D 20. B 30. D

Supporting computations:

Questions 16 to 20:

January February
Cost of sales P1,400,000 P1,640,000
Add: Desired Minimum Inventory 492,000 456,000
Total 1,892,000 2,096,000
Less: Beginning Inventory (1,400,000 x 0.3) (17) 420,000 492,000
Gross Purchases (16) 1,472,000 1,604,000
Less: Cash discount 14,720 16,040
Net cost of purchases P1,457,280 P1,587,960

Payments of Purchases
60% - month of purchase P874,368 P 952,776
40% - following month 582,912
Total (18) P1,535,688

(19)
February
Cash
Gross Discount Net
Current months sales (with
discount) 35% P595,000 P11,900 P583,100
Current months sales (without
discount) 15% 255,000 0 255,000

Previous months sales (with


discount) 4.5% 67,500 1,350 66,150
Previous months sales (without
discount) 40.5% 607,500 607,500
P1,525,000 P13,250 P1,511,750

(20)Total Collections in February P1,511,750


Add: Cash sales 350,000
Total P1,861,750

(21)Estimated cash receipts

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Collections from customers P1,350,000


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

(22)Net income P120,000


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

(23)Cash Receipts for February 2005


From February sales (60% x 110,000) P 66,000
From January sales 38,000
Total P104,000

(24)Pro-forma Income Statement, February 2005


Sales P110,000
Cost of sales (75%) 82,500
Gross profit P 27,500
Less: Operating expenses 16,500
Depreciation 5,000
Bad debts 2,200 23,700
Net operating income P 3,800

(25)Accounts Payable on February 28, 2005 will be the unpaid purchases in


February - (75% x P120,000) = P90,000.

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Questions 26 to 29:

Net sales P2,000,000


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

* Determined by working back from net income to sales.

Schedule I

Raw materials used


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

(30)Variable factory overhead


P150,000
48,000 P3.125

Fixed factory overhead


P240,000
48,000
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5.000

Total factory overhead P8.125

CHAPTER 16

STANDARD COSTS AND OPERATING


PERFORMANCE MEASURES

I. Questions
1. Standard costs are superior to past data for comparison with actual costs
because they ask the question Is present performance better than the
past?.
2. No. Cost control and cost reduction are not the same, but cost reduction
does affect the standards which are used as basis for cost control. Cost
reduction means finding ways to achieve a given result through
improved design, better methods, new layouts and so forth. Cost
reduction results in setting new standards. On the other hand, cost
control is a process of maintaining performance at or as new existing
standards as is possible.
3. Managerial judgment is the basis for deciding whether a given variance
is large enough to warrant investigation. For some items, a small
amount of variance may spark scrutiny. For some items, 5%, 10% or
25% variances from standard may call for follow-up. Management may
also derive the standard deviation based on past cost data.
4. The techniques for overhead control differ because
1) The size of individual overhead costs usually does not justify
elaborate individual control systems;
2) The behavior of individual overhead item is either impossible or
difficult to trace to specific lots or operations; and
3) Various overhead items are the responsibility of different people.
5. In the year-to-year planning of fixed costs, managers must consider:

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1) the projected maximum and minimum levels of activity,


2) prices of cost factors, and
3) changes in facilities and organization.

6. Four criteria for selecting a volume base are:


1) Cause of cost variability.
2) Adequacy of control over the base.
3) Independence of activity unit.
4) Ease of understanding.
7. Non-volume factors which cause costs to vary are:
1) Changes in plant and equipment.
2) Changes in products made, materials used, or methods of
manufacturing.
3) Changes in prices paid for cost factors.
4) Changes in managerial policy toward costs.
5) Lag between cost incurrence and measurement of volume.
8. A budget is usually expressed in terms of total pesos, whereas a standard
is expressed on a per unit basis. A standard might be viewed as the
budgeted cost for one unit.
9. Under management by exception, managers focus their attention on
operating results that deviate from expectations. It is assumed that
results that meet expectations do not require investigation.
10. Separating an overall variance into a price variance and a quantity
variance provides more information. Moreover, prices and quantities are
usually the responsibilities of different managers.
11. The materials price variance is usually the responsibility of the
purchasing manager. The materials quantity variance is usually the
responsibility of the production managers and supervisors. The labor
efficiency variance generally is also the responsibility of the production
managers and supervisors.
12. If used as punitive tools, standards can breed resentment in an
organization and undermine morale. Standards must never be used as an
excuse to conduct witch-hunts, or as a means of finding someone to
blame for problems.

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13. Several factors other than the contractual rate paid to workers can cause
a labor rate variance. For example, skilled workers with high hourly
rates of pay can be given duties that require little skill and that call for
low hourly rates of pay, resulting in an unfavorable rate variance. Or
unskilled or untrained workers can be assigned to tasks that should be
filled by more skilled workers with higher rates of pay, resulting in a
favorable rate variance. Unfavorable rate variances can also arise from
overtime work at premium rates.
14. Poor quality materials can unfavorably affect the labor efficiency
variance. If the materials create production problems, a result could be
excessive labor time and therefore an unfavorable labor efficiency
variance. Poor quality materials would not ordinarily affect the labor
rate variance.
15. If labor is a fixed cost and standards are tight, then the only way to
generate favorable labor efficiency variances is for every workstation to
produce at capacity. However, the output of the entire system is limited
by the capacity of the bottleneck. If workstations before the bottleneck
in the production process produce at capacity, the bottleneck will be
unable to process all of the work in process. In general, if every
workstation is attempting to produce at capacity, then work in process
inventory will build up in front of the workstations with the least
capacity.
16. A quantity standard indicates how much of an input should be used to
make a unit of output. A price standard indicates how much the input
should cost.
17. Chronic inability to meet a standard is likely to be demoralizing and may
result in decreased productivity.
18. A variance is the difference between what was planned or expected and
what was actually accomplished. A standard cost system has at least two
types of variances. A price variance focuses on the difference between
the standard price and the actual price of an input. A quantity variance is
concerned with the difference between the standard quantity of the input
allowed for the actual output and the actual amount of the input used.

II. Matching Type

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

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III. Exercises

Exercise 1 (Setting Standards; Preparing a Standard Cost Card)

Requirement 1

Cost per 2 kilogram container ..................................................................................


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

Requirement 2

Beta ML12 required per capsule as per bill of materials ......................................... 6.00 grams
Add allowance for material rejected as unsuitable
(6 grams 0.96 = 6.25 grams;
6.25 grams 6.00 grams = 0.25 grams) ...............................................................
0.25 grams
Total ..........................................................................................................................
6.25 grams
Add allowance for rejected capsules
(6.25 grams 25 capsules) ...................................................................................
0.25 grams
Standard quantity of Beta ML12 per salable capsule ............................................... 6.50 grams

Requirement 3

Standard Quantity Standard Price Standard Cost


Item per Capsule per Gram per Capsule
Beta ML12 6.50 grams P2.99 P19.435

Exercise 2 (Material Variances)

Requirement 1
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Number of chopping blocks .....................................................................................


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

Actual cost incurred .................................................................................................


P18,700
Standard cost above ..................................................................................................
18,000
Total varianceunfavorable ....................................................................................
P 700
Requirement 2

Actual Quantity of Inputs, at Actual Quantity of Inputs, at Standard Quantity Allowed for
Actual Price Standard Price Output, at Standard Price
(AQ AP) (AQ SP) (SQ SP)
P18,700 11,000 board feet 10,000 board feet
P1.80 per board foot P1.80 per board foot
= P19,800 = P18,000
Price Variance, Quantity Variance,
P1,100 F P1,800 U

Total Variance, P700 U

Alternatively:
Materials Price Variance = AQ (AP SP)
11,000 board feet (P1.70 per board foot* P1.80 per board foot) =
P1,100 F
* P18,700 11,000 board feet = P1.70 per board foot.

Materials Quantity Variance = SP (AQ SQ)


P1.80 per board foot (11,000 board feet 10,000 board feet) = P1,800 U

Exercise 3 (Labor and Variable Overhead Variances)

Requirement 1

Number of units manufactured .................................................................................


20,000
Standard labor time per unit .....................................................................................
0.4*

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Total standard hours of labor time allowed ..............................................................


8,000
Standard direct labor rate per hour ...........................................................................
P6
Total standard direct labor cost ................................................................................
P48,000
*24 minutes 60 minutes per hour = 0.4 hour

Actual direct labor cost ............................................................................................


P49,300
Standard direct labor cost .........................................................................................
48,000
Total varianceunfavorable ....................................................................................
P 1,300

Requirement 2

Actual Hours of Input, at Actual Hour of Input, at Standard Hours Allowed for
the Actual Rate Standard Rate Output, at the Standard Rate
(AH AR) (AH SR) (SH SR)
P49,300 8,500 hours P6 per hour 8,000 hours* P6 per hour
= P51,000 = P48,000
Rate Variance, Efficiency Variance,
P1,700 F P3,000 U

Total Variance, P1,300 U

*20,000 units 0.4 hour per unit = 8,000 hours

Alternative Solution:

Labor Rate Variance = AH (AR SR)


8,500 hours (P5.80 per hour* P6.00 per hour) = P1,700 F
*P49,300 8,500 hours = P5.80 per hour

Labor Efficiency Variance = SR (AH SH)


P6 per hour (8,500 hours 8,000 hours) = P3,000 U

Requirement 3

Actual Hours of Input, at Actual Hour of Input, at Standard Hours Allowed for
the Actual Rate Standard Rate Output, at the Standard Rate
(AH AR) (AH SR) (SH SR)
P39,100 8,500 hours P4 per hour 8,000 hours P4 per hour
= P34,000 = P32,000

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Spending Variance, Efficiency Variance,


P5,100 U P2,000 U

Total Variance, P7,100 U

Alternative Solution:

Variable Overhead Spending Variance = AH (AR SR)


8,500 hours (P4.60 per hour* P4.00 per hour) = P5,100 U
*P39,100 8,500 hours = P4.60 per hour
Variable Overhead Efficiency Variance = SR (AH SH)
P4 per hour (8,500 hours 8,000 hours) = P2,000 U

Exercise 4 (Working Backwards from Labor Variances)

Requirement 1

If the total variance is P330 unfavorable, and if the rate variance is P150
favorable, then the efficiency variance must be P480 unfavorable, since the
rate and efficiency variances taken together always equal the total variance.

Knowing that the efficiency variance is P480 unfavorable, one approach to


the solution would be:
Efficiency Variance = SR (AH SH)
P6 per hour (AH 420 hours*) = P480 U
P6 per hour AH P2,520 = P480**
P6 per hour AH = P3,000
AH = 500 hours
* 168 batches 2.5 hours per batch = 420 hours
** When used with the formula, unfavorable variances are positive and
favorable variances are negative.

Requirement 2

Knowing that 500 hours of labor time were used during the week, the actual
rate of pay per hour can be computed as follows:
Rate Variance = AH (AR SR)
500 hours (AR P6 per hour) = P150 F

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500 hours AR P3,000 = P150*


500 hours AR = P2,850
AR = P5.70 per hour

* When used with the formula, unfavorable variances are positive and
favorable variances are negative.

Exercise 5 (Direct Labor Variances)

1. Number of meals prepared ................................................... 6,000


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

Actual cost incurred ............................................................. P11,500


Total standard direct labor cost (above) .............................. 11,400
Total direct labor variance ................................................... P 100 Unfavorable

2. Standard Hours
Actual Hours of Actual Hours of Input, at the Allowed for Output, at the
Input, at the Actual Rate Standard Rate Standard Rate
(AH AR) (AH SR) (SH SR)
1,150 hours 1,150 hours 1,200 hours
P10.00 per hour P9.50 per hour P9.50 per hour
= P11,500 = P10,925 = P11,400

Rate Variance, Efficiency Variance,
P575 U P475 F

Total Variance, P100 U

Alternatively, the variances can be computed using the formulas:

Labor rate variance = AH(AR SR)


= 1,150 hours (P10.00 per hour P9.50 per hour)
= P575 U

Labor efficiency variance = SR(AH SH)

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= P9.50 per hour (1,150 hours 1,200 hours)


= P475 F

Exercise 6 (Variable Overhead Variances)

1. Number of items shipped .................................................................. 140,000


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

Actual variable overhead cost incurred............................................. P15,950


Total standard variable overhead cost (above) ................................. 15,680
Total variable overhead variance ...................................................... P 270 Unfavorable

2. Standard Hours
Actual Hours of Actual Hours of Input, at the Allowed for Output, at the
Input, at the Actual Rate Standard Rate Standard Rate
(AH AR) (AH SR) (SH SR)
5,800 hours 5,800 hours 5,600 hours
P2.75 per hour* P2.80 per hour P2.80 per hour
= P15,950 = P16,240 = P15,680

Variable overhead spending Variable overhead
variance, P290 F efficiency variance, P560 U

Total variance, P270 U

*P15,950 5,800 hours =P2.75 per hour

Alternatively, the variances can be computed using the formulas:

Variable overhead spending variance:


AH(AR SR) = 5,800 hours (P2.75 per hour P2.80 per hour)
= P290 F

Variable overhead efficiency variance:

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SR(AH SH) = P2.80 per hour (5,800 hours 5,600 hours)


= P560 U

IV. Problems

Problem 1 (Comprehensive Variance Analysis)

Requirement 1
a.
Actual Quantity of Inputs, at Actual Quantity of Inputs, at Standard Quantity Allowed for
the Actual Price Standard Price Output, at the Standard Price
(AQ AP) (AQ SP) (SQ SP)
25,000 pounds x 25,000 pounds x 20,000 pounds* x
P2.95 per pound P2.50 per pound P2.50 per pound
= P73,750 = P62,500 = P50,000
Price Variance,
P11,250 U
19,800 pounds x P2.50 per pound
= P49,500
Quantity Variance,
P500 F

* 5,000 metal molds 4.0 pounds per metal mold = 20,000 pounds

Alternatively:
Materials Price Variance = AQ (AP SP)
25,000 pounds (P2.95 per pound P2.50 per pound) = P11,250 U
Materials Quantity Variance = SP (AQ SQ)
P2.50 per pound (19,800 pounds 20,000 pounds) = P500 F

b.
Actual Hours of Input, at Actual Hours of Input, at Standard Hours Allowed for
the Actual Rate the Standard Rate Output, at the Standard Rate
(AH AR) (AH SR) (SH SR)
3,600 hours x 3,600 hours x 3,000 hours* x
P8.70 per hour P9.00 per hour P9.00 per hour
= P31,320 = P32,400 = P27,000

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Rate Variance, Efficiency Variance,


P1,080 F P5,400 U

Total Variance, P4,320 U


* 5,000 metal molds 0.6 hour per metal mold = 3,000 hours
Alternatively:
Labor Rate Variance = AH (AR SR)
3,600 hours (P8.70 per hour P9.00 per hour) = P1,080 F
Labor Efficiency Variance = SR (AH SH)
P9.00 per hour (3,600 hours 3,000 hours) = P5,400 U

c.
Actual Hours of Input, at Actual Hours of Input, at Standard Hours Allowed for
the Actual Rate the Standard Rate Output, at the Standard Rate
(AH AR) (AH SR) (SH SR)
P4,320 1,800 hours P2 per hour 1,500 hours* P2 per hour
= P3,600 = P3,000
Spending Variance, Efficiency Variance,
P720 U P600 U

Total Variance, P1,320 U

*5,000 metal molds 0.3 hours per metal mold = 1,500 hours

Alternatively:
Variable Overhead Spending Variance = AH (AR SR)
1,800 hours (P2.40 per hour* P2.00 per hour) = P720 U
* P4,320 1,800 hours = P2.40 per hour
Variable Overhead Efficiency Variance = SR (AH SH)
P2.00 per hour (1,800 hours 1,500 hours) = P600 U

Requirement 2

Summary of variances:

Material price variance ............................................................................................


P11,250 U
Material quantity variance .......................................................................................
500 F

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Labor rate variance ..................................................................................................


1,080 F
Labor efficiency variance ........................................................................................
5,400 U
Variable overhead spending variance ......................................................................
720 U
Variable overhead efficiency variance .....................................................................
600 U
Net variance .............................................................................................................
P16,390 U

The net unfavorable variance of P16,390 for the month caused the plants
variable cost of goods sold to increase from the budgeted level of P80,000 to
P96,390:

Budgeted cost of goods sold at P16 per metal mold ................................................


P80,000
Add the net unfavorable variance (as above) ..........................................................
16,390
Actual cost of goods sold .........................................................................................
P96,390

This P16,390 net unfavorable variance also accounts for the difference
between the budgeted net operating income and the actual net loss for the
month.

Budgeted net operating income ...............................................................................


P15,000
Deduct the net unfavorable variance added to cost of goods
sold for the month ................................................................................................
16,390
Net operating loss ....................................................................................................
P(1,390)

Requirement 3

The two most significant variances are the materials price variance and the
labor efficiency variance. Possible causes of the variances include:

Materials Price Outdated standards, uneconomical quantity


Variance: purchased, higher quality materials, high-
cost method of transport.

Labor Efficiency Poorly trained workers, poor quality


Variance: materials, faulty equipment, work
interruptions, inaccurate standards,
insufficient demand.

Problem 2

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1. 1,000 units 4. 14,900 lbs.


2. 25,000 lbs. 5. 3,100 hours
3. P2.01 per lb. 6. P3.98 per hour

Problem 3

Material mix variance:


Actual quantity x Standard price
Material A (8,000 x P0.30) P2,400
Material B (2,400 x P0.20) 480
Material C (2,800 x P0.425) 1,190 P4,070
Less: Total actual input x Average
Standard price (13,200 x 0.30*) 3,960
Unfavorable Mix Variance P 110
P 720
* Average Standard price = 2,400 = P0.30

Material yield variance:


Total actual input at Average Standard price P3,960
Less: Total actual output at Standard raw material cost
(10,000 x 0.36**) 3,600
Unfavorable yield variance P 360
P 720
** Standard Material Cost = = P0.36
2,000

Problem 4 (Comprehensive Variance Analysis; Journal Entries)

Requirement 1

a.
Actual Quantity of Inputs, at Actual Quantity of Inputs, at Standard Quantity Allowed for
Actual Price Standard Price Output, at Standard Price
(AQ AP) (AQ SP) (SQ SP)
21,120 yards x 21,120 yards x 19,200 yards* x
P3.35 per yard P3.60 per yard P3.60 per yard
= P70,752 = P76,032 = P69,120
Price Variance, Quantity Variance,
P5,280 F P6,912 U

Total Variance, P1,632 U


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* 4,800 units 4.0 yards per unit = 19,200 yards

Alternatively:
Materials Price Variance = AQ (AP SP)
21,120 yards (P3.35 per yard P3.60 per yard) = P5,280 F
Materials Quantity Variance = SP (AQ SQ)
P3.60 per yard (21,120 yards 19,200 yards) = P6,912 U

b. Raw Materials (21,120 yards @ P3.60 per yard) .....................................................


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

Work in Process (19,200 yards @ P3.60 per


yard)......................................................................................................................
69,120
Materials Quantity Variance
(1,920 yards U @ P3.60 per yard) ........................................................................
6,912
Raw Materials (21,120 yards @ P3.60 per
yard) ..............................................................................................................
76,032

Requirement 2

a.
Actual Hours of Input, at Actual Hours of Input, at Standard Hours Allowed for
the Actual Rate the Standard Rate Output, at the Standard Rate
(AH AR) (AH SR) (SH SR)
6,720 hours* x 6,720 hours x 7,680 hours** x
P4.85 per hour P4.50 per hour P4.50 per hour
= P32,592 = P30,240 = P34,560
Rate Variance, Efficiency Variance,
P2,352 U P4,320 F

Total Variance, P1,968 F

* 4,800 units 1.4 hours per unit = 6,720 hours

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** 4,800 units 1.6 hours per unit = 7,680 hours

Alternatively:
Labor Rate Variance = AH (AR SR)
6,720 hours (P4.85 per hour P4.50 per hour) = P2,352 U
Labor Efficiency Variance = SR (AH SH)
P4.50 per hour (6,720 hours 7,680 hours) = P4,320 F

b. Work in Process (7,680 hours @ P4.50 per hour) ....................................................


34,560
Labor Rate Variance
(6,720 hours @ P0.35 per hour U) .......................................................................
2,352
Labor Efficiency Variance
(960 hours F @ P4.50 per hour) ...................................................................
4,320
Wages Payable (6,720 hours @ P4.85 per
hour) .............................................................................................................
32,592

Requirement 3

Actual Hours of Input, at Actual Hours of Input, at Standard Hours Allowed for
the Actual Rate the Standard Rate Output, at the Standard Rate
(AH AR) (AH SR) (SH SR)
6,720 hours x 6,720 hours x 7,680 hours x
P2.15 per hour P1.80 per hour P1.80 per hour
P14,448 = P12,096 = P13,824
Spending Variance, Efficiency Variance,
P2,352 U P1,728 F

Total Variance, P624 U

Alternatively:
Variable Overhead Spending Variance = AH (AR SR)
6,720 hours (P2.15 per hour P1.80 per hour) = P2,352 U
Variable Overhead Efficiency Variance = SR (AH SH)
P1.80 per hour (6,720 hours 7,680 hours) = P1,728 F

Requirement 4

No. This total variance is made up of several quite large individual

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variances, some of which may warrant investigation. A summary of


variances is shown on the next page.

Materials:
Price variance ......................................................................................................
P5,280 F
Quantity variance .................................................................................................
6,912 U P1,632 U
Labor:
Rate variance .......................................................................................................
2,352 U
Efficiency variance ..............................................................................................
4,320 F 1,968 F
Variable overhead:
Spending variance ................................................................................................
2,352 U
Efficiency variance ..............................................................................................
1,728 F 624 U
Net unfavorable variance .........................................................................................
P 288 U

Requirement 5

The variances have many possible causes. Some of the more likely causes
include:

Materials variances:

Favorable price variance: Fortunate buy, inaccurate standards, inferior


quality materials, unusual discount due to quantity purchased, drop in market
price.

Unfavorable quantity variance: Carelessness, poorly adjusted machines,


unskilled workers, inferior quality materials, inaccurate standards.

Labor variances:

Unfavorable rate variance: Use of highly skilled workers, change in wage


rates, inaccurate standards, overtime.

Favorable efficiency variance: Use of highly skilled workers, high quality


materials, new equipment, inaccurate standards.

Variable overhead variances:

Unfavorable spending variance: Increase in costs, inaccurate standards,

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waste, theft, spillage, purchases in uneconomical lots.

Favorable efficiency variance: Same as for labor efficiency variance.

V. Multiple Choice Questions

1. C 11. B 21. A 31. A 41. B


2. C 12. A 22. C 32. B 42. C
3. A 13. B 23. C 33. B 43. D
4. B 14. C 24. C 34. D 44. A
5. A 15. A 25. C 35. B 45. B
6. B 16. D 26. D 36. B
7. C 17. D 27. E 37. C
8. C 18. A 28. B 38. D
9. B 19. D 29. B 39. D
10. B 20. B 30. A 40. A

CHAPTER 17

APPLICATION OF QUANTITATIVE TECHNIQUES IN


PLANNING, CONTROL AND DECISION MAKING - I

I. Questions
1. a. Decision tree analysis provides a systematic framework for
analyzing a sequence of interrelated decisions which may be made
over time. Decision making is formulated in terms of the
consequence of acts, events and consequences because it is believed
that present decisions affect future profitability. The study and
understanding of alternative scenarios is encouraged with the use of
decision tree analysis.
b. Advantages of Decision Tree Analysis
1. Clarifies the choices, risks, and monetary gains involved in an
investment problem.
2. Presents the relevant information more clearly.

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3. Combines action choices with different possible events or results


of action which are partially affected by chance or other
uncontrollable circumstances.
4. Encourages the focus on the relationship between current and
future decisions.
5. Utilizes such analytical techniques as present value and
discounted cash flow.
6. Considers various alternatives with greater ease.
Weaknesses of Decision Tree Analysis
1. Not all events that can happen can be/are identified.
2. Not all the decisions that must be made on a subject under
analysis are listed because choices are usually not restricted to
two or three.
3. If a large number of choices is involved, decision tree analysis
by hand becomes complicated.
4. Uncertain alternatives are generally treated as if they were
discrete, well-defined possibilities.
2. Refer to page 665 of the textbook.
II. Multiple Choice Questions

6. A 6. C 31. B 41. B 46. B


7. A 7. B 32. D 42. C 47. D
8. B 8. D 33. C 43. D 48. B
9. B 9. A 34. B 44. D 49. B
10. B 10. D 35. A 45. A 50. D

CHAPTER 18

APPLICATION OF QUANTITATIVE TECHNIQUES IN


PLANNING, CONTROL AND DECISION MAKING - II

I. Questions
1. PERT is superior to Gantt Charts in complex projects because:

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a. PERT charts are flexible and can reflect slippage or changes in


plans, but Gantt charts simply plot a bar chart against a calendar
scale.
b. PERT charts reflect interdependencies among activities; Gantt charts
do not.
c. PERT charts reflect uncertainties or tolerances in the time estimates
for various activities; Gantt charts do not.
2. The use of PERT provides a structured foundation for planning complex
projects in sufficient detail to facilitate effective control.
A workable sequence of events that comprise the project are first
identified. Each key event should represent a task; then the
interdependent relationships between the events are structured.
After the network of events is constructed, cost and time parameters are
established for each package. Staffing plans are reviewed and analyzed.
The critical path computation identifies sequence of key events with
total time equal to the time allotted for the projects completion. Jobs
which are not on the critical path can be slowed down and the slack
resources available on these activities reallocated to activities on the
critical path.
Use of PERT permits sufficient scheduling of effort by functional areas
and by geographic location. It also allows for restructuring scheduling
efforts and redeployment of workers as necessary to compensate for
delays or bottlenecks. The probability of completing this complex
project on time and within the allotted budget is increased.
3. Time slippage in noncritical activities may not warrant extensive
managerial analysis because of available slack, but activity cost usually
increases with time and should be monitored.
4. The critical path is the network path with the longest cumulative
expected activity time. It is critical because a slowdown along this path
delays the entire project.
5. Crashing the network means finding the minimum cost for completing
the project in minimum time in order to achieve an optimum tradeoff
between cost and time. The differential crash cost of an activity is the
additional cost of that activity for each period of time saved.

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6. Slack is the amount of time an event can be delayed without affecting


the projects completion date. Slack can be utilized by management as a
buffer against bottlenecks that may occur on the critical path.
7. Unit gross margin are typically computed with an allocation of fixed
costs. Total fixed costs generally will not change with a change in
volume within the relevant range. Unitizing the fixed costs results in
treating them as though they are variable costs when, in fact, they are
not. Moreover, when multiple products are manufactured, the relative
contribution becomes the criterion for selecting the optimal product mix.
Fixed costs allocations can distort the relative contributions and result in
a suboptimal decision.
8. This approach will maximize profits only if there are no constraints on
production or sales, or if both products use all scarce resources at an
equal rate. Otherwise management would want to maximize the
contribution per unit of scarce resource.
9. The opportunity cost of a constraint is the cost of not having additional
availability of the constrained resources. This is also called a shadow
price.
10. The feasible production region is the area which contains all possible
combinations of production outputs. It is bounded by the constraints
imposed on production possibilities. The production schedule which
management chooses must come from the feasible production region.
11. The accountant usually supplies the contribution margin data that is used
in formulating a profit-maximizing objective function. In addition, the
accountant participates in the analysis of linear programming outputs by
assessing the costs of additional capacity or of changes in product mix.
12. a. Hourly fee for inventory audit (C)
b. Salary of purchasing supervisor (N)
c. Costs to audit purchase orders and invoices (P)
d. Taxes on inventory (C)
e. Stockout costs (P)
f. Storage costs charged per unit in inventory (C)
g. Fire insurance on inventory (C)
h. Fire insurance on warehouse (N)
i. Obsolescence costs on inventory (C)
j. Shipping costs per shipment (P)

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13. Although the inventory models are developed by operations researchers,


statisticians and computer specialists, their areas of expertise do not
extend to the evaluation of the differential costs for the inventory
models. Generally, discussions of inventory models take the costs as
given. It is the role of the accountant to determine which costs are
appropriate for inclusion in an inventory model.
14. Cost of capital represents the interest expense on funds if they were
borrowed or opportunity cost if funds were provided internally or by
owners. It is included as carrying cost of inventory because funds are
tied up in inventory.
15. Costs that vary with the average number of units in inventory:
Inventory insurance P 2.80
Inventory tax 2.05 (P102.25 x 2%)
Total P 4.85
Costs that vary with the number of units purchased:
Purchase price P102.25
Insurance on shipment 1.50
Total P103.75
Total carrying cost = (25% x P103.75) cost of capital + P4.85 = P25.94
+ P4.85 = P30.79
Order costs:
Shipping permit P201.65
Costs to arrange for the shipment 21.45
Unloading 80.20
Stockout costs 122.00
Total P425.30

II. Problems

Problem 1 (Solution is found on the next page.)

Problem 2

Requirement (a)

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Chapter 18 Application of Quantitative Techniques in Planning, Control and Decision Making - II

The critical path through each of the three alternative paths calculated as the
longest is 0 - 1 - 6- 7- 8.

0-1-2-5-8 2 + 8 + 10 + 14 = 34
0-1-3-4-7-8 2+8+7+5+3 = 25
0-1-6-7-8 2 + 26 + 9 + 3 = 40*
________
* critical

Requirement (b)

40 - 3 - 5 = 32

Requirement (c)

If path 4 - 7 has an unfavorable time variance of 10, this means it takes a


total time of 15 to finish this activity rather than 5. This gives the path 0 - 1
- 3 - 4 - 7 - 8 a total time of 35, but since this is less than the critical path of
40, it has no effect.

Requirement (d)

The earliest time for reaching event 5 via 0 - 1 - 2 - 5 is 20, the sum of the
expected times.

Problem 3

No, they didnt make a right decision, since they included fixed costs which
do not differ in the short run. If they had used contribution margin instead of
gross margin, they would have had P5 for G1 and P6.50 for G2, therefore
they would have decided to produce G2 exclusively.

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Problem 1
Requirement (a)

TASKS 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28

H Order 1 Order 3 Order 4 Order 2


o
b
b
i
n
g

M X X X
X Order 1 X X Order 3 X X X Order 4 Order 2
a
c
h
i
n
i
n
g

___________
X Dead Time

Requirement (b)

28 days are required for the four orders.

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Problem 4

Order costs = Insurance + Other order costs

P = P860 + P18 = P878

Carrying costs = Out-of-pocket Cost of capital


+
costs on inventory
S = P65 + 20% x P222 = P119.40

a. Carrying costs:
QS 250 x P109.40
= = P13,675.00
2 2

Order costs:
AP 1,500 x P878
= = P 5,268.00
Q 250

Total P18,943.00

b. Economic order quantity:


2 x 1,500 x P878
Q* = = 24,077 = 155 units
P109.40

Carrying costs:
QS 155 x P109.40
= = P 8,478.50
2 2

Order costs:
AP 1,500 x P878
= = P 8,496.77