Managerial Accounting PDF

sixth edition
Managerial
Accounting
James Jiambalvo
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MANAGERIAL ACCOUNTING
Managerial...
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Managerial
Accounting
A Note to Students...
Dear Students of Managerial Accounting,

Managerial Accounting is concerned with using information to effectively plan and
control operations and make good business decisions. The overall objective of this
book is to provide you with the concepts and tools needed in planning, control, and
decision making. I’ve taught Managerial Accounting for many years, and my former
students, many of whom are in senior executive positions, tell me that they’ve used
these concepts and tools throughout their business careers. So, trust me. Work hard
in this course, and you will reap major benefits!
In approaching the course, realize that you need to take personal responsibility
for your success. Of course your instructor will help you understand the material, but
you’re the one who must make time to read the material before class and complete
all assigned problems and cases. I recommend that you take a three-step approach
to the study of each chapter in Managerial Accounting:
• First, skim the chapter for a quick overview.

• Second, read the chapter carefully, and pay particular attention to the illustra-
tions. When you’re finished, make sure you understand each of the learning
objectives.
• Third, enhance and test your knowledge using the materials within WileyPLUS.
If at all possible, you should also form a study group with one or two of your
classmates. You’ll learn a lot from each other, and going over the homework together
may actually be fun!
With my best wishes for success,
Jim Jiambalvo
Dean and Kirby L. Cramer
Chair in Business Administration
Michael G. Foster School of Business
University of Washington
Sixth Edition
Managerial
Accounting
James Jiambalvo
University of Washington
To my wife, Cheryl
Vice President & Director George Hoffman

Executive Editor Michael McDonald
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About the Author
JAMES JIAMBALVO, Dean of the Michael G. Foster

School of Business at the University of Washington and
Kirby L. Cramer Chair in Business Administration, joined
the accounting faculty at Foster after receiving a Ph.D. in
accounting from The Ohio State University. A CPA, he has
audit experience with the firm of Haskins and Sells (now
Deloitte & Touche), and has served on the national academic
advisory board of Deloitte & Touche LLP. Dean Jiambalvo has
served as chairman of the University of Washington Accounting
Department and previously held the PricewaterhouseCoopers
and Alumni Endowed Professorship.
Dean Jiambalvo’s research has been published in top
accounting journals, including The Accounting Review,
Contemporary Accounting Research, the Journal of
Accounting and Economics, and the Journal of Accounting Research. He is a
former associate editor of The Accounting Review and has served on the editorial
boards of The Accounting Review, Contemporary Accounting Research, and the
Journal of Management Accounting Research.
Dean Jiambalvo has received the Notable Contribution to the Auditing Literature
Award, the Burlington Northern Foundation Faculty Achievement Award, the Andrew
V. Smith Faculty Development Award, and the Lex N. Gamble Award for Excellence
in the Field of E-Commerce. He has also been recognized for his teaching of mana-
gerial accounting with the MBA Professor of the Year and Professor of the Quarter
awards. He has taught numerous executive education courses, including courses for
Alcoa, Boeing, Microsoft, Tyson, and other major firms. He currently serves on the
board of Saltchuk Resources.
ix
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Approximately 50 videos are newly available to the Sixth Edition. The videos serve as guides through
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xi
Preface
This book is intended to drive home the fundamental ideas of managerial accounting
and motivate students to actually want to study the subject. As you will see, the text has a
number of unique features that help accomplish these goals. Based on my teaching experi-
ence and from what we have heard from professors using the previous editions, we believe
students and professors want a textbook that:
• Recognizes that most students will become managers, not accountants
• Focuses attention on decision making
• Stresses the fact that “You Get What You Measure”
• Motivates students to learn managerial accounting by connecting concepts and
techniques to the real world
• Recognizes the growing importance of service businesses
• Is clear, concise (can be covered in one semester), and current
• Provides students with ample opportunities to test their knowledge.
Here’s how the sixth edition of Managerial Accounting reflects these desires.
Recognizes that most students will become managers, not accountants.

Most students of introductory managerial accounting will pursue careers as managers, not
accountants. Future managers most likely will not need to know the FIFO approach to process
costing or how to calculate four overhead variances—so these and other less essential topics
are not covered.
Focuses more attention on decision making. Instructors want their students

to be able to solve the types of problems that real managers face. This requires that
more emphasis be placed on decision making skills. Accordingly, three of the chapters
(Chapters 7, 8, and 10) focus specifically on decision making. Additionally, decision mak-
ing, and the use of incremental analysis, are discussed in the first chapter and integrated
throughout the book. By the time students get to Chapter 7 (The Use of Cost Information
in Management Decision Making), they will already have a good understanding of costs
that are relevant in making a decision. After reading Chapter 7, working homework prob-
lems and discussing the material in class, students will have a greater understanding of
decision making!
Stresses the fact that “You Get What You Measure” Senior managers know
that performance measures greatly affect how subordinates focus their time and attention.
Thus, the subject of performance measurement is of great practical importance. In this
book, every chapter makes reference to the critical idea that You get what you measure.
Chapter 12 has an extensive discussion of performance measures.
Motivates students to learn managerial accounting by connecting concepts
and techniques to the real world. Business people often say that they wish they had
known how important managerial accounting would have been to their success on the job—
they would have studied the subject harder in school! Here, every effort is made to convince
students that managerial accounting is of critical importance in the real world. Link to
xii
P r e f a c e xiii
Practice boxes relate the text material to real companies. Additionally, each chapter has
cases developed with feedback from managers who attested to their realism and relevance.
An often-heard comment: “We had that exact situation at my company!”
Recognizes the growing importance of service businesses. In the last 20 years,

employment has shifted from manufacturing to the service sector. Now, more than 75%
of all jobs are in the service economy. With this in mind, numerous examples of service
companies are in the chapter and end-of-chapter materials.
Clear, concise (can be covered in one semester), and current. According

to students and faculty who used the previous editions, a major and much appreciated
strength of the text is the clear and concise writing style. Discussions are to the point, ideas
are illustrated, and examples are presented to make the ideas concrete. The entire text can
be comfortably covered in one semester. Coverage is also up-to-date, including: Theory
of Constraints, Economic Value Added, The Balanced Scorecard, Strategy Maps, Activity-
Based Costing and Activity-Based Management, Why Budget-Based Compensation Can
Encourage Padding and Income-Shifting, etc.
Provides students with ample oppourtunities to test their knowledge. In

each chapter, students are presented with a feature called Test Your Knowledge. At the end
of each chapter, there are two comprehensive review problems as well as several multiple
choice problems with solutions. These features allow students to assess their understad-
ing of the material as they read through the chapter as well as after they have finished
reading the entire chapter. The features also set students up for success in completing end-
of-chapter assignments.
WILEYPLUS Resources
WileyPLUS is an innovative, research-based online environment for effective teaching
and learning. WileyPLUS builds students’ confidence because it takes the guesswork
out of studying by providing students with a clear roadmap: what to do, how to do it,
if they did it right. Students will take more initiative, so you’ll have greater impact on
their achievement in the classroom and beyond.
Instructor Resources
Solutions Manual
The Solutions Manual provides detailed solutions for all end-of-chapter questions, exer-
cises, problems, and cases.
Test Bank
The Test Bank consists of over 2,000 examination questions and exercises accompanied by
solutions. Question types include true-false, multiple choice, completion, exercises, and
short-answer.
Instructor’s Manual
The Instructor’s Manual is a comprehensive resource guide designed to assist professors in
preparing lectures and assignments. The manual includes chapter reviews, lecture outlines,
assignment classification tables, teaching illustrations, and quizzing exercises.
xiv P r e f a c e
PowerPoint™ Presentations
PowerPoint™ Presentations contain key concepts and images from the textbook.
Student Resources
Study Guide
The Study Guide is comprised of a chapter review with true-false question, multiple-
choice exercises, and problems.
Excel Templates
The Excel Templates help students to complete select end-of-chapter exercises and problems
identified by an icon in the margin of the textbook.
Acknowledgments
I am indebted to my academic colleagues and former students for enriching my understanding of
managerial accounting. The team at Wiley provided expert help, guidance, and support throughout
the publication process. In particular, Michael McDonald, executive editor, made a number of valu-
able suggestions for improving the sixth edition. Other Wiley staff who contributed to the text and
media are: Rebecca Costantini, associate development editor; Allie Morris, product design manager;
Greg Chaput, senior product designer; Elena Santa Maria, production editor; Maureen Eide, senior
designer; Mary Anne Price, senior photo editor.
Other individuals whose input is greatly appreciated are indicated below.
Ancillary Authors, Proofers, and Accuracy Checkers for the Sixth Edition
LuAnn Bean, Florida Institute of Technology; Debby Bloom CMA, CFM; Bea Chiang, The College
of New Jersey; Jill Misuraca, University of Tampa; Alice Sineath, University of Maryland University
College; Diane Tanner, University of North Florida; Melanie Yon, WileyPLUS developer.
Reviewers
The development of this sixth edition of Managerial Accounting benefited greatly from the com-
ments and suggestions of colleagues who teach managerial accounting. I would like to acknowledge
the contributions made by the following individuals:
Stephen Asare, University of Florida; LuAnn Bean, Florida Institute of Technology; Brenda
Bradford, Missouri Baptist University; Kurt Fanning, Grand Valley State University; Amanda Farmer,
University of Georgia, Athens; Timothy Foley, University at Albany; George Gerner, University at
Albany; John Giles, North Carolina State University; Michael Hammond, Missouri State University;
Catherine Katagiri, The College of Saint Rose; Ethan Kinory, Baruch College; Curtis Ksenak, Saint
Joseph’s College; Gary Laycock, Ivy Tech Community College; Daniel McGeough, Mt. San Antonio
College; Christopher McKittrick, North Carolina State University; James McKittrick, University of
Portland; Michael Newman, University of Houston; Jorge Romero, Towson University; Anwar Salimi,
University of Laverne; Jason Stanfield, Purdue University, West Lafayette; Michael Sweeney, Hillsdale
College; Diane Tanner, University of North Florida; Robin Thomas, North Carolina State University;
Kim Walker, Johnson C. Smith University
Prior Edition Reviewers

Ajay Adhikari, American University; Gilda Agacer, Monmouth University; Natalie Allen, Texas A&M
University; Sekhar Anantharaman, Indiana University of Pennsylvania; Christie Anderson, Whitworth
College; Walt Austin, Mercer College; Noah Barsky, Villanova University; Connie Belden, Butler
Community College; William Blosel, California University of Pennsylvania; Cynthia Bolt, The Citadel—
The Military College of South Carolina; Nat Briscoe, Northwestern State University; Wayne Bremser,
Villanova University; Ann Brooks, Central New Mexico Community College; Carol Brown, Oregon
State University; Leonor Cabrera, San Mateo County Community College; Betty Chavis, California
State University, Fullerton; Richard Claire, San Mateo County Community College; Cheryl Crespi,
Central Connecticut State University; Terry Dancer, Arkansas State University; Carleton Donchess,
Bridgewater State College; Bob Everett, Lewis and Clark Community College; Anthony Fortner, Carl
Albert College; Cynthia Greeson, Ivy Tech Community College; Rosalie Hallbauer, Florida Memorial
University; Deborah Hanks, Cardinal Stritch University; Candice Heino, Anoka-Ramsey Community
College; Dave Henderson, College of Charleston; Carol Hutchinson, Asheville-Buncombe Technical
Community College; Ron Krug, Allegony College of Maryland; D. Jordan Lowe, Arizona State
University; Steven Markoff, Montclair State University; Laurie McWhorter, Mississippi State University;
Cathy Montesarchio, Broward Community College; Carmen Morgan, Oregon Institute of Technology;
Al Oddo, Niagara University; Nick Powers, Devry University—Chicago; Denise C. Probert, Viterbo
College; Dr. Anwar Y. Salimi, California State University, Pomona; Betty Saunders, University of North
Florida; Charles Stanley, Baylor University; Sakaran Venkateswar, Trinity University; Jeffery Yost,
College of Charleston; Christian E. Wurst Jr., Temple University
xv
Contents
1
Managerial Accounting in the Information Age 2
GOAL OF MANAGERIAL ACCOUNTING 4 Software Systems That Impact Value
Planning4 Chain Management 16
Budgets for Planning, 4 Enterprise Resource Planning Systems, 16 Supply
Chain Management Systems, 16 Customer
Control4
Relationship Management Systems, 17
Performance Reports for Control, 5 Ethical Considerations in Managerial
Decision Making 6 Decision Making 18
A Comparison of Managerial and Financial Accounting 7 Ethical and Unethical Behavior 18
Internal versus External Users, 7 Need to Use Sarbanes-Oxley Act, 19
GAAP, 7 Detail of Information, 8 Emphasis A Framework for Ethical Decision Making 20
on Nonmonetary Information, 8 Emphasis
on the Future, 8 IMA Statement of Ethical Professional Practice 20
Similarities between Financial and Managerial The Controller as the Top Management
Accounting8 Accountant21
Summary of Learning Objectives 23
Cost Terms Used in Discussing Planning,
Appendix IMA Statement of Ethical
Control, and Decision Making 8
Professional Practice2
24
Variable and Fixed Costs 9
Principles24
Variable Costs, 9 Fixed Costs, 9 Standards24
Sunk Costs 10
Resolution of Ethical Conflict 24
Opportunity Costs 10
Direct and Indirect Costs 10 Link to Practice:
Controllable and Noncontrollable Costs 11 Long Supply Chains Create Opportunity Costs, 10 Problems
Related to the Wrong Performance Measures, 14 Casinos
Two Key Ideas in Managerial Manage with Data from CRM Systems, 17 Feds Investigat-
Accounting12 ing Walmart Over Bribery in Mexico, 19 Are the Procurement
Decision Making Relies on Incremental Practices of the Hershey Company Ethical?, 21
Analysis, 12
Review Problems 25
The Information Age and Managerial Key Terms 26
Accounting14
Self-Assessment26
Impact of Information Technology on Management Questions27
of the Value Chain 15
Exercises28
Information Flows between Milano and Customers, 16 Problems31
Information Flows between Milano and Suppliers, 16
Cases34
Using Information Technology to Gain Internal
Efficiencies, 16
xvii
xviii C o n t e n t s
2
Job-Order Costing for Manufacturing and Service Companies 36
Cost Classifications for Manufacturing Relation Between the Costs of Jobs and
Firms38 the Flow of Costs in Work in Process,
Manufacturing Costs 38 Finished Goods, and Cost of Goods Sold 55
Direct Material, 38 Direct Labor, 39 Allocating Overhead to Jobs:
Manufacturing Overhead, 39 A Closer Look 56
Nonmanufacturing Costs 39 Overhead Allocation Rates 56
Selling Costs, 39 General and Administrative The Overhead Allocation Base 56
Costs, 39 Activity-Based Costing (ABC) and Multiple
Product and Period Costs 40 Overhead Rates 57
Product Costs, 40 Period Costs, 40 Predetermined Overhead Rates 58
Eliminating Overapplied or Underapplied
Product Cost Information in Financial Overhead59
Reporting and Decision Making 41
Job-Order Costing for Service
Balance Sheet Presentation of Product Companies60
Costs42 Comprehensive Example 61
Flow of Product Costs in Accounts 43 Modern Manufacturing Practices
and Product Costing Systems 63
Income Statement Presentation Just-in-Time (JIT) Production 63
of Product Costs 43
Lean Manufacturing, 64
Cost of Goods Manufactured, 44 Cost of Goods
Computer-Controlled Manufacturing 64
Sold, 44
Total Quality Management 65
Types of Costing Systems 46 Summary of Learning Objectives 67
Overview of Job Costs and Financial Link to Practice:
Statement Accounts 46
Product and Period Costs at SpaceX, 41 Examples of
Job-Order Costing System 48 Companies Using Job-Order and Process Costing Systems,
Direct Material Cost 49 46 Lean Principles Are Not Just for Manufacturing Firms,
64 Just-in-Time or Just-in-Case, 65 Can There Be Too Much
Direct Labor Cost 50 Emphasis on Quality?, 66
Journal Entry to Record Direct Labor, 51
Manufacturing Overhead 52 Review Problems 68
Key Terms 71
Journal Entries to Record Manufacturing
Overhead, 52 Self-Assessment71
Questions72
Assigning Costs to Jobs: A Summary 53
Exercises72
Eastlake Revisited: Using Job Cost Problems76
Information53 Cases83
3
Process Costing 86
Difference Between Job-Order Cost Flows through Accounts 90
and Process Costing Systems 88 Direct Material, 91 Direct Labor, 91 Manufacturing
Product and Cost Flows 89 Overhead, 91 Transferred-in Cost, 91
Product Flows through Departments 89 Calculating Unit Cost 92
C o n t e n t s xix
Equivalent Units 92 Process Costing and incremental

Cost per Equivalent Unit 93 analysis100
“You get What You measure!” and
Calculating and Applying Cost Per Equivalent
manufacturing processes 102
Unit: Mixing Department Example 93
Cost Transferred Out 95 Summary of Learning Objectives 102
Ending Work in Process 95 Link to Practice:
Production Cost Report 95 What Type of Costing System Is Used by ExxonMobil Corpora-
tion for the Product Mobil 1?, 88 Virtual Plant Tour for
Reconciliation of Units 96
Company Using Process Costing, 90
Reconciliation of Costs 97
Basic Steps in Process Costing: Review Problems 103
A Summary 97 Key Terms 105
Self-Assessment106
Kent Chemical Revisited:
Answering Stacy’s Question 98 Questions107
Exercises107
Dealing with Transferred-In Cost:
Problems111
Packaging Department Example 98
Cases119
4
Cost-Volume-Profit Analysis 122
COMMON COST BEHAVIOR PATTERNS 124 MULTIPRODUCT ANALYSIS 141
Variable Costs 124 Contribution Margin Approach 141
Fixed Costs 125 Contribution Margin Ratio Approach 142
Discretionary versus Committed Fixed ASSUMPTIONS IN CVP ANALYSIS 145
Costs, 125
CODECONNECT EXAMPLE REVISITED:
Mixed Costs 126
ANSWERING MARY’S QUESTIONS 146
Step Costs 126
Planning, 146 Control, 146 Decision Making, 47
Relevant Range 127
OPERATING LEVERAGE 148
CONSTRAINTS149
COST ESTIMATION METHODS 129
Account Analysis 129 Summary of Learning Objectives 150
Scattergraphs131 Appendix USING REGRESSION IN EXCEL TO
High-Low Method 131 ESTIMATE FIXED AND VARIABLE COSTS 150
Regression Analysis 134 Setting Up the Spreadsheet 150
The Relevant Range and Cost Estimation 135 Interpreting the Output of the Regression Program 151
Link to Practice:
COST-VOLUME-PROFIT ANALYSIS 136 Using Less Water but Paying Higher Rates!, 125 Breaking Even
The Profit Equation 137 on a Golf Course Is Harder than Making Par, 138 Deciding to
Use the Contribution Margin per Unit or the Contribution Margin
Break-Even Point 137 Ratio, 146 Which Firm Has the Higher Contribution Margin
Margin of Safety, 138 Ratio?, 147 Impact of Operating Leverage at Vulcan Materials,
Contribution Margin 139 148 Fixed Costs Too High—Make Them Variable!, 149
Units Needed to Achieve Profit Target, 139 Review Problems 152
Contribution Margin Ratio 140 Key Terms 154
Dollar Sales Needed to Achieve Profit Self-Assessment 154
Target, 140 Questions155
“What If” Analysis 140 Exercises156
Change in Fixed and Variable Costs, 141 Change in Problems161
Selling Price, 141 Cases170
xx C o n t e n t s
5
Variable Costing 174
Full (Absorption) and Variable Costing 176 Variable Costing Limits Management of
Variable Costing Income Statement 177 Earnings via Production Volume 186
EFFECTS OF PRODUCTION ON INCOME FOR FULL Summary of Learning Objectives 186

VERSUS VARIABLE COSTING: THE CLAUSENTUBE Link to Practice:
EXAMPLE178
German Companies More Likely to Use Variable Costing, 177
Quantity Produced Equals Quantity Sold 179 Overproduction to Avoid Showing a Loss, 179 Cut in Produc-
Quantity Produced Is Greater Than Quantity Sold 181 tion at John Deere Likely to Hurt Profit Margin, 184
Quantity Produced Is Less Than Quantity Sold 182
Review Problems 187
Explaining What Happened at ClausenTube 184
Key Terms 189
Impact of JIT on the Income Effects
of Full versus Variable Costing 185 Self-Assessment189
Questions190
Benefits of Variable Costing for Internal Exercises191
Reporting185
Problems193
Variable Costing Facilitates CVP Analysis 185
Cases202
6
Cost Allocation and Activity-Based Costing 204
Purposes of Cost Allocation 206 ACTIVITY-BASED COSTING 218
To Provide Information for Decision Making 206 The Problem of Using Only Measures of Production
To Reduce Frivolous Use of Common Resources 207 Volume to Allocate Overhead 218
To Encourage Evaluation of Services 207 The ABC Approach 219
To Provide “Full Cost” Information 208 Hierarchy of Activities, 220
Relating Cost Pools to Products Using Cost Drivers 221
PROCESS OF COST ALLOCATION 209 The ABC Approach at McMaster Screen Technologies:
Determining the Cost Objective 209 A Comprehensive Example 221
Forming Cost Pools 209 McMaster’s Costs under the Traditional Approach,
221 McMaster’s Costs under the ABC Approach, 222
Selecting an Allocation Base 210
Pros and Cons of ABC 225
ALLOCATING SERVICE DEPARTMENT COSTS 212 Benefits, 225 Limitations, 226
Direct Method of Allocating Service Department ACTIVITY-BASED MANAGEMENT 226
Costs212
Allocating Budgeted and Actual Service Remember—You Get What You Measure! 228
Department Costs 213 Summary of Learning Objectives 228
PROBLEMS WITH COST ALLOCATION 213 Appendix Activity-Based Management 229

Responsibility Accounting and Controllable Step 1: Determine Major Activities 229
Costs213 Step 2: Identify Resources Used by Each Activity 230
Arbitrary Allocations 214 Step 3: Evaluate the Performance of the Activities 230
Unitized Fixed Costs and Lump-Sum Allocations 215 Step 4: Identify Ways to Improve the Efficiency and/or
The Problem of Too Few Cost Pools 217 Effectiveness of the Activities 231
Using Only Volume-Related Allocation Bases 218 CONCLUSION231
C o n t e n t s xxi
Link to Practice: Review Problems 231

Cost-plus Contracts Create Incentive to Misallocate Costs, Key Terms 234
208 Basis for Allocating Costs to Federal Grants and Self-Assessment234
Contracts, 211 Disputes over Allocations not Limited to the
Questions235
Private Sector, 215 Avoiding a Disastrous Decision by Using
ABC, 225 Banks and Other Service Companies Use ABM, Exercises236
227 ABC Points to Process Improvement and Cost Control, Problems240
227 Cases251
7
The Use of Cost Information in Management Decision Making 254
INCREMENTAL ANALYSIS 256 Step 1: Identify the Binding Constraint 273
When Your Boss Asks, “What Does This Product Step 2: Optimize Use of the Constraint 274
(Service) Cost?” You Should Say, “Why Do You Step 3: Subordinate Everything Else to the
Want to Know?” 258 Constraint275
Analysis of Decisions Faced Step 4: Break the Constraint 275
by Managers 259 Step 5: Identify a New Binding Constraint 275
Additional Processing Decision 259
IMPLICATIONS OF TOC FOR INSPECTIONS, BATCH
Make-or-Buy Decisions: The General Refrigeration SIZES, AND ACROSS-THE-BOARD CUTS 275
Example261
Dropping a Product Line 265 Link to Practice:
Sell Partially Completed Superyacht?, 261 Boeing’s Global
Beware of the Cost Allocation Death Spiral! 267
Outsourcing Strategy Blamed for 3-Year Delay in 787,
Summary of Incremental, Avoidable, 262 PACCAR Decides to Make as Well as Buy!, 264
Sunk, and Opportunity Costs 267 Indian Wireless Company Outsources to U.S. and European
Firms!, 264, Spike TV Drops Impact Wrestling, 266 Ronald
Decisions Involving Joint Costs 269
H. Coase’s Contribution to Incremental Analysis, 268 The Sunk
Allocation of Joint Costs 269 Cost Effect, 270 Qualitative Considerations in Outsourcing to
Additional Processing Decisions and China, 272
Joint Costs 271
Review Problems 276
Qualitative Considerations in Decision Key Terms 278
Analysis271
Self-Assessment278
Summary of Learning Objectives 273 Questions279
Exercises279
Appendix The Theory of Constraints 273
Problems284
THE FIVE-STEP PROCESS OF TOC 273 Cases292
8
Pricing Decisions, Customer Profitability Analysis, and
Activity-Based Pricing 294
The Profit-Maximizing Price 296 Analyzing Customer Profitability: Revisiting
the Priced Right Office Supplies Case 302
Pricing Special Orders 297
Customer Profitability and Performance
Cost-Plus Pricing 299 Measures306
Target Costing 301 Activity-Based Pricing 306
xxii C o n t e n t s
Summary of Learning Objectives 307 Review Problems 308

Key Terms 313
Link to Practice:
Self-Assessment 313
Pricing Strategy: Apple’s Approach to Pricing, 297 Pricing
Power More Important Than Management, 298 Pricing Questions314
Treasure Hunt Items at Costco, 300 Insull’s Most Radical Exercises314
Innovation Wasn’t Technology—It Was Pricing!, 301 Target Problems319
Costing Analyst Position at Whirlpool, 302 How to Fix Unprof- Cases324
itable Customers, 305 Sprint Drops Customers for Excessive
Use of Customer Service, 305
9
Capital Budgeting and Other Long-Run Decisions 326
CAPITAL BUDGETING DECISIONS 328 Payback Period Method 344
EVALUATING INVESTMENT OPPORTUNITIES: Accounting Rate of Return 345
TIME VALUE OF MONEY APPROACHES 328 The Accounting Rate of Return Is Not a Reliable
Basic Time Value of Money Calculations 329 Estimate of the Internal Rate of Return, 347
The Net Present Value Method 331 CONFLICT BETWEEN PERFORMANCE
Steps in the NPV Method, 331 An Example EVALUATION AND CAPITAL BUDGETING 347
of the NPV Approach, 331 Comparing WILSON AIR EXAMPLE REVISITED 349
Alternatives with NPV, 333
The Internal Rate of Return Method 334
The Internal Rate of Return with Unequal ®
Appendix A USING EXCEL TO CALCULATE NPV
Cash Flows 336 AND IRR 350
Summary of Net Present Value and Internal Rate Link to Practice:
of Return Methods 337
Royal Caribbean International Invests $1.4 Billion in Cruise
CONSIDERING “SOFT” BENEFITS Ship, 329 NPV of Livengood Gold Mine Depends on Esti-
IN INVESTMENT DECISIONS 337 mates, 333 College Education Yields 15% Return, 336 Use
Calculating the Value of Soft Benefits Required of NPV and IRR by CFOs, 338 Soft Benefits Related to
to Make an Investment Acceptable 338 Investing in ERP System, 339 Cost of Capital for Various Busi-
ness Sectors, 340 Depreciation Tax Shield at Delta Air Lines,
ESTIMATING THE REQUIRED RATE OF RETURN 339 342 Payback on Home Solar Power, 345
ADDITIONAL CASH FLOW CONSIDERATIONS 340 Review Problems 354
Cash Flows, Taxes, and the Depreciation Tax Shield 340 Key Terms 355
Adjusting Cash Flows for Inflation 342 Self-Assessment355
OTHER LONG-RUN DECISIONS 343 Questions356
Exercises357
SIMPLIFIED APPROACHES TO CAPITAL
Problems359
BUDGETING344
Cases366
10
BUDGETARY Planning and Control 368
USE OF BUDGETS IN PLANNING AND CONTROL 370 DEVELOPING THE BUDGET 370
Planning370 Budget Time Period 372
Control370 Zero-Based Budgeting 372
C o n t e n t s xxiii
THE MASTER BUDGET 373 Why Budget-Based Compensation Can Lead

Sales Budget 373 to Budget Padding and Income Shifting 388
Production Budget 375 EVALUATION, MEASUREMENT, AND MANAGEMENT
Direct Material Purchases Budget 376 BEHAVIOR389
Direct Labor Budget 376 THE PRESTON JOYSTICK CASE REVISITED 390
Manufacturing Overhead Budget 377 Summary of Learning Objectives 390
Selling and Administrative Expense Budget 377
Link to Practice:
Budgeted Income Statement 377
Problems with Five-Year Budgets, 372 People Problems in
Capital Acquisitions Budget 379 Budgeting, 372 Budget Process in Great Britain, 374
Cash Budget 379 Address Cash Flow Uncertainty with a Revolving Loan,
Budgeted Balance Sheet 382 383 Spreadsheets for Budgeting, 383 Using Rolling Budgets
to Deal with Changes in Economic Conditions, 387 Ratcheting
USE OF COMPUTERS IN THE BUDGET and the Ability to Achieve Budget Targets, 389
PLANNING PROCESS 383
Review Problems 391
BUDGETARY CONTROL 384
Key Terms 395
Budgets as a Standard for Evaluation 384
Self-Assessment395
Static and Flexible Budgets 384
Questions396
INVESTIGATING BUDGET VARIANCES 386 Exercises397
CONFLICT IN PLANNING AND CONTROL USES Problems400
OF BUDGETS 387 Cases412
11
Standard Costs and Variance Analysis 414
STANDARD COSTS 416 TEST YOUR KNOWLEDGE: COMPREHENSIVE
Standard Costs and Budgets 416 EXAMPLE426
Development of Standard Costs 416 Material Variances 428
Ideal versus Attainable Standards 417 Labor Variances 428
Overhead Variances 429
A GENERAL APPROACH TO VARIANCE INVESTIGATION OF STANDARD COST
ANALYSIS418 VARIANCES429
MATERIAL VARIANCES 419 Management by Exception 430
Material Price Variance 419 Favorable Variances May Be Unfavorable 430
Material Quantity Variance 420 Can Process Improvements Lead to Unfavorable
Variances?431
DIRECT LABOR VARIANCES 421 Beware: Evaluation in Terms of Variances
Labor Rate Variance 421 Can Lead to Excess Production 431
Labor Efficiency Variance 421 RESPONSIBILITY ACCOUNTING AND VARIANCES 432
OVERHEAD VARIANCES 422
Controllable Overhead Variance 422 Appendix Recording Standard Costs in
Accounts433
Detailed Analysis of the Controllable Overhead
Variance422 Recording Material Costs 433
Overhead Volume Variance 424 Recording Labor Cost 433
Computing the Overhead Volume Variance, 424 Recording Manufacturing Overhead 434
Interpreting the Overhead Volume Variance, 425 Recording Finished Goods 434
Calculating the Financial Impact of Operating Recording Cost of Goods Sold 435
at More or Less than Planned Capacity 426 Closing Variance Accounts 435
xxiv C o n t e n t s
Link to Practice: Self-Assessment438

Starbucks Uses Standard Costs, 416 How Often Do Questions438
Companies Update Standards?, 417 Standard Costing— Exercises439
In the Beginning, 418 You Get What You Measure!, 420 Problems443
Cases449
Review Problems 435
Key Terms 438
12
Decentralization and Performance Evaluation 450
Why Firms Decentralize 452 Scenario 3. Customer Dimension, 470 Scenario 4.
Advantages of Decentralization 452 Financial Dimension, 470
Disadvantages of Decentralization 453 How Balance Is Achieved in a Balanced Scorecard 470
Why Companies Evaluate the Performance Developing a Strategy Map For a

of Subunits and Subunit Managers 454 Balanced Scorecard 471
Evaluating Subunits 454 Keys to a Successful Balanced Scorecard:
Evaluating Subunit Managers 454 Targets, Initiatives, Responsibility, Funding,
Top Management Support 472
Responsibility Accounting and Performance
Evaluation454 Targets, 472 Initiatives, 472 Responsibility, 472
Funding, 472 Top Management Support, 472
Cost Centers, Profit Centers,
and Investment Centers 455 Summary of Learning Objectives 473
Cost Centers 455 Appendix TRANSFER PRICING 474
Profit Centers 456 MARKET PRICE AS THE TRANSFER PRICE 474
Investment Centers 456
MARKET PRICE AND OPPORTUNITY COST 475
Evaluating Investment Centers with ROI 457
VARIABLE COST AS THE TRANSFER PRICE 476
Measuring Income and Invested Capital
When Calculating ROI 458 FULL COST PLUS PROFIT AS THE TRANSFER
Problems with Using ROI 460 PRICE477
Problems of Overinvestment and Underinvestment: NEGOTIATED TRANSFER PRICES 478
You Get What You Measure! 461
TRANSFER PRICING AND INCOME TAXES
Evaluation in Terms of Profit Can Lead to
IN AN INTERNATIONAL CONTEXT 478
Overinvestment, 461 Evaluation in Terms of
ROI Can Lead to Underinvestment, 462 Link to Practice:
Evaluation Using Economic Value Added Subunits at Nordstrom, 457 The Focus on ROI and Share-
(EVA)462 holder Value Is Not the Same in France, Germany, and Japan
as It Is in the United States and Great Britain, 458 Did Boeing’s
Residual Income (RI) 463
Focus on ROI Lead to Excessive Outsourcing?, 461 Companies
Revisiting the Situation at Action Industries, 463 That Have Used EVA, 464 Deere & Company Uses SVA Rather
Solving the Overinvestment and Underinvestment Than EVA, 464 Focus on EVA Affects Key Decisions across an
Problems463 Organization, 466 Use of EVA at Whole Foods, 468 Brigham
and Women’s Hospital Receives Award for Its Balanced Score-
Economic Value Added (EVA) 464
card, 473 Transfer Pricing at Starbucks, 478
EVA Example, 465
Review Problems 478
Using a Balanced Scorecard to Evaluate
Performance468 Key Terms 483
Tying the Balanced Scorecard Measures to the Self-Assessment483
Strategy for Success, 469 Scenario 1. Learning Questions484
and Growth Dimension, 469 Scenario 2. Internal Exercises484
Process Dimension, 469 Problems487
Cases493
C o n t e n t s xxv
Chapters 13 & 14 Available in WileyPlus
13
Statement of Cash Flows 496
NEED FOR A STATEMENT OF CASH FLOWS 498 INTERPRETING INFORMATION IN THE STATEMENT
OF CASH FLOWS: THE SITUATION AT RAVIRA
TYPES OF BUSINESS ACTIVITIES AND THE RESTAURANT SUPPLY 509
CLASSIFICATION OF CASH FLOWS 498
You Get What You Measure and Incremental Analysis
Operating Activities 500 Linked to the Statement of Cash Flows 509
Investing Activities 500
Financing Activities 500
Link to Practice:
Spotting a Cash Cow, 508
THE STATEMENT OF CASH FLOWS PREPARED
USING THE DIRECT METHOD 500 Review Problems 511
Current Asset and Current Liability Accounts, Key Terms 513
501 Long-Term Asset Accounts, 503 Long-Term
Self-Assessment513
Liabilities and Stockholders’ Equity, 504
Questions514
PREPARING THE STATEMENT OF CASH FLOWS Exercises515
USING THE INDIRECT METHOD 504 Problems519
Five-Step Approach to Calculating Cash Flows Cases529
from Operating Activities under the Indirect
Method504
Statement of Cash Flows for Ravira Restaurant
Supply—Indirect Method 506
14
Analyzing Financial Statements: A Managerial Perspective 530
WHY MANAGERS ANALYZE OTHER SOURCES OF INFORMATION
FINANCIAL STATEMENTS 532 ON FINANCIAL PERFORMANCE 538
Control of Operations 532 Management Discussion and Analysis 538
Assessment of Vendors, Customers, and Other Credit Reports 539
Business Partners 532 News Articles 539
Assessment of Appearance to Investors and
Creditors533 RATIO ANALYSIS 540
Profitability Ratios 540
HORIZONTAL AND VERTICAL ANALYSES 533 Financial Leverage, 541 Summary of the
Analysis of the Balance Sheet 533 Profitability Ratios, 541
Analyzing the Income Statement 535 Turnover Ratios 541
Summary of Turnover Ratios, 543
EARNINGS MANAGEMENT AND THE NEED TO
COMPARE EARNINGS AND CASH-FLOW Debt-Related Ratios 543
INFORMATION537 Summary of Debt-Related Ratios, 544
xxvi C o n t e n t s
A MANAGERIAL PERSPECTIVE ON THE Link to Practice:

ANALYSIS OF HGW’S FINANCIAL STATEMENTS 544 Watching Cash Flow versus Earnings, 537 Tribune
Control of Operations 544 Company Took on Too Much Debt, 544 Comparative
Financial Ratios and Decision Making, 544 Ratio Data, 545
Financial Ratios in a Balanced Scorecard: You Get Review Problems 548

What You Measure!, 545 Key Terms 550
Stability of Vendors, Customers, and Other Self-Assessment550
Business Partners 545 Questions551
Appearance to Investors and Creditors 545 Exercises552
SUMMARY OF ANALYSES 546 Problems557
Cases567
List of Cases
Each chapter of Managerial Accounting includes one or more Chapter 5
cases that: 5–1: MicroImage Technology, INC.
A start-up company has a negative gross margin and it appears
• Promote critical thinking and decision making skills. that “the more it sells, the more it loses.” Use of variable costing
• Provide an opportunity for group work and/or written reveals that this is not the case.
communication work. 5–2: RainRuler Stains
• Integrate information from other business disciplines. A variable-costing income statement is used to show the finan-
cial impact of sales related to a new customer category.
Chapter 1
Chapter 6
1–1: LOCAL 635 6–1: EASTSIDE MEDICAL TESTING
A union is disputing “cost of meal” charges to hotel employees. This case presents a service company example of ABC.
1–2: BOSWELL PLUMBING PRODUCTS 6–2: QuantumTM
A senior manager wants to know a product’s cost. But the This case shows how ABC affects product costs and considers
“cost” information needed depends on the decision the s enior the use of ABC information in decision making.
manager is facing.
Chapter 7
Chapter 2 7–1: PRIMUS CONSULTING GROUP
2–1: Ethics Case: BRIXTON SURGICAL DEVICES A consulting firm is considering a client offer of a fee that is less
To meet an aggressive earnings target, two senior executives are than standard rates.
planning to increase production to “bury” fixed overhead costs
in inventory. 7–2: FIVE STAR TOOLS
A tool manufacturer is faced with a production constraint, and
2–2: YSL MARKETING RESEARCH needs to consider the financial impact of a plan to deal with the
A marketing research firm is considering various costs when situation.
bidding on a job.
2–3: DUPAGE POWDER COATING
Chapter 8
8–1: PRESTON CONCRETE
A company’s product costs are being distorted by its approach to
overhead allocation. The company is considering moving away from its cost-plus
pricing approach when an increase in interest rates reduces
Chapter 3 housing starts and the demand for c oncrete.
3–1: TEch-Tonic Sports Drink 8–2: Galloway University Medical Center Pharmacy
A producer of a sports drink is considering alternative treat- A university hospital pharmacy is considering the profit impli-
ments for the cost of lost units. cations of alternative approaches to encouraging prescription
3–2: JENSEN PVC renewals from “out-of-area” patients.
A company is considering lowering prices to increase sales and
reduce unit costs by making better use of excess capacity. Chapter 9
9–1: Ethics Case: JUNIPER PACKAGING SOLUTIONS
Chapter 4 A plant manager is considering a plan to circumvent a freeze on
4–1: ROTHMUELLER MUSEUM
capital expenditures.
A curator at a museum is trying to estimate the financial 9–2: SERGO GAMES
impact of a planned e xhibit. A game company is considering outsourcing manufacturing of
4–2: MAYFIELD SOFTWARE, CUSTOMER TRAINING
CDs.
The customer training facility of a software company is show- Chapter 10
ing a loss. The manager needs to determine the number of 10–1: Ethics Case: COLUMBUS PARK—WASTE TREATMENT
classes that must be offered to break even. FACILITY
4–3: KROG’S METALFAB, INC. The manager of a waste treatment facility is planning to pad
A company is estimating the lost profit related to fire damage so it costs in her budget because the city controller is likely to cut
can submit an insurance claim. whatever budget is submitted.
xxvii
xxviii L i s t o f C a s e s
10–2: ABRUZZI OLIVE OIL COMPANY 12–2: Win Tech Motors

A small producer of olive oil is preparing production budgets to Owners of a sports and luxury auto dealership are faced with
consider the impact of various sales levels. (Note that this case negative EVA and must cut their investment in inventory.
is best “solved” using a spreadsheet.)
For Cases in Chapters 13 and 14 go to www.wiley.com/college/
Chapter 11 jiambalvo
11–1: Jackson Sound Chapter 13
Work in process inventory is building up at Jackson Sound even
13–1: Wellcomp COMPUTERS
though the company has a JIT system.
A computer company is considering the impact of a price
11–2: CHAMPION INDUSTRIES reduction on cash flow.
A purchasing manager is considering a material that has a price
higher than standard, but also a number of desirable properties. Chapter 14
14–1: JORDAN-WILLIAMS, INCORPORATED
Chapter 12
A publisher of college textbooks is evaluating the financial
12–1: Home Value Stores condition of a potential business partner.
A company that operates membership warehouse stores is
evaluating using EVA.
1
Managerial Accounting in
the Information Age
What type of job will you hold in the future?
You may be a marketing manager for a consumer electronics firm, you may be the
director of human resources for a biotech firm, or you may be the president of your
own company. In these and other managerial positions you will have to plan oper-
ations, evaluate subordinates, and make a variety of decisions using accounting
information. In some cases, you will find information from your firm’s balance sheet,
income statement, statement of retained earnings, and statement of cash flows to
be useful. However, much of the information in these statements is more relevant
to external users of accounting information, such as stockholders and creditors. In
addition, you will need information prepared specifically for firm managers, the internal
users of accounting information. This type of information is referred to as managerial
accounting information.
If you are like most users of this book, you have already studied financial account-
ing. Financial accounting stresses accounting concepts and procedures that relate
to preparing reports for external users of accounting information. In comparison,
managerial accounting stresses accounting concepts and procedures that are
relevant to preparing reports for internal users of accounting information. This book
is devoted to the subject of managerial accounting, and this first chapter provides an
overview of the role of managerial accounting in planning, control, and decision mak-
ing. The chapter also defines important cost concepts and introduces key ideas that
will be emphasized throughout the text. The chapter ends with a discussion of the
information age and the impact of information technology on business, a framework
for ethical decision making, and the role of the controller as the top management
accountant. Note that you can enhance and test your knowledge of the chapter using
Wiley’s online resources and the self-assessment quiz at the end of the chapter. The
end-of-chapter material also includes two solved review problems.
Monkey Business Images/Shutterstock
Learning Objectives
1 Explain the primary goal of managerial accounting and distinguish between financial and mana-
gerial accounting.
2 Define cost terms used in planning, control, and decision making.
3 Explain the two key ideas in managerial accounting.
4 Discuss the impact of information technology on business processes and the interactions
companies have with suppliers and customers.
5 Describe a framework for ethical decision making and discuss the duties of the controller.
3
4 c h a p te r 1 M a n a g e r i a l A c c o u n t i n g i n t h e I n f o r m a t i o n A g e
Learning GOAL OF MANAGERIAL ACCOUNTING

Objective 1
Virtually all managers need to plan and control their operations and make a variety of
Explain the primary goal decisions. The goal of managerial accounting is to provide the information they need
of managerial account- for planning, control, and decision making. If your goal is to be an effective manager,
ing and distinguish a thorough understanding of managerial accounting is essential.
between financial and
managerial accounting.
Planning
Planning is a key activity for all companies. A plan communicates a company’s goals to
employees aiding coordination of various functions, such as sales and production. A plan
also specifies the resources needed to achieve company goals.
Budgets for Planning. The financial plans prepared by managerial accountants are
referred to as budgets. A wide variety of budgets may be prepared. For example, a profit bud-
get indicates planned income, a cash-flow budget indicates planned cash inflows and outflows,
and a production budget indicates the planned quantity of production and the expected costs.
Consider the production cost budget for the Surge Performance Beverage Company.
In the coming year, the company plans to produce 5,000,000 12-ounce bottles of bev-
erage. This amount is based on forecasted sales. To produce this volume, the company
estimates it will spend $1,500,000 on bottles, $400,000 on ingredients, $150,000 on water,
and pay workers at its bottling plant $300,000. It also expects to pay $60,000 for rent,
incur $80,000 of depreciation of equipment, and pay $100,000 for other miscellaneous
costs. The production cost budget presented in Illustration 1-1 summarizes this informa-
tion. This budget informs the managers of Surge about how many bottles the company
intends to produce and what the necessary resources will cost.
Control
Control of organizations is achieved by evaluating the performance of managers and the
operations for which they are responsible. The distinction between evaluating managers
and evaluating the operations they control is important. Managers are evaluated to deter-
mine how their performance should be rewarded or punished, which in turn motivates
them to perform at a high level. Based on an evaluation indicating good performance,
a manager might receive a substantial bonus. An evaluation indicating a manager per-
formed poorly might lead to the manager being fired. In part because evaluations of
managers are typically tied to compensation and promotion opportunities, managers
work hard to ensure that they will receive favorable evaluations. (Of course, managers
Illustration 1-1
Production cost budget
Budgeted Production Costs
For the Year Ended December 31, 2017
Budgeted Production 5,000,000 Bottles
Cost of bottles $1,500,000
Ingredient cost 400,000
Water 150,000
Labor cost 300,000
Rent 60,000
Depreciation 80,000
Other 100,000
Total budgeted production cost $2,590,000
Goal of Managerial Accounting 5
may also work hard because they love their jobs, receive respect from coworkers, or value
the sense of accomplishment from a job well done!)
Operations are evaluated to provide information as to whether they should be
changed or not (i.e., expanded, contracted, or modified in some way). An evaluation of
an operation can be negative even when the evaluation of the manager responsible for
the operation is basically positive. For example, the manager of one of the two bottling
plants at Surge Performance Beverage Company may do a good job of controlling costs
and meeting deadlines, given that the plant is old and out-of-date. Still, senior manage-
ment may decide to close the plant because, given the outdated equipment in the plant,
it is not an efficient operation. In this scenario, the manager receives a positive evaluation
whereas the operation receives a negative evaluation.
Company plans often play an important role in the control process. Managers can
compare actual results with planned results and decide whether corrective action is
necessary. If actual results differ from the plan, the plan may not have been followed
properly; the plan may have not have been well thought out; or changing circumstances
may have made the plan out-of-date.
Illustration 1-2 presents the major steps in the planning and control process. Once a
plan has been made, actions are taken to implement it. These actions lead to results that
are compared with the original plan. Based on this evaluation, managers are rewarded (e.g.,
given substantial bonuses or promoted if performance is judged to be good) or punished
(e.g., given only a small bonus, given no bonus, or even fired if performance is judged to
be poor). Also, based on the evaluation process, operations may be changed. Changes may
consist of expanding (e.g., adding a second shift), contracting (e.g., closing a production
plant), or improving operations (e.g., training employees to do a better job answering
customer product inquiries). Changes may also consist of revising an unrealistic plan.
Performance Reports for Control. The reports used to evaluate the performance
of managers and the operations they control are referred to as performance reports.
Although there is no generally accepted method of preparing a performance report,
such reports frequently involve a comparison of current-period performance with per-
formance in a prior period or with planned (budgeted) performance.
Illustration 1-2
Planning and control process Plan
Decisions to change Action taken to

operations or revise plans implement plan
Results
Decisions to reward Comparison of planned

or punish managers and actual results
Evaluation
Suppose, for example, that during 2017, Surge Performance Beverage Company
actually produced 5,000,000 bottles and incurred these costs:

Water 152,000
Labor cost 295,000
Rent 60,000
Depreciation 80,000
Other 101,000
Total actual production cost $2,788,000
A performance report comparing these actual costs to the budgeted costs is presented
in Illustration 1-3.
Typically, performance reports only suggest areas that should be investigated; they
do not provide definitive information on performance. For example, the performance
report presented in Illustration 1-3 indicates that something may be amiss in the control
of bottle and ingredient cost. Actual costs are $150,000 more than planned for bottles
and $50,000 more than planned for ingredients. There are many possible reasons why these
costs are greater than the amounts budgeted. Perhaps the price of bottles or key ingredients
increased, or perhaps bottles were damaged in the production process. Management
must investigate these possibilities before taking appropriate corrective action.
Although performance reports may not provide definitive answers, they are still extremely
useful. Managers can use them to flag areas that need closer attention and to avoid areas
that are under control. It would not seem necessary, for example, to investigate labor, rent,
depreciation, or other costs, because these costs are either equal to or relatively close to the
planned level of cost. Typically, managers follow the principle of management by exception
when using performance reports. This means that managers investigate departures from the
plan that appear to be exceptional; they do not investigate minor departures from the plan.
Decision Making
As indicated in Illustration 1-2, decision making is an integral part of the planning and
control process—decisions are made to reward or punish managers, and decisions are
Illustration 1-3
Performance report
Performance Report, Production Costs
For the Year December 31, 2017
Difference
Actual Budget (Actual Minus Budget)
Production (number of bottles) 5,000,000 5,000,000 -0-
Cost of bottles $1,650,000 $1,500,000 $150,000*
Ingredient cost 450,000 400,000 50,000*
Water 152,000 150,000 2,000
Labor cost 295,000 300,000 (5,000)
Rent 60,000 60,000 -0-
Depreciation 80,000 80,000 -0-
Other 101,000 100,000 1,000
Total production cost $2,788,000 $2,590,000 $ 198,000
*Red numbers indicate differences deemed deserving of investigation.

Goal of Managerial Accounting 7
made to change operations or revise plans. Should a firm add a new product? Should it
drop an existing product? Should it manufacture a component used in assembling its
major product or contract with another company to produce the component? What price
should a firm charge for a new product? These questions indicate just a few of the key
decisions that confront companies. How well they make these decisions will determine
future profitability and, possibly, the survival of the company. Recognizing the impor-
tance of making good decisions, we devote all of Chapters 7, 8, and 9 to the topic. Below
you’ll see that one of the two key ideas of managerial accounting relates to decision making
and its focus on so-called incremental analysis. Finally, at the end of each chapter, there
is a feature called Making Business Decisions. This feature will remind you of how the
chapter material is linked to decision making, and it will summarize the knowledge and
skills presented in the chapter that will help you make good decisions as a manager.
T est y o u r K N O W L E D G E
With respect to managerial accounting, which of the following statements are valid?
a. Budgets are used for planning.
b. Performance reports are used for control.
c. A goal of managerial accounting is to provide information useful in decision making.
d. All of the above are valid statements.
Correct answer is d.
A Comparison of Managerial and Financial Accounting

As suggested in the opening of this chapter, there are important differences between
managerial and financial accounting:
1. Managerial accounting is directed at internal rather than external users of accounting
information.
2. Managerial accounting may deviate from generally accepted accounting principles
(GAAP).
3. Managerial accounting may present more detailed information.
4. Managerial accounting may present more nonmonetary information.
5. Managerial accounting places more emphasis on the future.
Internal versus External Users. Financial accounting is aimed primarily at external

users of accounting information, whereas managerial accounting is aimed primarily at
internal users (i.e., company managers). External users include investors, creditors, and
government agencies, which need information to make investment, lending, and regu-
latory decisions. Their information needs differ from those of internal users, who need
information for planning, control, and decision making.
Need to Use GAAP. Much of financial accounting information is required. The
Securities and Exchange Commission (SEC) requires large, publicly traded companies
to prepare reports in accordance with generally accepted accounting principles (GAAP).
Even companies that are not under the jurisdiction of the SEC prepare financial account-
ing information in accordance with GAAP to satisfy creditors. Managerial accounting,
however, is completely optional. It stresses information that is useful to internal managers
for planning, control, and decision making. If a company believes that deviating from
GAAP will provide more useful information to managers, GAAP need not be followed.
Detail of Information. Financial accounting presents information in a highly summa-

rized form. Net income, for example, is presented for the company as a whole. To run a
company, however, managers need more detailed information; for example, information
about the cost of operating individual departments versus the cost of operating the com-
pany as a whole or sales broken out by product versus total company sales.
Emphasis on Nonmonetary Information. Both managerial and financial accounting
reports generally contain monetary information (information expressed in dollars, such
as revenue and expense). But managerial accounting reports often contain a substantial
amount of additional nonmonetary information. The quantity of material consumed in
production, the average time taken to process a customer service call, and the number of
product defects are examples of important nonmonetary data that appear in managerial
accounting reports.
Emphasis on the Future. Financial accounting is primarily concerned with present-
ing the results of past transactions. Managerial accounting, however, places considerable
emphasis on the future. As indicated previously, one of the primary purposes of mana-
gerial accounting is planning. Thus, managerial accounting information often involves
estimates of the costs and benefits of future transactions.
Similarities between Financial and Managerial Accounting

We should not overstate the differences between financial accounting and managerial
accounting in terms of their respective user groups. Financial accounting reports are
aimed primarily at external users, and managerial accounting reports are aimed primarily
at internal users. However, managers also make significant use of financial accounting
reports, and external users occasionally request financial information that is generally
considered appropriate for internal users. For example, creditors may ask management
to provide them with detailed cash-flow projections.
Which of the following is false?
a. Compared to financial accounting, managerial accounting places more emphasis
on generally accepted accounting principles (GAAP).
b. Compared to financial accounting, managerial accounting may present more non-
monetary information.
c. Compared to financial accounting, managerial accounting places more emphasis
on the future.
d. Compared to financial accounting, managerial accounting may present more
detailed information.
Correct answer is a.
Learning Cost Terms Used in Discussing Planning,

Objective 2
Control, and Decision Making
Define cost terms used
in planning, control, and When managers discuss planning, control, and decision making, they frequently use the
decision making. word cost. Unfortunately, what they mean by this word is often ambiguous. This section
defines key cost terms so that you will have the accounting vocabulary necessary to begin
discussing issues related to planning, control, and decision making. The treatment will
Cost Terms Used in Discussing Planning, Control, and Decision Making 9
be brief because we will return to these cost terms and examine them in detail in later
chapters.
Variable and Fixed Costs

The classification of a cost as variable or fixed depends on how the cost changes in rela-
tion to changes in the level of business activity.
Variable Costs. Costs that increase or decrease in proportion to increases or decreases
in the level of business activity are variable costs. Material and direct labor are generally
considered to be variable costs because in many situations they fluctuate in proportion to
changes in production (business activity). Suppose that for Surge Performance Beverage
Company, the cost of bottles, ingredients, water, and labor are variable costs and in the
prior month, when production was 400,000 bottles, costs were $120,000 for bottles,
$32,000 for ingredients, $12,000 for water, and $24,000 for labor. How much variable
cost should the company plan on for the current month if production is expected to
increase by 20 percent, to 480,000 bottles? Since the variable costs change in proportion
to changes in activity, if production increases by 20 percent, these costs should also
increase by 20 percent. Thus, the cost of bottles should increase to $144,000, the cost
of ingredients should increase to $38,400, the cost of water to $14,400, and the cost of
labor to $28,800.
Prior Month Current Month
Production 400,000 Bottles Per Unit 480,000 Bottles Per Unit

Variable costs:
Cost of bottles $120,000 $0.30 $144,000 $0.30
Ingredient cost 32,000 0.08 38,400 0.08
Water 12,000 0.03 14,400 0.03
Labor cost 24,000 0.06 28,800 0.06
Total variable cost $188,000 $0.47 $225,600 $0.47
Note that although the total variable cost increases from $188,000 to $225,600 when
production changes from 400,000 to 480,000 units, the variable cost per unit does not
change. It remains $0.47 per bottle. With variable cost of $0.47 per bottle, variable
cost increases by $37,600 (i.e., $0.47 × 80,000) when production increases by 80,000
bottles.
Fixed Costs. Costs that remain constant when there are changes in the level of
business activity are fixed costs. Depreciation and rent are costs that typically do
not change with changes in business activity. Suppose that in the prior month, Surge
Performance Beverage Company incurred $20,000 of fixed costs including $5,000
of rent, $6,667 of depreciation, and $8,333 of other miscellaneous fixed costs. If the
company increases production to 480,000 bottles in the current month, the levels of
rent, depreciation, and other fixed costs incurred should remain the same as when
production was only 400,000 bottles. However, with fixed costs, the cost per unit does
change when there are changes in production. When production increases, the con-
stant amount of fixed cost is spread over a larger number of units. This drives down
the fixed cost per unit. With an increase in production from 400,000 to 480,000 units,
total fixed costs remains at $20,000. Note, however, that fixed cost per unit decreases
from $0.0500 per unit to $0.0417 per unit.
Prior Month Current Month
Production 400,000 Bottles Per Unit 480,000 Bottles Per Unit

Fixed costs:
Rent $ 5,000 $0.0125 $ 5,000 $0.0104
Depreciation 6,667 0.0167 6,667 0.0139
Other 8,333 0.0208 8,333 0.0174
Total fixed cost $20,000 $0.0500 $20,000 $0.0417
Sunk Costs
Costs incurred in the past are referred to as sunk costs. These costs are not relevant for
decision making because they do not change when decisions are made. For example,
suppose you buy a ticket to a play for $30. Before the play, you run into a friend who
invites you to a party. If you go to the party, you won’t be able to attend the play. The cost
of the ticket is irrelevant to the decision as to whether you should go to the party. What
matters is how much you will enjoy the party versus the play and how much you can sell
the ticket for (not how much you paid for it). Whether you go to the play or go to the
party, you are out $30 (the price of the ticket to the play, which is sunk).
Opportunity Costs
The value of benefits forgone when one decision alternative is selected over another is an
opportunity cost. For example, suppose Surge Performance Beverage Company refuses
an order to produce 50,000 bottles for a grocery chain because taking on the order will
require the company to miss delivery deadlines on orders already taken. Suppose the
order would have generated $50,000 of additional revenue (the product sells for $1 per
bottle) and $23,500 of additional costs. Then the opportunity cost (the net benefit forgone)
associated with meeting current delivery deadlines is $26,500 ($50,000 − $23,500).
Link to Practice
Long Supply Chains Create Opportunity the production process. Further, the distance shipped
Costs creates delays in getting products to market. Both of
these situations create opportunity costs. Wrong colors
Today, much of the textiles sold in the United States
and errors in stitching patterns may mean lost sales, as
come from China and other Asian countries. Labor is
may delays in getting textiles into the hands of consum-
relatively cheap in Asia, and the direct cost of ship-
ers. These lost sales are opportunity costs associated
ping isn’t that significant. Given this, why are some
with the decision to use a supplier located thousands
U.S. companies considering manufacturing closer to
of miles away.
home—such as in Mexico? The reason is opportunity
costs. With a long-distance supplier in, say, China, there Source: Peter T. Leach, “What Goes Around Comes Around:
may be a lack of reliability due to misunderstandings Long Supply Chains Can Create Opportunity Costs,” Gulf
and the inability of the purchaser to directly monitor Shipper (December 2007), 6–9.
Direct and Indirect Costs

Costs that are directly traceable to a product, activity, or department are direct costs.
Indirect costs are those that either cannot be directly traced to a product, activity, or
department or are not worth tracing. The distinction between a direct and an indirect
cost depends on the object of the cost tracing. For example, Surge Performance Beverage
C o s t T e r m s U s e d i n D i s c u s s i n g P l a n n i n g , C o n t r o l , a n d D e c i s i o n M a k i n g 11
Illustration 1-4
Insurance as both a direct and Insurance for
indirect cost Bottling Plant
Direct Cost Indirect Cost to Various Drinks

to Bottling Plant Bottled at the Plant
Surge Original Green
Surge Blue with

Electrolytes and Metabolites
Surge Red with

Caffeine and Ginseng
Company has a production facility in Memphis for which it incurs insurance costs. The
insurance cost related to the Memphis plant is obviously a direct cost of the Memphis
plant. However, the insurance cost is an indirect cost with respect to the individual types
of sports drinks produced in the Memphis plant because direct tracing of the insurance
cost to each type of drink is not possible. This situation is presented in Illustration 1-4.
Controllable and Noncontrollable Costs

A manager can influence a controllable cost but cannot influence a noncontrollable cost.
The distinction between controllable and noncontrollable costs is especially important
when evaluating a manager’s performance. A manager should not be evaluated unfavorably
if a noncontrollable cost sharply increases.
As an example of controllable and noncontrollable costs, consider a plant supervisor.
This individual influences labor and material costs by scheduling workers and ensur-
ing an efficient production process. Thus, labor and material costs are the supervisor’s
controllable costs. However, the supervisor cannot determine insurance for a plant. A
plant manager or an insurance specialist makes decisions regarding insurance. Therefore,
insurance cost is a supervisor’s noncontrollable cost but a plant manager’s or an insurance
specialist’s controllable cost.
Susan Evans paid a $5,000 nonrefundable fee to attend a 5-day management seminar on
leadership, hosted by the Bradford College of Business. After registering for the course, her
boss asked Susan to be the lead consultant on a project with a major client and, unfortunately,
the start of the engagement conflicted with the seminar. Her boss, however, said that she’d
be happy to ask another coworker to be the lead if Susan still wanted to attend the seminar.
With respect to the decision Susan faces (go to the seminar or take the lead position
on a consulting engagement), the $5,000 cost of the seminar is:
a. A variable cost. b. A fixed cost.
c. A sunk cost. d. An opportunity cost.
Correct answer is c.
Learning Two Key Ideas in Managerial Accounting

Objective 3
The subject of managerial accounting has many concepts. However, two ideas are fun-
Explain the two key damental to understanding the use of managerial accounting information in planning,
ideas in managerial control, and decision making. Keep these two ideas in mind as you progress through your
accounting. business career—you’ll find them to be invaluable! Because the ideas are so important,
one or both will be emphasized in each chapter of the book and identified with an icon.
1. Decision making relies on incremental analysis—an analysis of the

revenues that increase (decrease) and the costs that increase (decrease)
if a decision alternative is selected.
2. You get what you measure!
Decision Making/ Decision Making Relies on Incremental Analysis. Incremental analysis is the

Incremental appropriate way to approach the solution to all business problems. Essentially, incremen-
Analysis tal analysis involves the calculation of the difference in revenue and the difference in cost
between decision alternatives. The difference in revenue is the incremental revenue of
one alternative over another, whereas the difference in cost is the incremental cost of
one alternative over another. If an alternative yields an incremental profit (the difference
between incremental revenue and incremental cost), it is the preferred alternative. In
the simplified example that follows, decision alternative 1 should be selected because,
compared with alternative 2, it yields an incremental profit of $3,000.
Comparison of Decision Alternatives
Alternative Alternative
1 2
Revenue $15,000 − $10,000 = $5,000 Incremental Revenue

Cost 8,000 − 6,000 = 2,000 Incremental Cost
Profit $ 7,000 − $ 4,000 = $3,000 Incremental Profit
Although the idea is simple, implementing it in practice can be difficult—that’s why we devote
all of Chapters 7, 8, and 9 to decision making. For now, let’s look at a decision facing Surge
Performance Beverage Company to gain a better understanding of incremental analysis.
Recall that at Surge Performance Beverage Company, the budgeted annual produc-
tion costs for 5,000,000 bottles was $2,590,000:
Production 5,000,000 bottles

Water 150,000
Labor cost 300,000
Rent 60,000
Depreciation 80,000
Other 100,000
Total production cost $2,590,000
Cost per unit $ 0.518
T w o K e y I d e a s i n M a n a g e r i a l A c c o u n t i n g 13
Currently, Surge sells its product only to grocery and health food stores, at $1 per
bottle. Now assume that Surge is approached by Costless, a company that sells products
in no-frills, self-service warehouse facilities. Costless offers to buy 200,000 bottles in
the coming year, but only if the price is reduced to $0.75 per bottle. In this case there
are two decision alternatives: (1) stick with the status quo and decline the offer, or (2)
accept the offer.
If the offer is accepted, incremental revenue (the increase in revenue due to accept-
ing the offer versus declining the offer) will be $150,000 and incremental cost (the
increase in cost due to accepting the offer versus declining the offer) will be $94,000.
Thus, the incremental profit of accepting the offer is $56,000. Assuming that the company
has the capacity to produce the additional 200,000 bottles and that other orders will not
have to be turned down if this large order is accepted (i.e., assuming that there are no
opportunity costs), Surge Performance Beverage Company should accept this order.
Incremental revenue ($.75 × 200,000 bottles) $150,000

Less incremental costs:
Increase in cost of bottles ($.30 × 200,000) $60,000
Increase in cost of ingredients ($.08 × 200,000) 16,000
Increase in cost of water ($.03 × 200,000) 6,000
Increase in cost of labor ($.06 × 200,000) 12,000 94,000
Incremental profit $ 56,000
Note that in the analysis, we use only four of the production cost items (cost of
bottles, cost of ingredients, cost of water, and cost of labor). These are the only costs that
increase with the new order, because all other costs (rent, depreciation, and other) are
fixed and will not increase with an increase in production. Therefore, they are not incre-
mental costs and are not relevant to the decision at hand. Think about rent expense. If the
special order is rejected, rent expense will be $60,000. If the special order is accepted, rent
expense will still be $60,000. Since rent expense does not change, it is not incremental,
and it is not relevant in analyzing the decision.
You get what you You Get What You Measure! The second key idea in managerial accounting is “You
M e a s u r e get what you measure!” In other words, performance measures greatly influence the
behavior of managers.
You Get What You Measure!
Performance Measures Drive Behavior
Performance Measures Potential Actions of Managers
Customer satisfaction at auto Give customers a loaner car while auto is

repair shop being repaired
Injuries on the job at home Develop training program for new employees at
construction site construction site
Sales to new customers of office More sales calls on potential versus current
supply company customers
Companies can select from a vast number of performance measures when deciding
how they want to assess performance. Profit, market share, sales to new customers, prod-
uct development time, number of defective units produced, and number of late deliveries
are examples of measures in common use. Because rewards often depend on how well
an employee performs on a particular measure, employees direct their attention to what

is measured and may neglect what isn’t measured.
For example, suppose that at Surge Performance Beverage Company, sales to new
customers is introduced as a primary measure of the performance of the sales manager.
How would this influence the behavior of the sales manager? Most likely, this measure
will lead the manager to spend more time developing business with new customers.
Although that may be just what senior management desires from the performance
measure, it could lead to problems. Suppose a sales manager greatly reduces the time
spent attending to the needs of existing customers, and the company loses the business
of several key accounts. To avoid this and other unintended consequences, companies
need to develop a balanced set of performance measures and avoid placing too much
emphasis on any single measure.
Jason Deen is the owner of Deen’s Custom Motorcycles. Recently, his cousin, Jake,
crashed his bike and brought it in for repairs. Jason offered to fix the bike and charge his
cousin for just the incremental costs.
Which of the following is an incremental cost associated with the repair job?
a. Depreciation on tools. b. Salary paid to the accountant at Deen’s.
c. Required parts. d. Utilities (e.g., heat and electricity).
Link to Practice
Problems Related to the Wrong employees to respond quickly to incoming calls. But to
Performance Measures do this, employees quickly and incompletely answered
customer calls so they could get off the line and pick
As documented by Dean Spitzer, a performance mea-
up the next incoming call. The result was that cus-
surement thought leader, in his book Transforming
tomers frequently had to call back to get additional
Performance Measurement, bad things can happen
information, and that certainly didn’t lead to customer
when the wrong performance measure is used to
satisfaction.
evaluate employees. For example, he notes that at
When the CEO of the company realized the problem,
an insurance company known for its customer focus,
the “wait time” measure was replaced with “percentage
digital scoreboards were mounted at a call center
of callers who complete their business on the first call
and reported on the average wait time for teams to
with no need for additional follow-up.”
respond to customer calls. The idea was to motivate
Learning The Information Age and Managerial

Objective 4
Accounting
Discuss the impact of
information technology In recent years, advances in information technology have radically changed access to
on business processes information and, as a consequence, the business landscape—so much so that the current
and the interactions business era is frequently referred to as the information age. Since managerial accounting
companies have with is about providing information in order to plan and control operations and to make deci-
suppliers and customers. sions, part and parcel of an understanding of managerial accounting is an understanding
of the impact of information technology on business processes and the interactions
companies have with suppliers and customers. These topics are discussed in this section.
T h e I n f o r m a t i o n A g e a n d M a n a g e r i a l A c c o u n t i n g 15
Illustration 1-5 Value Chain

The value chain
Inbound Outbound Marketing & Customer

Operations
logistics logistics sales service
Infrastructure
Human Resource Management
Technology Development
Procurement
Impact of Information Technology on Management

of the Value Chain
The value chain comprises the fundamental activities a firm engages in to create value.
The idea was developed by Michael Porter in his groundbreaking book, Competitive
Advantage. According to Porter, firms engage in a series of primary and secondary
activities. The primary activities are inbound logistics (receiving and storing goods and
materials), operations to transform materials into finished products, outbound logistics
(storing and shipping products to customers), marketing and sales, and after-sale cus-
tomer service. (See Illustration 1-5.) The secondary activities include firm infrastructure
(e.g., accounting, finance, and legal affairs), human resource management (e.g., hiring,
training, benefits administration), technology development, and procurement of goods
and services. When the value to the customer of receiving products and services exceeds
the cost of these activities, firm value is created.
Information flows up and down a company’s value chain and also between the
company and its suppliers and between the company and its customers. Illustration 1-6
shows this for Milano Clothiers. Milano has 35 stores throughout the United States and
annual sales of over $800 million. For Milano to be successful, its suppliers must provide
high-quality items, on time, to the right location, at a reasonable price. Also, Milano’s
own operations must be efficient. It must be able to market effectively and offer prod-
ucts that customers want. How can Milano ensure that this happens? The key is to take
advantage of information flows up and down the value chain and between Milano and its
suppliers and between Milano and its customers. This is where advances in information
technology are having an impact. Note that in Illustration 1-6, the lines between suppliers
and Milano and between customers and Milano are dashed lines. These represent the fact
that the organizational boundaries are somewhat permeable because a lot of information
is being transmitted both ways. Let’s see some examples of how this works.
Illustration 1-6 Information Flows

Information flows within Milano
and between Milano and its Milano Clothiers
Suppliers Customers
suppliers and Milano and its Value Chain
customers
Information Flows between Milano and Customers. When customers make pur-
chases, a Milano employee scans a bar code attached to the sale item, thereby automat-
ically transferring the sale information into a database. This information can be used to
update inventory records and ensure the company does not run out of “hot” items. The
database also provides information on slow-moving merchandise that Milano can sell
to a discount department store so that it doesn’t take up valuable floor space. Further
analysis of the sales data can reveal regional tastes in clothes, helping Milano to buy the
right styles for stores in different parts of the country. Milano may also track the buying
patterns of customers who identify themselves by using Milano’s credit card or a special
customer discount card. This information can help Milano direct targeted selling mes-
sages to different customer types via direct-mail advertising.
Information Flows between Milano and Suppliers. With several key suppliers,
Milano has set up processes whereby the suppliers monitor Milano’s sales of their
merchandise using information from Milano’s internal database. Milano shares this
information because the suppliers use it to improve their production scheduling, gain
efficiencies, and pass along some of the related cost savings to Milano in the form of
lower prices. Milano also tracks the status of its orders using its suppliers’ websites. Thus,
Milano knows the exact time merchandise will be arriving at each of its locations, and
this information is available any time of the day. Milano uses this information, in part,
to time its advertising campaigns.
Using Information Technology to Gain Internal Efficiencies. Internally, Milano

uses information technology to automate purchasing and accounts payable, sales
and customer billing, as well as other accounting and finance functions. While in
the past the company could not close its books until 1 month after year-end, it can
now close in a week. This provides senior managers with timely information on the
company’s profitability and allows the company to provide timely financial reports to
shareholders and creditors. The company has over 2,000 employees. Each employee
has access to a company human resources (HR) Web site that provides comprehen-
sive information on company policies and allows employees to select from a menu
of alternative health and retirement plans. The launch of the Web site has eliminated
the need for five full-time HR staff who previously responded to employee questions
and processed paperwork.
Software Systems That Impact Value

Chain Management
Companies use a variety of software systems to process information and improve the
operation of the value chain. Here, we briefly discuss three systems: enterprise resource
planning (ERP) systems, supply chain management (SCM) systems, and customer
relationship management (CRM) systems.
Enterprise Resource Planning Systems. ERP systems grew out of material require-
ments planning (MRP) systems that have been used since the 1960s. MRP systems com-
puterized inventory control and production planning. Key features included an ability to
prepare a master production schedule and a bill of materials and generate purchase orders.
ERP systems update MRP systems with better integration, relational databases, and
graphical user interfaces. ERP components now include accounting and finance, human
resources, and other applications including SCM and CRM, which are discussed next.
Supply Chain Management Systems. Supply chain management (SCM) is the

organization of activities between a company and its suppliers in an effort to provide for
T h e I n f o r m a t i o n A g e a n d M a n a g e r i a l A c c o u n t i n g 17
the profitable development, production, and delivery of goods to customers. By sharing

information, production lead times and inventory holding costs have been reduced,
while on-time deliveries to customers have been improved. SCM software systems
support the planning of the best way to fill orders and help tracking of products and
components among companies in the supply chain. Walmart and Procter & Gamble
(P&G) are two companies that have become well known for their cooperation in the use
of SCM. When P&G products are scanned at a Walmart store, P&G receives information
on the sale via satellite and, thus, knows when to make more product and the specific
Walmart stores to which the product should be shipped. Related cost savings are passed
on, at least in part, to Walmart customers.
Customer Relationship Management Systems. CRM systems are used to manage

information related to a variety of customer interactions. At their heart is a database of
many, if not all, customer interactions. Company employees (and, in some cases, cus-
tomers) can access this database for many purposes, including these:
• Salespeople can examine the history of all sales calls made to customers and
customers’ responses. This allows the sales force to personalize their messages so
that they match a specific customer’s needs.
• Analysis of data in the CRM system can support targeted direct-mail advertising,
taking into account customers’ past purchases.
• A CRM system can be used to suggest future purchases to customers based
on their past purchases. This is a well-known feature of the CRM system at
Amazon.com.
• A CRM system can allow customers to track the status of their orders. For example,
the CRM system used by FedEx allows customers to track their shipments.
• A CRM system can allow customers to access information on product updates.
For example, Canon has a CRM system that allows customers to update printer
drivers.
Link to Practice
Casinos Manage with Data from CRM address is available. As another example, if a casino
Systems learns that a customer plays golf, then the casino can
offer a discount on this activity. This would be especially
Casinos have been leaders in using data collected from
profitable if a golf outing caused a customer to stay 2
their CRM systems in marketing decisions. Some give
or 3 days longer at the casino and gamble.
customers a card that they can use as they bet, buy meals,
Customers who are especially profitable, such as
buy spa services, and pay for golf outings. Information from
those who play higher-denomination slot machines,
applying for and using the card includes patron age and
would also be offered incentives and advertising stressing
home location, e-mail address, number and length of visits,
the excitement and glamour of playing slots. Individuals
retail purchase data, food and beverage data, table game
who avoided playing slot machines but loved playing
preference, and slot machine denomination preference.
blackjack might be sent ads stressing the excitement
Casinos can use this information to determine which
and glamour of playing this game. And individuals like
customers are most profitable and then target them with
me won’t be sent any incentives since I don’t find gam-
promotions that encourage repeat visits. These promo-
bling to be either exciting or glamorous!
tions can be sent via e-mail since the customer’s e-mail
a. Companies use CRM systems to manage information related to customers.
b. Supply chain management systems may be used to share information with suppliers.
c. Enterprise resource planning systems may include CRM and SCM applications.
d. CRM systems are primarily used to manage information generated by suppliers.
Learning Ethical Considerations in Managerial

Objective 5
Decision Making
Describe a framework
for ethical decision Remember that when we discuss decision making throughout this book, we will focus
making and discuss the on incremental analysis as the approach to making good decisions. However, in addi-
duties of the controller. tion to performing incremental analysis, it is equally important that managers consider
the ethical aspects of their decisions. Why focus on ethics? First and foremost, ethical
decision making is simply the right thing to do. But additionally, when managers behave
ethically, they gain the confidence of their customers, suppliers, subordinates, and com-
pany stockholders, and that confidence is likely to translate into gains to the bottom line
and to their company’s stock price.
Ethical and Unethical Behavior

Ethical behavior requires that managers recognize the difference between what’s right
and what’s wrong and then make decisions consistent with what’s right. In recent years,
we’ve witnessed a plethora of disclosures, indictments, and convictions, indicating that
key managers in major companies either can’t tell right from wrong or don’t care to make
decisions consistent with what’s right. Some examples:
Enron managers misled investors by hiding debt in so-called special-purpose
entities. Kenneth Lay, Enron’s CEO, touted Enron’s stock to employees just weeks
before the energy company imploded, leaving many with worthless 401(k)
retirement accounts. Lay was found guilty of securities fraud and related charges.
He faced a sentence of more than 20 years but died of a heart attack in 2006, prior
to sentencing.
WorldCom, America’s number two long-distance company, disclosed the
biggest case of fraudulent accounting in U.S. history, with profits overstated
by billions. The result—the company declared bankruptcy and laid off 17,000
employees. Bernard Ebbers, CEO of WorldCom, received a 25-year prison
sentence in 2005.
Dennis Kozlowski, who made more than $300 million as head of Tyco, was
charged with conspiring with art dealers to avoid sales tax on art he bought for
$13.2 million. Tyco’s share price took a nosedive following the disclosure. In 2005,
Kozlowski was convicted for misappropriations of corporate funds including
granting himself unauthorized bonuses and having millions of dollars of personal
expenses paid by Tyco, including a $15,000 umbrella stand and a $6,000 shower
curtain. He was sentenced to a jail term of 8 to 20 years.
E t h i c a l C o n s i d e r a t i o n s i n M a n a g e r i a l D e c i s i o n M a k i n g 19
Sarbanes-Oxley Act. The abuses just cited, along with others, led Congress to
enact the Sarbanes-Oxley Act in July 2002. This law, named after Senator Paul
Sarbanes and Representative Michael Oxley, has changed the financial reporting
landscape for public companies and their auditors. Some of the act’s most important
provisions are:
• A requirement that chief executive officers and chief financial officers of a
company certify that, based on their knowledge, their financial statements do not
contain any untrue statements or omissions of material facts that would make the
statements misleading.
• A ban on certain types of work by the company’s auditors to ensure their
independence. For example, the act bans auditors from performing bookkeeping
services and designing or implementing financial information systems for clients.
• Longer jail sentences and larger fines for corporate executives who knowingly and
willfully misstate financial statements. Fines now run up to $5 million and jail
terms up to 20 years.
• A requirement that companies report on the existence and reliability of their
internal controls as they relate to financial reports.
The cost of complying with Sarbanes-Oxley has been substantial. According to a
survey conducted by Charles River Associates of 90 companies with average annual
gross revenue of $8.1 billion, the average cost to comply with the act in the first year was
$7.8 million. This amount should be contrasted with the $63 billion lost by shareholders
in Enron. Will the net benefits of Sarbanes-Oxley outweigh the costs? Time will tell.
There is no doubt, however, that the act has reminded corporate leaders that they have
a clear obligation to ensure that financial statements do not mislead investors. And the
act has put needed distance between senior managers and auditors of publicly traded
companies.
In addition to conspicuous and rather clear-cut examples of unethical behavior,
some companies and individuals have been accused of paying unconscionably low wages
to workers in undeveloped countries, using child labor, endangering the environment
with toxic chemicals, and bribing officials to promote sales abroad. But are these accu-
sations clearly indicative of ethical lapses? Low wages are better than no wages, and,
while child labor is reprehensible, the additional income earned by a child may save a
family from starvation. The point is that ethical dilemmas are often complex and the
situations managers face are often gray rather than black and white. When this is the
case, a framework for ethical decision making may help understanding of “what’s right.”
Link to Practice
Feds Investigating Walmart Over Bribery be a violation of the U.S. Foreign Corrupt Practices Act
in Mexico (FCPA). The probe expanded to China, India, and Brazil
and is ongoing as of 2015. Walmart spent $439 million
Wouldn’t it have been wonderful if corporate wrongdoing
in FCPA investigation and compliance costs in 2013
had ceased after the events at Enron, WorldCom, and
and 2014. And the company estimates such costs will
Tyco? Unfortunately, that hasn’t been the case. Here’s
exceed $200 million in fiscal 2015!
an example of more recent alleged wrongdoing:
In 2012, the Justice Department began a criminal Sources: Asri Horwithz and Jia Lynn Yang, “Wal-Mart Faces
Criminal Probe into Bribery Allegations,” The Washington
investigation of Walmart related to allegations the com- Post, April 24, 2012; David Voreaqcos and Renee Dudley,
pany paid more than $24 million in bribes to Mexican “Wal-Mart Says Bribe Probe Cost $439 Million in Two Years,”
officials for construction permits. Such bribes would Bloomberg News, March 26, 2014.
A Framework for Ethical Decision Making

The following framework for ethical decision making consists of seven questions.1
Hopefully, answering these questions will serve as an aid in identifying “what’s right.”
But certainly, answering them doesn’t guarantee ethical decision making.
A Seven-Question Framework for Ethical Decision Making
When evaluating a decision, ask:
1. What decision alternatives are available?
2. What individuals or organizations have a stake in the outcome of my decision?
3. Will an individual or an organization be harmed by any of the alternatives?
4. Which alternative will do the most good with the least harm?
5. Would someone I respect find any of the alternatives objectionable?
After deciding on a course of action, but before taking action, ask:

6. At a gut level, am I comfortable with the decision I am about to make?
7. Will I be comfortable telling my friends and family about this decision?
Any Q ue s tion s ?
Q: Why focus on the seven-question framework for ethical decision making?
Many, if not most, companies have written codes of ethics, so when managers
make decisions, they just need to consult their company’s code to determine
whether their decision stacks up to what’s right in their company’s environment.
A : Managers should definitely be familiar with their company’s code of ethics. However,
codes of ethics aren’t always good guides to ethical behavior. Part of the problem is that
codes often specify what can’t be done rather than what should be done. And some codes
focus more on ensuring that decisions are legal rather than right!
A number of exercises, problems, and cases in the end-of-chapter material present

ethical dilemmas, and you should refer to this framework when preparing your answers
to them. Alternatively, you may wish to consider other ethical perspectives. A large
amount of material is available on the Web to help your understanding of ethical deci-
sion making.
IMA Statement of Ethical Professional Practice

The Institute of Management Accounting (IMA) is a professional organization that
focuses, as its name indicates, on management accounting. One of the contributions
of the IMA is the development of a Statement of Ethical Professional Practice, which is
presented in the appendix to this chapter. The IMA has also developed an ethics helpline
that members can call to discuss ethical dilemmas they face at their companies. Callers
are assigned a code number to preserve anonymity and are then referred to a counselor
1
Developing these questions was aided by three resources located on the Web. The first is A Guide to Moral
Decision Making by Chris MacDonald in the Department of Bioethics at Dalhousie University. The second
is material developed by the W. Maurice Young Centre for Applied Ethics at the University of British
Columbia, and the third is Complete Guide to Ethics Management: An Ethics Toolkit for Managers, by Carter
MacNamera.
T h e C o n t r o l l e r a s t h e T o p M a n a g e m e n t A c c o u n t a n t 21
Link to Practice
Are the Procurement Practices of the enabling small producers to afford adult workers, make
Hershey Company Ethical? important improvements in their farming practices, and
support development of schools and hospitals.
The Hershey Company is the largest producer of choc-
In 2010, Hershey issued a corporate social respon-
olates in North America. Like most other producers of
sibility report in which it said, “As the largest chocolate
chocolate, Hershey relies on cocoa sourced from West
producer in the United States and one of the largest in
Africa, which accounts for approximately 80 percent
the world, the well-being of the global cocoa supply chain
of the world’s cocoa. This is controversial, however,
is of vital importance to us. Even as we seek to assure a
because West Africa’s cocoa production involves wide-
continuing supply of high-quality cocoa, we embrace our
spread use of child labor. And, in many cases, the chil-
responsibility to ensure that the cocoa we buy is grown
dren are exposed to dangerous pesticides used because
and harvested in a sustainable manner.” In 2013, amid
of the extent of crop infestations.
growing protests (including removal of Hershey’s high-
What should Hershey do about this? Some critics
end Scharffen Berger brand from Whole Foods), Hershey
are calling on Hershey to purchase fair-trade cocoa. In
vowed to use only fair-trade cocoa by 2020.
a fair-trade system, Hershey would pay a higher price,
who explains how the dilemma relates to the provisions of the standards of ethical pro-
fessional practice.
The IMA also publishes Strategic Finance Magazine and Management Accounting
Quarterly, and since 1973 it has conducted a comprehensive examination to test what
knowledge a management accountant must have in order to be successful in a complex
and fast-changing business world. More than 3,000 individuals take the exam each year.
Those who pass the exam are issued a Certificate in Management Accounting and are
proud to indicate the designation Certified Management Accountant (CMA) on resumes
and business cards. For details on student and professional memberships in the IMA
and information on the CMA examination, visit the IMA Web site (www.imanet.org).
a. Ethical behavior requires an assessment of what’s right and what’s wrong.
b. The seven-question framework for ethical decision making requires asking if you are
comfortable with your decision at a “gut level.”
c. Ethical dilemmas are often complex without answers that are clearly right.
d. The Sarbanes-Oxley Act insured that business leaders would behave ethically.
The Controller as the Top Management

Accountant
Who is responsible for preparing the information needed for planning, control, and
decision making? In most organizations, the top managerial accounting position is held
by the controller. The controller prepares reports for planning and evaluating company
activities (e.g., budgets and performance reports) and provides the information needed
to make management decisions (e.g., decisions related to purchasing office equipment or
decisions related to adding or dropping a product). The controller also has responsibility
Controller
Financial Analysis
Financial Reporting Cost Accounting
and Special Studies
Budgeting and
Taxation Reporting
Perfomance Reporting
Illustration 1-7
Organization chart for the
controller’s office for all financial accounting reports and tax filings with the Internal Revenue Service and
other taxing agencies, as well as coordinating the activities of the firm’s external auditors.
A simplified example of the organization chart for the controller’s office is shown in
Illustration 1-7. Note that one of the areas reporting to the controller is cost accounting.
Most medium-size and large manufacturing companies have such a department. Cost
accountants estimate costs to facilitate management decisions and develop cost infor-
mation for purposes of valuing inventory.
Many companies seeking to fill the position of controller send a clear message to
applicants: “Bean counters need not apply!” This means that they want a managerial
accountant who does more than concentrate on tracking costs (“counting beans”). They
want an individual who will be an integral part of the top management team.
It is obvious that if you want a high-level career in managerial accounting, you will
need strong accounting skills. But this is not enough. To be an important player on the
management team, you will need the skills required of all high-level executives: excellent
written and oral communication skills, solid interpersonal skills, and a deep knowledge
of the industry in which your firm competes.
In addition to the position of controller, many companies have positions called trea-
surer and chief information officer (CIO). The treasurer has custody of cash and funds
invested in various marketable securities. In addition to money management duties, the
treasurer generally is responsible for maintaining relationships with investors, banks,
and other creditors. Thus, the treasurer plays a major role in managing cash and market-
able securities, preparing cash forecasts, and obtaining financing from banks and other
lenders. The chief information officer (CIO) is the person responsible for a company’s
information technology and computer systems. Both the controller and the treasurer
report to the chief financial officer (CFO), who is the senior executive responsible for
both accounting and financial operations. At some companies, the CIO also reports to
the CFO. However, as we saw earlier, information technology is playing a critical role in
managing the value chain. Therefore, it’s not surprising that the CIO is frequently part
of the senior management team reporting directly to the chief executive officer (CEO).
The top managerial accountant is typically the:
a. Controller. b. Chief financial officer.
c. Chief information officer. d. Treasurer.
T h e C o n t r o l l e r a s t h e T o p M a n a g e m e n t A c c o u n t a n t 23
Decision Making
As discussed in this chapter, decisions are made to reward or punish managers
Insight and to change operations or revise plans. Should a company add a new product?
Should it drop an existing product? Should a company outsource a business process
or perform it internally? What price should a company charge for a new product?
Appropriate answers to these types of questions are critical to firm profitability, and
much of this book will focus on how to address them. While gut feeling will always
play a role in decision making, so too will careful analysis. The type of analysis we
focus on is called incremental analysis, which is an analysis of the costs and reve-
nues that change when one decision alternative is selected over another.
Summary of Learning Objectives

Learning Objective 1 State the primary goal Learning Objective 3 Explain the two key ideas
of managerial accounting and distinguish between in managerial accounting.
financial and managerial accounting. The first key idea is “Decision making relies on incremental anal-
The primary goal of managerial accounting is to provide infor- ysis.” This means that the solution to business problems involves
mation that helps managers plan and control company activities the calculation of the difference in revenue (incremental revenue)
and make business decisions. and the difference in costs (incremental costs) between decision
The financial plans prepared by managerial accountants are alternatives. The second key idea is “You get what you measure!”
referred to as budgets. These plans help employees understand In other words, how companies measure performance affects how
company goals and what resources are needed to achieve them. managers behave. This can create problems if managers spend too
Control of organizations is achieved by evaluating the per- much time focused on any single performance measure.
formance of managers and the operations for which they are
responsible. The reports used to evaluate the performance of Learning Objective 4 Discuss the impact of
managers and the operations they control are referred to as information technology on, business processes
performance reports. Often the reports compare current period and the interactions companies have with suppliers
performance with performance in a prior period or to planned and customers.
(budgeted) performance. Since evaluations affect the rewards and
punishments managers receive, the evaluation process causes Information technology is having a profound effect on the value
them to work hard to receive good evaluations. Evaluations may chain and on company interactions with suppliers and custom-
also lead to modifications in operations, as needed. ers. Companies use IT to coordinate activities with suppliers
Managerial accounting differs from financial accounting and to gain information on customers. IT is also being used to
in many ways. A key difference is that managerial accounting improve the internal processes of companies.
stresses information that is useful to firm managers, whereas
Learning Objective 5 Describe a framework for
financial accounting stresses information that is useful to
external parties. In addition, financial accounting information ethical decision making and discuss the duties of
must be prepared in accordance with GAAP, but managerial the controller.
accounting information need not be. The framework for ethical decision making consists of seven
questions. See page 20.
Learning Objective 2 Define cost terms used in The controller is the top management accountant in most
planning, control, and decision making. organizations. The controller is responsible for preparing reports
A number of cost terms are used in discussing planning, control, for planning and evaluating company activities and for preparing
and decision making. The terms include variable cost (a cost that information and reports needed to make management decisions.
changes in proportion to a change in business activity), fixed cost In contrast to the controller, the treasurer is responsible for main-
(a cost that does not change in response to a change in business taining relationships with investors, banks, and other creditors.
activity), sunk cost (a cost incurred in the past), opportunity cost The treasurer also has custody of cash and funds invested in var-
(a benefit forgone by selecting one decision alternative over ious marketable securities. The chief information officer (CIO)
another), direct cost (a cost that is directly traceable to a product, is responsible for information technology. The controller and the
activity, or department), indirect cost (a cost that is not directly treasurer report to the chief financial officer (CFO), who is the
traceable to a product, activity, or department or is not worth senior executive responsible for accounting and financial opera-
tracing), controllable cost (a cost that a manager can influence), tions. The CIO has historically reported to the CFO, but the trend
and noncontrollable cost (a cost that a manager cannot influence). today is for the CIO to report to the chief executive officer (CEO).
Appendix
IMA Statement of Ethical Professional

Practice2
Members of IMA shall behave ethically. A commitment to ethical professional practice includes:
overarching principles that express our values, and standards that guide our conduct.
Principles
IMA’s overarching ethical principles include: Honesty, Fairness, Objectivity, and Responsibility.
Members shall act in accordance with these principles and shall encourage others within their
organizations to adhere to them.
Standards
A member’s failure to comply with the following standards may result in disciplinary action.
I. Competence. Each member has a responsibility to:

1. Maintain an appropriate level of professional expertise by continually developing
knowledge and skills.
2. Perform professional duties in accordance with relevant laws, regulations, and technical
standards.
3. Provide decision support information and recommendations that are accurate, clear,
concise, and timely.
4. Recognize and communicate professional limitations or other constraints that would
preclude responsible judgment or successful performance of an activity.
II. Confidentiality. Each member has a responsibility to:

. Keep information confidential except when disclosure is authorized or legally required.
1
2. Inform all relevant parties regarding appropriate use of confidential information. Monitor
subordinates’ activities to ensure compliance.
3. Refrain from using confidential information for unethical or illegal advantage.
III. Integrity. Each member has a responsibility to:

1. Mitigate actual conflicts of interest. Regularly communicate with business associates to
avoid apparent conflicts of interest. Advise all parties of any potential conflicts.
2. Refrain from engaging in any conduct that would prejudice carrying out duties
ethically.
3. Abstain from engaging in or supporting any activity that might discredit the profession.
IV. Credibility. Each member has a responsibility to:

. Communicate information fairly and objectively.
1
2. Disclose all relevant information that could reasonably be expected to influence an
intended user’s understanding of the reports, analyses, or recommendations.
3. Disclose delays or deficiencies in information, timeliness, processing, or internal controls
in conformance with organization policy and/or applicable law.
Resolution of Ethical Conflict

In applying the Standards of Ethical Professional Practice, you may encounter problems
identifying unethical behavior or resolving an ethical conflict. When faced with ethical issues,
2
Institute of Management Accountants Statement of Ethical Professional Practice. Adapted with permission.
R e v i e w P r o b l e m 1 25
you should follow your organization’s established policies on the resolution of such conflict.
If these policies do not resolve the ethical conflict, you should consider the following courses
of action:
1. Discuss the issue with your immediate supervisor except when it appears that the
supervisor is involved. In that case, present the issue to the next level. If you cannot
achieve a satisfactory resolution, submit the issue to the next management level. If your
immediate superior is the chief executive officer or equivalent, the acceptable reviewing
authority may be a group such as the audit committee, executive committee, board of
directors, board of trustees, or owners. Contact with levels above the immediate superior
should be initiated only with your superior’s knowledge, assuming he or she is not
involved. Communication of such problems to authorities or individuals not employed or
engaged by the organization is not considered appropriate, unless you believe there is a
clear violation of the law.
2. Clarify relevant ethical issues by initiating a confidential discussion with an IMA Ethics
Counselor or other impartial advisor to obtain a better understanding of possible courses
of action.
3. Consult your own attorney as to legal obligations and rights concerning the ethical
conflict.
Review Problem 1
Sterling Auto Detail is currently open Monday through Friday. In the past year, income before
taxes was as follows:
Numbers of cars detailed 2,080
Revenue $ 468,000
Less operating expenses:
Supplies (polish, wax, etc.) $ 5,824
Salaries of detailers 104,000
Water and other variable costs 12,480
Supervisor’s salary 65,000
Rent 36,000
Depreciation 5,000
Other fixed costs 1,050 229,354
Income before taxes $ 238,646
Quincy Davis, the owner of Sterling, is considering extending the workweek through Saturday. If
he takes this action, he’ll hire a part-time employee for $300 per day to act as the Saturday man-
ager so the supervisor still can have Saturday off. Quincy estimates that his company will detail
an additional 10 cars per Saturday, 52 weeks per year.
Req u ir ed
a. Calculate the annual incremental revenue associated with being open on Saturday.
b. Calculate the incremental cost associated with being open on Saturday.
c. Ignoring taxes, what is the incremental profit? Should Quincy open the business on
Saturdays?
A n s wer
a. The price of a detail is $225 ($468,000 ÷ 2,080). In total, 520 (10 × 52) additional cars will be
detailed. Thus, annual incremental revenue is $117,000 ($225 × 520).
b. The incremental cost per detail job is as follows:

Supplies (polish, wax, etc.) ($5,824 ÷ 2,080) $ 2.80
Salaries of detailers 50.00
Water and other variable costs 6.00
$ 58.80
Thus, the incremental cost per year is:
520 details × $58.80 $30,576
Incremental cost of Saturday manager ($300 × 52 days) 15,600
Total incremental cost per year $46,176
c. The incremental profit is $70,824 ($117,000 − $46,176), suggesting that Quincy should stay
open on Saturdays.
Review Problem 2
Brennan Wealth Planning offers financial advice to high-net-worth individuals. Services include
tax advice, estate planning, and advice regarding the allocation of investments so that they are
consistent with customers’ risk profiles. Financial advisors at the firm also sell investments and
insurance products to customers. All advisors are paid a base salary plus a bonus based on the
total revenue they generate.
Hampton Financial Services is very similar to Brennan. However, at this firm, financial advi-
sors are paid a base salary plus a bonus based solely on customer satisfaction.
Req u i r ed
Discuss the concept of “You get what you measure!” and comment on how this may affect cus-
tomers at the two companies.
A n sw e r
The idea behind “You get what you measure!” is that performance measures drive the behavior
of managers. At Brennan, financial advisors have a clear incentive to sell as many services and
products as possible—even if customers don’t need the services. At Hampton, financial advisors
have a strong incentive to make customers happy with the advice and the services they receive.
Thus, it is quite possible that their customers will receive less biased recommendations and have
high levels of satisfaction.
Key Terms Budgets (4) Enterprise resource planning Noncontrollable cost (11)
Chief financial officer (CFO) (22) (ERP) systems (16) Opportunity cost (10)
Chief information officer (CIO) Fixed costs (9) Performance reports (5)
(22) Incremental analysis (12) Supply chain management
Controllable cost (11) Incremental cost (12) (SCM) systems (16)
Controller (21) Incremental revenue (12) Sunk costs (10)
Customer relationship manage- Indirect costs (10) Treasurer (22)
ment (CRM) systems (16) Management by exception (6) Value chain (15)
Direct costs (10) Managerial accounting (12) Variable costs (9)
Self-Assessment (Answers Below)

1. The primary goal of managerial accounting is to: c. Provide information to creditors, taxing authorities,
a. Provide information to current and potential inves- and current and prospective investors.
tors in the company. d. Provide information for planning, control, and deci-
b. Provide information to creditors as well as current sion making.
and prospective investors.
Q u e s t i o n s 27
2. Match the following terms with the management activ- c. Rent.

ities described below: d. Advertising.
a. Planning 6. Which of the following is most likely to be a fixed
b. Control cost?
c. Decision making a. The cost of material used in production.
(1) This management activity involves changing b. Rent.
operations, revising plans, or rewarding/ c. Assembly labor cost.
punishing managers.
d. Commissions.
(2) This management activity compares actual
7. Costs incurred in the past are:
results with planned outcomes as a basis for
corrective action. a. Opportunity costs.
(3) This management activity formulates goals, b. Direct costs.
communicates them to employees, and specifies c. Sunk costs.
the resources needed to achieve them. d. Variable costs.
3. Which of the following statements about budgets is 8. ______________ costs are directly traceable to a prod-
false? uct, activity, or department, whereas _____________
a. Budgets may be expressed in dollars, quantities, or costs are not.
both. 9. The salary a student forgoes while in college is an exam-
b. Budgets may reflect projected revenues, projected ple of:
expenses, projected cash flows, or projected quanti- a. Opportunity cost.
ties of inputs or outputs. b. Direct cost.
c. Budgets must be prepared in accordance with c. Sunk cost.
GAAP.
d. Variable cost.
d. Budgets are useful both for planning and control.
10. Which of the following is not one of the seven
4. Which of the following statements is false? questions in the framework for ethical decision

a. Managerial accounting statements do not necessarily making?
comply with GAAP. a. Will an individual or an organization be harmed by
b. Financial accounting statements normally reflect any of the decision alternatives?
more detail than would be found in managerial b. Would someone I respect find any of the alterna-
accounting reports. tives objectionable?
c. Managerial accounting reports emphasize future c. At a gut level, am I comfortable with the decision I
activities and future costs. am about to make?
d. Financial accounting data are directed primarily at d. Are any of the alternatives illegal?
external users rather than internal users.
5. Which of the following is most likely to be a variable cost? Answers to Self-Assessment
a. Depreciation. 1. d 2. (1)-c, (2)-b, (3)-a 3. c 4. b 5. b
b. The cost of material used in production. 6. b 7. c 8. direct, indirect 9. a 10. d
Questions 1. What is the goal of managerial accounting?

2. In a performance report, current-period performance is compared with some benchmark.
What might be a useful benchmark?
3. List three differences between financial and managerial accounting.
4. List three examples of nonmonetary information that might appear in a managerial account-
ing report.
5. Explain the difference between fixed and variable costs.
6. Consider the manager of the home appliance department at a Sears store. For this manager,
list a cost that is controllable and a cost that is noncontrollable.
7. What is incremental analysis? How is the concept used in decision making?

8. What is meant by the statement “You get what you measure!”?
9. How have changes in information technology impacted management of the value chain?
10. If an action is legal, is it necessarily ethical? Explain.
Exercises EXERCISE 1-1. You Get What You Measure [LO 3] A key idea in this book is that “You get what
you measure!” Essentially, this means that performance measures have a great influence on the
behavior of managers.
R equ i red
Select a company with which you are familiar. Identify three performance measures that the com-
pany might use. For each measure, identify a favorable outcome and an unfavorable outcome that
might occur because the measure is used to evaluate manager performance.
EXERCISE 1-2. Sunk Cost [LO 2] Rachel Cook owns Campus Copies, a copy business with sev-
eral high-speed copy machines. One is a color copier that was purchased just last year at a cost of
$25,000. Recently a salesperson got Rachel to witness a demo of a new $23,000 color copier that
promises higher speed and more accurate color representation. Rachel is interested but she can’t
get herself to trade in a perfectly good copier for which she paid $25,000 and replace it with one
that will cost $23,000.
R equ i r ed
Write a paragraph explaining why the cost of the old copier is irrelevant to Rachel’s decision.
EXERCISE 1-3. [LO 4] Guthrie Wilson is an accountant at Bellwether Systems, a company that
sells and installs customer relationship management (CRM) systems. The company sells third-
party software at cost plus 25 percent and charges a fee of $300 per hour of installation/integration
time spent on each engagement. Recently Guthrie’s boss asked him to charge 60 hours of time to
the Bradley account when the time was actually worked servicing the IMG account. The rationale:
“Look, IMG is a struggling start-up and they can barely afford our service. We ran over our time
estimate due to some unforeseen problems, and they’ll balk if we charge them for all of our time.
Bradley, on the other hand, is a highly profitable company, and we’re providing services that are
going to make them even more profitable. They’ll have no problem with their bill.”
R equ i red
Review the IMA’s ethical standards in the appendix. What do the standards suggest that Guthrie
should do to resolve the issue he’s facing?
EXERCISE 1-4. Information Age [LO 4] The Wellington Hotel is a posh hotel in Manhattan that
uses a customer relationship management (CRM) system to track customer preferences and pur-
chases. Provide two examples of specific information the CRM system might capture and how the
hotel could use the information to enhance revenue and/or the customer experience.
EXERCISE 1-5. Budgets [LO 1] Megan Kelly is the chief financial officer of a chain of 25 drug-
stores. Explain how she can use budgets in both planning profit and controlling operations.
EXERCISE 1-6. Performance Reports [LO 1] Which of the following statements related to per-
formance reports is false?
a. Performance reports may provide a comparison of actual performance with planned perfor-
mance.
b. Performance reports may provide a comparison of actual performance with performance in a
prior period.
E x e r c i s e s 29
c. If actual costs exceed planned costs in a performance report, this clearly indicates managerial
incompetence.
d. Performance reports are used to evaluate managers and the operations they control.
EXERCISE 1-7. Performance Reports [LO 1] At Designs by Deirdre, the budgeted income state-
ment for December 2017 indicated sales of $600,000 and cost of sales of $400,000. Actual sales
and cost of sales were $700,000 and $425,000, respectively. Should Deirdre Nelson, owner of the
company, be concerned that cost of sales is $25,000 greater than planned? Explain the basis for
your answer.
EXERCISE 1-8. Financial versus Managerial Accounting [LO 1] Bob Stevens is taking Mana-
gerial Accounting at State University next term and asked his friend, Summer Adams, who has
already taken the course, to explain its focus. “Are we going to learn more about balance sheets
and income statements? Is it just an extension of the financial accounting course I had last year?”
Req u i red
Assume the role of Summer and explain the focus of managerial accounting and some of the ways
it differs from financial accounting.
EXERCISE 1-9. Financial versus Managerial Accounting [LO 1] Consider a large manufacturing
company like Boeing that rewards its sales force with bonuses based on sales. For this purpose,
should the company record sales when orders are placed or, to be consistent with GAAP, wait until
orders are delivered?
EXERCISE 1-10. Cost Terms [LO 2] Identify each of the following statements with fixed costs or
variable costs by writing “fixed” or “variable” in the space provided.
______ a. A cost that varies in total with changes in the activity level.
______ b. A cost that varies on a per-unit basis with changes in the activity level.
______ c. A cost that remains fixed per unit with changes in the activity level.
______ d. A cost that remains fixed in total with changes in the activity level.
EXERCISE 1-11. Cost Terms [LO 2] Indicate whether each of the following costs is most likely a
fixed cost or a variable cost by writing “fixed” or “variable” in the space provided.
______ a. Assembly labor.
______ b. The cost of material used in production.
______ c. Rent.
______ d. Depreciation.
______ e. Fuel cost at an airline.
EXERCISE 1-12. Cost Terms [LO 2] Explain how a cost can be controllable at one administrative
level and noncontrollable at another administrative level.
EXERCISE 1-13. Sunk Cost [LO 2, 3] Peter Takesha, the manager of testing services at a medical
diagnostics firm, purchased a new lab testing machine last year for $30,000. This year a new ma-
chine, which is faster and more reliable than Peter’s current model, is on the market. In deciding
whether to purchase the new machine, should Peter consider how much he paid for the old ma-
chine? Should he consider the value of the old machine in the used equipment market?
EXERCISE 1-14. Opportunity Costs [LO 2] Parrish Plumbing provides plumbing services to res-
idential customers from Monday through Friday. Ken Parrish, the owner, believes that it is im-
portant for his employees to have Saturday and Sunday off to spend with their families. However,
he also recognizes that this policy has implications for profitability, and he is considering staying
open on Saturday.
Ken estimates that if his company stays open on Saturday, it can generate $2,500 of daily
revenue each day for 52 days per year. The incremental daily costs will be $700 for labor, $500
for parts, $100 for transportation, and $200 for office staff. These costs do not include a share of
monthly rent or a share of depreciation related to office equipment.
Ken is determined not to have employees work on Sunday, but he would like to know the
opportunity cost of not working on Saturday. Provide Ken with an estimate of the opportunity
cost, and explain why you do not have to consider rent or depreciation of office equipment in
your estimate.
EXERCISE 1-15. Opportunity Cost [LO 2] Zachary made plans to visit a friend in New York
during the Memorial Day weekend. However, before the trip, his employer asked him if he would
work overtime for 16 hours at $35 per hour during the weekend. What will be the opportunity cost
if Zachary decides to visit his friend in New York?
EXERCISE 1-16. Incremental Analysis [LO 2, 3] Wilmington Chemicals produces a chemical,

PX44, which is used to retard fading in exterior house paint. In the past year, the company pro-
duced 200,000 gallons at a total cost of $1,200,000 ($6 per gallon). The company is currently con-
sidering an order for 15,000 gallons from a paint company in Canada. (To date, Wilmington has
not sold the product in markets outside the United States.) Explain why the incremental cost
associated with this order is likely to be less than $90,000.
EXERCISE 1-17. Incremental Analysis [LO 3] In the past year, Williams Mold & Machine had
sales of $7,000,000 and total production costs of $5,000,000. In the coming year, the company
believes that sales and production can be increased by 25 percent, but this will require adding a
second production shift to work from 4:00 p.m. to 1:00 a.m.
Req u i red
a. Indicate three production costs that are likely to increase because of the addition of a second
production shift.
b. Suggest a production cost that most likely will not increase when the second shift is added.
EXERCISE 1-18. You Get What You Measure! [LO 3] At LA Porsche, customers receive an
online survey asking them to rate their satisfaction after every car service. How is this measure
likely to affect the financial welfare of Hulmut Schmidt, manager of the service department?
List three actions that Hulmut can take to ensure the ratings indicate that customers are very
satisfied.
EXERCISE 1-19. [LO 5] Shauna Miller is an accountant at Western Building Supplies. Recently, in
the course of her normal processing of transactions and related documents, she noticed that two of
her company’s top sales executives were taking the purchasing agents of important customers on
lavish golf vacations to Hawaii. The average cost was over $6,000 per person per trip.
Review the Institute of Management Accountant’s Statement of Ethical Professional Practice
in the appendix to this chapter. As a member of the IMA, does Shauna have any specific obligations
related to her discovery? What steps should she consider?
EXERCISE 1-20. Duties and Skills of Controller [LO 5] Search the Web for a company seeking
to hire a controller. What duties does it specify, and what skills does it want the controller to
have?
EXERCISE 1-21. Career Connection Select one or two concepts from this chapter and describe
how you might use those concepts in your future career. Briefly describe the career or job you will
be performing. Then specifically describe the type of situation for which the concept could be ap-
plied. Also include a discussion of how use of the concept would allow you to make informed de-
cisions or improve your job performance. Envision specific instances where these concepts would
be useful to you.
P r o b l e m s 31
Problems PROBLEM 1-1. Budgets in Managerial Accounting [LO 1, 2] Santiago’s Salsa is in the process of
preparing a production cost budget for May. Actual costs in April were:
Santiago’s Salsa
Production Costs
April 2017
25,000
Production Jars of Salsa
Ingredient cost (variable) $20,000

Labor cost (variable) 12,000
Rent (fixed) 5,000
Depreciation (fixed) 6,000
Other (fixed) 1,000
Total $44,000
Req u i red
a. Using this information, prepare a budget for May. Assume that production will increase to
30,000 jars of salsa, reflecting an anticipated sales increase related to a new marketing campaign.
b. Does the budget suggest that additional workers are needed? Suppose the wage rate is $20 per
hour. How many additional labor hours are needed in May? What would happen if management
did not anticipate the need for additional labor in May?
c. Calculate the actual cost per unit in April and the budgeted cost per unit in May. Explain why
the cost per unit is expected to decrease.
PROBLEM 1-2. Incremental Analysis [LO 2, 3] Consider the production cost information for
Santiago’s Salsa in Problem 1-1. The company is currently producing and selling 325,000 jars of
salsa annually. The jars sell for $5.00 each. The company is considering lowering the price to $4.60.
Suppose this action will increase sales to 375,000 jars.
Req u i red
a. What is the incremental cost associated with producing an extra 50,000 jars of salsa?
b. What is the incremental revenue associated with the price reduction of $0.40 per jar?
c. Should Santiago’s lower the price of its salsa?
PROBLEM 1-3. Budgets in Managerial Accounting [LO 1, 2] Matthew Gabon, the sales manager
of Office Furniture Solutions, prepared the following budget for 2017:
Sales Department
Budgeted Costs, 2017
(Assuming Sales of $10,000,000)
Salaries (fixed) $400,000

Commissions (variable) 150,000
Advertising (fixed) 75,000
Charge for office space (fixed) 3,000
Office supplies & forms (variable) 2,000
Total $630,000
After he submitted his budget, the president of Office Furniture Solutions reviewed it and
recommended that advertising be increased to $100,000. Further, she wanted Matthew to
assume a sales level of $11,000,000. This level of sales is to be achieved without adding to
the sales force.
Matthew’s sales group occupies approximately 250 square feet of office space out of total
administrative office space of 20,000 square feet. The $3,000 space charge in Matthew’s budget is
his share (allocated based on relative square feet) of the company’s total cost of rent, utilities, and
janitorial costs for the administrative office building.
Req u i r ed
Prepare a revised budget consistent with the president’s recommendation.
PROBLEM 1-4. Performance Reports [LO 1] A performance report that compares budgeted and
actual profit in the sporting goods department of Maxwell’s Department Store for the month of
December follows:
Maxwell’s Department Store

Sporting Goods
Performance Report December 2017
Budget Actual Difference
Sales $700,000 $775,000 $75,000

Less:
Cost of merchandise 350,000 430,000 80,000
Salaries of sales staff 70,000 78,000 8,000
Controllable profit $280,000 $267,000 ($13,000)
Req u i r ed
a. Evaluate the department in terms of its increases in sales and expenses. Do you believe it would
be useful to investigate either or both of the increases in expenses?
b. Consider storewide electricity cost. Would this cost be a controllable or a noncontrollable cost
for the manager of sporting goods? Would it be useful to include a share of storewide electricity
cost on the performance report for sporting goods?
PROBLEM 1-5. Performance Reports [LO 1, 2] At the end of 2017, Cyril Fedako, CFO for
Central Products, received a report comparing budgeted and actual production costs for the
company’s plant in Forest Lake, Minnesota:
Manufacturing Costs
Forest Lake Plant
Budget versus Actual 2017
Difference
Budget Actual (Actual Minus Budget)
Materials $3,200,000 $3,500,000 $300,000

Direct labor 2,300,000 2,500,000 200,000
Supervisory salaries 475,000 500,000 25,000
Utilities 125,000 135,000 10,000
Machine maintenance 350,000 380,000 30,000
Depreciation of building 90,000 90,000 -0-
Depreciation of equipment 250,000 255,000 5,000
Janitorial 220,000 235,000 15,000
Total $7,010,000 $7,595,000 $585,000
P r o b l e m s 33
His first thought was that costs must be out of control since actual costs exceed the budget by
$585,000. However, he quickly recalled that the budget was set assuming a production level of
60,000 units. The Forest Lake plant actually produced 65,000 units in 2017.
Req u i red
a. Given that production was greater than planned, should Cyril expect that all actual costs will
be greater than budgeted? Which costs would you expect to increase, and which costs would you
expect to remain relatively constant?
PROBLEM 1-6. Financial versus Managerial Accounting [LO 1, 2, 3] Linda Vendetto is the
manager of contact lenses and related products sold online by a large retail chain (think Walmart.
com). In this capacity, she is responsible for approximately 250 different products.
R equ ir ed
a. Explain why the level of detail in the company’s income statement, balance sheet, and statement
of cash flows is not sufficient for Linda to manage her operation.
b. List three nonfinancial measures that Linda may find useful to manage her operation.
c. Linda’s own performance is evaluated, in part, based on customer satisfaction ratings. What can
Linda do to improve performance on this measure?
d. List three likely costs in Linda’s operation and indicate whether they are fixed or variable.
PROBLEM 1-7. You Get What You Measure! [LO 3] Each year the president of Smart-Toys
Manufacturing selects a single performance measure and offers significant financial bonuses to
all key employees if the company achieves a 10 percent improvement on the measure in compar-
ison to the prior year. She recently said, “This focuses my managers on a single, specific target
and gets them all working together to achieve a major objective that will increase shareholder
value.”
Sarabeth Robbins is a new member of the company’s board of directors, and she has
begun to question the president’s approach to rewarding performance. In particular, she
is concerned that placing too much emphasis on a single performance measure may lead
managers to take actions that increase performance in terms of the measure but decrease the
value of the firm.
Req u i r ed
a. What negative consequence might occur if the performance measure is sales to new customers ÷
total sales in the current year versus the prior year? (Note: To receive a bonus, managers would
need to increase this ratio compared with the prior year.)
b. What negative consequence might occur if the performance measure is cost of goods sold ÷
sales in the current year versus the prior year? (Note: To receive a bonus, managers would need to
decrease this ratio compared with the prior year.)
c. What negative consequence might occur if the performance measure is selling and administra-
tive expenses ÷ sales in the current year versus the prior year? (Note: To receive a bonus, managers
would need to decrease this ratio compared with the prior year.)
PROBLEM 1-8. Incremental Analysis [LO 2, 3] The Riverview Hotel is a deluxe four-star estab-
lishment. Late on Friday, it had 20 of its 300 rooms available when the desk clerk received a call
from the Pines Hotel. The Pines Hotel made a booking error and did not have room for four guests
(each of whom had a “confirmed” room). The Pines wants to send its customers to the Riverview
but pay the rate the guests would have been charged at the Pines ($160 per room) rather than
paying the normal rate of $260 per room at the Riverview.
34 c h a p te r 14 M
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Req u i red
a. If the Riverview accepts the guests, what will be the incremental revenue?
b. Provide examples of incremental costs that the Riverview will incur if it accepts the guests.
c. In your opinion, will the incremental revenue be greater than the incremental cost?
PROBLEM 1-9. Ethics and Code of Conduct [LO 5] Search the Web for the Code of Conduct for
Sears Holdings Corporation (the parent company for Sears and Kmart). For each of the following
cases, indicate whether it is allowable under the Code of Conduct. In your answer, cite specific
language in the code.
a. A purchasing agent is negotiating with two suppliers A and B. The agent tells supplier B the bid
price offered by supplier A in an effort to get B to lower its bid.
b. An employee is running for city council and distributes materials supporting his campaign via
company email.
c. A purchasing agent accepts samples of various clothing items.
d. An employee writes an anonymous blog on her experience at Sears that provides insights into
the company’s strategy for success.
CASE
1-1 Local 635 [LO 2, 5]
Local 635 represents kitchen workers at hotels in sev- plained, “Look, that dinner goes for $32 on the menu so assigning
eral southern cities. Part of their labor agreement states that a cost of $22 represents a very good value to the kitchen workers.
workers “shall receive one free meal per shift up to a cost of $12, The contention that the meal only costs $8 is nonsense. True, the
with any cost over $12 being deducted from wages paid to said meat costs $7 and the salad ingredients cost $1, but there’s also the
employee.” labor costs related to preparing the meal and the numerous over-
A labor dispute arose at the Riverside Hotel shortly after it was head costs, like the cost of the oven that the prime rib is cooked in.
opened in June. Kitchen workers who ate dinner on the late shift That oven cost more than $20,000. And there’s heat, light, power,
found that their wages were reduced by $10 for each meal they etc. Each meal we prepare should be assigned part of these over-
consumed at the hotel during their dinner break. Josh Parker, a head costs. And don’t forget that when the worker finishes his or
line cook, stated the widely held belief of the workers. “There’s her meal, someone has to clean up. That costs money too. When
no way these dinners cost the Riverside Hotel $12 to make, let you add up all of these items, a prime rib dinner easily adds up
alone $22. This is just another case of management trying to rip us to $22!”
off. Take last night. I had the prime rib dinner. The piece of meat
cost about $7 and the salad less than $1. That’s only $8 in total.
Really, there aren’t any other costs to speak of. The cook, well, he’s R eq uired
going to be working in the kitchen and getting paid for 8 hours
whether he makes my meal or not. This claim that my meal cost a. List examples of costs at the Riverside Hotel that are variable,
$22 is baloney!” fixed, and sunk. Provide an example of an opportunity cost.
Management of the Riverside Hotel sees the situation differ- b. What is the source of conflict between labor and manage-
ently. Take the case of Josh’s dinner. In presenting the hotel’s case ment? What changes would you recommend in the wording of
to a labor arbitration board, Sandy Ross, manager of the hotel, ex- the labor agreement?
C a s e 35
Case
1-2 Boswell Plumbing Products [Lo 3]
Boswell Plumbing Products produces a variety of valves, product. For each of these decisions, the cost information that you
connectors, and fixtures used in commercial and resi- need is different.”
dential plumbing applications. Recently a senior manager
walked into the cost accounting department and asked Nick
R eq uired
Somner to tell her the cost of the D45 valve. Nick quickly re-
plied, “Why do you want to know?” Noticing that the manager Using the concept of incremental analysis, expand on Nick’s re-
appeared somewhat startled by this question, he explained, “The sponse of, “Why do you want to know?” What cost information
cost information you need depends on the decision you’re going would be relevant to a decision to drop the product that would
to make. You might be thinking of increasing a scheduled produc- not be relevant to a decision to increase a production run by
tion run of 3,000 D45s by 100 units or scheduling an additional 100 units?
production run, or you might even be thinking of dropping the
2
Job-Order Costing for
Manufacturing and Service
Companies
While working in the software industry, Bob Williams spent
his limited free time restoring an old wooden motorboat.
After 15 years at Mayfield Software, Bob was able to retire difference between product and period costs, fixed and
and pursue his love affair with old boats on a full-time basis. variable costs, and how the job cost sheets relate to inven-
He’s now the new owner of Eastlake Motorboat Company, tory on our balance sheet. Frankly, I’m really glad you’re
a small (and, heretofore, barely profitable) manufacturer interested in the accounting side of things. The previous
of custom-built wooden motorboats patterned after the owner was great with boats but never paid much attention
classic lake cruisers built in the 1930s through the 1950s. to financial information. That’s probably one of the main
During his first week on the job, he had a lunch meet- reasons the company never really prospered.”
ing with his accountant, Nancy Young, and expressed To determine the cost of manufactured products like
his interest in two key drivers of company success—cost the boats made by Eastlake Motorboat, companies use
estimation and pricing. a product costing system, an integrated set of doc-
“Nancy, I know that before we take an order and set uments, ledgers, accounts, and accounting procedures
a price for a custom boat, we estimate material, labor, used to measure and record the cost of manufactured
and overhead costs. What I want to do is look at what the products. In this chapter, we consider cost classifications
boats are actually costing us and compare the actual costs for manufacturing firms and how the costs of manufactured
to estimates. I think one of our problems may be that we products are reflected in a company’s financial statements.
are underestimating cost and pricing too low. How hard In particular, we consider a type of product costing system
will it be to put together some cost data for a number of referred to as a job-order costing system. While the pri-
recent orders so I can get a handle on this?” mary example in the chapter focuses on a manufacturing
“Not hard at all,” Nancy replied. “We have what’s called firm, Eastlake Motorboat Company, job-order costing also
a job-order costing system that tracks the cost of each applies to service companies that need to calculate the
custom boat. I can get you the material later this afternoon.” cost of services they provide to customers. Thus, as we
“That’s great, Nancy. And while you’re at it, maybe will discuss, job-order costing is used by law firms, con-
you can bring me up to speed on how the costing system sulting firms, hospitals, auto repair shops, and other service
works. As you know, my background is in computer pro- companies. Finally, we address modern manufacturing
gramming, and I’m afraid I don’t know a lot about accounting. practices and how they are helping companies succeed in
Do you think you can help me out with the basics?” a competitive global economy. These practices are important
“You bet,” Nancy assured him. “In fact, when we get to the study of managerial accounting because they affect
back to the office, let’s grab a cup of coffee and I’ll begin the type and amount of costs and, to some extent, the
your accounting education. Before long, you’ll know the design of the product costing system.
Rhoberazzi/iStock/Getty Images Plus
Learning Objectives
1 Distinguish between manufacturing and nonmanufacturing costs and between product and
period costs.
2 Discuss the three inventory accounts of a manufacturing firm and describe the flow of product
costs in a manufacturing firm’s accounts.
3 Discuss the types of product costing systems and explain the relation between the cost of jobs
and the Work in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold accounts.
4 Describe how direct material, direct labor, and manufacturing overhead are assigned to jobs.
5 Explain the role of a predetermined overhead rate in applying overhead to jobs, and explain the
treatment of the difference between actual overhead and overhead allocated to jobs using a
predetermined rate.
6 Explain how service companies can use job-order costing to calculate the cost of services pro-
vided to customers.
7 Discuss modern manufacturing practices and how they affect product costing.
37
38 chapter 2 J o b - O r d e r C o s t i n g f o r M a n u f a c t u r i n g a n d S e r v i c e C o m p a n i e s
Learning Cost Classifications for Manufacturing

Objective 1
Firms
Distinguish between
manufacturing and Companies need to know the cost of their products so that they can set prices, calculate
nonmanufacturing profit when products are sold, and assess the reasonableness of the costs incurred in
costs and between manufacturing products. Determining the cost of items a merchandising firm purchases
product and period from a supplier is relatively easy. The cost of the items is the purchase price plus shipping
costs. charges. Determining the cost of items a manufacturing firm produces is more complex.
Using both labor and machinery, a manufacturing firm converts raw materials into
finished goods. Complexity arises because the costs of the resources used in production
must be assigned to the units produced.
Merchandising and manufacturing firms are compared in Illustration 2-1. This section
discusses the broad classifications of manufacturing and nonmanufacturing costs. It also
discusses product and period costs, which are other ways in which costs can be classified.
Manufacturing Costs
Manufacturing costs (also known as product costs) are all the costs associated with the
production of goods. They include three cost categories: direct material, direct labor,
and manufacturing overhead.
Direct Material. Direct material cost is the cost of all materials and parts that are
directly traced to items produced. For the Eastlake Motorboat Company, a manufacturer
of motorboats, direct material includes the wood, the steering assembly, the motor, and
Illustration 2-1 a variety of other items.
Comparison of merchandising
and manufacturing firms
Merchandising Firms (e.g., clothing store)
Buy completed items Stock completed Sell items to

from suppliers items customers
Y'S
JUDESS
DR RN
BA
Suppliers Warehouse or store Customers
Manufacturing Firms (e.g., boat producer)
Buy raw materials Manufacture product in factory Stock completed Sell items to
from suppliers items customers
Direct labor cost Direct material cost
Production process
SOLD
Suppliers Manufacturing overhead cost Warehouse or store Customers

C o s t C l a s s i f i c a t i o n s f o r M a n u f a c t u r i n g F i r m s 39
Direct material cost often does not include the cost of minor materials, such as
screws and glue. Although such minor material costs could be traced to a particular
boat, tracing the costs may not be worth the time it would take to do so. Materials that
are not directly traced to a product are referred to as indirect materials.
Direct Labor. Direct labor cost is the cost of labor that is directly traced to items
produced. The Eastlake Motorboat Company’s direct labor includes the labor cost of the
workers directly involved in constructing each motorboat. It probably does not include
the cost of production supervisors, such as the salary of Carl Jensen, the master builder.
This manager supervises the production of 10 or more different boats at once. He spends
5 minutes to an hour on a job before directing his attention to another job or to other
aspects of production, such as scheduling workers and ordering equipment. It would be
very difficult, if not impossible, to directly trace the time Carl spends scheduling workers to
individual jobs. And although it might be possible to directly trace the time he spends
supervising production of a particular job, it may not be worthwhile to do so. Labor costs
that are not traced directly to products produced are referred to as indirect labor costs.
Manufacturing Overhead. Manufacturing overhead is the cost of all manufacturing
activities other than direct material and direct labor. It includes indirect material and
indirect labor, which were explained earlier, as well as a wide variety of other cost items.
For the Eastlake Motorboat Company, manufacturing overhead includes the costs of
screws, glue, varnish, supervisor salary, depreciation of tools, depreciation of the building
where manufacturing takes place, utilities, and a number of other items. Illustration 2-2
lists some common manufacturing overhead costs.
Nonmanufacturing Costs
Nonmanufacturing costs (also known as period costs) can be defined simply as all costs
that are not associated with the production of goods. These costs typically include selling
and general and administrative costs.
Selling Costs. Selling costs include all the costs associated with securing and filling
customer orders. Thus, selling costs include advertising costs, sales personnel salaries,
depreciation of automobiles and office equipment used by the sales force, and costs of
storing and shipping finished goods.
General and Administrative Costs. General and Administrative Costs are all the
costs associated with the firm’s general management. These costs include the salaries
of the company president and accounting personnel, depreciation of the general office
building, depreciation of office equipment used by general managers, and the cost of
supplies used by clerical employees.
In many cases, a cost is classified by its use rather than by its specific nature.
Consider janitorial costs. Janitorial costs associated with maintaining a production area
Illustration 2-2
Common manufacturing Indirect factory labor Power, heat, and light in the factory
overhead costs Indirect material Depreciation of factory equipment
Overtime premium Depreciation of plant
Nightshift premium Insurance on plant and factory
Vacation and holiday pay for factory equipment
workers Repair of factory equipment
Social Security and Medicare taxes Maintenance of factory building and
for factory workers grounds
Health insurance for factory workers Property taxes related to the factory
are classified as a manufacturing costs (specifically, manufacturing overhead). In contrast,

janitorial costs associated with maintaining the general office building are classified as
nonmanufacturing costs (specifically, General and Administrative Costs).
Any Q u e s t i o n s ?
Q: I see that in Illustration 2-2, overtime premium is listed as manufacturing
overhead. Why is that? Can’t we directly trace overtime to specific jobs worked on
after 5 p.m., or on weekends or holidays when overtime is paid?
A: The fact that a specific job is worked on after 5 p.m. or on a weekend or holiday doesn’t
necessarily mean that it’s a job that caused overtime premium to be incurred. Plant super-
visors try to schedule jobs in a way that’s efficient. It could be that a particular job is worked
on after 5 p.m. simply because it’s efficient to make it the last job worked on during the day.
Because of the difficulty of assigning overtime to specific jobs that caused it, most companies
simply spread overtime premium among all jobs by including it in manufacturing overhead.
Product and Period Costs

As mentioned previously, costs that are classified as manufacturing and nonmanu-
facturing costs can also be classified as product and period costs. This latter distinction
is made to emphasize differences in the timing of when costs are recognized as expenses.
Product costs are identified with goods produced and expensed when goods are sold.
Period costs are identified with accounting periods and expensed in the period incurred.
Product Costs. Product costs are those costs assigned to goods produced. Thus, the
terms product costs and manufacturing costs are used interchangeably. Both include direct
material, direct labor, and manufacturing overhead. Product costs are considered an asset
(inventory) until the finished goods are sold. When the goods are sold, the product costs
are expensed. Thus, direct labor costs incurred in 2016 to produce goods sold in 2017
do not reduce income until 2017, the year of the sale. This ensures a proper matching of
revenue with the costs necessary to produce it.
Period Costs. Period costs are identified with accounting periods rather than with
goods produced. Selling and general and administrative costs (nonmanufacturing costs)
are period costs. We recognize period costs as expenses in the period incurred. For
example, rent paid on an office building is a period cost and becomes an expense in the
period incurred. In contrast, the rent paid on a factory building is a product cost and
becomes an expense when goods are sold. Differences between product and period costs
are summarized in Illustration 2-3.
Illustration 2-3
Relationships among cost Type of Cost When Expensed
categories
Product costs
Manufacturing Direct material 
costs Direct labor  Expensed when goods are sold
Manufacturing overhead 
Period costs
Nonmanufacturing Selling cost  Expensed in period in which they
costs General and  are incurred
administrative cost 
P r o d u c t C o s t I n f o r m a t i o n i n F i n a n c i a l R e p o r t i n g a n d D e c i s i o n M a k i n g 41
T est yo u r KNO W LE D GE
Which of the following is not a product cost?
a. Depreciation of manufacturing equipment. b. Indirect materials.
c. Insurance on manufacturing equipment. d. Bonuses and compensation
to the company president.
Product Cost Information

in Financial Reporting
and Decision Making
Decision Making/ Manufacturing companies need product cost information in order to prepare financial
Incremental statements in accordance with generally accepted accounting principles (GAAP). GAAP
Analysis requires that inventory on the balance sheet and cost of goods sold on the income
statement be presented using full cost information. Full cost means that product cost
includes both variable and fixed manufacturing overhead as well as direct material and
direct labor, which are generally variable costs.
Product cost information is also needed for a variety of managerial decisions.
Often the product cost information needed for management decision making is
different from the product cost information produced for external financial reports.
Recall from Chapter 1 that decision making relies on incremental analysis—an analysis
of the revenues that increase (decrease) and the costs that increase (decrease) if a
decision alternative is selected. In most cases, in order to perform incremental analysis,
you need to separate fixed and variable cost components. For example, suppose Bob
Williams, the owner of Eastlake Motorboat Company, is considering taking out an
advertisement in Wooden Boat Magazine. The ad will cost $25,000, and Bob believes
it will result in at least one additional order for a custom boat. On average, Eastlake
boats sell for $90,000. Thus, he expects that there will be $90,000 of incremental
revenue and $25,000 of incremental costs related to the ad. But what about incremental
production costs?
Link to Practice
Product and Period Costs at SpaceX 1. Cost of producing components such as nozzles
through which gases are discharged to generate thrust.
SpaceX designs, manufactures, and launches rockets
2. Cost of rocket engine design.
and spacecraft, and it was the first private company to
return a spacecraft from low-Earth orbit. Subsequently, 3. Salary of plant manager.
the company has delivered cargo to the International 4. Salary of marketing vice president.
Space Station multiple times. 5. Cost of testing rocket engine prior to shipment.
Classify each of the following costs as a product or 6. Salary of the division president.
period cost for SpaceX:
7. Cost of legal staff who draft contracts.
Answer: (1) Product, (2) Product, (3) Product, (4) Period, (5) Product, (6) Period, (7) Period.
Bob knows that, on average, the production cost of a boat includes $25,000 of direct
material cost, $20,000 of direct labor cost, and $30,000 of manufacturing overhead. Thus,
the full production cost of a boat is $75,000.
Direct material $25,000

Direct labor 20,000
Manufacturing overhead 30,000
$75,000
It may appear that Bob should not place the ad because the revenue of $90,000 is less than
the cost of advertising and the cost of producing the boat, which is $100,000 ($25,000
of advertising and $75,000 of production costs). However, suppose Bob analyzes pro-
duction costs and concludes that while direct material and direct labor are incremental
costs, only 10 percent of manufacturing overhead, or $3,000, is incremental. The reason
for this is that much of manufacturing overhead includes fixed costs, such as depreciation
on equipment, depreciation on production facility, the salary of the master builder, and
other fixed cost items.
Let’s perform incremental analysis and see whether Bob should place the ad:
Incremental revenue $ 90,000

Incremental cost:
Cost of advertisement (25,000)
Incremental production costs
Direct labor 20,000
Manufacturing overhead 3,000 (48,000)
As indicated, incremental revenue exceeds incremental cost, and there will be an incre-
mental profit of $17,000. Thus, Bob should place the ad. The important point here is
that product cost information produced for external reporting purposes may not be
appropriate for management decisions unless it is modified or adjusted.
Learning Balance Sheet Presentation of Product

Objective 2
Costs
Discuss the three
inventory accounts of As noted earlier, product costs are treated as an asset until the finished goods are sold.
a manufacturing firm In this section, we learn how product costs appear on the balance sheet in three asset
and describe the flow accounts related to inventory: Raw Materials, Work in Process, and Finished Goods. In
of product costs in a the next section, we discuss how costs flow from one account to another. Then we turn
manufacturing firm’s our attention to how the costs are reflected on a company’s income statement.
accounts. The Raw Materials Inventory account includes the cost of materials on hand that
are used to produce a company’s products. For the Eastlake Motorboat Company, steer-
ing assemblies, motors, wood, screws, varnish, and glue are included in Raw Materials
Inventory.
Work in Process Inventory is the inventory account for the cost of goods that are
only partially completed. For example, suppose that at the end of the year, the Eastlake
I n c o m e S t a t e m e n t P r e s e n t a t i o n o f P r o d u c t C o s t s 43
Illustration 2-4
Balance sheet presentation of Motorboat Company
inventory accounts
Balance Sheet
As of December 31, 2017
Assets Liabilities and Stockholders’ Equity
Cash $ 20,000 Accounts payable $ 10,000
Accounts receivable 40,000 Notes payable 60,000
Inventory Long-term debt 100,000
Raw Materials $ 30,000 Common stock 400,000
Work in Process 50,000 Retained earnings 70,000
Finished Goods 100,000 180,000
Equipment (net) 400,000 Total liabilities and
Total Assets $640,000 stockholders’ equity $640,000
Motorboat Company has 10 partially completed boats. The cost of direct material, direct
labor, and manufacturing overhead incurred to bring the boats to their current state of
partial completion is included in Work in Process.
Finished Goods Inventory is the account for the cost of all items that are complete
and ready to sell. Suppose that at the end of the year, the Eastlake Motorboat Company
has four boats that are completed and ready to sell. Finished Goods includes the cost of
direct material, direct labor, and manufacturing overhead incurred to bring those boats
to their finished state. A simplified balance sheet showing the three inventory accounts
is presented in Illustration 2-4.
Flow of Product Costs in Accounts

In an accounting system, product costs flow from one inventory account to another.
Illustration 2-5 shows the flow of product costs in the accounts.
The cost of direct material used reduces the Raw Material Inventory account and
increases Work in Process Inventory. Indirect material used, however, is not added
directly to Work in Process; instead, it is accumulated in Manufacturing Overhead. The
amount of direct labor used increases Work in Process, but indirect labor is not added
directly to Work in Process. Like indirect material, indirect labor is accumulated in
Manufacturing Overhead. The cost accumulated in Manufacturing Overhead, which
includes indirect material, indirect labor, and a variety of other overhead costs, is also
added to Work in Process.
Once items are finished, the cost of the completed items is transferred from Work
in Process into Finished Goods. The cost of items completed is referred to as cost of
goods manufactured. When the completed items are sold, the cost of the items sold is
transferred from Finished Goods into Cost of Goods Sold.
Income Statement Presentation

of Product Costs
When finished goods are sold, the cost of the inventory sold is considered an expense
and must be removed from Finished Goods Inventory and charged to Cost of Goods
Sold. This provides a matching of revenue (sales dollars) with the cost of producing the
revenue (the cost of goods sold).
44 c h a p t e r 2 J o b - O r d e r C o s t i n g f o r M a n u f a c t u r i n g a n d S e r v i c e C o m p a n i e s
Balance Sheet Income Statement

Accounts Account
Raw Materials Inventory Work in Process Inventory Finished Goods Inventory Cost of
Goods Sold
Direct Cost of Cost of

Material Goods Goods
Indirect Material
Manufactured Sold
SI
N SOLD
RE
Labor
Direct Labor
Indirect Labor
Overhead
Overhead Applied
Illustration 2-5
Flow of product costs in Cost of Goods Manufactured. Before cost of goods sold can be calculated, however,
accounts we must calculate cost of goods manufactured. Recall that cost of goods manufactured is
the cost associated with items completed during a period. Cost of goods manufactured
can be calculated using a simple formula. It is equal to the beginning balance in Work
in Process plus current manufacturing costs (direct material, direct labor, and manu-
facturing overhead incurred in the current period) minus the ending balance in Work
in Process.
Beginning Current Ending Cost

Balance in Work in Manufacturing Balance in Work in of Goods
Process Costs Process Manufactured
Direct Material
Direct Labor
Manufacturing Overhead
Cost of Goods Sold. Once cost of goods manufactured is known, cost of goods sold
can also be calculated using a simple formula. It is equal to the beginning balance in
finished goods plus the cost of goods manufactured minus the ending balance in finished
goods.
Beginning Cost of Ending Cost

Balance in Finished + Goods – Balance in Finished = of Goods
Goods Manufactured Goods Sold
Illustration 2-6 presents a schedule of cost of goods manufactured and a sim-

plified income statement showing cost of goods sold for the Eastlake Motorboat
I n c o m e S t a t e m e n t P r e s e n t a t i o n o f P r o d u c t C o s t s 45
Illustration 2-6
Schedule of cost of goods Motorboat Company
manufactured and an income
statement showing cost of Schedule of Cost of Goods Manufactured
goods sold For the Year Ended December 31, 2017
Beginning balance in work in process inventory $ 40,000
Plus current manufacturing costs:
Direct material $ 600,000
Direct labor 480,000
Manufacturing overhead
Heat, light, and power $ 15,000
Rent for production facility 45,000
Depreciation of equipment 50,000
Supervisor Salary 150,000
Other 460,000 720,000 1,800,000
Total 1,840,000
Less ending balance in work in process inventory 50,000
Cost of goods manufactured $1,790,000
Income Statement
Sales $ 2,160,000
Less cost of goods sold:
Beginning finished goods inventory $ 80,000
Add cost of goods manufactured 1,790,000
Cost of goods available for sale 1,870,000
Less ending finished goods inventory 76,000 1,794,000
Gross profit 366,000
Less nonmanufacturing expenses:
Selling and administrative expenses 220,000
Net Income $ 146,000
Company. Note that in the income statement, the sum of the beginning balance in
Finished Goods plus the cost of goods manufactured is referred to as the cost of
goods available for sale.
The formula to determine cost of goods sold is:
a. Beginning work in process inventory + Cost of goods manufactured − Ending
finished goods inventory.
b. Beginning work in process inventory + Cost of goods manufactured − Ending work
in process inventory.
c. Beginning finished goods inventory + Cost of goods manufactured − Ending finished
goods inventory.
d. Beginning work in process inventory + Current manufacturing costs − Ending work
in process inventory.
Learning Types of Costing Systems

Objective 3
As noted in the introduction to this chapter, companies use product costing systems (an
Discuss the types integrated set of documents, ledgers, accounts, and accounting procedures) to measure
of product costing and record the cost of manufactured products. There are two major product costing
systems and explain systems: job-order costing systems and process costing systems. The best system to use
the relation between depends on the type of manufacturing.
the cost of jobs and the Companies that produce individual products or batches of products that are unique
Work in Process, use a job-order costing system. This is the case when a company manufactures goods
Inventory, Finished to a customer’s unique specifications. Companies using job-order systems include con-
Goods Inventory, and struction companies, producers of equipment and tools, shipbuilding companies, and
Cost of Goods Sold printing companies. In the context of job-order costing, a job is an individual product
accounts. or batch for which a company needs cost information. When the items that make up the
job are completed and sold, the company can match the cost of the job with the revenue
it produced and obtain an appropriate measure of gross profit.
Companies that use a process costing system generally produce large quantities
of identical items. Such companies include metal producers, chemical producers, and
producers of paints and plastics. Products such as chemicals, paints, and plastics pass
through uniform and continuous production operations. Costs are accumulated by each
operation, and the unit cost of items is determined by dividing the costs of the produc-
tion operations by the large number of identical items produced:
Total cost of production
Unit cost of items produced =
Total number of units produced
In a process costing system, there is no need to trace costs to specific items produced,
since all items are identical. It is sufficient to assign each item its average unit cost of
production. You will learn more about process costing systems in Chapter 3. The sections
that follow focus on job-order costing.
Overview of Job Costs and Financial

Statement Accounts
As previously discussed, product costs include three cost items: direct material, direct
labor, and manufacturing overhead. In a job-order costing system, the cost of a job is
the sum of these three cost items. Thus, a job-order system must be able to relate these
costs to specific jobs (see Illustration 2-7).
Link to Practice
Examples of Companies Using Job-Order Dow Chemical Company
and Process Costing Systems Pfizer, Inc.
Goodyear Tire and Rubber Company
Which of the following companies use job-order systems
Cray, The Supercomputer Company
and which ones use process costing systems to deter-
Learjet, a subsidiary of Bombardier Aerospace,
mine product cost?
Precision Castparts, a manufacturer of custom metal
Companies components
Grand Banks Yachts
Jones Soda Company
are Jones Soda, Dow Chemical, Pfizer, and Goodyear.
Answer: Job-order companies are Grand Banks, Cray, Learjet, and Precision Castparts. Process costing companies
O v e r v i e w o f J o b C o s t s a n d F i n a n c i a l S t a t e m e n t A c c o u n t s 47
Illustration 2-7 Product Cost Jobs

Relating product costs to jobs
Job C
ost Sh
Job 2 eet
57
N
SI
RE
Direct material Job 257
Job C
ost Sh
Job 2 eet
58
Assign
costs
to jobs
Job 258
Direct labor
Job C
ost Sh
Job 2 eet
59
Job 259
You should also recall that product costs are reflected in Work in Process
Inventory and Finished Goods Inventory on the balance sheet and in Cost of Goods
Sold on the income statement. In a job-order costing system, Work in Process will
include the cost of all jobs that are currently being worked on (i.e., are in process).
Finished Goods will include the cost of all jobs that are completed but not yet sold.
Cost of Goods Sold will include the cost of all jobs that are sold during the accounting
period (see Illustration 2-8).
Cost flow through a job-order costing system is based on the status of jobs. First,
direct material, direct labor, and manufacturing overhead costs related to jobs being
worked on are added to the Work in Process Inventory account. When specific jobs are
completed, the costs of those jobs (referred to as the costs of goods manufactured) are
deducted from Work in Process Inventory and added to the Finished Goods Inventory
account. When specific jobs are sold, the costs of those jobs are removed from Finished
Goods Inventory and added to Cost of Goods Sold. These cost flows are indicated in
Illustration 2-9.
As you read the following material, keep in mind the components of a job-order
costing system: (a) the items making up the costs of a job (direct material, direct labor,
Illustration 2-8 Work in Process Inventory Finished Goods Inventory Cost of Goods Sold
Job costs and financial
statement accounts Cost of jobs being Cost of jobs completed
Cost of jobs sold
worked on but not yet sold
Work in Process Finished Goods

Inventory Inventory Cost of Goods Sold
SOLD
Direct material, direct labor, and Cost of jobs completed Cost of jobs sold
manufacturing overhead related to (cost of goods manufactured)
jobs being worked on
Illustration 2-9
Flow of costs in job-order
system and manufacturing overhead) and (b) the way the status of jobs triggers the flow of costs
through financial statement accounts (Work in Process, Finished Goods, and Cost of
Goods Sold). These are basic structural elements that we build on in our discussion of
the procedures of a job-order costing system.
The following values relate to Royal Custom Molds for the current year:
Beginning Work in Process Inventory $ 200,000
Ending Work in Process Inventory $ 300,000
Beginning Finished Goods Inventory $ 600,000
Ending Finished Goods Inventory $ 900,000
Cost of Goods Manufactured $4,000,000
Based on this information, what is cost of goods sold?
a. $3,900,000 c. $1,200,000
b. $3,700,000 d. $ 100,000
Correct answer is b.
Learning Job-Order Costing System

Objective 4
Job-order costing operations begin when a company decides to produce a specific prod-
Describe how direct uct for stock (i.e., with no specific buyer in mind for the item) or in response to an order
material, direct labor, for a custom product. For example, an electric motor manufacturer decides to build five
and manufacturing model XL25 motors for stock, a print shop receives an order for 20,000 spring catalogs
overhead are assigned from a clothing manufacturer, or a residential construction company receives an order
to jobs. to build a summer home.
If the company decides to accept the order, a job cost sheet is prepared. A job cost
sheet is a form, typically computer generated, used to accumulate the cost of producing
the item or items ordered (i.e., the cost of the job). Illustration 2-10 shows a job cost
J o b - O r d e r C o s t i n g S y s t e m 49
Illustration 2-10
Top of first page and bottom of last page of job cost sheets
Motorboat Company
65 Shore Place
Kirkland, Washington 98006
Job number: 20126 Requested Delivery Date: 5/30 Date Started: 4/15 Date Completed: 5/25
Customer: Mary and John Hughes, 647 Circle Drive, Redmond, Washington 98042
Description: 18-foot runabout, mahogany hull, 75 h.p. inboard, deluxe interior (cream/maroon)
Direct Materials Direct Labor Manufacturing Overhead
Date Requisition number Cost Labor report number Hours Cost $57.60 per direct labor hour
4/15 255 1,542.68 105 24 880.00 $1,362.40
4/16 261 5,450.00 106 12 432.00 691.20
4/17 266 4,225.42 107 15 576.00 864.00
4/18 272 1,820.65 108 7 262.50 403.20
4/19 282 436.80 109 9 297.50 518.40
4/22 289 854.64 110 4 140.00 230.40
4/23 295 1,620.22 111 5 175.00 288.00
(last page of job cost report)
5/25 382 655.50 133 4 160.00 230.40
Total 24,500.50 Total 568 21,025.30 Total 32,716.80
Cost summary
Direct materials $24,500.50
Direct labor 21,025.30
Manufacturing overhead 32,716.80
$78,242.60
sheet for a custom product to be built by Eastlake Motorboat Company. The job is
identified by a job number: 20126. How specific amounts end up on the job cost sheet
will be explained later. For now, simply note that the job cost sheet contains detailed
information on the three categories of product costs: direct material, direct labor, and
manufacturing overhead.
Direct Material Cost

A material requisition form is used to request the release of materials from a company’s
storage area. Illustration 2-11 shows a material requisition form for Eastlake Motorboat
Company job 20126. The form lists the type, quantity, and cost of material as well as the
number of the job requiring the materials. Because the form includes the job number,
it can be used to trace material cost to specific jobs. Requiring a supervisor’s signature
helps to prevent the unauthorized issuance of material.
Each material requisition form is listed in summary form on the job cost sheet.
For example, on material requisition form number 255, presented in Illustration 2-11,
the total cost of items requested amounts to $1,542.68. When these items are released
Illustration 2-11
Material requisition form
Material requisition number 255
Job number 20126Date 4/15
Item Description Cost
T5627 Floor tarp $ 246.36
L2005 120 feet mahogany planking 1,296.32
$1,542.68
Approved by: Carl Jensen
from storage, the total cost is posted to the job cost sheet (see Illustration 2-10) and
cross-referenced by the material requisition number.
Removal of materials from storage for use on a specific job decreases Raw
Materials and increases Work in Process Inventory. Periodically (daily, weekly, or
monthly), the total cost of materials issued to jobs is calculated and recorded in the
company accounts. Suppose $60,000 of materials are issued to specific jobs. The entry
to record this is:
Raw Materials Inventory Work in Process Inventory

Materials used on jobs
(date) Work in Process Inventory 60,000.00
Raw Materials Inventory 60,000.00
To record raw materials used
Direct Labor Cost

Workers in a company that uses a job-order costing system fill out time tickets (also
called job tickets or work tickets) to keep track of the amount of time spent on each
job. Illustration 2-12 shows a time ticket for Eastlake Motorboat Company job 20126.
If there are many workers on a particular job, individual time tickets may not be posted
directly to job cost sheets since that would produce too much detail. Illustration 2-13
presents a daily labor cost summary by job. As you can see, time ticket number 1587 is
just one of three time tickets indicating work performed on job number 20126 on April
15. In total, on April 15, 24 hours were spent on job 20126 at a cost of $880.00. The total
labor cost traced to job 20126 ($880.00) is the amount posted to the job cost sheet (see
Illustration 2-10).
J o b - O r d e r C o s t i n g S y s t e m 51
Illustration 2-12
Labor time ticket
Time ticket number 1587
Employee number 21 Grade 3
Job number 20126 Date 4/15
Time start 8:00 Time stop 5:00
Total hours 8
Journal Entry to Record Direct Labor. Periodically, the amount of direct labor cost
attributed to jobs being worked on must be debited to Work in Process. Suppose $40,000
of direct labor cost is incurred. The appropriate journal entry is:
Wages Payable Work in Process Inventory
Direct labor related to jobs
Wages Payable 40,000.00
To record direct labor cost
Illustration 2-13
Daily labor cost summary Motorboat Company
Daily labor report number: 105 Date: 4/15/2017
Job Time ticket Hours Grade Rate Cost

20124 1583 8 4 42.00 $ 336.00
20124 1582 5 3 37.00 185.00
20124 1583 3 2 31.00 93.00
16 614.00
20125 1584 3 3 37.00 111.00
20125 1585 5 2 31.00 155.00
8 266.00
20126 1586 8 4 42.00 336.00
20126 1587 8 3 37.00 296.00
20126 1588 8 2 31.00 248.00
24 880.00
Total daily labor $1,760.00
So far, we have traced raw material and direct labor costs to jobs. The final and more
complex cost component to assign is manufacturing overhead, which we discuss in a
general way here before going into more detail later in this chapter and in Chapter 6.
Recall that manufacturing overhead costs are not directly traced to goods produced.
For that reason, an indirect method of assigning overhead costs to jobs is needed. The
basic approach involves assigning overhead to jobs based on some characteristic that
jobs share in common, such as direct labor hours or direct labor cost. The common
characteristic is referred to as an allocation base. Essentially, the allocation base spreads
the overhead among the various jobs.
An overhead allocation rate is calculated by dividing estimated overhead costs by
the estimated quantity of the allocation base. For example, suppose Eastlake Motorboat
Company anticipates $720,000 of manufacturing overhead and 12,500 direct labor hours
during the year. With these estimates, Eastlake’s accountant, Nancy Young, can calculate
that $57.60 of overhead will be incurred for every direct labor hour worked ($720,000 ÷
12,500). Based on this overhead rate, each job will receive $57.60 of overhead for every
direct labor hour worked. The more labor hours spent on a job, the more overhead will
be indirectly assigned to the job by means of the overhead rate. The amount of overhead
assigned to jobs is referred to as overhead applied. Look back at Illustration 2-10 and
note that Eastlake assigns overhead to jobs on the basis of labor hours. With an over-
head rate of $57.60 and 568 labor hours, $32,716.80 of manufacturing overhead will be
assigned to job number 20126.
Journal Entries to Record Manufacturing Overhead. Recording manufacturing
overhead is a two-step process. First, when actual overhead costs are incurred, they are
debited to the Manufacturing Overhead account. Second, when overhead is applied to jobs,
the Manufacturing Overhead account is credited, and Work in Process Inventory is debited.
Step 1 Step 2
Manufacturing
Various Cost Accounts Overhead Work in Process Inventory
Various overhead Overhead applied

costs incurred to jobs
Step 1. Overhead costs include depreciation of manufacturing equipment, utilities

related to manufacturing, indirect materials, and a variety of other costs.
Therefore, the credit side of the entry to record manufacturing overhead can
include a large number of accounts. Suppose $4,000 of depreciation, $1,000
of utility costs, $1,000 of indirect materials, and $60,000 of various other
overhead costs are incurred. The journal entry to record these costs is:
(date) Manufacturing Overhead 66,000.00
Accumulated Depreciation 4,000.00
Utilities Payable 1,000.00
Raw Materials Inventory 1,000.00
Accounts Payable 60,000.00
To record overhead costs incurred
E a s t l a k e R e v i s i t e d : U s i n g J o b C o s t I n f o r m a t i o n 53
Step 2. The total amount of estimated overhead costs applied to jobs is calculated peri-
odically, and an entry is made to take the cost out of Manufacturing Overhead
and debit it to Work in Process. Suppose $60,000 of overhead is applied to jobs.
The journal entry is:
Manufacturing Overhead 60,000.00
To record overhead costs applied to jobs
Assigning Costs to Jobs: A Summary

Direct material costs are traced to jobs using material requisition forms. Direct labor
costs are traced to jobs using labor time tickets. Manufacturing overhead costs cannot
be directly traced to jobs. Instead, they are assigned to jobs using an overhead rate that
is multiplied by each job’s measure of the allocation base. Illustration 2-14 summarizes
the methods used to relate manufacturing costs to jobs.
Eastlake Revisited: Using Job Cost

Information
At this point we have reviewed a good deal of financial accounting information related
to job-order costing systems. Of what use is all this information to management? Let’s
consider Eastlake Motorboat Company to illustrate.
Illustration 2-14 Product Cost Method of assigning Jobs

How manufacturing costs are costs to jobs
related to jobs
Job C
MATERIAL
REQUISITION ost Sh
FORM
Job 2 eet
57
Direct material Material requisition Job 257

form
Job C
ost Sh
Job 2 eet
ET 58
SHE
TIME
Job 258
Direct labor Labor time sheet
Job C
ost Sh
Job 2 eet
59
Overhead rate
×
allocation base
Job 259
Recall from the chapter-opening vignette that Bob Williams, the new owner of
Eastlake Motorboat, is concerned that his company is underestimating costs and setting
prices too low for its custom boats. Using information from job-cost sheets, his accoun-
tant, Nancy Young, prepared an analysis of estimated and actual cost for three recent jobs
(see Illustration 2-15). Using this information, Bob can see that his hunch is right: Actual
costs are higher than estimated. The information indicates that, in particular, there has
been a problem in estimating material costs; on average, these costs have been running
14 percent higher than estimated.
The problem is reflected in the difference between the estimated and actual profit
margin percentages [(Price − Cost) ÷ Price]. For example, consider job 20124. Based on
estimated costs, the company would have earned a profit margin of 22 percent. However,
due primarily to the difference between estimated and actual material cost, the actual
profit margin is only 16 percent.
Estimate Actual
Sales price $115,000 $115,000
Less:
Material 27,000 31,600
Labor 24,100 25,200
Overhead 38,078 39,816
Total 89,178 96,616
Profit margin $25,822 $18,384
Profit margin as % of sales 22% 16%
Armed with the knowledge that costs have been underestimated, Bob can work to
improve the estimation process, especially with respect to cost of materials. However,
Illustration 2-15
Analysis of estimated and Motorboat Company
actual costs for Eastlake
Motorboat Material Labor Overhead
Job 20126 Price $102,000
Estimated 22,000.00 21,200.00 33,600.00 Est. margin 25%
Actual 24,500.00 21,025.00 33,219.00 Act. margin 23%
Difference (2,500.00) 175.00 381.00 Difference −2%
Percent of estimate −11% 1% 1%
Job 20125 Price 105,000
Difference (3,600.00) (1,000.00) (1,580.00) Difference −6%
Percent of estimate −14% −4% −4%
Job 20124 Price 115,000
Difference (4,600.00) (1,100.00) (1,738) Difference −6%
Total estimated 74,000.00 67,800.00 107,228.00
Total actual 84,700.00 69,725.00 110,165.00
Total Difference (10,700.00) (1,925.00) (2,937.00)
Note: Actual overhead is applied using a predetermined rate times actual labor hours.
R e l a t i o n B e t w e e n t h e C o s t s o f J o b s 55
should he raise prices consistent with higher estimated cost? That’s a complex question.
The fact that his costs have been higher than planned doesn’t necessarily mean prices
have been too low.
Decision Making/ As explained more fully in Chapter 8, in addition to considering production cost, when
Incremental setting prices, managers need to consider what customers are willing to pay. Let’s look at
Analysis job 20124. Suppose the customer for this boat was only willing to pay $115,000. Should
Bob have turned down the sale? Probably not.
Remember that when making a decision, we need to perform incremental analysis.
Let’s assume that only 10 percent of overhead is variable and the remainder is composed
of fixed costs, such as depreciation and the salary of the master builder. In this case, the
incremental costs of the job are $31,600 for materials, $25,200 for direct labor, and $3,982
for manufacturing overhead. This totals to $60,782. The incremental profit of the job is
$54,218, and turning the job down would have hurt financial performance.
Incremental revenue $115,000

Incremental cost:
Direct material 31,600
Direct labor 25,200
Manufacturing overhead 3,982 60,782
In adjusting prices, Bob will have to be careful that he doesn’t turn down business
that will actually improve profitability.
Relation Between the Costs of Jobs and

the Flow of Costs in Work in Process,
Finished Goods, and Cost of Goods Sold
Earlier in the chapter, we discussed in general terms how product costs flow in the
accounts of a manufacturing firm (see Illustration 2-5). Now that we have a good under-
standing of the cost of a job, we can make a link between the cost of jobs and cost flows.
When a company begins work on a job, production costs are applied to Work in Process
using journal entries such as those illustrated earlier. When jobs are completed, Work
in Process is reduced and Finished Goods is increased. When completed jobs are sold,
Finished Goods is reduced by the cost of the completed jobs sold and the Cost of Goods
Work in Process Inventory Finished Goods Inventory Cost of Goods Sold
Cost of completed jobs Cost of jobs sold
SOLD
Sold account is increased. Suppose the cost of jobs completed is $160,000 and the cost
of jobs sold is $85,000. The journal entries are:
(date) Finished Goods Inventory 160,000
Work in Process Inventory 160,000
To record cost of jobs completed
(date) Cost of Goods Sold 85,000
Finished Goods Inventory 85,000
To record cost of goods sold expense
Allocating Overhead to Jobs:

A Closer Look
We have seen how direct material, direct labor, and manufacturing overhead are accu-
mulated in a job-order costing system. However, in discussing the process of assigning
manufacturing overhead to specific jobs and recording overhead in various accounts,
referred to as overhead allocation, we did not go into much detail. It’s time for a more
thorough discussion.
Overhead Allocation Rates

Because cost items that make up overhead are related only indirectly to jobs being pro-
duced, some means of allocating or assigning overhead costs to jobs must be developed.
As mentioned, overhead costs are allocated to jobs by means of an overhead allocation
rate. The rate is calculated as the ratio of overhead costs to activity. Common measures
of activity include direct labor hours, direct labor cost, machine hours, and direct mate-
rial cost. Recall that the measure of these activities is referred to as the allocation base.
Overhead cost
Overhead allocation rate =
Allocation base
Suppose a company had $50,000 of overhead cost and used 10,000 labor hours during
the year. In this example, an average actual overhead cost per labor hour of $5 ($50,000 ÷
10,000) can be calculated, and overhead can be assigned to jobs based on the amount
of labor hours worked on each job. For example, if a particular job required 100 labor
hours, it would receive an overhead allocation of $500 (100 × $5).
The Overhead Allocation Base

In choosing among alternative allocation bases (such as direct labor hours, direct labor
cost, machine hours, and direct material cost), keep in mind that jobs with greater
quantities of an allocation base will receive larger allocations of overhead. For example,
suppose machine hours are used as an allocation base and an overhead rate is calculated
as $10 per machine hour. If one job uses 40 machine hours and another job uses 20
machine hours, the first job will receive an allocation of $400 and the second job will
receive an allocation of only $200. This is appropriate if greater activity, as measured by
machine time, generally requires the firm to incur more overhead cost.
The allocation base used should be strongly associated with overhead cost. That
is, increases in overhead cost should coincide with increases in the allocation base.
If increases in overhead are more closely associated with increases in machine hours
than with increases in labor hours, it would be best to allocate overhead on the basis of
machine hours. In selecting the allocation base, consider whether the production pro-
cess is labor intensive or machine intensive. If an operation is labor intensive (i.e., large
A l l o c a t i n g O v e r h e a d t o J o b s : A C l o s e r L o o k 57
quantities of labor are used to produce most jobs), then direct labor hours or direct labor
cost is likely to be a reasonable allocation base. If an operation is highly mechanized,
then machine hours are likely to be a reasonable allocation base.
You get what you In selecting an allocation base, you also need to remember that “You get what you
M e a s u r e measure!” Manufacturing managers try to reduce costs because it reflects well on their
managerial skill. If labor hours are used as the overhead allocation base, managers may
try to cut labor to reduce overhead charges to the jobs for which they are responsible.
Similarly, if machine hours are used, managers may try to reduce machine run time.
But if labor or machine time is reduced, will overhead costs be reduced? That’s not clear,
because, at least in the short run, much of the overhead cost may be fixed. Thus, apparent
cost savings may not be realized. In other words, the costing system will make it appear
that costs are decreasing when in fact they are not.
For example, suppose the performance of Carl Jensen, the master builder at Eastlake
Motorboat Company, is evaluated in terms of building boats below the cost estimated in
pricing custom orders. Carl is a supervisor, and his salary is included in manufacturing
overhead. He knows that overhead costs of $57.60 per direct labor hour are assigned to
each boat. On job 20130, estimated cost was $75,000 and, although the boat is only 80
percent complete, costs assigned to the job are already around $70,000.
To cut costs, Carl personally works on completing the boat and assigns craftsmen
to other jobs, saving 40 direct labor hours. This results in the following apparent cost
savings:
Direct labor (80 hours × $38 per hour) $3,040
Overhead (40 × $57.60) 2,304
Total apparent savings $5,344
Now let’s ask ourselves: “How much cost did reducing direct labor hours really save
the company?” The answer, as in many cases, is “It depends!” Suppose the company isn’t
at capacity and craftsmen typically work and get paid for a 40-hour workweek. There is
no overtime. In this case, no direct labor is being saved by Carl taking over for craftsmen
on job 20130.
And how much overhead is saved by reducing direct labor? Let’s assume that 90 per-
cent of overhead is fixed. Then clearly the most overhead saved is 10 percent of the $2,304
of overhead, or $230. Thus, in this case, Carl has pulled himself away from his import-
ant job of supervising workers in order to look better with respect to his performance
measure. And the accounting system is making it look like he has indeed saved $5,344
when he may have saved only $230 or less! Why did this happen? The performance
measure used to evaluate Carl led him to cut direct labor even when it apparently wasn’t
a good idea. This clearly makes the point that “You get what you measure!” It’s critical
to carefully consider the effects of performance measures on the behavior of managers.
Activity-Based Costing (ABC) and Multiple Overhead Rates

Many companies allocate overhead to jobs using a single overhead rate with an alloca-
tion base of direct labor. However, overhead costs are created by a variety of factors, and
allocating costs just on the basis of labor, or any single allocation base, may seriously
distort product costs.
Activity-based costing (ABC) is a method of assigning overhead costs to products
using a number of different allocation bases. In the ABC approach, the major activities
that create overhead costs are identified. The costs of the major activities are grouped
into so-called cost pools. Multiple overhead rates are calculated by dividing the amount
of each cost pool by a measure of its corresponding activity (referred to as a cost driver).
Overhead is then assigned to a product based on how much of each activity (cost driver)
it caused. The topic of ABC costing is examined in detail in Chapter 6.
Which of the following is false with respect to manufacturing overhead?
a. Manufacturing overhead is allocated to jobs using a predetermined overhead rate.
b. A predetermined overhead rate is calculated by dividing estimated overhead by an
estimate of the allocation base.
c. The difference between overhead applied and actual overhead may be closed to
either Cost of Goods sold or apportioned among Cost of Goods Sold, Work in
Process, and Finished Goods.
d. Actual overhead is a cost indicated on a Job Cost Sheet.
Learning Predetermined Overhead Rates

Objective 5
Companies can develop overhead rates by dividing actual overhead by the actual level of
Explain the role of a the allocation base. Most companies do not follow this practice, however, because total
predetermined over- actual overhead cost and the total actual level of the allocation base are not known until
head rate in applying the end of the accounting period, making it impossible to determine the actual overhead
overhead to jobs, and rate until that time. In many cases, however, an immediate cost figure is also needed to
explain the treatment determine the profitability of jobs.
of the difference Typically, then, overhead rates are based on estimates of overhead cost and estimates
between actual of the level of the allocation base rather than on actual costs and quantities. Overhead
overhead and overhead rates calculated in this way are referred to as predetermined overhead rates (also called
allocated to jobs using a budgeted overhead rates). Once the estimated overhead cost and estimated allocation
predetermined rate. base are established, the predetermined overhead rate is obtained by dividing the esti-
mated overhead by the estimated level of the allocation base:
Estimated total overhead cost
Predetermined overhead rate =
Estimated level of alloction base
Let’s return to our example of Eastlake Motorboat Company. Suppose management
estimates that $720,000 of total manufacturing overhead will be incurred in the coming
year and that 12,500 labor hours will be required. In that case, the predetermined over-
head rate is $57.60 per labor hour ($720,000 ÷ 12,500), and a job requiring 600 direct
labor hours to complete would be allocated $34,560.00 of overhead ($57.60 × 600 labor
hours).
The estimated or budgeted overhead cost and the estimated level of the allocation
base are generally estimated for a year so that the overhead allocation rate stays the same
from month to month. If a shorter period, such as one month, were used, the overhead
rate would fluctuate from month to month, causing identical jobs produced in different
months to have different costs. This happens because some overhead charges only occur
in certain months. For example, in summer months, extra power costs may be incurred
because the plant is air-conditioned. Another reason for fluctuation in a shorter period
of time is that overhead includes both variable and fixed cost items. When expected levels
P r e d e t e r m i n e d O v e r h e a d R a t e s 59
of the allocation base decrease, the expected amount of variable overhead also decreases.
However, the expected amount of fixed overhead does not decrease. Thus, the overhead
rate is likely to be higher in slow months.
Eliminating Overapplied or Underapplied Overhead

As indicated earlier, recording manufacturing overhead is a two-step process. First, the
actual costs of various overhead items are accumulated in the Manufacturing Overhead
account. Second, overhead is applied to individual jobs using the predetermined over-
head rate. This increases Work in Process and decreases Manufacturing Overhead.
Thus, two types of entries are made to the Manufacturing Overhead account: The debit
entries record actual overhead costs incurred, and the credit entries record the amount
of overhead applied to jobs in process.
Actual overhead Overhead costs
costs incurred applied to jobs
Unless estimated overhead equals actual overhead and the estimated level of the allo-
cation base equals the actual level of the allocation base, the amount of overhead applied
to jobs using a predetermined overhead rate will not equal actual overhead cost incurred.
Because estimates are seldom perfectly accurate, there is likely to be a difference between
the debits to manufacturing overhead (recording actual overhead costs) and the credits
to manufacturing overhead (recording the amount of overhead applied to jobs using the
predetermined overhead rate). The difference is referred to as underapplied overhead
if actual overhead is greater than the amount of overhead applied and as overapplied
overhead if actual overhead is less than the amount applied.
At the end of the accounting period, the amount of under- or overapplied overhead
is equal to the balance in Manufacturing Overhead. This account must be closed, and
accounts must be adjusted to reflect actual overhead costs. If a reasonable job of esti-
mation has been done in developing the predetermined overhead rate, the amount of
over- or underapplied overhead will not be large. In this case, most companies simply
close the account and adjust Cost of Goods Sold.
For example, suppose a company had $50,000 of actual overhead and applied
$48,000 to jobs using a predetermined overhead rate. In this case, overhead is underap-
plied by $2,000, the debit balance in the manufacturing overhead account. To close the
account, the following journal entry is made:
(date) Cost of Goods Sold 2,000.00
To close manufacturing overhead and
eliminate underapplied overhead
Theoretically, the amount of under- or overapplied overhead should be apportioned
among Work in Process, Finished Goods, and Cost of Goods Sold. This follows from
the fact that use of a predetermined rate results in job costs that differ from the actual
cost of jobs by the amount of over- or underapplied overhead. Because the cost of jobs
is reflected in Work in Process, Finished Goods, and Cost of Goods Sold, all of these
accounts should be adjusted to reflect actual overhead costs.
Apportioning costs among Work in Process, Finished Goods, and Cost of Goods
Sold can be accomplished based on the relative cost recorded in these accounts. For
example, suppose a company has Work in Process of $10,000, Finished Goods of $10,000,
Cost of Goods Sold of $20,000, and underapplied overhead of $2,000. The apportionment
rate would be $.05 for each dollar in the accounts (i.e., $2,000 ÷ $40,000). Thus, Work
in Process would receive $500, Finished Goods would receive $500, and Cost of Goods
sold $1,000. The following journal entry would be made:
(date) Work in Process Inventory 500.00

Finished Goods Inventory 500.00
Cost of Goods Sold 1,000.00
To apportion underapplied overhead
Whether the amount of over- or underapplied overhead is applied to Cost of Goods

Sold or apportioned among Work in Process, Finished Goods, and Cost of Goods
Sold depends on the dollar value of over- or underapplied overhead. If the amount is
immaterial (i.e., relatively small), it is sufficient for practical purposes simply to debit
(for underapplied overhead) or credit (for overapplied overhead) the amount to Cost
of Goods Sold. If the amount is material (i.e., relatively large), it should be apportioned
among Work in Process, Finished Goods, and Cost of Goods Sold.
Overapplied overhead is.
a. Overhead applied to production greater than actual overhead.
b. Overhead in excess of standard overhead.
c. Equal to the predetermined overhead rate.
d. Overhead in excess of the amount in the previous period.
Learning Job-Order Costing for Service

Objective 6
Companies
Explain how service
companies can use All the examples used so far have involved manufacturing companies, but many service
job-order costing to companies also use job-order costing (e.g., hospitals, law firms, accounting firms, con-
calculate the cost of sulting companies, and repair shops). For example, a hospital might want to know the
services provided to cost of treating a patient. In this case, the patient becomes a “job,” and costs incurred in
customers. treating the patient (cost of physician and nursing care, cost of medicine, cost of X-rays,
etc.) are accumulated on a report much like a job cost sheet used in a manufacturing
setting. Repair shops also use job costing systems. When you bring your car in for ser-
vice, the repair shop traces labor and parts to a job cost sheet that becomes your bill.
Typically, these shops do not assign overhead to jobs. Rather, they mark up the charges
for labor and parts to cover overhead and generate profit.
Consider the company Kendall/Allan, a consulting firm that specializes in installing
computer information systems. Each consultant keeps track of his or her time and at the
end of the month fills out a time sheet that indicates how much time was spent on each
consulting engagement. For purposes of the company’s accounting system, each consult-
ing engagement is considered to be a “job.” The data from the time sheets are then posted
on job cost sheets (see Illustration 2-16). Consultants also keep track of so-called billable
items that include the cost of software and training manuals provided to customers.
These costs are also entered on job cost sheets. Note that this is much like the accumu-
lation of direct labor and direct materials on the job cost sheets of manufacturing firms.
J o b - O r d e r C o s t i n g f o r S e r v i c e C o m p a n i e s 61
To allocate overhead to jobs, Kendall/Allan must develop a predetermined overhead

rate using estimated overhead and an allocation base. Overhead for the company would
include depreciation of the company’s office building; depreciation of computers, fax
machines, and other office equipment; utilities; salaries of office staff; and other indirect
costs. The company has decided that these overhead costs are most highly associated with
the salaries paid to consultants. At the start of the year, the company estimates that over-
head will be $4,000,000 and consultants’ salaries will be $20,000,000. Thus, the predeter-
mined overhead rate is 20 percent of consultants’ salaries. As indicated in Illustration 2-16,
consultants’ salaries charged to the job performed for Design Works, Inc. are $2,782.25.
Therefore, $556.45 of overhead is assigned to this job (.20 × $2,782.25). In total, the cost
of the job for Design Works is $9,332.55, and this is made up of $2,782.25 of consultant
cost, $5,993.85 of billable items, and $556.45 of overhead.
Comprehensive Example
To expand your understanding of how job-order costing applies to service companies,
let’s work through a more comprehensive example. India Call Management Services
(ICMS) is a company located in Bangalore, India. It provides call service management
to 26 large companies located primarily in the United States and the United Kingdom.
Each customer is considered a “job,” and the cost of the job is determined monthly.
The amount charged to each customer is negotiated annually, and ICMS tries to earn
a return of 30 percent above full cost. It is important for ICMS to determine the cost
of servicing each customer so that customer profitability can be assessed. If it turns
out that actual costs are higher or lower than anticipated when the annual contract
was negotiated, the company will take this into account when contracts come up for
renegotiation.
Illustration 2-16
Job cost sheet for a service
firm
Client Design Works, Inc.
Engagement Installation of billing system linked to existing G/L program.
Consultant time
Reference Date Name Hours Rate Total
S325 15-Feb S. Wilson 8.0 45.50 $ 364.00
S325 15-Feb H. Starr 8.0 65.50 524.00
S326 16-Feb S. Wilson 8.0 45.50 364.00
S326 16-Jan H. Starr 8.0 65.50 524.00
S326 16-Feb J. Kendall 3.5 125.00 437.50
S327 19-Feb S. Wilson 8.0 45.50 364.00
S328 20-Feb S. Wilson 4.5 45.50 204.75
Total 2,782.25
Billable items
Reference Description
E8102 SQA software 5,868.25
E8156 SQA training manual 125.60
Total 5,993.85
Overhead (20% of consultant salary) 556.45
Total cost $9,332.55
One of ICMS’s customers is RCP Communications. The contract with this com-
pany is $4.2 million per year, or $350,000 per month. In early July, ICMS determined
the cost of providing services to RCP Communications. Illustration 2-17 shows the
analysis.
The call center employs 60 operators over three shifts dedicated to the RCP account.
The operators are paid, on average, $15.75 per hour. Thus, the job is charged $151,200
of operator cost.
The operators process calls at 20 workstations that are dedicated to the RCP
account. In total, the 20 workstations cost $500,000, and each workstation has a 4-year
life. Thus, depreciation for a month is $10,416.67.
ICMS operates out of a 60,000-square-foot facility with annual depreciation of
$1,000,000. This depreciation is allocated to the RCP account based on the square
feet occupied by the 20 workstations, which is 2,000. For one month, the allocation is
$2,777.78.
Each of the three shifts has a supervisor who is paid $4,500 per month. Thus, $13,500
of supervisory salary is assigned to the RCP account.
Finally, all remaining costs of operating the call center are assigned using an over-
head allocation rate of $1.053 per dollar of operator salary. The rate was determined
as follows. At the start of the year, ICMS estimated that the annual amount of all
costs other than operator salary, depreciation of workstations, depreciation of facility,
and shift supervisor salary would amount to $38,782,800. Additionally, the company
estimated that annual operator salaries would be $36,843,660. With this information,
the rate was calculated to be $1.053 per dollar of operator salary (i.e., $38,782,800 ÷
$36,843,600).
Is RCP a profitable customer? Note that the total cost of the job for June was
$337,108.50. The monthly revenue for the job is $350,000, which is one-twelfth of the
annual revenue of $4.2 million. With profit on the job equal to $12,891.95 ($350,000 −
$337,108.50), the mark up over cost is only 3.8 percent, which is much lower than the com-
pany’s goal of 30 percent. This information will be very useful the next time the contract
is up for negotiation—especially if RCP Communications presses for price concessions!
($350,000.00 − $337,108.50) ÷ $337,108.50 = .038
Illustration 2-17
Job-order cost for call center India Call Management Services
ICMS—Simply the Best
Customer: RCP Communications
Call center operators
60 operators × 160 hours × $15.75 per hour $151,200.00
Depreciation associated with
20 workstations costing $500,000 in total
($500,000 ÷ 4-year life) ÷ 12 months 10,416.67
Annual depreciation of $1,000,000 for 60,000-
square-foot building
2,000-square feet occupied by 20 workstations
(($1,000,000 ÷ 60,000 square feet) ÷ 12 months) × 2,000 square feet 2,777.78
3 shift supervisors × $4,500 monthly salary 13,500.00
Other overhead allocated at $1.053 × operator salary
$1.053 × $151,200 159,213.60
Total $337,108.05
M o d e r n M a n u f a c t u r i n g P r a c t i c e s a n d P r o d u c t C o s t i n g S y s t e m s 63
a. Service companies may use job-order costing.
b. Service companies may use a predetermined overhead rate.
c. Job-order costing is used by manufacturing firms, not service firms.
d. A consulting firm may use a job-order costing system.
Learning Modern Manufacturing Practices

Objective 7
and Product Costing Systems
Discuss modern
manufacturing practices To compete effectively in a global economy, many U.S. manufacturers made fundamental
and how they affect changes in their operations and business philosophies starting in the late 1980s. These
product costing. changes in the manufacturing environment affect the types of costs that are incurred and,
to some extent, the way the costs are recorded in the product costing system.
Here we briefly discuss three of the major changes: just-in-time production,
computer-controlled manufacturing, and total quality management. The purpose of
the discussion is to make sure you have a basic understanding of the setting in which
companies are calculating product costs. In addition, you need to speak the language
of top management and operating personnel if you want to have a significant impact
on important decisions. Increasingly, the language includes references to just-in-time
production, computer-controlled manufacturing, and total quality management.
Just-in-Time (JIT) Production

Japanese companies, following the lead of Toyota Motor Company, were the first to
use an innovative manufacturing system referred to as a just-in-time (JIT) system.
One important goal of such manufacturing systems is to minimize inventories of raw
materials and work in process. Companies with JIT systems make arrangements with
suppliers to deliver materials just before they are needed in the production process. In
addition, when products need to be manufactured on multiple production lines (e.g.,
first a production line that involves welding and then a production line that involves
machining), production on one line is scheduled so that operations are completed just
in time to meet the requirements of the next production line. With such a system,
there is no buildup of raw material and work in process inventories to clog the factory
floor. It is partly for this reason that JIT systems are also referred to as lean production
systems. With JIT, there is no “fat” associated with wasted space and excess investment
in inventory.
JIT is, however, much more than an effort to reduce companies’ investments in
inventory. The goals of a JIT system are to develop a balanced production system
that is flexible and allows for smooth, rapid flow of materials. To achieve these goals,
companies using JIT concentrate on improving quality (since quality problems dis-
rupt the production system), eliminating production breakdowns, and preventing
missed delivery deadlines by suppliers. To improve coordination with suppliers,
many companies are using the Internet to link their production facilities to sup-
pliers (see the discussion in Chapter 1 on supply chain management). Dramatic
improvements in manufacturing performance have been attributed to use of JIT
Link to Practice
Lean Principles Are Not Just for And the hospital saved $180 million in capital expen-
Manufacturing Firms ditures by using its facilities more efficiently. According
to Ms. All, Akron Children’s Hospital performed an
While Lean principles were developed by manufacturing
overhaul of its process for sterilizing instruments, which
firms such as Toyota, they have been widely adopted by
helped it avoid a $3.5 million expansion of its surgery
service firms such as banks and hospitals. According
department.
to blogger Ann All, the president of Seattle Children’s
Hospital says that Lean improvement efforts cut costs Source: Ann All, Hospitals Use Lean Principles to Achieve
per patient by 3.7 percent, for a savings of $23 million. Efficiency Gains, July 14, 2010.
production. Some companies report 90 percent reductions in production lead

time, 89 percent reductions in work in process, and 80 percent reductions in space
required for production.1
JIT can also have an effect on product costing. What happens to over- or underap-
plied overhead when a company uses a JIT system? With a JIT system, Work in Process
and Finished Goods Inventory balances are generally quite small compared to the
balance in Cost of Goods Sold. Thus, the difference between assigning all of over- or
underapplied overhead to Cost of Goods Sold or allocating it among Work in Process,
Finished Goods, and Cost of Goods Sold is likely to be quite small. Thus, simply charging
the amount to Cost of Goods Sold is expedient and appropriate.
Lean Manufacturing. Closely related to JIT is the concept of lean manufacturing.
Indeed, some authors use the terms interchangeably. However, most people associate
JIT with an intense focus on inventory management, while they associate lean with
eliminating waste across the value chain.
Computer-Controlled Manufacturing
Many manufacturing companies are also using highly automated computer-controlled
manufacturing systems. Using computers to control equipment, including robots,
generally increases the flexibility and accuracy of the production process. But while
state-of-the-art equipment and computer-controlled systems may help firms meet the
challenge of global competition, they also have a significant effect on the composition
of product costs.
Survey data indicate that, on average, product costs in recent years have consisted
of 53 percent material, 15 percent direct labor, and 32 percent overhead. Some highly
automated companies, such as Hewlett-Packard, however, report that direct labor
accounts for as little as 3 percent of total production costs. Decreasing labor costs are
causing many companies to reconsider their overhead allocation bases. Currently, the
most commonly used allocation bases for assigning overhead to jobs are direct labor
hours and direct labor cost. However, in highly mechanized companies where direct
labor is a small part of total manufacturing costs, using labor as an allocation base is
generally not appropriate.
1
See for example, “The Just-In-Time Breakthrough: Implementing the New Manufacturing Basics,” Edward J.
Hay, 1988, John Wiley & Sons.
Link to Practice
Just-in-Time or Just-in-Case to hold more inventory. As in the last point, what
would happen if a snowstorm shut down highways
Companies that have adopted just-in-time systems have
and disrupted the flow of components needed for
generally found that they create shareholder value by
production?
reducing their investment in inventory and by eliminat-
ing costs associated with non–value-added activities. • A terrorist attack or pandemic flu outbreak could
However, in some cases it makes sense to hold sub- severely disrupt the supply chain of a company. But
stantial buffer inventory (i.e., inventory that buffers the should a company hold more inventory in light of
company from shocks to the smooth flow of inventory). these potential catastrophes? Obviously, companies
Here are some examples when holding more buffer have to weigh the cost of holding more inventory
inventory is appropriate: against the low probability but high cost of such
disastrous events.
• Expected price increases may make investing in an
inventory buildup a good financial move. The need for buffer inventory was very apparent after
• If a company’s supplier is in an undeveloped country the 2011 earthquake and tsunami in Japan. As a result
with poor infrastructure, it makes sense to hold more of the disaster, many factories, ports, and roads were
inventory. Think about what would happen if a bridge closed, impacting shipments of parts to the U.S. and
collapsed and needed materials could not reach the port other countries.
on a timely basis.
• If a company’s supplier is in an area where weather Source: The Associated Press, “Japan Crisis Disrupts Firms’
can disrupt transportation, it also makes sense Supply Routes,” The Seattle Times, (March 17, 2011), A14.
Investing in state-of-the-art equipment also changes the mix of fixed and variable
costs. When equipment is substituted for labor, fixed costs generally increase and variable
costs decrease.
Total Quality Management

To survive in an increasingly competitive environment, firms realize that they must
produce high-quality products. An increasing number of companies have instituted
total quality management (TQM) programs to ensure that their products are of
the highest quality and that production processes are efficient. Currently, there is no
generally agreed-on “right” way to institute a TQM program. However, most com-
panies with TQM develop a company philosophy that stresses listening to the needs
of customers, making products right the first time, reducing defective products that
must be reworked, and encouraging workers to continuously improve their production
processes.
Indeed, some TQM programs are referred to as continuous quality improvement
programs. At Marlow Industries, a manufacturer of thermoelectric cooling devices,
workers sign a Quality Pledge that reads: “I pledge to make a constant, conscious effort
to do my job right today, better tomorrow, recognizing that my individual contribution
is critical to the success of Marlow Industries.”
The results of an effective TQM program can be impressive. In a relatively
early effort, Sundstrand Data Control, a manufacturer of electronic instruments in
Washington state, found that its TQM program reduced rework on some instrument
production lines by 66 percent and scrap costs by 60 percent. The company also
Link to Practice
Can There Be Too Much Emphasis on Quality?
In Chapter 1 we identified a key idea in managerial accounting: You get what

You get what you
M e a s u r e you measure! Many companies have quality measures, but can there be too
much emphasis on quality?
Consider the case of Wallace Company, a Texas- measures with an emphasis on measures of financial per-
based industrial distributor of pipes, valves, and fit- formance, measures of innovation, and measures of cus-
tings that launched a “quality at all cost” campaign. tomer satisfaction. Otherwise, they may end up producing a
Apparently, the campaign was suc- high-quality product that customers don’t
cessful, since the company won the want or for which customers are unwilling
prestigious Malcolm Baldrige National National Institute of Standards and Technology. to pay a premium price.
Courtesy Baldridgoz National Quality Program/
Quality Award. However, in the year Perhaps not surprisingly, given the
the company won the award, it had a financial difficulties of the Wallace
$691,000 loss on sales of $88 million. Company and others that have won the
While racking up financial losses, the Baldrige Award, the criteria for winning
company was processing 100 requests the award have shifted. There is now
a day for information about its quality less emphasis on quality and more
programs! John Wallace, CEO, noted: emphasis on financial results. In 1988,
“We spent too much time telling the when the Baldrige award was launched,
story [about quality] and should have the word quality appeared 13 times in
been out drumming up more business.” the point scoring summary. In 2001, the
The point of this example is not to Baldrige Award. word quality does not appear even once
suggest that emphasis on high quality in the scoring summary. And in 2001,
is a bad idea—far from it. For example, General Electric 450 out of the 1,000 maximum points for winning the
has a quality program aimed at reducing product defects, award relate to financial performance!
which is called the Six Sigma program. This program is Source: “Is the Baldrige Award Still About Quality?” Richard
cited as a major factor in GE’s continuing earnings growth. Schonberger, qualitydigest.com, www.qualitydigest.com/
However, companies must balance the emphasis on quality dec01.html/baldrige.html.
reduced cycle time (the time it takes to produce a product from beginning to end) by
90 percent.2
How does TQM affect product costing systems? Strong advocates would argue that
without TQM, there is no need for product costing, since companies without TQM will
not survive! Undoubtedly there is some truth to this position. In addition, TQM affects
product costing by reducing the need to track the cost of scrap and rework related to each
job. If TQM is able to reduce these costs to an insignificant level, the benefit of tracking
the costs is unlikely to exceed the cost to the accounting system.3
Decision Making
When using job cost information to make a decision, care must be taken because
Insight some costs going into a job are fixed (e.g., depreciation on equipment that is
included in manufacturing overhead) and some costs are variable (e.g., direct material
costs). Thus, the full cost of a job is not the same as the incremental cost of a job.
2
Steve Wilhelm, “Quality Program Keeps Spreading at Sundstrand, ”Puget Sound Business Journal 11, No. 52
(May 13, 1991), Sec. 1, p. 17.
3
Many service firms, such as banks, insurance companies, and hospitals, have adopted the TQM programs
initially developed by manufacturers. TQM is especially popular in the healthcare field.
a. Use of computer-controlled manufacturing systems is likely to increase fixed costs.
b. Companies that utilize JIT are likely to have more raw materials inventory.
c. Companies that utilize JIT are likely to close the difference between actual over-
head and overhead applied using a predetermined overhead rate to cost of goods
sold.
d. A singular focus on quality could be counterproductive.

Learning Objective 1 Distinguish between Learning Objective 3 Discuss the types of
manufacturing and nonmanufacturing costs and product costing systems and explain the relation
between product and period costs. between the cost of jobs and the Work in Process
Manufacturing costs include all the costs associated with the Inventory, Finished Goods Inventory, and Cost of
production of goods. They include direct material, direct labor, Goods Sold accounts.
and manufacturing overhead. Nonmanufacturing costs are all There are two types of product costing systems: job-order sys-
the costs not associated with the production of goods. Selling tems and process costing systems. Companies using job-order
and general and administrative costs are nonmanufacturing systems generally produce individual products or batches of
costs. Costs can also be classified as either product costs or products that are unique. Companies using process costing
period costs. Product costs are identical to manufacturing costs systems generally produce large quantities of identical items in
and include direct labor, direct material, and manufacturing a continuous production operation.
overhead. Product costs are considered an asset (inventory) Work in Process Inventory includes the cost of all jobs that
until finished goods are sold. When the goods are sold, the are currently being worked on; Finished Goods Inventory
product costs are expensed. Period costs, however, are expensed includes the cost of all jobs that are completed but not yet sold;
in the period in which they are incurred. Period costs include and Cost of Goods Sold includes the cost of all jobs that are sold
both selling and general and administrative costs, which are during the accounting period.
also referred to as nonmanufacturing costs.
Learning Objective 2 Discuss the three inventory Learning Objective 4 Describe how direct
accounts of a manufacturing firm and describe material, direct labor, and manufacturing overhead
the flow of product costs in a manufacturing firm’s are assigned to jobs.
accounts. Job cost sheets track the direct material, direct labor, and manu-
The three inventory accounts are Raw Materials Inventory, facturing overhead cost of each job. Direct material cost is traced
Work in Process Inventory, and Finished Goods Inventory. Raw to jobs by means of material requisition forms. Direct labor is
Materials Inventory includes the cost of the materials on hand traced to jobs by means of labor time tickets. Manufacturing
that are used to produce a company’s products. Work in Process overhead is applied to jobs using an overhead rate.
Inventory is the inventory account for the cost of goods that are
only partially completed. Finished Goods Inventory is the account Learning Objective 5 Explain the role of a
for the cost of all items that are complete and ready to sell. predetermined overhead rate in applying overhead
As they are incurred, product costs are assigned to Work in
to jobs and explain how the difference between actual
Process Inventory. When the items in work in process are com-
pleted, the cost of the completed items is removed from Work in
overhead and overhead allocated to jobs using a
Process and added to Finished Goods. When the finished goods predetermined rate is treated.
are sold, the cost of the items sold is removed from Finished Most companies apply overhead to jobs using a predetermined
Goods and added to Cost of Goods Sold Expense. Thus, prod- overhead rate rather than an actual overhead rate. Actual over-
uct costs become an expense when completed items are sold. head cannot be determined until the end of the accounting
period, and companies cannot wait until the end of the period information system) for a specific client is a “job.” Using job-
before applying overhead to jobs. order costing, the salaries of consultants are charged to the job
If the amount of overhead applied to inventory does not as well as any materials provided to the client. Materials might
equal actual overhead, the difference must be apportioned include training manuals or software. Overhead, such as depre-
among Work in Process, Finished Goods, and Cost of Goods ciation of office equipment, utilities, and the salaries of office
Sold. This adjusts the accounts to reflect actual overhead costs. staff, is assigned to a job using a predetermined overhead rate.
If the amount of under- or overapplied overhead is small, the
balance can be closed to Cost of Goods Sold. Learning Objective 7 Discuss modern manufac-
turing practices and how they affect product costing.
Learning Objective 6 Explain how service
U.S. companies face stiff competition from companies abroad.
companies can use job-order costing to calculate In response, many have adopted manufacturing systems that
the cost of services provided to customers. minimize inventories of raw materials and work in process.
Much like manufacturing firms, service companies such as In addition, many companies have become highly automated
hospitals, law firms, accounting firms, consulting companies, and have instituted total quality management programs. JIT
and repair shops use job-order costing. Using job-order costing, production systems have reduced inventory levels, automa-
they assign wages, various material costs, and overhead to “jobs.” tion has increased levels of overhead and fixed costs, and total
Consider a consulting firm that provides services to various quality management programs have reduced product defects
clients. A specific engagement (e.g., installation of a computer and waste.
Review Problem 1
Ellie Richard’s Commercial Flooring installs stone, tile, and carpet flooring in office buildings, con-
dominiums, and restaurants. The company traces labor and materials to each job, but overhead is
assigned based on labor hours. At the start of the year, the company estimated overhead as follows:
Rent $ 35,000
Depreciation of trucks 25,000
Supervisor salaries 150,000
Other overhead 20,000
$235,000
Total labor hours were estimated to be 11,520.

During the first week in December, the company started and completed a job installing black granite
tiles in the remodeled lounge of Joey D’s Restaurant. In total, the job took 36 hours. The average
wage rate of installers is $35 per hour. Materials for the job including tiles and grouting cost $7,500.
Req u i red
a. What is the cost of the job?
b. Assuming that the company charges $80 per installer hour plus the cost of materials, with a
markup of 30 percent, what was the profit on the job?
An s w er
a. The overhead rate is $20.40 per labor hour ($235,000 ÷ 11,520 labor hours). Thus, the cost of
the job is:
Labor
36 hours × $35 per hour $1,260.00
Materials 7,500.00
Overhead
$20.40 × 36 hours 734.40
Total $9,494.40
b. Charges are $12,630. Thus, the profit on the job is $3,136.60.

Labor $80 × 36 hours $ 2,880.00
Materials $7,500 × 1.3 9,750.00
Total charges 12,630.00
Less cost of job (9,494.40)
Profit $ 3,135.60
Review Problem 2
Herbert Plumbing Products produces a variety of valves, connectors, and fixtures used in commercial
and residential plumbing applications. The company has a just-in-time inventory and production
system, and it has relatively small amounts of material, work in process, and finished goods inventory.
At the end of October, the company had $20,000 of raw material inventory. In addition, jobs
281 and 282 were in process and job 279 was complete and awaiting shipment. The job cost sheets
for these jobs were as follows:
End of October
Direct Material Direct Labor Overhead Total Job Status
Job 279 $50,000 $15,000 $30,000 $ 95,000 Finished but not shipped
Job 281 20,000 5,000 10,000 35,000 In process
Job 282 60,000 20,000 40,000 120,000 In process
During November, the company began work on Jobs 283, 284, and 285. The status of the jobs at
the end of November is as follows:
End of November
Direct Material Direct Labor Overhead Total Job Status
Job 279 $50,000 $15,000 $30,000 $ 95,000 Shipped

Job 281 25,000 8,000 16,000 49,000 Shipped
Job 282 62,000 21,000 42,000 125,000 Shipped
Job 283 30,000 20,000 40,000 90,000 Shipped
Job 284 80,000 30,000 60,000 170,000 Shipped
Job 285 15,000 10,000 20,000 45,000 In process
Also during November, Herbert Plumbing Products purchased $120,000 of materials and incurred
$130,000 of actual overhead costs. The company charges over- or underapplied overhead to Cost
of Goods Sold.
Req u i red
Assume that all material used in November is direct.
a. What is the balance in Raw Materials Inventory at the end of November?
b. What is the balance in Work in Process Inventory at the end of November?
c. What is the balance in Finished Goods Inventory at the end of November?
d. What is the cost of goods manufactured for the month of November?
e. What is the cost of goods sold for the month of November?
An s w er
a. The beginning balance in raw materials inventory is $20,000.
Purchases are $120,000.

Inventory used in November:
Job 281 $ 5,000
Job 282 2,000
Job 283 30,000
Job 284 80,000
Job 285 15,000
Total $132,000
Beginning balance + Purchases − Amount used = Ending balance

$20,000 + $120,000 − $132,000 = $8,000
b. The ending balance in Work in Process Inventory is the cost of jobs in process at the end of
November. This is the cost of job 285, which is $45,000.
c. The ending balance in Finished Goods Inventory is the cost of jobs that are completed but
not shipped. Since all completed jobs have been shipped, the balance is zero.
d. The beginning balance in Work in Process Inventory is:
Job 281 $ 35,000

Job 282 120,000
Total $155,000
Additional costs added during November are:

Material cost $ 132,000 per part a
Direct labor cost
Job 281 $ 3,000
Job 282 1,000
Job 283 20,000
Job 284 30,000
Job 285 10,000 64,000
Overhead
Job 281 6,000
Job 282 2,000
Job 283 40,000
Job 284 60,000
Job 285 20,000 $ 128,000
Total $324,000
The ending balance in Work is Process Inventory is $45,000 per part b.
Beginning balance in WIP Inventory + Current manufacturing costs − Ending balance

in WIP Inventory = Cost of goods manufactured
$155,000 + $324,000 − $45,000 = $434,000
e. Beginning balance in Finished Goods Inventory is the cost of job 279, which is $95,000.
Cost of Goods Manufactured is $434,000, per part d.
Ending balance in Finished Goods Inventory is zero, per part c.
Beginning balance in Finished Goods Inventory + Cost of goods manufactured − Ending

balance in Finished Goods Inventory = Cost of goods sold
$95,000 + $434,000 − 0 = $529,000

S e l f - A s s e s s m e n t 71
Alternatively, we could simply add up the cost of jobs shipped this period:
Job 279 $ 95,000
Job 281 49,000
Job 282 125,000
Job 283 90,000
Job 284 170,000
Total $529,000
Note, however, that actual overhead is $130,000, while overhead applied to production at the
standard rate of $2 per dollar of direct labor is $128,000 per part d. Thus, cost of goods sold
must be increased by $2,000.
Cost of goods sold = $529,000 + $2,000 = $531,000
Key Terms Activity-based costing General and Administrative Overhead allocation rate (52)
(ABC) (57) Costs (39) Overhead applied (52)
Allocation base (52) Indirect labor costs (39) Period costs (40)
Computer-controlled manufac- Indirect materials (39) Predetermined overhead rates (58)
turing systems (64) Job (46) Process costing system (46)
Cost driver (57) Job cost sheet (48) Product costing system (36)
Cost of goods available for Job-order costing system (46) Product costs (40)
sale (45) Just-in-time (JIT) (63) Raw Materials Inventory (42)
Cost of goods manufactured (43) Manufacturing costs (38) Selling costs (39)
Cost pools (57) Manufacturing overhead (39) Time tickets (50)
Direct labor cost (39) Material requisition form (49) Total quality management
Direct material cost (38) Nonmanufacturing costs (39) (TQM) (65)
Finished Goods Inventory (43) Overapplied overhead (59) Underapplied overhead (59)
Full cost (41) Overhead allocation (56) Work in Process Inventory (42)

1. Which of the following is a period cost? 4. The beginning balance in Finished Goods Inventory is
a. Raw materials costs. $50,000, the ending balance in Finished Goods Inven-
b. Manufacturing plant maintenance. tory is $100,000, and Cost of Goods Manufactured is
$200,000. What is Cost of Goods Sold?
c. Wages for production-line workers.
a. $100,000 c. $150,000
d. Salary for the vice president of finance.
b. $250,000 d. None of the above.
2. Full costing includes which of the following in deter- 5. Which entity would most likely use a job-order costing
mining product cost? system?
a. Only variable costs of production. a. Textile manufacturer.
b. Only fixed costs of production. b. Concrete block producer.
c. Administrative overhead. c. Petroleum refiner.
d. All fixed and variable costs of production. d. Antique automobile restorer.
3. Cost of Goods Sold is $200,000, the beginning balance 6. The predetermined overhead rate is determined as:
in Finished Goods Inventory is $50,000, the ending a. Estimated overhead costs divided by estimated
balance in Finished Goods Inventory is $100,000, and allocation base.
the ending balance in Work in Process Inventory is b. Actual overhead costs divided by estimated
$10,000. What is Cost of Goods Manufactured? allocation base.
a. $100,000 c. Estimated overhead costs divided by actual
b. $250,000 allocation base.
c. $50,000 d. Actual overhead costs divided by actual allocation
d. None of these answer choices is correct. base.
7. Overhead is overapplied if: c. Do not cost their services.

a. The actual overhead rate is greater than the d. Produce durable products.
budgeted overhead rate. 10. All of the following are true about just-in-time (JIT)
b. The Manufacturing Overhead account has a credit production except:
balance at the end of the period. a. JIT seeks to minimize inventories of raw materials
c. The actual overhead rate is greater than the rate and work in process.
used in prior periods. b. JIT is often referred to as “fat” production.
d. The overhead rate is material. c. JIT companies concentrate on improving quality.
8. Compared to traditional methods of allocating over- d. JIT companies need dependable suppliers.
head, activity-based costing (ABC) uses:
a. More allocation bases.
Answers to Self-Assessment
b. Only allocation bases related to direct labor.
c. Machine hours as an allocation base. 1. d 2. d 3. b 4. c 5. d 6. a
7. b 8. a 9. b 10. b
d. None of these answer choices is correct.
9. Service companies:
a. Do not use job-order costing.
b. Often use job-order costing.
Questions 1. What is the difference between manufacturing and nonmanufacturing costs?

2. What is the difference between product and period costs?
3. Identify the two most common types of product costing systems and discuss the manufacturing
environments associated with each system.
4. What is a job cost sheet? What information does it contain?
5. Why do companies apply overhead to jobs using a predetermined (budgeted) overhead rate
instead of applying actual overhead to jobs?
6. Discuss an important characteristic of a good overhead allocation base.
7. Some modern, capital-intensive production facilities have significantly reduced the propor-
tion of direct labor cost to total production cost. Discuss the effect this might have on the
selection of an allocation base for the application of overhead.
8. When might it be necessary to assign over- or underapplied overhead to Finished Goods,
Work in Process, and Cost of Goods Sold?
9. Would an unexpected increase in sales and production result in underapplied or overapplied
overhead? Explain.
10. As companies move to computer-controlled manufacturing systems, what happens to the mix
of product costs (direct material, direct labor, and manufacturing overhead)?
Exercises EXERCISE 2-1. You Get What You Measure! [LO 4] Consider three very similar companies.
Company A allocates manufacturing overhead to jobs using labor hours as the allocation base;
Company B allocates manufacturing overhead to jobs using machine hours as the allocation
base; and Company C allocates manufacturing overhead to jobs using material cost as the
allocation base.
R equ i r ed
Explain why, in spite of the fact that the companies are very similar, supervisors at Company A
are very focused on controlling labor, whereas supervisors at Company B are very focused on
controlling machine run time, and supervisors at Company C are very focused on controlling
material costs. Use the concept of “You get what you measure!” in your answer.
EXERCISE 2-2. Just-in-Time Manufacturing and Assigning Over- or Underapplied Overhead

[LO 5, 7] At Star Plastics, the balance in manufacturing overhead (which represents over- or under-
applied overhead) is always closed to Cost of Goods Sold. This is done even when the balance is
relatively large. Suzette Barger, the controller, explains that this makes sense because Star uses a
just-in-time (JIT) manufacturing system and jobs are shipped to customers within hours of being
completed.
Req u i red
Write a paragraph elaborating on the justification provided by Suzette Barger. Why is there no need
to apportion the balance in manufacturing overhead among Work in Process, Finished Goods,
and Cost of Goods Sold?
EXERCISE 2-3. Applying Overhead to Jobs [LO 4, 5] At Precision Custom Molds, manufactur-
ing overhead was estimated to be $20,000,000 at the start of the year and direct labor hours were
estimated to be 200,000. Overhead is applied to jobs using a predetermined overhead rate with
direct labor hours as the allocation base. During the current year, Job 525 was assigned 25 labor
hours. How much overhead was applied to this job?
EXERCISE 2-4. Product Costing Systems [LO 3] For the list of product manufacturers below,
indicate whether a job-cost system (J) or a process-cost system (P) would be most appropriate.
______ a. Chemicals processor
______ b. Paint manufacturer
______ c. Law firm
______ d. Producer of molds used by other manufacturing firms to shape their products
______ e. Dog food producer
______ f. Custom home builder
EXERCISE 2-5. Inventory-Related Accounts [LO 1, 2] Place Y (yes) beside the general ledger
accounts related to inventory in a job-order cost system and N (no) by those that are not.
______ a. Raw Materials Inventory
______ b. Administrative Expense
______ c. Work in Process Inventory
______ d. Finished Goods Inventory
______ e. President’s salary
______ f. Cost of Goods Sold
______ g. Manufacturing overhead
______ h. Advertising expense
EXERCISE 2-6. Recording Material Cost in Job-Order Costing [LO 2, 4] During the month of
August, Star Plastics had material requisitions for $200,000 of materials related to specific jobs and
$10,000 of miscellaneous materials classified as overhead.
R equ i red
Prepare journal entries to record the issuance of materials during August.
EXERCISE 2-7. Recording Material Cost in Job-Order Costing [LO 2, 4] Five material requisi-
tions (MR) forms were received by the materials storeroom of the Saint Louis Foundry during the
first week of 2014. MR101 was for $250 of direct materials for job number 1501. MR102 was for
$350 of direct materials for job number 1502. MR103 was for $100 of indirect materials issued to
the factory floor. MR 104 was for $400 of direct materials issued to job number 1501. MR105 was
for $500 of direct materials issued to job number 1503.
Req u i r ed
Prepare summary journal entries to record the issuance of these materials. (Hint: There should be
a separate journal entry for direct and indirect materials.)
EXERCISE 2-8. Recording Labor Cost in Job-Order Costing [LO 2, 4] During the month of
August, Star Plastics had $70,000 of labor costs that were traced to specific jobs. The company also
had $50,000 of indirect labor related to supervisory pay.
Req u i r ed
Prepare journal entries to record labor cost during August. (Hint: There should be separate journal
entries for direct and indirect labor.)
EXERCISE 2-9. Recording Labor Cost in Job-Order Costing [LO 2, 4] Johnson Products had
the following labor time tickets for the month of February:
Ticket # Employee # Pay Rate Hours Worked Job #

2101 011 $10.00 110 201
2102 008 21.00 90 201
2103 011 12.00 40 201
2104 008 20.00 50 202
2105 008 18.00 70 203
Req u i r ed
a. Calculate the amount of direct labor cost assigned to each job.
b. Summarize the labor time tickets and prepare a journal entry to record direct labor for the month.
EXERCISE 2-10. Overhead Allocation Bases [LO 5] Lawler Manufacturing Company expects
annual manufacturing overhead to be $900,000. The company also expects 60,000 direct labor
hours costing $1,800,000 and machine run time of 30,000 hours.
Req u i r ed
Calculate predetermined overhead allocation rates based on direct labor hours, direct labor cost,
and machine time.
EXERCISE 2-11. Service Company Allocation of Overhead [LO 4, 5, 6] Franklin Computer

Repair treats each repair order as a job. Overhead is allocated based on the cost of technician time.
At the start of the year, annual technician wages were estimated to be $800,000, and company
overhead was estimated to be $500,000.
Req u i r ed
a. Discuss why use of a predetermined overhead rate would be preferred to assigning actual over-
head to repair jobs.
b. Suppose a job required parts costing $200 and technician time costing $100. What would be the
total cost of the job?
EXERCISE 2-12. Allocating Manufacturing Overhead to Jobs [LO 4, 5] Webber Fabricating

estimated the following annual hours and costs:
Expected annual direct labor hours 40,000

Expected annual direct labor cost $ 625,000
Expected machine hours 20,000
Expected material cost for the year $ 800,000
Expected manufacturing overhead $1,000,000
Req u i red
a. Calculate predetermined overhead allocation rates using each of the four possible allocation
bases provided.
b. Determine the cost of the following job (number 253) using each of the four overhead allocation
rates:
Job 253
Direct materials $3,000
Direct labor (150 hrs @ $12/hr) $1,800
Machine hours used 150
EXERCISE 2-13. Recording Actual Overhead and Overhead Applied to Jobs [LO 2, 4, 5]
During the month of August, Star Plastics applied overhead to jobs using an overhead rate of
$3 per dollar of direct labor. Direct labor in August was $100,000. Actual overhead in August was
$260,000. Assume that actual overhead was composed of the following items.
Indirect materials $ 40,000

Indirect labor 80,000
Utilities 25,000
Depreciation 60,000
Repair expense 55,000
Total $260,000
Req u i red
a. Prepare a journal entry to record overhead applied to jobs.
b. Prepare a journal entry to record actual overhead.
EXERCISE 2-14. Closing the Manufacturing Overhead Account [LO 5] Refer to the information
in Exercise 2-13.
Req u i red
a. Determine the balance in manufacturing overhead, and prepare a journal entry to close the
balance to cost of goods sold.
b. Why is it important to close the balance in manufacturing overhead?
c. Assume that Star Plastics uses a JIT inventory system. What is the justification for assigning the
balance in manufacturing overhead to Cost of Goods Sold rather than apportioning it to Work in
Process, Finished Goods, and Cost of Goods Sold?
EXERCISE 2-15. Cost of Jobs [LO 4, 5] Milton Company is a steel fabricator, and job 325 con-
sists of producing 500 steel supports for Wendell Construction Company. Overhead is applied
on the basis of direct labor hours, using a predetermined overhead rate of $25 per hour. Direct
costs associated with Job 325 are: direct materials, $10,000; direct labor, 250 hours at $16 per
hour.
Req u i red
Calculate the cost of Job 325.
EXERCISE 2-16. Service Company Use of Predetermined Overhead Rate [LO 4, 5, 6] Smith
and Baker Legal Services employs five full-time attorneys and nine paraprofessionals. Bud-
geted salaries are $100,000 for each attorney and $50,000 for each paraprofessional. Budgeted
indirect costs (e.g., rent, secretarial support, copying, etc.) are $210,000. The company traces
the cost of attorney and paraprofessional time to each client and uses the total to assign indi-
rect costs.
Req u i red
What amount of indirect cost would be assigned if services to a client required $25,000 of attorney
cost and $20,000 of paraprofessional cost? (Round overhead rate to 2 decimal places.)
EXERCISE 2-17. Underapplied and Overapplied Manufacturing Overhead [LO 8] Injection

Molding Services uses a job-order costing system. The account balances at the end of the period
for the product cost-related accounts are as follows:
Raw Materials Inventory $300,000

Cost of Goods Sold 900,000
Manufacturing Overhead (credit) 90,000
R equ i r ed
Prepare a journal entry to close the manufacturing overhead account assuming that the amount
($90,000) is material.
EXERCISE 2-18. Modern Manufacturing Practices [LO 7] Just-in-time production systems seek
to reduce the amount of material, work in process, and finished goods inventory. However, com-
panies must hold some amount of inventory to buffer themselves from various negative events.
List three such events and briefly indicate why they require holding a buffer inventory.
EXERCISE 2-19. Incremental Analysis and Overhead Allocation [LO 4] At the start of the year,
Vencor Company estimated manufacturing overhead to be $2,000,000. Eighty percent of the over-
head is fixed and relates to depreciation of equipment. The remaining 20 percent is variable. The
company estimated machine hours to be 100,000 and thus used a predetermined overhead rate of
$20 per machine hour.
During the year, the company devised a new way to sequence movements of material among
the machines, which resulted in a savings of 30,000 machine hours.
R equ i r ed
Estimate the amount of manufacturing overhead that the company would save related to the
reduction in machine hours. Why is the savings less than $20 per machine hour?
EXERCISE 2-20. Career Connection Select one or two concepts from this chapter and describe
how you might use those concepts in your future career. Briefly describe the career or job you will
be performing. Then specifically describe the type of situation for which the concept could be
applied. Also include a discussion of how use of the concept would allow you to make informed
decisions or improve your job performance.
Problems PROBLEM 2-1. Cost of Goods Manufactured, Cost of Goods Sold, and Income [LO 2] The
following information is available for Satterfield’s Custom Glass for the fiscal year ending Decem-
ber 31, 2017:
Beginning balance in Work in Process Inventory $ 210,000
Ending balance in Work in Process Inventory 300,000
Beginning balance in Finished Goods Inventory 500,000
Ending balance in Finished Goods Inventory 400,000
Direct material cost 2,500,000
Direct labor cost 3,000,000
Manufacturing overhead 1,700,000
Selling and administrative expenses 1,350,000
Sales 8,500,000
P r o b l e m s 77
Req u i red
a. Prepare a schedule of cost of goods manufactured.
b. Prepare an income statement for fiscal 2017. Ignore income taxes.
PROBLEM 2-2. Cost of Goods Manufactured and Cost of Goods Sold [LO 2] Terra Cotta
Designs manufactures custom tiles. The following information relates to the fiscal year ending
December 31, 2017:
Beginning balance in Raw Material Inventory $ 450,000
Purchases of raw material 1,500,000
Ending balance in Raw Material Inventory 200,000
Beginning balance in Work in Process Inventory 650,000
Ending balance in Work in Process Inventory 350,000
Direct labor cost 2,500,000
Manufacturing overhead applied 650,000
Beginning balance in Finished Goods Inventory 750,000
Ending balance in Finished Goods Inventory 350,000
Sales 7,000,000
Selling expenses 500,000
General and administrative expenses 850,000
Req u ir ed
a. Prepare a schedule of cost of goods manufactured. Assume that there are no indirect material
costs.
b. Prepare an income statement for fiscal 2017. Ignore income taxes.
PROBLEM 2-3. Job-Order Costing: Inventory Accounts and Cost of Goods Sold [LO 4] Smith
Die Company manufactures cutting dies for the shoe industry. Each set of dies is custom designed
to a customer’s templates. During the first week of May, six orders were received from customers.
They were assigned job numbers 1005 to 1010. The following transactions occurred during the
first week of May:
Smith Die purchased steel on account from Eastern City Steel costing $5,500. The company
received and paid for supplies (indirect materials) from Mallard Supply costing $2,400.
Material requisitions indicated that materials were issued to the factory floor as follows:
Job No. Direct Materials Indirect Materials
1005 $ 650
1006 850
1007 1,550
1008 650
1009 450
1010 350
Totals $4,500 $1,000
The labor time ticket summary reflected the following costs for the week:
Job No. Direct Labor Indirect Labor
1005 $1,600
1006 2,000
1007 3,300
1008 1,400
1009 900
1010 700
Totals $9,900 $6,500
Overhead was applied to all jobs in process at 180 percent of direct labor cost. Jobs 1005, 1006,
1007, and 1008 were completed and transferred to finished goods. Jobs 1009 and 1010 were still
in process at the end of the week. Jobs 1005, 1006, 1007, and 1008 were shipped to customers and
billed at 150 percent of total job cost.
Req u i r ed
a. Calculate the total cost of each job.
b. Prepare journal entries to record the above information.
PROBLEM 2-4. Job Cost Sheets and Inventory Accounts [LO 2, 4] Renton Custom Windows
produces custom windows for business and residential customers who supply Renton with archi-
tectural specifications.
At the start of 2017, three jobs were in process:
Cost incurred as of 1/1/2017

Job 258 $5,000
Job 259 6,000
Job 260 3,500
Also at the start of 2017, one job was completed and awaiting shipment:
Job 257 $9,000

During 2017, the company incurred the following costs:
Direct labor 1,650,000
At the end of 2017, two jobs were in process:
Job 345 $2,500

Job 346 5,900
In addition, four jobs were completed and awaiting shipment:
Job 341 $1,500

Job 342 3,300
Job 343 2,400
Job 344 4,500
Req u i r ed
a. What are the beginning and ending balances in Work in Process Intenvory?
b. What are the beginning and ending balances in Finished Goods Intenvory?
c. What is Cost of Goods Sold? What job numbers likely relate to the balance in Cost of Goods Sold?
PROBLEM 2-5. Various Predetermined Overhead Rates for Job-Order Costing [LO 4, 5] Retter
Shoe Company has expected overhead costs of $12,000,000. The majority of the overhead costs are
incurred providing production support to the direct labor force. Direct labor rates vary from $10
to $20 per hour, and more complex tasks are assigned to more skilled workers who have higher
pay rates. Retter projects direct labor costs of $4,800,000 and 300,000 direct labor hours. More
complex tasks require proportionally more support than do the less complex tasks.
P r o b l e m s 79
Each model/size of shoe is produced in a single production run and constitutes a job. During
the year, the company produced 9,000 pairs of the model K25, size 8 dress shoe. A total of 11,000
direct labor hours, costing $165,000, were assigned to the job.
Req u i red
a. Determine the amount of overhead assigned to the model K25, size 8 dress shoe, using both
direct labor hours and direct labor cost as the allocation base.
b. Justify selection of either direct labor hours or direct labor cost as the allocation base.
PROBLEM 2-6. Job Costs Using Different Overhead Rates [LO 4, 5] Custom Auto Parts man-
ufactures parts to order for antique cars. Custom Auto Parts makes everything from fenders to
engine blocks. Each customer order is treated as a job. The company currently has two jobs, Job
9823 and Job 9824, that are complete, although overhead has not yet been applied. The company
wants to know what each job’s cost would be under alternative overhead allocation rates based on: (1)
direct labor cost, (2) direct labor hours, and (3) machine hours. Estimates for this year are as follows:
Direct labor cost $300,000

Direct labor hours 25,000
Machine hours 8,000
Overhead costs $200,000
Depreciation on machinery accounts for 75 percent of the overhead costs. The job-cost sheets
show:
Job 9823 Job 9824
Direct material $1,000 $2,000

Direct labor cost $1,400 $1,400
Direct labor hours 150 130
Machine hours 130 270
Req u ir ed
a. Determine the overhead allocation rate under the three suggested allocation bases. Round to
two decimal places.
b. Calculate the cost of Job 9823 and Job 9824 using each of the three bases. Round to nearest dollar.
c. Discuss which allocation base appears preferable.
PROBLEM 2-7. Underapplied or Overapplied Overhead [LO 5] In the past year, Oak Crafters
Cabinets had total revenue of $2,500,000, cost of goods sold of $1,000,000 (before adjustment
for over- or underapplied overhead), administrative expenses of $600,000, and selling expenses
of $400,000. During the year, overhead was applied using a predetermined rate of 75 percent of
direct labor cost. Actual direct labor was $700,000. Actual overhead was $450,000. The ending
balances in the inventory accounts (prior to adjustment for overapplied overhead) are:

Req u i red
a. Calculate net income treating the amount of overrapplied overhead as immaterial and assigning
it to Cost of Goods Sold.
b. Calculate net income treating the amount of overapplied overhead as material and apportioning
it to the appropriate inventory accounts and Cost of Goods Sold. Round proportions to 3 decimal
places. Round adjustments to the nearest whole dollar.
c. Discuss the impact of the alternative treatments.
PROBLEM 2-8. Underapplied or Overapplied Overhead [LO 5] World Window Company

produces custom windows to specifications provided by architects. At the end of its accounting
period, its account balances indicated the following:
Raw Materials Inventory $ 80,000

Cost of Goods Sold 440,000
Manufacturing Overhead (credit balance) 50,000
Req u i r ed
a. Determine the adjusted balances of the accounts if the balance in Manufacturing Overhead is
considered immaterial in amount and assigned to Cost of Goods Sold.
b. Determine the adjusted balances of the accounts if the balance in Manufacturing Overhead is
considered material in amount. Round to the nearest whole dollar.
PROBLEM 2-9. Job Costing (Service Example) [LO 4, 5, 6] LaPlatt & Associates is an accounting
firm that provides audit, tax, and accounting services to medium-size retail companies. It employs
50 professionals (10 partners and 40 associates) who work directly with clients. The average ex-
pected total compensation per professional for the year is $120,000. The services of LaPlatt are in
high demand, and each professional works for clients to their maximum of 1,600 billable hours.
All professional salaries are traced to individual client service summaries. All costs other than
professional salaries are included in a single indirect cost pool (professional support). The indi-
rect costs are assigned to service summaries using professional hours as the allocation base. The
expected amount of indirect costs for the year is $5,200,000.
Req u i r ed
a. Compute the budgeted indirect cost rate per hour of professional service.
b. LaPlatt & Associates is bidding on tax and audit services for a potential client that are expected
to require 100 hours of professional service time. Calculate the estimated cost of the work using
average professional wage rates and basing indirect costs on estimated service time.
PROBLEM 2-10. Recording Inventory-Related Costs [LO 2, 4] Fill in the missing infor-
mation:
Raw Materials Inventory
Beginning Balance 30,000

Purchases 40,000 (a)
Ending Balance 15,000
Work in Process Inventory

DM (a) (b)
DL 45,000
OH 63,000
70,000 60,000
(d)
P r o b l e m s 81
Finished Goods Inventory

(b) (c)
Cost of Goods Sold
(c)
(d)
PROBLEM 2-11. Recording Inventory Costs [LO 4, 5] Vulcan Molding produces molded rubber
components. At the start of the year, the company estimated that it would incur $3,500,000 of di-
rect labor cost and $9,000,000 of manufacturing overhead. Overhead is allocated to production on
the basis of direct labor cost. Actual materials used during the year were $5,750,000, actual direct
labor cost was $4,000,000, and actual overhead was $11,000,000.
Req u i r ed
a. Calculate the overhead rate for the current year. Round to 2 decimal places.
b. Prepare the journal entry to record use of direct material.
c. Prepare the journal entry to record direct labor.
d. Prepare the journal entry to record manufacturing overhead applied to production.
e. Prepare the journal entry to close the balance in manufacturing overhead to cost of goods
sold.
PROBLEM 2-12. Multiple Overhead Rates [LO 4, 5] Vulcan Molding has three production
departments: A, B, and C. At the start of the year, the company estimated that it would incur
$3,080,000 of direct labor cost and $10,000,000 of manufacturing overhead as follows:
Dept. A Dept. B Dept. C Total
Estimated Overhead $4,000,000 $3,000,000 $3,000,000 $10,000,000

Estimated Direct Labor $1,200,000 $ 630,000 $1,250,000 $3,080,000
Overhead Rate $3.33 $4.76 $2.40 $3.25
Along with many others, Vulcan Molding worked on the following three jobs during the year:
Direct Labor Cost

Job 201 $9,500 $3,000 $4,500 $17,000

Job 202 $5,000 $6,500 $9,000 $20,500
Job 203 $2,000 $5,000 $2,000 $ 9,000
Req u i r ed
a. Calculate the overhead that would be assigned to each job assuming the company uses one
plant-wide overhead allocation rate based on expected labor cost.
b. Calculate the overhead that would be assigned to each job assuming the company uses a sepa-
rate overhead allocation rate for each production department based on direct labor cost.
c. Which is preferable: a single overhead rate or separate rates by production department? Explain.
PROBLEM 2-13. Comprehensive Job-Order Costing Problem [LO 2, 4, 5] Lane Confection-

ers produces special orders of sugar candies and chocolates for airlines and hotels. During March,
Lane purchased, on credit, 2,100 pounds of confectioner’s sugar at $.80 per pound, 2,300 pounds of
granulated sugar at $.90 per pound, 900 pounds of chocolate at $4.00 per pound, and 300 pounds
of caramel at $1.50 per pound from Seattle Confectionery Supply. In addition, it purchased for cash
60 dozen eggs at $.85 per dozen and 90 pounds of paraffin at $.50 per pound from PMG Foods.
The beginning balances in the inventory accounts were:
The ending balances in the inventory accounts were:
Direct labor costs were $5,400 for 450 hours, indirect labor costs were $2,500, utilities were $400,
rent was $750, and other overhead costs totaled $5,000. Manufacturing overhead is applied at
$17 per direct labor hour. Sales during the month were $35,000, and selling and administration
expenses were $9,000. (Assume that all of the above were noncash transactions.)
Req u i red
a. Prepare journal entries to record the transactions for the month of March. Assume that over-
or underapplied overhead is closed to Cost of Goods Sold.
b. Prepare an income statement for the month of March.
PROBLEM 2-14. Selection of an Overhead Allocation Base [LO 4, 5] Wolf Manufacturing

expects the following overhead costs in the current year:
Indirect material $ 45,000
Indirect labor 55,000
Depreciation of machinery 160,000
Repair and maintenance on machinery 135,000
Utilities and taxes 55,000
Total $450,000
It expects to use 25,000 direct labor hours at a cost of $525,000 and 15,000 machine hours during
the year.
Req u i red
Justify the selection of an appropriate allocation base and calculate the predetermined overhead
allocation rate.
PROBLEM 2-15. Applying Overhead in a Service Company [LO 5, 6] The following cost data
relate to the office overhead costs of the Charles Wright Tax Preparation Company during the
just-completed year:
Overhead costs incurred:

Office rent $ 25,000
Office supplies 6,000
Utilities, office 15,000
Salary, office manager 55,000
Salary, receptionist 35,000
Depreciation—office equipment 10,000
Software licensing fees 24,000
Other miscellaneous expenses 30,000
Total overhead costs $200,000
The company uses a predetermined overhead rate to apply overhead cost to each tax job. The rate for
the year was $6 per tax-preparer hour. A total of 35,000 tax preparer hours was recorded for the year.
C a s e 83
Req u i red
Compute the amount of under- or overapplied overhead cost for the year.
PROBLEM 2-16. Predetermined Overhead Rates in a Service Company; Over- or Under-

applied Overhead [LO 5, 6] Rosemont Music is a musical instrument repair facility located in
Akron, Ohio. The repair shop uses a job-order costing system and applies overhead costs to repair
jobs on the basis of repair technician hours. The following estimates were used in preparing the
predetermined overhead rate at the beginning of the year:
Repair technician hours 10,000
Estimated overhead costs $170,000
During the year, the opening of another musical instrument repair shop in the same area resulted
in fewer repair jobs being worked at Rosemont Music. The company’s cost records revealed the
following actual cost and operating data for the year:
Technician hours 7,000
Overhead costs $140,000
R equ ired
a. Compute the company’s predetermined overhead rate.
b. Compute the under- or overapplied overhead.
c. Assume that the company closes any under- or overapplied overhead directly to Cost of Goods
Sold. Prepare the appropriate journal entry.
PROBLEM 2-17. Service Company Use of Predetermined Overhead Rate [LO 4, 5, 6] Southwest
Community Hospital uses a job-order costing system to track charges for each patient. The following
charges relate to Candice O’Dea, who had laparoscopic knee surgery:
Pharmacy $ 450
Sterile supply 1,500
Supplies, other 4,500
Operating room service (nursing staff) 4,500
Anesthesia 1,500
Anesthesiologist 3,500
Southwest charges patients for the use of the operating room based on a predetermined overhead
rate. The estimated overhead costs of the operating room are $5,500,000, and the activity base is
available hours of 2,000. Note that the hospital does not charge for the services of the surgeon.
These charges are billed directly by the surgeon.
Req u i r ed
a. Calculate the predetermined overhead rate for the operating room, and determine the charge to
Candice. Assume that her surgery took 3 hours in the operating room.
b. Calculate the total cost for the knee surgery.
Case
2-1 Ethics Case: Brixton Surgical Devices [LO 4, 5]
Brixton Surgical Devices, a public company with sales of At the end of the third quarter of 2017, it became clear to Ed
over $900,000,000, is one of the world’s largest produc- Walters, chief operating officer, and Robin Smith, chief finan-
ers of surgical clamps, saws, screws, and stents. Its busi- cial officer, that the company would not make the aggressive
ness involves production of both stock items and custom pieces annual earnings target specified by the board of directors. In
for doctors at research hospitals. consequence, Ed and Robin would not receive bonuses, which
historically had averaged about 35 percent of their base com- production equipment, we’ve got a ton of overhead. But the more
pensation. The two devised the following strategy. we produce, the more overhead we can bury in inventory. With
“Here’s what we’ll do,” suggested Ed. “We’ve never offered our lower unit costs and higher sales, profit will go way up. Let’s get
customers a discount. Let’s change that right now. We’ll offer a 25 going on execution. I’ve got to get the marketing people work-
percent discount on all orders placed in October and November ing on the promotion, and you’ve got to update the production
for delivery in December of 2017.” schedule. This could end up being our best year ever in terms of
“That will certainly boost fourth-quarter sales,” said Robin. bonuses!”
“But you know, it won’t really increase total sales. It’ll just transfer
some sales from the first quarter of 2018 to the fourth quarter of
R eq uired
2017. Of course, 2017 is where we need earnings to hit our bonus
target. Hey, I’ve got another idea. We can also jack up production Are the proposed actions of Ed and Robin ethical? What is the
of our stock items in the fourth quarter. With our high-priced likely effect of their actions on shareholder value?
Case
2-2 YSL Marketing Research [LO 6]
YSL Marketing Research is a small firm located in addition, the company is reimbursed for all out-of-pocket costs
Seattle, Washington. On behalf of its clients, the firm conducts related to travel and paper and postage costs for surveys. YSL is in
focus group meetings, telephone and mail opinion surveys, and high demand, and if it undertakes the Surenex job, it will have to
evaluations of marketing strategies. The firm has three partners turn down another potential client.
and six nonpartner professionals. At the start of the year, the com- Connie estimates that the Surenex engagement will require
pany estimated total professional compensation (for the three the following costs in addition to overhead support costs:
partners and six nonpartner professionals) to be $1,600,000. Connie Bachmann (partner), 40 hours at a salary averaging
To evaluate the profitability of its engagements, the firm traces $120 per hour = $4,800.
actual professional compensation to each engagement along with
Ambrose Bundy (professional staff), 100 hours at a salary of
so-called direct charges. Direct charges consist of travel costs and
$40 per hour = $4,000.
costs of conducting surveys (e.g., paper and postage). In addi-
tion, each engagement receives an allocation of overhead based Direct charges for actual travel, mailing, and postage =
on professional compensation charges. Overhead consists of all $3,000.
support costs including rent, utilities, and depreciation of office Total of above = $11,800.
equipment. At the start of the year, these costs were estimated to
be $496,000. R eq uired
Recently, Connie Bachmann, a YSL partner, was asked to con-
a. Calculate the expected full cost of the Surenex engagement,
duct a survey for Surenex, a new high-tech company. Connie is
including an allocation of overhead. Round answer to nearest
excited about this opportunity since she expects that this hot
dollar and predetermined overhead rate to two decimal places.
small company will, in 3 to 5 years, become a hot big company
with premium billing opportunities. At this point, however, b. What is the lowest amount that Connie can bill on this
Connie wants to quote a low fee since Surenex has cash-flow engagement without hurting company profit?
problems and is clearly unwilling to pay YSL’s normal rates. On c. In deciding on a price for the engagement, what should Connie
most jobs, YSL’s fee is 1.5 times professional compensation. In consider in addition to the amount calculated in (b)?
Case
2-3 Dupage Powder Coating [Lo 4, 5]
DuPage Powder Coating applies powder coating finishes In prior years, finishes were applied by hand, and man-
to a variety of materials and parts used by small and ufacturing overhead was allocated to jobs based on direct
medium-size manufacturing firms. Essentially, powder coat- labor hours. (The rate was $12 per hour based on overhead
ing involves the application of powder (finely divided particles of of $1,080,000 and 90,000 direct labor hours.) At the start
organic polymer containing pigments, fillers, and additives) to a of the current year, the company purchased and installed a
surface, after which the powder is fused into a continuous film by computer-controlled electrostatic powder coating system at a
the application of heat or radiant energy. The process results in a cost of $1,800,000. With a five-year life, the equipment adds
durable finish that resists rust. $360,000 a year to manufacturing overhead. (Thus, expected
C a s e 85
total overhead is now $1,440,000.) However, labor has been R eq uired

reduced by 25,000 hours per year (because the equipment
a. Based on the limited information, estimate the full cost of the
reduces the need for labor). At an average wage rate of $20
job in the current year. Assume the company uses one company-
per hour, $500,000 of wages are expected to be saved in the
wide overhead rate.
current year.
While the company purchased a computer-controlled system b. What would have been the cost of the job in part (a) in the
including a new spray chamber, it kept its old spray booth and prior year?
manual equipment for use on small jobs. c. Bill McCally, plant manager, observed: “Last year, jobs like
DuPage Powder Coating has just received an order from the one we did for Cedargreen Enterprises cost less. But I know
Cedargreen Enterprises (a small manufacturer of outdoor we’re not less efficient at handling small jobs. We use the same
furniture) to powder coat 4 tables and 16 chairs. On small equipment, the same labor, and the same products on small
orders such as this, DuPage uses its old spray booth and manual jobs this year as last year, and yet the accounting system is making
equipment rather than the new computer-controlled system. small jobs look more expensive!”
Material cost for the job will be $500, and 7 labor hours are Explain why the accounting system is making small jobs
required. appear to be more costly in the current year.
Small jobs like the one for Cedargreen are worked on while
d. Does the fact that small jobs have a higher cost in the
the computer-controlled electrostatic system is being changed
current year suggest that prices for small jobs should be
over (cleaning, different colors, etc.) between large jobs.
increased?
3
Process Costing
Stacy Brannen was just completing a tour
at Kent Chemical Company’s Midwest plant.
Only 2 weeks ago, Stacy had graduated from State University with a degree in
mechanical engineering, and now she was nearing the end of her first day on the job
at Kent. The assistant plant manager, Bill Merton, conducted the tour and pointed out
the steps involved in processing paints, stains, and wood preservatives.
Although the tour concentrated on the equipment used in the production pro-
cesses, Stacy found herself wondering how the cost of products was determined.
“Bill, can you give me a rough idea of how you calculate product costs?” she asked.
“I noticed, for example, that to end up with a gallon of wood preservative ready to
ship, we perform both mixing and packaging operations. With labor, material, and
overhead added in these separate operations, is assigning costs to wood preserva-
tive a difficult job?”
“Well,” Bill replied, “let’s see if we can catch Walter Hunt before he goes home
for the day. He’s the plant controller, and no one can do a better job than Walt of
explaining how we do product costing at Kent Chemical.”
The type of product costing system used at Kent Chemical Company is a process
costing system. Such systems are in common use by companies that produce large
numbers of homogeneous items in a continuous production process. Companies
using process costing include producers of paints, plastics, paper products, cereals,
cosmetics, and metals. Thus, well-known companies like DuPont, the Quaker Oats
Company, and the Ralston Purina Company use process costing. This chapter intro-
duces you to the essential elements of a process costing system.
Science Photo Library/Shutterstock
Learning Objectives
1 Describe how products flow through departments and how costs flow through accounts.
2 Discuss the concept of an equivalent unit and calculate the cost of goods completed and the
ending Work in Process balance in a processing department.
3 Prepare a production cost report.
87
88 chapt e r 3 P r o c e s s C o s t i n g
Difference Between Job-Order

and Process Costing Systems
As explained in Chapter 2, there are two primary systems for calculating the cost of
inventory: a job-order system and a process costing system. In a job-order system,
each unique product or batch is a “job” for which the company needs cost information.
Therefore, it is necessary to trace manufacturing costs to specific jobs. When jobs are
completed, the costs of the jobs are removed from Work in Process and included in
Finished Goods. When completed jobs are sold, the costs of the jobs are removed from
Finished Goods and included in Cost of Goods Sold.
Process costing, in contrast, is essentially a system of averaging. Dividing produc-
tion costs by the total number of homogeneous items produced results in an average
unit cost. When items are completed, multiplying the number of units completed by the
average unit cost determines the costs to be removed from Work in Process Inventory and
included in Finished Goods Inventory. When items are sold, multiplying the number of
units sold by the average unit cost determines the costs to remove from Finished Goods
Inventory and include in Cost of Goods Sold. Illustration 3-1 presents a comparison of
job-order and process costing systems. The remainder of the chapter describes process
costing systems in more detail.
Q: I noticed that some companies produce a large number of somewhat identi-
cal items. For example a company may produce thousands of very similar laptop
computers. Different models may have the same case, keyboard, and screen, but
one may have a faster processor and more memory than the other. Or consider
a producer of Cabernet wine. Two of the company’s wines could be similar in
all respects except one is aged in French oak barrels while the other is aged in
American oak barrels. What do these companies use, process costing or job-order
costing?
A : Good observation! In practice, firms frequently use a hybrid system that combines
features of job-order costing and process costing. The hybrid system is called operations
costing. In operations costing, conversion costs are assigned to products, as in process
costing. Different materials, however, are assigned to products, as in job-order costing.
Those of you who become managers most likely won’t need to know much more than this.
Those of you who plan on becoming accountants will receive more information in your cost
accounting course.
Link to Practice
What Type of Costing System One product you may have heard of is Mobil 1, the
Is Used by ExxonMobil Corporation world’s leading synthetic motor oil. What type of
for the Product Mobil 1? costing system do you think the company uses for
this product? Large quantities of identical units are
ExxonMobil is one of the world’s largest compa-
Courtesy Amsoil
produced in continuous production processes. So,

nies engaged in the exploration, production, and
to account for the cost of Mobil 1, ExxonMobil uses
sale of crude oil and natural gas. The company
process costing.
also manufactures numerous petroleum products.
P r o d u c t a n d C o s t F l o w s 89
Illustration 3-1
Comparison of job-order and process costing systems
Job-Order System—Use Costs of Specific Jobs for Custom Home Manufacturing
Work in Process Finished Goods Cost of Goods Sold

Direct
material
credit debit credit debit

Direct
labor
Cost of Jobs Completed Cost of Jobs Sold
Process Costing System—Use Average Unit Cost Information for Chemical Manufacturing
Work in Process Finished Goods Cost of Goods Sold
Direct Number Number

material of Units of Units
credit Completed debit credit Sold debit
Direct labor × ×
Average Average
Unit Unit
Cost Cost
Learning Product and Cost Flows

Objective 1
Just as a product passes through several departments before it is completed, costs flow
Describe how products through several accounts before the product costs of the product is recorded in finished
flow through depart- goods. Here we discuss the flow of products through departments and the flow of costs
ments and how costs through accounts of companies that use process costing.
flow through accounts.
Product Flows through Departments
In the manufacturing operations of a company using process costing, a product typi-
cally must pass through two or more departments, and costs are accumulated in each
department. The Kent Chemical Company manufactures wood preservative in two
departments: mixing and packaging. After chemical materials are blended in the Mixing
Department, the liquid preservative is transferred to the Packaging Department, where
it is placed in plastic containers. Materials, labor, and overhead are added at different
stages in each processing department.
Generally, identifying the stage when materials enter the production process is easy.
In the Mixing Department, the chemical materials are added at the start of the process.
Illustration 3-2 Material added at

Flow of items through start of process
processing departments
Mixing
Department CHE
MIC
Packaging AL
Department CHE
MIC
AL
CHE
MIC
CHE AL
MIC
AL
Start End
of of
Production Production
Labor and overhead

added evenly
Determining exactly when labor and overhead are added to the process is more difficult.
Labor and overhead are often grouped together and referred to as conversion costs.
These costs are often assumed to be added evenly throughout the process.
Illustration 3-2 shows how items flow through the two processing departments
and how costs are incurred. As indicated, materials enter the Mixing Department at the
start. However, conversion costs (labor and overhead) are assumed to enter mixing at
a constant rate.
Cost Flows through Accounts

The product costs accumulated in a process costing system are essentially the same
costs considered in job-order costing: direct material, direct labor, and manufacturing
overhead. Additionally, a processing department may have a cost called transferred-in
cost. This is the cost incurred in one processing department that is transferred to the
next processing department. For example, at Kent Chemical, the cost incurred in the
Mixing Department is transferred to the Packaging Department. In essence, the cost
transferred in from Mixing becomes a material cost added to Packaging. However, it is
called a “transferred-in” cost.
Link to Practice
Virtual Plant Tour for Company Using has such a production process? If not, take a virtual
Process Costing tour of one.
Endot Industries is a producer of pipes used to move
Process costing is used by companies that produce
liquids and gas and as conduit for pulling wires in con-
large numbers of homogeneous items in a continuous
struction projects. A tour of the company is available at
production process. Have you ever been in a plant that
Endot Industries’ company website.
P r o d u c t a n d C o s t F l o w s 91
Each processing department accumulates product cost in a separate departmental

Work in Process account. The sum of the departmental Work in Process accounts is the
amount in Work in Process for the entire company. The following entries illustrate the
flow of costs between processing departments.
Direct Material. Suppose that $142,000 of direct materials are used during April in
the Mixing Department of Kent Chemical Company. The following entry would be
appropriate for this transaction:
(date) Work in Process, Mixing 142,000

Raw Materials 142,000
To record use of raw material
Direct Labor. Suppose that $62,200 of direct labor costs are incurred during
April in the Mixing Department. The following entry would be appropriate for this
transaction:

Wages Payable 62,200
To record direct labor cost
Manufacturing Overhead. To assign overhead to products in a process costing

system, a company may use either actual overhead costs or a predetermined overhead
rate. Unless the amount of overhead cost and the level of production are fairly constant
from month to month, using actual overhead costs results in substantial fluctuations in
the unit cost of goods produced. For this reason, most companies use a predetermined
overhead rate.
Suppose that at the start of the year, the Mixing Department estimates it will incur
$2,160,000 of overhead cost and $720,000 of direct labor cost. Using direct labor as an
allocation base, the department calculates a predetermined overhead rate of $3 for each
dollar of direct labor cost (i.e., $2,160,000 ÷ $720,000). Assuming $62,200 of direct labor
cost was incurred in the month of April, $186,600 of overhead ($62,200 × $3 = $186,600)
would be assigned to Work in Process that month.

Manfacturing Overhead 186,600
To record manufacturing overhead
applied to Work in Process
Transferred-in Cost. When one processing department completes its work, the items
are transferred to the next department along with their related cost. As mentioned ear-
lier, this cost is referred to as transferred-in cost. Suppose that during April, the Mixing
Department completes units with a cost of $360,000. The completed units are transferred
to the Packaging Department, and the related cost becomes a transferred-in cost to
packaging. The entry to record the transfer is:
(date) Work in Process, Packaging 360,000

Work in Process, Mixing 360,000
To record transfer of units from
Mixing to Packaging
The flow of costs between departmental Work in Process accounts is presented in

Illustration 3-3.
Illustration 3-3 Work in Process Work in Process

Flow of costs between Mixing Department Packaging Department Finished Goods
processing departments
Direct Cost Transferred-
material transferred in cost
to Packaging
Direct Direct
labor labor Cost
of completed
items
Manufacturing Direct
overhead material
Manufacturing
overhead
Learning Calculating Unit Cost

Objective 2
Process costing, as we have seen, is essentially a system of averaging. This section shows
Discuss the concept how to calculate an average unit cost in a process costing system.1 First, however, we
of an equivalent unit must explain an essential concept in process costing—the concept of an equivalent unit.
and calculate the cost
of goods completed
and the ending Work Equivalent Units
in Process balance in a In calculating the average unit cost, it is necessary to convert the number of partially
processing department. completed units in Work in Process to an equivalent number of whole units. Otherwise,
the denominator in the average unit cost calculation will be misstated. When partially
completed units are converted to a comparable number of completed units, they are
referred to as equivalent units. For example, if 100 units in Work in Process are 50 per-
cent completed, then they are equivalent to 50 completed units (100 × 50%), as shown
The number of equivalent units in Work in Process may be different for material
and conversion costs. This is because material and conversion costs enter the produc-
tion process at different times. For example, suppose that at the end of July, the Mixing
Department at Kent Chemical has 100 gallons (units of production) of wood preser-
vative in Work in Process that are 50 percent through the mixing process. Further,
assume that materials enter into the process at the start, while conversion costs enter
evenly throughout the process. Even though the units are only halfway through the
process, they have received 100 percent of material since material was added immedi-
ately at the start of the process (see Illustration 3-2). Therefore, with respect to material
cost, there are 100 equivalent units in Work in Process. However, because the units are
only halfway through the process, they have received only 50 percent of the labor and
overhead needed for completion. Since the 100 gallons are only 50 percent complete
Illustration 3-4
How equivalent units are
100 Units × 50% Complete 50 Equivalent Units
calculated
1
The approach we take is referred to as the weighted average method. Other approaches, such as the first-in,
first-out method, are also used. These methods are discussed in cost accounting textbooks.
Ca l c u la t in g a n d Ap p ly in g C o s t Pe r E q u iv a le n t Un it : M ix in g De p a r t m e n t E x am p le 93
Illustration 3-5
Differences in equivalent units
for material and conversion
costs, assuming material
added at start of process
100 Units,
50% through the Production Process
CHE
MIC
AL
CHE
MIC
AL With Respect to With Respect to
CHE
MIC
Material Costs CHE
MIC
Conversion Costs
AL AL
100 Equivalent 50 Equivalent
CHE
MIC
Units CHE
MIC
Units
AL AL
with respect to conversion costs, there are 50 equivalent units for labor and overhead
(see Illustration 3-5).
Cost per Equivalent Unit

The average unit cost in a process costing system is referred to as a cost per equivalent
unit. The formula for determining the cost per equivalent unit is:
Cost in beginning WIP + Cost incurred in current period
Cost per equivalent unit =
Units completed + Equivalent units in ending WIP
The numerator contains the cost in beginning Work in Process (WIP) plus the cost
incurred in the current period. This amount represents the total cost for which a processing
department must account in each period. The total cost is divided by the units completed
plus the equivalent units in ending work in process. The result is a cost per equivalent unit
amount that can be used to spread the cost at the start of the period and the cost incurred
during the period over the units completed and the units in process at the end of the period.
T e st y our K NOWLE D GE
At Rainier Chemical, conversion costs (labor and overhead) enter evenly throughout the
production process. At the end of the year, 200 units in work in process are 80 percent com-
plete. With respect to conversion costs, how many equivalent units are in Work in Process?
a. 200. b. 160. c. 360. d. 280.
Calculating and Applying Cost Per

Equivalent Unit: Mixing Department
Example
Next, we consider cost per equivalent unit calculations for the Mixing Department of
Kent Chemical Company. At the start of April, the Mixing Department has on hand
beginning Work in Process inventory consisting of 10,000 gallons of wood preservative
Illustration 3-6
Calculation of cost per equiva- Material Labor Overhead Total
lent unit, Mixing Department
Cost
Beginning WIP $ 18,000 $ 7,800 $ 23,400 $ 49,200
Cost incurred during April 142,000 62,200 186,600 390,800
Total cost $160,000 $70,000 $210,000 $440,000
Units
Units completed 60,000 60,000 60,000
Equivalent units, ending WIP 20,000 10,000 10,000
Total units 80,000 70,000 70,000
Cost per Equivalent Unit
(Total cost ÷ total units) $2 + $1 + $3 = $6
that are 80 percent complete. During the month, 70,000 gallons are started and 60,000 are
completed. At the end of April, 20,000 gallons are on hand that are 50 percent complete.
The cost in beginning Work in Process consists of $18,000 of material cost, $7,800 of
labor cost, and $23,400 of overhead cost. During April, the Mixing Department incurs
$142,000 of material cost and $62,200 of labor cost. Because the Mixing Department’s
predetermined overhead rate is $3 for each dollar of labor cost, $186,600 ($3 × $62,200)
of overhead is applied to production during the month.
The cost per equivalent unit calculations for the Mixing Department is presented
in Illustration 3-6. The cost of material includes the $18,000 in beginning Work in
Process and the $142,000 of material cost incurred during April. The total of $160,000 is
divided by 80,000 units, the sum of the number of units completed (60,000 gallons) and
the equivalent units in ending Work in Process (20,000 gallons). Dividing total cost by
the total number of units yields a cost per equivalent unit for materials of $2. A similar
procedure is used to find the cost per equivalent unit for labor and overhead cost.
Let’s look more closely at the equivalent units used in these calculations. Note that
at the end of April, there are 20,000 units on hand that are only 50 percent through the
mixing process. However, since material cost enters at the start of the mixing process,
the 20,000 units are 100 percent complete with respect to material cost. Thus, there are
20,000 equivalent units in ending Work in Process for materials. In contrast, for both
labor and overhead, the 20,000 units on hand are only 50 percent complete, so they
correspond to only 10,000 equivalent units.
As shown in the last line of Illustration 3-6, the total cost per equivalent unit is $6,
consisting of $2 of material cost, $1 of labor cost, and $3 of overhead cost. These unit
cost figures can be used to calculate the cost of goods completed and transferred out of
the Mixing Department and the cost of ending Work in Process.
At Rainier Chemical, labor cost in beginning Work in Process at the start of April was
$50,000, and $450,000 of labor was incurred during the month. At the end of April,
200 units are in WIP, and they are 80 percent complete with respect to labor. During this
month, 840 units were completed. What is the cost per equivalent unit for labor?
a. $225. b. $481. c. $536. d. $500.
Correct answer is d. ($50,000 + $450,000) ÷ [840 + (200 × .8)]

P r o d u c t i o n C o s t R e p o r t 95
Cost Transferred Out

Recall that 60,000 gallons were completed by the Mixing Department during April and
transferred to the Packaging Department. We know that the unit cost is $6. Therefore,
$360,000 of cost (60,000 gallons × $6) is related to the units completed and transferred
out. The entry at the end of April to record the transfer was presented earlier and is
repeated here:
(date) Work in Process, Packaging 360,000

Work in Process, Mixing 360,000
To record transfer of units from
Mixing to Packaging
Ending Work in Process

The ending balance in Work in Process in the Mixing Department is $80,000. This bal-
ance is made up of 20,000 equivalent units for material at $2 per equivalent unit, 10,000
equivalent units for labor at $1, and 10,000 equivalent units for overhead at $3.
Ending Balance in Work in Process, Mixing
Material (20,000 equiv. units at $2) $40,000

Labor (10,000 equiv. units at $1) 10,000
Overhead (10,000 equiv. units at $3) 30,000
Total $80,000
Here is a summary of the cost activity for the Mixing Department resulting in the
$80,000 ending balance in Work in Process:
Work in Process, Mixing
Beginning balance 49,200
Material 142,000 360,000 Cost transferred out
Cost added Labor 62,200

EN
Overhead 186,600
Ending balance 80,000
Learning Production Cost Report

Objective 3
A production cost report is an end-of-the-month report for a process costing system
Prepare a production that provides a reconciliation of units and a reconciliation of costs as well as the details
cost report. of the cost per equivalent unit calculations. The reconciliations help ensure that mistakes
are not made in calculations. A production cost report for the Mixing Department of
Illustration 3-7
Production cost report, Production Cost Report
Mixing Department Mixing Department
April
Unit Reconciliation
Units in beginning WIP (100% material, 80% conversion costs) 10,000
Units started during April 70,000
Units to account for 80,000
Units completed and transferred to packaging 60,000
Units in ending WIP (100% material, 50% conversion costs) 20,000
Units accounted for 80,000
Cost per Equivalent Unit Calculation

Material Labor Overhead Total
Cost
Beginning WIP $ 18,000 $ 7,800 $ 23,400 $ 49,200
Cost incurred during April 142,000 62,200 186,600 390,800
Total $160,000 $70,000 $210,000 $440,000
Units
Units completed 60,000 60,000 60,000
Equivalents units, ending WIP 20,000 10,000 10,000
Total 80,000 70,000 70,000
Cost per equivalent unit $2 $1 $3 $6
Cost Reconciliation
Total cost to account for $440,000
Cost of completed units transferred to Packaging (60,000 × $6) $360,000
Cost of ending WIP
Material (20,000 equivalent units × $2) $40,000
Labor (10,000 equivalent units × $1) 10,000
Overhead (10,000 equivalent units × $3) 30,000 80,000
Total cost accounted for $440,000
Kent Chemical Company is provided in Illustration 3-7. The unit cost calculations in
the production report are identical to the ones just presented. We will concentrate now
on the reconciliation of units and the reconciliation of costs.
Reconciliation of Units
Assuming no units are lost (e.g., due to evaporation, damage, or theft), the number of
units in beginning Work in Process inventory plus the number of units started during
the period should be equal to the number of units completed plus the number of units
in Work in Process at the end of the period. For the Mixing Department, 10,000 units
were in beginning inventory and 70,000 units were started during the period, which
means that 80,000 units must be accounted for. Since 60,000 units were completed
and 20,000 units are in Work in Process at the end of the period, all of the units are
accounted for.
B a s i c S t e p s i n P r o c e s s C o s t i n g : A S u m m a r y 97
Reconciliation of Costs
For each period, the total cost that must be accounted for is the sum of the costs in
beginning Work in Process and the costs incurred during the period. In the Mixing
Department, this amounts to $440,000. The cost must be either transferred out with the
completed units or remain in ending Work in Process inventory. The amount transferred
out is $360,000, and the amount in ending Work in Process inventory is $80,000. Because
their sum is $440,000, the total amount of cost is accounted for.
Cost in beginning $ 49,200 Cost $360,000

Work in Process transferred out
+ Cost incurred 390,800 + Cost in ending 80,000
during the period
= Work in Process
$440,000 $440,000
Basic Steps in Process Costing:

A Summary
Unless process costing is approached in a systematic way, it is easy to get lost in the cal-
culations. Here is a summary of the basic steps presented earlier. As you can see, each of
the steps is performed when the production cost report is prepared.
Step 1. Account for the number of physical units. The number of units at the start of
the period plus the number of units started during the period should equal the
number of units completed plus the number of units in ending Work in Process.
Step 2. Calculate the cost per equivalent unit for material, labor, and overhead. Re-
member that cost (numerator in the calculation) includes both beginning cost
and cost incurred during the period. The number of equivalent units (denomi-
nator in the calculation) includes both the number of units completed and the
number of equivalent units in ending Work in Process.
Step 3. Assign cost to items completed and items in ending Work in Process. The cost
of items completed is simply the product of the total cost per equivalent unit
and the number of units completed. The cost of items in Work in Process is the
sum of the products of equivalent units in process and cost per equivalent unit
for material, labor, and overhead.
Step 4. Account for the amount of product cost. The cost of beginning inventory plus
the cost incurred during the period should equal the amount of cost assigned
to completed items plus the amount of cost assigned to items in ending Work
in Process.
Kent Chemical Revisited:

Answering Stacy’s Question
Recall that in the scenario at the beginning of the chapter, Stacy Brannen asked how the
cost of products like wood preservative are calculated at the Kent Chemical Company.
At this point you should be able to answer that question. Essentially, material, labor, and
overhead costs are accumulated in each processing department. In each department,
the cost per equivalent unit is calculated for material, labor, and overhead (Step 2 in the
previous section). Then the costs per equivalent unit are used to determine the cost of
items completed and the cost of ending Work in Process (Step 3).
Dealing with Transferred-In Cost:

Packaging Department Example
As previously noted, companies using process costing systems generally use several pro-
cesses to make their products. When items are completed in one processing department,
the cost of the completed units is transferred to the next processing department. This
procedure is repeated until the units are completed in the last process. At that point, the
cost of the items is transferred to finished goods.
Here we consider an example to illustrate the method for dealing with cost transfers.
The example involves the Packaging Department of Kent Chemical. To calculate product
costs in the Packaging Department, we will use the same procedures already used to
calculate product costs in the Mixing Department, thereby providing you with another
opportunity to enhance your understanding of process costing.
Step 1. In working through the Packaging Department example, it will be helpful
to examine the information provided in the Production Cost Report for the
Packaging Department (see Illustration 3-8). At the start of April, the Packaging
Department has 15,000 gallons that are 50 percent through the packaging
operation. During the month of April, the department receives 60,000 gal-
lons from the Mixing Department. There are now 75,000 gallons to account
for. At the end of April, 5,000 gallons are 40 percent complete, and 70,000
gallons are completed and transferred to finished goods, which accounts
for the total of 75,000 gallons. Reconciling the physical number of units is
the first of the four steps in solving a process costing problem and is shown
in the quantity reconciliation section of the Production Cost Report (see
Illustration 3-8).
Step 2. The second step is to calculate the cost per equivalent unit. The beginning
balance in Work in Process includes $10,500 of material cost, $4,500 of labor,
$9,000 of overhead, and $92,250 of cost transferred in from the Mixing De-
partment. In addition, $49,500 of material cost, $27,900 of labor cost, $55,800
of overhead, and $360,000 of cost transferred in from the Mixing Department
were incurred during the month of April. The sum of these costs is divided
by the number of completed units plus the equivalent units in ending Work
in Process for each cost category. As the Production Cost Report shows, this
yields cost per equivalent unit values of $.80 for material, $.45 for labor, $.90
for overhead, and $6.03 for transferred-in cost. Note that the calculation for
material assumes that material is added at the start of the packaging process—
thus the 5,000 units in ending Work in Process are 100 percent complete with
respect to materials.
Because it was not covered in the previous example, note especially the
calculation of cost per equivalent unit for transferred-in cost. The sum of
D e a l i n g w i t h T r a n s f e r r e d - I n C o s t : P a c k a g i n g D e p a r t m e n t E x a m p l e 99
Illustration 3-8
Production cost report, Production Cost Report
Packaging Department Packaging Department
April
Unit Reconciliation
Units received from Mixing during April 60,000
Units completed and transferred to finished goods 70,000

Material Labor Overhead Trans. In Total
Cost
Beginning WIP $10,500 $ 4,500 $ 9,000 $ 92,250 $116,250
Cost incurred
during April 49,500 27,900 55,800 360,000 493,200
Total $60,000 $32,400 $64,800 $452,250 $609,450
Units
Units completed 70,000 70,000 70,000 70,000
Equivalent units,
ending WIP 5,000 2,000 2,000 5,000
Total 75,000 72,000 72,000 75,000
Cost per equivalent unit $0.80 $0.45 $0.90 $6.03 $8.18
Cost Reconciliation
Cost of completed units transferred
to Finished Goods (70,000 × $8.18) $572,600
Cost of ending WIP
Material (5,000 equivalent units × $0.80) $ 4,000
Labor (2,000 equivalent units × $0.45) 900
Overhead (2,000 equivalent units × $0.90) 1,800
Transferred-in (5,000 equivalent units at $6.03) 30,150 36,850
transferred-in cost in beginning Work in Process ($92,250) plus the cost

transferred-in during April ($360,000) is the numerator of the calculation
($452,250). The denominator (75,000 units) is the sum of the units completed
(70,000) plus the equivalent units in ending Work in Process (5,000). The result
is a cost per equivalent unit for transferred-in cost of $6.03.
One aspect of the calculation may be confusing: the equivalent units in
ending Work in Process. At the end of April, there are 5,000 units in process
that are only 40 percent through the packaging process. However, these units
are 100 percent complete with respect to transferred-in cost, because they were
transferred in with all of the Mixing Department cost that they will receive.
Therefore, there are 5,000 equivalent units in ending Work in Process for
transferred-in cost.
Step 3. The third step in solving the process costing problem is to assign cost to items
completed and items in ending Work in Process. The cost of the completed
items is $572,600. As indicated in the Production Cost Report (see Illustration 3-8),
this is computed as the cost per equivalent unit ($8.18) times the number
of units completed (70,000). Once the units are completed in the Packaging
Department, they include the cost of both the mixing operation and the pack-
aging operation and they are ready to be transferred to Finished Goods. The
entry to record the transfer is:
(date) Finished Goods 572,600
Work in Process, Packaging 572,600
To record cost of units completed
and transferred to Finished Goods
The cost of ending Work in Process is composed of material, labor,
overhead, and transferred-in cost. For each cost category, the equivalent units
in ending Work in Process are multiplied by the cost per equivalent unit. As
indicated in the production cost report, the sum of the cost categories is the
ending balance of $36,850.
Step 4. The fourth and final step is to account for the amount of product cost. The cost
of beginning inventory ($116,250) plus the amount of cost incurred during the
period ($493,200) is the total cost that must be accounted for ($609,450). As
indicated in the production cost report, this is accounted for by the cost of the
completed items ($572,600) plus the cost of ending Work in Process ($36,850).
The packaging department at Rainier Chemical had no beginning Work in Process inventory
at the start of April. During April, the department received $300,000 of transferred-in cost
from the Mixing Department. During April, the department completes 600 units, and 200
are in Work in Process. Packaging has not yet started on the in-process units since they
were received right before the plant closed on April 30. With respect to transferred-in cost,
the 200 units in work in process are:
a. Equivalent to 200 completed units.
b. Equivalent to 0 completed units.
c. Equivalent to 100 completed units.
d. Identical to the equivalent units for conversion costs.
Process Costing and incremental

analysis
Decision Making/ Recall from Chapter 1 that whenever we make a decision, we need to perform incre-
Incremental mental analysis. That is, we need to determine the change in revenue and the change in
Analysis cost, assuming a particular decision alternative is selected. If the net change is positive,
the decision alternative is “good” since it will have a positive impact on firm profit. If
the net change is negative, the decision alternative is “bad” in that it will have a negative
impact on firm profit.
When using process costing information (or, for that matter, job-order costing infor-
mation) to make a decision, we have to be careful to recognize that the cost per unit is
P r o c e s s C o s t i n g a n d I n c r e m e n t a l A n a l y s i s 101
typically the average of fixed and variable costs. Thus, it does not measure the change in
cost associated from producing an additional unit. Let’s consider a simplified example to
clarify this point. Later in Chapter 7, we’ll go into more detail on decision making with
product cost information.
Suppose that a company has no beginning Work in Process inventory and no ending
Work in Process inventory for 2017. During 2017, the company incurs $100,000 of direct
material cost, $200,000 of direct labor cost, and $300,000 of manufacturing overhead in
producing 200,000 units that sell for $3.25 per unit. Further, let’s assume that material
and labor are variable costs and, for simplicity, that manufacturing overhead is com-
pletely fixed. In this case, the annual profit for 2017 is $50,000, as follows:
200,000 Units Per Equivalent Unit
Direct material cost $100,000 $0.50

Direct labor cost 200,000 1.00
Manufacturing overhead cost 300,000 1.50
Total $600,000 $3.00
Current selling price $3.25
Profit = Sales − Cost
= ($3.25 × 200,000) − $600,000
= $50,000
Now suppose that the company is considering decreasing its price to $2.90 for 2018 and
expects that demand for its product will increase 75,000 units to 275,000. Note that the
price of $2.90 is less than the cost per equivalent unit in 2017 so it might appear that
decreasing the price is a poor decision. However, to evaluate the decision properly, we
must perform incremental analysis.
New revenue ($2.90 × 275,000) $797,500

Old revenue ($3.25 × 200,000) 650,000
New cost
Material: variable ($0.50 × 275,000) $137,500
Labor: variable ($1.00 × 275,000) 275,000
Overhead: fixed 300,000 $712,500
Old Cost 600,000
Incremental cost $112,500
Net change $ 35,000
Note that at the new price, revenue will increase by $147,500. However, costs will increase
by only $112,500. Thus, there will be a net benefit of $35,000 associated with decreasing
the price to $2.90 even though it is below the old cost per unit of $3.00! We can see this
only by performing incremental analysis. And in performing incremental analysis, we
must take into account that some of the costs are variable (material and labor) and some
costs are fixed (manufacturing overhead). We would have made a serious error if we had
assumed that the new cost would be $825,000 (i.e., $3.00 × 275,000). Costs won’t increase
by $3.00 per unit because $1.50 of the old unit cost is actually fixed.
“You get What You measure!” and

manufacturing processes
You get what you Cost information for a manufacturing firm can be quite useful, as we just saw with
M e a s u r e the pricing decision in the previous section. Additionally, nonmonetary performance
measures can help a manufacturing company create value. For example, a key nonmon-
etary measure for Kent Chemical is the safety measure reportable instance. A reportable
instance is an occurrence that could have or did lead to harm and that could have been
prevented by a change in how an operation or task was performed. For example, if an
employee handling a chemical in the mixing process burned her hand because she was
not wearing protective gloves, this would be a reportable instance.
If this performance measure is viewed as important (which would certainly be the
case if the number of reportable instances is tied to bonuses!), then employees will pay
more attention to safety, reduce the number of reportable instances, and create value
related to fewer insurance claims and days off recovering from injuries.
The important point to remember is that manufacturing companies can create value
by measuring performance related to important company goals. If safety is important,
then they should develop and report safety measures, such as number of reportable
instances. If the time it takes to package 4,000 1-gallon containers of wood preservative
is important, the company should measure that time and make sure employees know
how they are performing with respect to the measure.
Decision Making Just as with job-order costing, process costing systems provide information on the
Insight full cost of units produced rather than their incremental cost. Since decision making
relies on incremental analysis, care must be taken not to treat full cost as if it were
incremental cost.

Learning Objective 1 Describe how products Process costing is essentially a system of averaging. The
flow through departments and how costs flow average unit cost is referred to as the cost per equivalent unit.
through accounts. It equals the sum of beginning Work in Process costs and
current-period costs divided by the sum of units completed and
Process costing systems are used to accumulate the cost equivalent units in ending Work in Process.
of inventory in companies that produce large numbers of To calculate the cost of completed items, the total cost per
identical items. Typically, several distinct processes are used equivalent unit is multiplied by the number of units completed.
to produce the items. When units are completed in one pro- To calculate the cost of units in Work in Process, it is necessary
cess, the cost of the units is transferred to the next process. to multiply the number of equivalent units in process by the cost
This procedure is repeated until the units are completed in per equivalent unit separately for each cost category (i.e., material,
the last process. Along with transferred-in costs, each pro- labor, overhead, and transferred-in cost). This is necessary because
cess may add its own material, labor, and overhead costs. the units in Work in Process at the end of the period may be
completed to different degrees with respect to each of these costs.
Learning Objective 2 Discuss the concept of
an equivalent unit and calculate the cost of goods Learning Objective 3 Prepare a production cost
completed and the ending Work in Process balance report.
in a processing department. A production cost report provides a reconciliation of units in
Units in work in process are not equal to fully completed units. beginning inventory and units started to units in ending inven-
Therefore, in calculating the average cost per unit, it is necessary tory and units completed. This report also provides a reconcilia-
to express these partially completed units in terms of equivalent tion of costs in beginning inventory and costs added during the
whole units. period to costs in ending inventory and costs transferred out.
B e vhiaevwi oPr rPoabtl teemr n 1s 103
Common Cost R
Review Problem 1
K/9 Plus Dog Treats has two departments, Mixing and Packaging. The Packaging Department
started in December with work in process inventory of 20,000 pounds (a 1-pound bag is a unit of
production). The units had $12,000 of transferred-in costs but no costs from Packaging.
During December, Packaging received 100,000 more pounds from Mixing and additional
transferred-in cost of $54,000. Packaging also incurred $17,250 of material cost, $13,800 of labor,
and $8,050 of overhead during the month of December.
At the end of December, Packaging had work in process inventory of 5,000 pounds. These
units were zero percent complete with respect to material, labor, and overhead in Packaging (they
had just been received from Mixing and had not been worked on by that department).
Req u i red
Prepare a production cost report for Packaging for the month of December.
K/9 Plus Dog Treats

Production Cost Report
Packaging Department December
Unit Reconciliation
Units in beginning WIP 20,000
Units started 100,000
Units completed 115,000
*
Units in ending WIP 5,000

*
Units completed = 120,000 units to account for –5,000 in ending WIP = 115,000.

Cost
Beginning WIP $ –0– $ –0– $ –0– $12,000 $ 12,000
Cost incurred in December 17,250 13,800 8,050 54,000 93,100
Total $17,250 $13,800 $8,050 $66,000 $105,100
Units
Units completed 115,000 115,000 115,000 115,000
Equivalent units in
ending WIP –0– –0– –0– 5,000
Total 115,000 115,000 115,000 120,000
Cost Reconciliation
Cost of completed units transferred to
Finished Goods (115,000 × $0.89) $102,350
Cost of ending WIP
($0.55 transferred-in cost × 5,000) 2,750
Review Problem 2
Little Gardener Company produces an environmentally safe general-purpose plant food that
can be used on flower beds and in vegetable gardens. The company operates two departments,
Mixing and Packaging. Liquid plant food is prepared in the Mixing Department and packaged in
1-gallon containers in the Packaging Department. Material is added at the start of each process,
and labor and overhead are added evenly throughout the processes. All units are completed each
month in Packaging. Therefore, there is no ending Work in Process in this department.
The following information is related to production in February:
Unit Information (gallons) Mixing Packaging
Beginning Work in Process
(Mixing) 2,000
(Packaging) –0–
Started during March 60,000 61,000
Ending Work in Process
(Mixing: 100% material, 60% conversion costs) 1,000
(Packaging) –0–
Cost Information, Beginning Work in Process

Direct material $4,000 $–0–
Direct labor 800 –0–
Manufacturing overhead 1,120 –0–
Transferred-in cost –0– –0–
Cost added during February

Direct labor 30,000 3,050
Transferred-in cost –0– ?
Req u i r ed
Prepare production cost reports for Mixing and Packaging for the month of February.
Little Gardener Company

Mixing Department
February
Unit Reconciliation
Units in beginning WIP 2,000
Units started during February 60,000
Cost
Beginning WIP $ 4,000 $ 800 $ 1,120 $ 5,920
Cost incurred during February 120,000 30,000 42,000 192,000
Total $124,000 $30,800 $43,120 $197,920
K e y T e r m s 105

Units
Units completed 61,000 61,000 61,000
Equivalent units, ending WIP 1,000 600 600
Total 62,000 61,600 61,600
Cost per equivalent unit $2.00 $0.50 $0.70 $3.20
Cost Reconciliation
Finished Goods (61,000 × $3.20) $195,200
Cost of ending WIP
Material (1,000 equivalent units × $2) $2,000
Labor (600 equivalent units × $0.50) 300
Overhead (600 equivalent units × $0.70) 420 2,720
Little Gardener Company

Packaging Department
February
Unit Reconciliation
Units in beginning WIP –0–
Units in ending WIP –0–

Cost
Beginning WIP $ –0– $ –0– $ –0– $ –0– $ –0–
Cost incurred during February 18,300 3,050 6,100 195,200 222,650
Total $18,300 $3,050 $6,100 $195,200 $222,650
Units
Units completed 61,000 61,000 61,000 61,000
Equivalent units, ending WIP –0– –0– –0– –0–
Total 61,000 61,000 61,000 61,000
Cost Reconciliation
Finished Goods (61,000 × $3.65) $222,650
Cost of ending WIP –0–
Key Terms Conversion costs (90) Equivalent units (92) Transferred-in cost (90)
Cost per equivalent unit (93) Production cost report (95)

1. Which of the following characteristics are associated a. All of the units in Work in Process are 100 percent
with a process costing system? (Choose all that apply). complete with respect to materials.
a. Heterogeneous products. b. All of the units in Work in Process are 50 percent
b. Homogeneous products. complete with respect to materials.
c. Continuous production. c. Equivalent units of materials are not a function
d. Discontinuous production. of when the materials are entered into the
process.
e. Costs are traced to jobs.
d. All of these choices are correct.
f. Costs are traced to processing departments.
7. A transfer of units from Production Department 1 to
2. The best example of a business requiring a process cost-
Production Department 2 would be recorded as a:
ing system would be a:
a. Debit to Work in Process, Department 1; credit to
a. Custom cabinet shop.
Work in Process, Department 2.
b. Antique furniture restorer.
b. Debit to Work in Process, Department 2; credit to
c. Soap manufacturer. Work in Process, Department 1.
d. Automobile repair shop. c. Debit to Cost of Goods Sold; credit to Work in
3. The costs in a process cost system are traced to: Process, Department 1.
a. Specific jobs. d. Debit to Cost of Goods Sold; credit to Work in
b. Specific customers. Process, Department 2.
c. Specific company administrators. 8. The unit reconciliation section of a production cost re-
d. Specific production departments. port includes all of the following except:
4. Match the following terms with the definitions in the a. Beginning units in process.
numbered list below. b. Ending units in process.
a. Conversion costs c. Units in finished goods.
b. Equivalent units d. Units completed and transferred out.
c. Transferred-in costs e. Units started during the period.
d. Cost per equivalent unit 9. The units as shown in the unit reconciliation section of
(1) The costs associated with units received from a pre- a production cost report are:
ceding department for further processing. a. Equivalent units of production.
(2) The unit cost in a process costing system. b. Units without regard to stage of completion.
(3) The costs associated with changing units of direct c. Units complete as to materials.
materials into finished products; they include both d. Units complete as to prime costs.
direct labor and manufacturing overhead. 10. Transferred-in costs occur in:
(4) The quantity of partially completed units expressed a. All production departments.
in terms of whole units. b. The first and last production departments.
5. Determine the amount of conversion cost in the follow- c. All production departments after the first.
ing list of costs. d. None of these answer choices is correct.
a. Direct material $25,000
b. Direct labor $35,000
c. Manufacturing overhead $45,000
1. b, c, f 2. c 3. d 4. (1)-c, (2)-d, (3)-a, (4)-b
d. Selling expenses $10,000 5. $80,000 6. a 7. b 8. c 9. b 10. c
e. Administrative expenses $50,000
6. If raw materials are introduced into a production de-
partment at the beginning of the process, which state-
ment is correct about the equivalent units in ending
Work in Process for materials?
Questions 1. Explain the major differences between job-order and process costing systems.
2. Identify three types of manufacturing companies for which process costing would be an ap-
propriate product costing system. What characteristic(s) do the products of these companies
have that would make process costing a good choice?
3. Explain the concept of an “equivalent unit,” including how it is calculated.
4. What is meant by the term conversion costs?
5. What is meant by the term transferred-in cost?
6. Why are units often in a different stage of completion with respect to raw materials and con-
version costs?
7. What items of production cost make up the “costs to account for” in a production cost report?
8. What is accomplished by preparing a reconciliation of the physical units as a part of the pro-
duction cost report?
9. Do transferred-in costs occur in all departments of a manufacturer using a process costing
system? Explain.
10. What are the four steps involved in the preparation of a production cost report?
Exercises EXERCISE 3-1. Equivalent Units [LO 2] Techno Enterprises is a manufacturer of microchips
( referred to as chips). Its production process is complex and involves more than 100 steps, starting
with production of small, round silicon wafers and ending with chips being put into individual pack-
ages that protect them and provide connections to the products for which the chips are developed.
The company uses a process costing system and has always made the simplifying assumption that
wafers in production, but not yet finished, are 50 percent complete with respect to conversion costs.
In the current year, the company has struggled due to a decline in computer sales and reduced
demand for chips. To boost profit, the company has decided to start a very large number of wafers
into production in the last few days of the year. Due to the use of ceramic carriers and other
high-performance features, the Techno Enterprises production process typically takes 30 days.
Req u ired
Explain why starting a large number of wafers into production will boost profit even though the
chips that ultimately result from the wafers are ones that have not been sold or even completed.
Is the company’s approach to boosting profit ethical?
EXERCISE 3-2. Cost per Equivalent Units [LO 2] Write a paragraph explaining the calculation of
the cost per equivalent unit (i.e., explain what goes in the numerator and what goes in the denom-
inator of the calculation). Be sure to explain why the denominator may be different for the cost per
equivalent unit of material and the cost per equivalent unit of labor and overhead.
EXERCISE 3-3. Cost Flows through Accounts [LO 1] What are the four cost items that may enter
a processing department?
EXERCISE 3-4. Physical Flow of Units [LO 3] In each case below, fill in the missing amount.
Case #1 Work in Process, October 1 5,000 gallons

Units started during October ?
Units completed during October 15,000 gallons
Work in Process, October 31 2,500 gallons
Case #2 Work in Process, March 1 16,000 tons
Units started during March 4,000 tons
Units completed during March 14,400 tons
Work in Process, March 31 ?
Case #3 Work in Process, December 1 300,000 pounds
Units started during December 950,000 pounds
Units completed during December ?
Work in Process, December 31 350,000 pounds
EXERCISE 3-5. Unit Reconciliation [LO 3] During August the Panama Paint Company com-
pleted 90,000 cans of paint. At the beginning of August, the company had 850 units that were
75 percent complete with respect to material and 50 percent complete with respect to conversion
costs. During the month, the company started production of 95,000 units.
Req u i red
How many units were in Work in Process at the end of August?
EXERCISE 3-6. Unit Reconciliation [LO 3] During August, Wilson Lubricant completed 31,000
gallons of product. At the start of August there were 4,500 gallons in Work in Process, and at the
end of August, there were 7,000 gallons in Work in Process.
R equ i red
How many gallons of product were started during the month of August?
EXERCISE 3-7. Cost per Equivalent Unit [LO 2] The balance in beginning Work in Process
at Bing Rubber Company for direct labor was $140,000. During the month of March, an ad-
ditional $800,000 of direct labor was incurred, and 35,000 pounds of rubber were produced.
At the end of March, 10,000 pounds of rubber were in process and the units were 50 percent
complete. At the start of March, the company had 6,000 pounds of rubber that were 40 percent
complete.
Req u ir ed
Calculate the cost per equivalent unit for labor, assuming that labor is added uniformly throughout
the production process.
EXERCISE 3-8. Cost Reconciliation [LO 3] During December, Western Solvent completed
40,000 units. At the end of December, there were 10,000 units in ending Work in Process
that were 30 percent complete with respect to labor and overhead and 100 percent complete
with respect to material. During the month of December, the company incurred $260,000
of material cost, $120,000 of labor cost, and $161,000 of manufacturing overhead. Costs
per equivalent unit for material, labor, and manufacturing overhead equal $6, $3, and $4,
respectively.
Req u i red
Calculate the amount of material cost, labor cost, and overhead cost in beginning Work in Process
inventory.
EXERCISE 3-9. Calculation of Equivalent Units [LO 2] The McMillian Tire Company produces
tires used on small trailers. The month of June ended with 600 tires in process, 90 percent complete
as to direct materials, and 50 percent complete as to conversion costs; 2,000 tires were transferred
to finished goods during the month, and 2,400 were started during the month. The beginning
Work in Process inventory was 60 percent complete as to direct materials and 40 percent complete
as to conversion costs.
Req u ir ed
Determine the denominators to be used in the calculations of cost per equivalent unit for materials
and conversion costs.
EXERCISE 3-10. Reconciliation of Units and Costs [LO 2] At the start of July, the Classic
Car Wax Company had beginning Work in Process of 2,500 units that were 90 percent com-
plete with respect to material and 45 percent complete with respect to conversion costs. The
cost of the units was $7,000 ($5,000 of material and $2,000 of conversion costs). During the
month, the company started production of 40,000 units and incurred $224,500 of material
cost and $91,750 of labor and overhead. Costs per equivalent unit were $6.00 for material and
$2.50 for labor and overhead (conversion costs). The cost of items completed was $314,500
($222,000 for materials and $92,500 for labor and overhead). Units in ending Work in Process
are 25 percent complete with respect to material and 10 percent complete with respect to
conversion costs.
Req u i red
a. Prepare a reconciliation of units.
b. What is the cost of ending Work in Process?
EXERCISE 3-11. Costing Units Completed and Ending Work in Process [LO 2] For the month
of September, the Wilber Pickle Company had cost per equivalent unit of $0.80 for materials
(pickles, vinegar, spices, etc.) and $.90 for conversion costs (labor and overhead). At Wilber Pickle,
units are measured in quarts. The company began the month with 600 quarts of pickles. By the
end of the month, the company had completed 4,500 quarts, and 950 quarts were in process. The
in-process units were 100 percent complete with respect to material and 75 percent complete with
respect to labor and overhead.
R equ ir ed
Determine the cost of the ending Work in Process inventory and the cost of items completed and
transferred to Finished Goods inventory. Round answers to the nearest dollar.
EXERCISE 3-12. Costing Units Completed and Ending Work in Process [LO 2] Magi-Clean
Vacuum produces a single product, a vacuum cleaner, in a continuous production process. At
the beginning of production, 85 percent of materials are added; the other 15 percent are added
immediately before transfer to the finished goods warehouse. Conversion costs are assumed to be
added evenly throughout the process. At the end of February, there were 20 vacuums in process,
80 percent complete as to labor and overhead. Ninety-five vacuums were completed during the
month. Assume that direct materials cost per equivalent unit during February was $2,050, labor
cost per equivalent unit was $800, and overhead per equivalent unit was $1,500.
Req u i red
Determine the cost of the ending Work in Process inventory and the cost of items completed and
transferred to Finished Goods inventory.
EXERCISE 3-13. Costing Units Completed and Ending Work in Process [LO 2] At the start of
November, Penco Refinery had Work in Process inventory consisting of 4,000 units that were 90
percent complete with respect to materials and 50 percent complete with respect to conversion
costs. The cost of the units was $43,000 ($30,000 of material cost and $13,000 of labor and overhead).
During November, the company started 44,000 units and incurred $421,990 of material cost and
$394,880 of labor and overhead. The company completed 45,000 units during the month, and 3,000
units were in process at the end of November. The units in ending Work in Process were 85 percent
complete with respect to materials and 45 percent complete with respect to conversion costs.
Req u ir ed
a. Calculate the cost per equivalent unit for materials and conversion costs.
b. Calculate the cost of items completed during November.
c. Calculate the cost of ending Work in Process.
d. Round cost per equivalent unit calculations to the nearest cent and cost of work in process to
the nearest dollar.
EXERCISE 3-14. Quantity Schedule and Equivalent Units [LO 3] The Simon Fishing Com-
pany processes salmon for various distributors. The two departments involved are Cleaning and
acking. The next table summarizes the data related to pounds of salmon processed in the Clean-
P
ing Department during June:
Pounds of Salmon Percent Complete*
Work in Process, June 1 40,000 50%

Started into processing during June 500,000 —
Work in Process, June 30 30,000 75%
*
Labor and overhead only
All materials are added at the beginning of the process in the Cleaning Department.
Req u i r ed
Prepare a reconciliation of units and a computation of equivalent units for June for the Cleaning
Department.
EXERCISE 3-15. Calculation of Equivalent Units [LO 2, 3] Tempe Chemicals refines a variety
of chemicals for cleaning products. The following data are from the company’s Greenville plant:
Work in Process, May 1 2,300,000 gallons
Direct material 100% complete
Conversion costs 40% complete
Units started in process during May 770,000 gallons
Work in Process, May 31 235,000 gallons
Direct material 100% complete
Conversion costs 60% complete
Req u i r ed
Compute the equivalent units for direct material and conversion costs for the month of May.
EXERCISE 3-16. Physical Flow and Equivalent Units [LO 1, 2] The Sacramento plant of M
ontero
Food Corporation produces a gourmet cheese. The following data pertain to the year ended
December 31, 2017:
Percentage of Completion
Units Direct Material Conversion Costs
Work in process, January 1 45,000 lb 65% 85%

Work in process, December 31 60,000 lb 80% 45%
During the year, the company started 200,000 pounds of material into production.
Req u i r ed
Prepare a schedule analyzing the physical flow of units and computing the equivalent units for
both direct material and conversion costs for the year.
EXERCISE 3-17. Cost per Equivalent Unit [LO 2] The Amigo Glass Company manufactures glass
for sliding glass doors. At the start of August 2,000 units were in process. During August, 15,000
units were complete and 3,000 units were in process at the end of August. These in-process units
were 100 percent complete with respect to material and 40 percent complete with respect to con-
version costs. Other information is as follows:
Work in process, August 1:

Conversion costs $45,000
Costs incurred during August:
Conversion costs $280,000
P r o b l e m s 111
Req u i red
Calculate the cost per equivalent unit, for both direct material and conversion costs, during
August.
EXERCISE 3-18. Incremental Analysis Woodinville Cement uses a process costing system.
In 2017, the company produced and sold 100,000 bags of cement and incurred the following
costs:
Total Per Equivalent Unit
Direct material $ 25,000 $0.25

Direct labor 100,000 1.00
Manufacturing overhead 200,000 2.00
Total $325,000 $3.25
The current selling price is $4 per unit, and the profit for 2017 was ($4 × 100,000) − $325,000 =
$75,000. Sales projections for 2017 at the current price look flat, but the sales manager believes
that if the sales price is reduced to $3.75, sales volume would increase by 12,000 units. Assume
that direct material and direct labor are variable costs and that manufacturing costs are primarily
fixed. Should Woodinville Cement lower the price?
Problems PROBLEM 3-1. Comprehensive Problem, One Department [LO 2] Regal Polish manufactures
a single product in one department and uses a process costing system. At the start of May, there
were 11,000 units in process that were 100 percent complete with respect to direct material and
60 percent complete with respect to conversion costs (labor and overhead). During the month,
the company began production of 105,000 units. Ending Work in Process inventory consisted of
5,100 units that were 100 percent complete with respect to material and 70 percent complete with
respect to conversion costs.
Cost Information Beginning Work in Process Costs Added in May
Direct material $4,000 $76,040.00

Direct labor 200 8,957.60
Manufacturing overhead 300 10,002.30
Total $4,500 $94,999.90
Req u ir ed
a. Calculate the cost per equivalent unit for each of the three cost items and in total. Round to
2 decimal places.
b. Calculate the cost of items completed in May and the cost of ending Work in Process. Round
to 2 decimal places.
c. Reconcile the sum of the two costs in part b to the sum of beginning Work in Process and costs
added in May.
PROBLEM 3-2. Comprehensive Problem, One Department [LO 2] Marquita Filters produces
an air filter for use in jet aircraft. Parts are added at several points in the production process. In
August, production began with 600 filters in Work in Process, 80 percent complete as to materials
and 70 percent complete as to labor and overhead. During the month, an additional 2,700 units
were started into production. Seven hundred filters were in Work in Process at the end of the
month, and they were 70 percent complete as to materials and 60 percent complete as to labor
and overhead.
Cost Information Beginning Work in

for August Process Inventory Cost Added in August
Direct material $ 45,000 $267,090

Total $136,000 $840,490
Req u i r ed
a. Calculate the cost per equivalent unit for each of the three cost items and in total. Round to
2 decimal places.
b. Calculate the cost of items completed in August and the cost of ending Work in Process inven-
tory. Round to 2 decimal places.
added in August.
PROBLEM 3-3. Production Cost Report [LO 2, 3] Kao Tiles is a specialized producer of ceramic
tiles. Its production process involves highly skilled workers and top-quality ceramic crafters. Work in
Process is relatively large because each tile is in process for up to 3 weeks because of art, mold work, and
drying time. October began with 5,000 units (a unit is one ceramic tile) in process, on average 65 percent
complete as to direct materials and 35 percent complete as to conversion costs; 6,000 units were started
during the month, and ending Work in Process inventory consisted of 7,000 units that were on average
75 percent complete as to direct materials and 50 percent complete as to conversion costs.
Cost Information Beginning Work in Process Costs Added in October
Direct material $170,000 $ 422,000

Direct labor 160,000 1,055,000
Req u i r ed
a. Prepare a production cost report for the month of October.
b. Prepare the journal entry to recognize the transfer of the units completed and transferred to
finished goods during October.
PROBLEM 3-4. Production Cost Report [LO 2, 3] Aussie Yarn is a U.S. producer of woolen yarn
made from wool imported from Australia. Raw wool is processed, spun, and finished before being
shipped out to knitting and weaving companies. Material is added in the beginning of processing,
and conversion costs are added evenly throughout processing.
Aussie began the month of August with 7,000 units in process that were 100 percent complete
as to materials and 70 percent complete as to labor and overhead. It started 34,000 units into pro-
duction during the month of August of which 8,000 remained in ending Work in Process inventory
and were 50 percent complete as to conversion costs. The cost data are as follows:
Beginning work in process:
Direct materials $ 6,000
Direct labor 2,000
$10,500
Costs added during August:
Direct labor 12,430
$53,340
P r o b l e m s 113
Req u i red
Prepare a production cost report for the month of August.
PROBLEM 3-5. Journal Entries in Process Costing [LO 1] Lakeland Solvent produces a single
product in two departments. The following costs relate to April:
Department 1 Department 2
WIP, March 31 $ 24,000 $ 44,000

Costs added during April
Direct material 80,000 15,000
Transferred-in costs N/A ?
WIP, April 30 –0– 30,000
Req u i red
Prepare journal entries to record:
a. The issuance of direct material.
b. The cost of direct labor (credit wages payable).
c. The application of manufacturing overhead.
d. The transfer of cost associated with units completed in both departments.
PROBLEM 3-6. Journal Entries in Process Costing [LO 1] The Wilmont Box Company pro-
duces a single box used by AirSpeed, an express shipping company. Wilmont uses a just-in-time
system and has almost no inventories of material, work in process, or finished goods. Indeed,
the balances are so small that the company treats them as zero for purposes of its accounting
reports.
During July, the company produced and shipped 125,000 boxes at a cost of $0.90 per box. The cost
consisted of 40 percent material cost, 15 percent labor cost, and 45 percent manufacturing overhead.
Req u ir ed
b. The cost of direct labor (credit wages payable).
d. The completion of units in process and their transfer to finished goods.
e. Cost of goods sold.
PROBLEM 3-7. Production Cost Report, Missing Data [LO 2, 3] Classic 50s Flooring produces
linoleum flooring. Below is a partial production cost report for the Mixing Department. In the
report, a unit is a gallon of linoleum cement (a mixture of linseed oil, pine resin, and wood flour).

Mixing Department
June
Quantity Reconciliation
Units in beginning WIP 700
Units started 2,700
Units in ending WIP (100% material, 70% conversion costs) (a)
Units accounted for (b)
Cost
Beginning WIP $ 475 $ 1,200 $ 2,400 $ 4,075
Cost incurred during June 4,125 11,610 23,830 39,565
Total $4,600 $12,810 $26,230 $43,640
Units
Units completed 2,300 2,300 2,300
Equivalent units, ending WIP (c) (d) (e)
Total (f) (g) (h)
Cost per equivalent unit (i) (j) (k) (l)
Req u i r ed
Fill in the missing data (items a through l). Round to 2 decimal places.
PROBLEM 3-8. Production Cost Report, Missing Information [LO 2, 3] Marion Chemicals
produces a chemical used as a base in paints. In the manufacturing process, all materials are
added at the start of the process, whereas labor and overhead are added evenly throughout
production.
Req u i r ed
Fill in the missing information in Marion’s Production Cost Report for the month of December.
Marion Chemicals
December 2017
Unit Reconciliation
Units started during December ?
Units to account for ?
Units completed ?
Units accounted for ?
Cost
Beginning WIP $45,200 $10,500 $26,300 $ 82,000
Cost incurred in December ? ? ? ?
Total ? ? ? ?
Units
Units completed ? ? ?
Equivalent units, ending WIP ? ? ?
Total ? ? ?
Cost per equivalent unit $1.80 $1.40 $2.64 ?
P r o b l e m s 115
Cost Reconciliation
Total cost to account for $3,020,640
Cost of completed items $3,007,600
Cost of ending WIP
Material $?
Labor ?
Overhead ? ?
Total cost accounted for $3,020,640
PROBLEM 3-9. Comprehensive Problem, Two Departments [LO 2, 3] Simply Shine Shampoo is
manufactured in two departments: Mixing and Packing. Once the shampoo mixture is completed
in the Mixing Department, it is sent to Packaging, where a machine fills and seals individual bot-
tles, which are then passed to a machine that places the bottles in individual boxes.
The following information is related to production in March:
Mixing Packing
Unit Information
Beginning WIP
(Packing: 60% material, 50% conversion costs) 14,500
Started during March: 660,000 63,000
Ending WIP
(Packing: 80% material, 60% conversion costs) 38,000
Direct material $ 8,500 $ 925
Direct labor 1,200 60
Manufacturing overhead 2,500 115
Transferred-in cost — 3,805
Cost Added during March
Direct material $254,750 $ 88,941
Req u i r ed
Prepare production costs reports for Mixing and Packing for the month of March. (Round costs
per unit to two decimal places and cost reconciliation amounts to nearest dollar.)
PROBLEM 3-10. Comprehensive Problem, Two Departments [LO 2, 3] The Carnival Caramel
Company makes a high-quality caramel candy. The manufacturing process involves mixing ingre-
dients (Mixing Department) and shaping the processed mixture into 1-pound balls (Shaping
Department), which are sold to retail outlets. No additional material is added in the shaping pro-
cess. The following information is related to production in March:
Mixing Shaping
Unit Information
Beginning WIP
(Shaping: 80% conversion costs) 5,000
Started during March 45,000 ?
Ending WIP
(Shaping: 60% conversion costs) 1,500
Mixing Shaping
Direct material $ 4,000 —
Direct labor 1,600 $ 800
Manufacturing overhead 1,900 600
Cost Added during March
Direct material $45,500 —
Direct labor 23,135 $13,592
Transferred-in cost — ?
Req u i red
Prepare production cost reports for Mixing and Shaping for the month of March. In your calcu-
lations, round to two decimal places.
PROBLEM 3-11. Production Report [LO 2, 3] Tropical Sun makes suntan lotion in two stages.
The lotion is first blended in the Blending Department and then bottled and packed in the Bottling
Department. The following information relates to the operations of the Blending Department for May.
Percent Completed
Units Materials Conversion
Beginning WIP 7,500 80% 55%
Started into production 97,000
Completed and transferred out 92,500
Ending WIP 12,000 65% 20%
Costs ($)
Beginning WIP $ 7,000 $ 8,000
Costs added during May $106,339 $143,840
Req u i r ed
Prepare a production report for the Blending Department for May. (Round cost percent to two
decimal places and cost reconciliation amounts to nearest dollar.)
PROBLEM 3-12. Determination of Production Costs [LO 2, 3] The Kioda Corporation assem-
bles various components used in the electronics industry. The company’s major product, a com-
puter chip, is the result of assembling three parts: X1, Y2, and Z3. The following information
relates to production in January:
• Beginning Work in Process inventory: 6,000 units, 85 percent complete as to conversion; cost-
ing $330,000 (direct materials, $260,000; conversion costs, $70,055).
• Production started: 33,000 units.
• Production completed: 29,500 units.
• Ending Work in Process inventory: 9,500 units, 55 percent complete as to conversion.
• Direct materials used: X1,$295,000; Y2, $750,000; Z3, $490,170.
• Hourly wages of direct laborers, $25; total direct-labor payroll, $162,500.
• Overhead application rate: $70 per direct-labor hour.
Req u i r ed
All parts are introduced at the beginning of Kioda’s manufacturing process; conversion costs are
incurred uniformly throughout production.
a. Calculate the total cost of direct material and conversion during January.
b. Determine the cost of goods completed during the month.
c. Determine the cost of the work in process inventory on January 31.
P r o b l e m s 117
PROBLEM 3-13. Conversion Costs [LO 2, 3] Hartwell Drug Company produces a supplement to
improve bone density. Conversion costs are added evenly throughout the production process. The
following information is available for March:
Units
Units (gallons) in process, March 1 (40% complete) 600

Units started in March 1,000
Units in process, March 31 (80% complete) 300
Costs
Conversion costs in WIP, March 1

Labor $ 36,000
Overhead 6,000
Labor costs in March (5,100 hours) 102,600
Overhead in March 47,900
Req u ir ed
a. Compute the number of units completed in March.
b. Compute the cost per equivalent unit for conversion costs.
c. Compute the conversion costs included in units completed in March.
d. Compute the conversion costs included in units in process at the end of March.
PROBLEM 3-14. Production Cost Report [LO 2, 3] Sassy Cotton produces fine cotton fabrics. The
cotton is processed and finished before being shipped out to clothing companies. Material is added
in the beginning of processing, and conversion costs are added evenly throughout processing.
At the beginning of July, Sassy had 8,000 units in process that were 100 percent complete as
to material and 40 percent complete as to labor and overhead. The company started 31,000 units
into production during the month of July. At the end of July, 8,500 units were in ending Work in
Process inventory and were 60 percent complete as to conversion costs. Cost data are as follows:
Beginning Work in Process:
Direct labor 3,400
Costs added during July:
Direct labor 10,484
Req u ir ed
Prepare a production cost report for the month of July.
PROBLEM 3-15. Comprehensive Problem, One Department [LO 2, 3] Lindy Manufacturing

uses a process costing system to track the production of the single product it makes in one de-
partment. At the start of November, there were 8,000 units in process that were 100 percent com-
plete for direct material and 70 percent complete for conversion costs (labor and overhead). Lindy
began the production of 83,000 units during the month. In ending Work in Process inventory,
there were 1,800 units that were 100 percent complete for material and 80 percent complete for
conversion costs.
Cost Information Beginning Work in Process Costs Added in November

Direct labor 300 8,764
Manufacturing overhead 200 13,396
$3,500 $93,780
Req u i red
a. Calculate the cost per equivalent unit for each of the three cost item and in total.
b. Calculate the cost of the units completed in November and the cost of ending Work in Process
inventory.
added in November.
PROBLEM 3-16. Comprehensive Problem [LO 2, 3] The Newberry Company accumulates costs
for its product using a process costing system. Direct materials are added at the beginning of the
production process, and conversion occurs evenly throughout the production process. Below is
information related to May.
Unit Information
Work in Process, May 1 (75% complete) 40,000
Units started during May 90,000
Total to account for 130,000
Units in ending WIP (45% complete) 20,000
Cost Information
Direct Material Conversion Total
Work in Process, May 1 $43,000 $340,300 $383,300

Cost incurred during May 87,000 733,080 820,080
Req u i r ed
a. Compute the cost per equivalent unit for material and for conversion costs for May.
b. Compute the costs of units completed during May.
c. Compute the cost of work in process at the end of May.
d. Prepare a journal entry to record the cost of goods completed.
PROBLEM 3-17. Journal Entries in Process Costing [LO 1] Douglas Basket produces a specialty
basket used by a gift basket company, Yours Truly Gifts. Douglas uses a just-in-time system and
has very little inventories of material, work in process, or finished goods. Since the balances are so
small, the company carries them at zero for purposes of accounting.
During August, the company produced and shipped 150,000 baskets at a cost of $1.75 per
basket. The cost was made up of 55 percent material cost, 25 percent labor cost, and 20 percent
manufacturing overhead.
Req u i r ed
b. The cost of direct labor (use wages payable).
d. The completion of units in process and their transfer to finished goods.
e. Cost of goods sold.
PROBLEM 3-18. You Get What You Measure! The Plastic Glow Company makes glow sticks. It
uses a process costing system and has had a just-in-time inventory policy. The plant has a capacity
to produce 500,000,000 units a year but currently operates at 300,000,000 units per year. Direct
C a s e 119
material and direct labor costs are variable, and manufacturing overhead is primarily fixed. Pro-
duction costs for 2017 are as follows:
Number of units produced and sold 300,000,000

Direct materials $ 15,000,000
Total costs $150,000,000
Equivalent cost per unit $0.50
Jim Taylor, the president, receives a bonus each year based on net operating profit and would like
to reduce costs in 2018 so that profit will increase. He decides to take advantage of the excess
plant capacity and increase production to 350,000,000 even though he expects the company will
be unable to increase unit sales in 2018.
Req u ir ed
a. If Jim increases production to 350,000 units per year, what will be the new equivalent cost per
unit?
b. Would increasing the production level be a good idea? Why or why not?
Case
3-1 Tech-Tonic Sports Drink [Lo 2, 3]
The Western Beverage Company is marketing a new c onversion costs; 300,000 gallons were completed during April and,
product, Tech-Tonic Sports Drink Syrup. The product sells unfortunately, 300,000 gallons were lost owing to worker e rror. The
for $16 per gallon, and in recent months the company has had production process calls for sodium to be added at the start of the
sales of more than 525,000 gallons per month. Consumers mix process. On two separate occasions, a new worker added too much
1 part syrup with 5 parts water to make a drink that “replenishes sodium, and batches were ruined. The errors were not identified
vital bodily fluids following exertion.” until the end of the production process when batches were tested
At the start of April, there were 200,000 gallons in beginning for quality assurance. Needless to say, the worker was fired.
Work in Process. The product was 100 percent complete with The controller of Western Beverage, Gunther Bergman, is
respect to material and 50 percent complete with respect to con- considering two ways to treat the cost of the “lost” units. One
version costs. During April, 500,000 gallons were started. Of the approach is to “bury” the cost in the units completed and the
700,000 units to account for, 100,000 gallons remained in pro- units in process. This would result in cost of units completed of
cess at the end of April. These units were 100 percent complete $1,669,000 and cost of ending Work in Process of $222,600 cal-
with respect to material and 20 percent complete with respect to culated as follows.
Approach No. 1
Tech-Tonic Sports Drink Syrup
April
Lost units 300,000

Cost
Beginning WIP $110,000 $ 50,000 $100,000 $ 260,000
Cost incurred during April 450,000 373,000 800,000 1,623,000
Total $560,000 $423,000 $900,000 $1,883,000
Units
Units completed 300,000 300,000 300,000
Total 400,000 320,000 320,000
Cost Reconciliation
Finished Goods (300,000 × $5.53) $1,659,000
Cost of ending WIP
Material (100,000 equivalent units × $1.40) $140,000
Labor (20,000 equivalent units × $1.32) 26,400
Overhead (20,000 equivalent units × $2.81) 56,200 222,600
$1,881,600
Difference due to rounding 1,400
A second approach involves identifying the lost units for April. Work in Process equal to $122,600, and cost of lost units equal to
The result is a cost of units completed equal to $879,000, cost of $879,000, which will be charged to Cost of Goods Sold.
Approach No. 2
Tech-Tonic Sports Drink Syrup
April
Units in beginning WIP (100% material,
50% conversion costs) 200,000
Lost units 300,000
Cost
Beginning WIP $110,000 $ 50,000 $100,000 $ 260,000
Cost incurred during April 450,000 373,000 800,000 1,623,000
Total $560,000 $423,000 $900,000 $1,883,000
Units
Units completed 300,000 300,000 300,000
Lost units 300,000 300,000 300,000
Total 700,000 620,000 620,000
C a s e 121
Cost Reconciliation
Finished Goods (300,000 × $2.93) 879,000
Cost of lost units (300,000 × $2.93) 879,000
Cost of ending WIP
Material (100,000 equivalent units × $0.80) $80,000
Labor (20,000 equivalent units × $0.68) 13,600
Overhead (20,000 equivalent units × $1.45) 29,000 122,600
$1,880,600
Difference due to rounding 2,400
R e q uir ed
a. Assume that 80 percent of the units completed in April are c. Senior managers at Western Beverage receive monthly bo-
sold in that month. What will be the difference in reported nuses determined as a percent of profit in excess of a targeted
profit between the two approaches? level of profit. Which method will they favor?
b. Which approach is most appropriate from a conceptual
standpoint?
Case
3-2 Jensen PVC [LO 2]
Jensen PVC, Inc., produces polyvinyl chloride (PVC) Elger, CFO of Jensen, r eviewed the data generated by the com-
irrigation pipes. In 2017, the cost of producing a foot of pipe was pany’s process costing system.
$0.30, and the selling price was $0.39 per foot. In 2018, produc- In 2017, overhead costs in all of the company’s departments
tion costs increased to $0.40 per foot, although the selling price (mixing, extrusion, cutting, and packing) were $1,500,000, and
remained at $0.39. pipe production was 10,000,000 feet. In 2018, overhead costs were
still approximately $1,500,000, but pipe production decreased to
2017 2018 6,000,000 feet. At a recent meeting of the senior management team,
Bob noted: “The problem is that we’re not making use of capacity.
Selling price $0.39 $0.39 We could easily produce 15,000,000 feet of pipe given our state-of-
Production cost 0.30 0.40 the-art equipment, but we’re operating at less than 50% of capacity.”
The increase in cost was obvious. Material and labor had
remained fairly constant per foot of pipe, but overhead costs, R eq uired
which were $0.15 per foot in 2017, had increased to $0.25 in Bob estimates that to sell 15,000,000 feet of pipe in the current
2018. The problem was that most overhead costs were fixed, market, the company would have to lower its price to $0.35 per
but output had decreased due to weak crop prices and a cor- foot, which is even lower than its current cost per foot of $0.40.
responding decrease in spending on irrigation projects. Bob Would decreasing the price be a good decision?
4
Cost-Volume-Profit
Analysis
Mary Stuart is the vice president of operations for
CodeConnect, a company that manufactures and sells
bar code readers.
As a senior manager, she must answer a variety of questions dealing with planning,
control, and decision making. Consider the following questions that Mary has faced:
Planning. Last year, CodeConnect sold 20,000 bar code readers at $200 per
unit. The cost of manufacturing these items was $2,940,000, and selling and admin-
istrative costs were $766,800. Total profit was $293,200. In the coming year, the
company expects to sell 25,000 units. What level of profit should be in the budget
for the coming year?
Control. In April, production costs were $250,000. In May, costs increased to
$260,000, but production also increased from 1,750 units in April to 2,000 units in
May. Did the manager responsible for production costs do a good job of controlling
costs in May?
Decision Making. The current price for a bar code reader is $200 per unit. If the
price is increased to $225 per unit, sales will drop from 20,000 to 17,000. Should
the price be increased?
The answer to each of these questions depends on how costs and, therefore,
profit change when volume changes. The analysis of how costs and profit change
when volume changes is referred to as cost-volume-profit (CVP) analysis. In this
chapter, we develop the tools to analyze cost-volume-profit relations. These tools
will enable you to answer questions like the ones listed above—questions managers
face on a daily basis.
Paul Bradbury/Getty Images
Learning Objectives
1 Identify common cost behavior patterns, and estimate the relation between cost and activity
using account analysis and the high-low method.
2 Perform cost-volume-profit analysis for single and multiple products.
3 Discuss the effect of operating leverage, and use the contribution margin per unit of the
constraint to analyze situations involving a resource constraint.
123
124 c h apt e r 4 C o s t - V o l u m e - P r o f i t A n a l y s i s
Learning COMMON COST BEHAVIOR PATTERNS

Objective 1
To perform cost-volume-profit (CVP) analysis, you need to know how costs behave
Identify common cost when business activity (e.g., production volume and sales volume) changes. This section
behavior patterns, and describes some common patterns of cost behavior. These patterns may not provide exact
estimate the relation descriptions of how costs behave in response to changes in volume or activity, but they
between cost and are generally reasonable approximations involving variable costs, fixed costs, mixed
activity using account costs, and step costs.
analysis and the
high-low method.
Variable Costs
As mentioned in Chapter 1, variable costs are costs that change in proportion to changes
in volume or activity. Thus, if activity increases by 10 percent, variable costs are assumed
to increase by 10 percent. Some common variable costs are direct and indirect materials,
direct labor, energy, and sales commissions.
Exactly how activity should be measured in analyzing a variable cost depends
on the situation. At McDonald’s restaurants, food costs vary with the number of
customers served. At United Airlines, fuel costs vary with the number of miles flown.
In these situations, number of customers and number of miles are good measures
of activity.
Let’s consider an example using CodeConnect, the company introduced in the
beginning of the chapter. Suppose that CodeConnect has variable production costs
equal to $91 per bar code reader. In this case, total variable cost at a production level
of 1,000 units (the measure of activity) is equal to $91,000 ($91 × 1,000), while total
variable cost at 2,000 units is equal to $182,000 ($91 × 2,000). A graph of the relation
between total variable cost and production is provided in Illustration 4-1. The slope of
the straight line in the figure measures the change in cost per unit change in activity.
Note that while total variable cost increases with production, variable cost per unit
remains at $91.
Illustration 4-1 $300,000

Variable cost behavior at
CodeConnect
$250,000
Change in cost
Slope =
Change in units produced
Variable production costs
= Variable cost per unit

$200,000
182,000 – 91,000
=
2,000 – 1,000
$182,000
= $91
$150,000
$100,000
$91,000
$50,000
0 500 1,000 1,500 2,000 2,500 3,000

Units produced
C o m m o n C o s t B e h a v i o r P a t t e r n s 125

Fixed cost behavior at
CodeConnect
$250,000
Fixed production costs

$200,000
$150,000
$100,000 Fixed cost = $94,000
$50,000
0 500 1,000 1,500 2,000 2,500 3,000

Units produced
Fixed Costs
Recall from Chapter 1 that fixed costs are costs that do not change in response to changes
in activity levels. Some typical fixed costs are depreciation, supervisory salaries, and
building maintenance. Suppose that CodeConnect has $94,000 of fixed costs per month.
A graph of the relation between the company’s fixed cost and production is provided in
Illustration 4-2. As you can see, whatever the number of units produced, the amount
of total fixed cost remains at $94,000. However, the amount of fixed cost per unit does
change with changes in the level of activity. When activity increases, the amount of fixed
cost per unit decreases because the fixed cost is spread over more units. For example, at
1,000 units, the fixed cost per unit is $94 ($94,000 ÷ 1,000), whereas at 2,000 units, the
fixed cost per unit is only $47 ($94,000 ÷ 2,000).
Discretionary versus Committed Fixed Costs. In the short run, some fixed costs
can be changed while others cannot. Discretionary fixed costs are those fixed costs that
management can easily change in the short run. Examples include advertising, research
and development, and repair and maintenance costs. Some companies cut back on these
expenditures when sales drop so that profit trends stay roughly constant. That, however,
may be shortsighted since a cut in research and development can have a negative effect on
long-run profitability, and a cut in repair and maintenance can have a negative effect on
Link to Practice
Using Less Water but Paying Higher Rates! Thus, the somewhat counterintuitive result is that the
utility is now considering raising rates to cover its costs.
As reported by the Associated Press, residents of Austin,
To the rate-payers this must seem like another example
Texas, are becoming victims of their own success at
of “no good deed goes unpunished!”
conserving water. Due to conservation efforts, the city’s
water utility had a $27 million loss in annual water sales. Source: Associated Press, February 25, 2014, kxan.com.
But less water use doesn’t reduce the utility’s fixed costs.
126 c h a p t e r 4 C o s t - V o l u m e - P r o f i t A n a l y s i s
the life of valuable equipment. Committed fixed costs, however, are those fixed costs that
cannot be easily changed in a relatively brief period of time. Such costs include rent, depre-
ciation of buildings and equipment, and insurance related to buildings and equipment.
Mixed Costs
Mixed costs are costs that contain both a variable cost element and a fixed cost element.
These costs are sometimes referred to as semivariable costs. For example, a salesperson
may be paid $80,000 per year (fixed amount) plus commissions equal to 1 percent of sales
(variable amount). In this case, the salesperson’s total compensation is a mixed cost. Note
especially that total production cost is also a mixed cost since it is composed of material,
labor, and both fixed and variable overhead cost items.
Suppose the total production cost of CodeConnect is composed of $94,000 of fixed
cost per month and $91 of variable cost per unit. In this case, total production cost is a
mixed cost. A graph of the cost is presented in Illustration 4-3. Note that the total cost
line intersects the vertical axis at $94,000 (just below the $100,000 point). This is the
amount of fixed cost per month. From this point, total cost increases by $91 for every
unit produced. Thus, at 3,000 units, the total cost is $367,000, composed of $94,000 of
fixed cost and $273,000 of variable cost ($91 × 3,000).
Step Costs
Step costs are those costs that are fixed for a range of volume but increase to a higher level
when the upper bound of the range is exceeded. At that point, the costs again remain
fixed until another upper bound is exceeded. Step costs are often classified as either

Mixed cost behavior Total cost = $367,000 at
production of 3,000 units
$350,000
$300,000
Total production costs
$250,000
Variable cost = $273,000
$200,000
$150,000
$100,000
$50,000 Fixed cost = $94,000
0 500 1,000 1,500 2,000 2,500 3,000

Units produced
C o m m o n C o s t B e h a v i o r P a t t e r n s 127
step variable costs or step fixed costs, depending on the range of activity for which
the cost remains fixed. If the range is relatively small, the cost is considered to be a step
variable cost. If the range is relatively large, the cost is considered to be a step fixed cost.
An example of a step variable cost at CodeConnect is the salary of individuals who test
the bar code readers before they leave the factory. Testers are paid $4,000 per month, and each
can test 300 units per month. A graph of this cost is presented in Illustration 4-4.
Given that the range of activity is relatively small before costs jump up to a higher
level (i.e., the steps are small), step variable costs can often be well approximated as
simply variable costs (i.e., costs that change in proportion to activity).
An example of a step fixed cost is the cost of plant supervisors. CodeConnect can
produce up to 3,000 bar code readers using one supervisor whose monthly salary is
$7,000. However, to produce 3,001 to 6,000 bar code readers, the company must add a
second shift. Now, another supervisor is needed, bringing the total cost for plant super-
visors to $14,000. To produce more than 6,000 bar code readers, the company must add
a third shift and a third supervisor. Now supervisor salaries will increase to $21,000. A
graph of this cost is presented in Illustration 4-5.
Note that the steps in Illustration 4-5 are much wider than those in Illustration 4-4.
Given this, the cost is not close to being a variable cost.
Relevant Range
The relevant range is the range of activity for which cost behavior assumptions are rea-
sonably valid. We might assume, for example, that plant supervisory salaries are fixed
even though we know they are step costs. If production is only going to be between
3,001 and 6,000 units (the relevant range), then the assumption that supervisor sal-
aries are fixed at $14,000 per month is valid. Making the assumption that the cost is
fixed at $14,000 would, however, not be valid if we went above or below this range. See
Illustration 4-6.
Illustration 4-4
Testing as a step variable cost $36,000
$32,000
Salary of testers (step variable cost)
$28,000
$24,000
$20,000
$16,000
$12,000
$8,000
$4,000
0
300 600 900 1,200 1,500 1,800 2,100 2,400 2,700
Units produced
Illustration 4-5
Salaries of plant supervisors $21,000
(step fixed cost)
Salary of supervisors (step fixed cost)

$14,000
$7,000
0
1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000
Units produced
Illustration 4-6 Relevant

Relevant range range
$21,000
Salary of supervisors (step fixed cost)
$14,000
$7,000
0
1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000
Units produced
C o s t E s t i m a t i o n M e t h o d s 129
Q: Is direct labor always a variable cost?
A : While we typically think of labor as a variable cost, it could also be a fixed cost. In some
countries, such as Japan and Korea, companies are very reluctant to lay off workers when
business decreases, and they are hesitant to increase labor when demand increases. Thus,
for many companies in Japan and Korea, labor is a fixed cost. In the United States, companies
are more willing to hire and fire with fluctuations in demand, making labor more reasonably
approximated as a variable cost. But some U.S. companies are so highly automated that they
can accommodate wide fluctuations in volume with the same workforce, and for them, labor is
more reasonably approximated as a fixed cost. To determine whether labor is variable or fixed
for a particular company, you must analyze the unique situation facing the company. Also, keep
in mind the notion of a relevant range. Within a particular range of activity, labor may be fixed,
but it may jump to a higher level if the company exceeds the upper limit of the range.
COST ESTIMATION METHODS

In order to predict how much cost will be incurred at various activity levels (a critical part
of CVP analysis), you must know how much of the total cost is fixed and how much is
variable. In many cases, cost information is not broken out in terms of fixed and variable
cost components; therefore, you must know how to estimate fixed and variable costs from
available information. In this section, we cover three techniques for estimating the amount
of fixed and variable cost: account analysis, the high-low method, and regression analysis.
Account Analysis
Account analysis is the most common approach to estimating fixed and variable costs.
This method requires that a manager use professional judgment to classify costs as either
fixed or variable. The total of the costs classified as variable can then be divided by a
measure of activity to calculate the variable cost per unit of activity. The total of the costs
classified as fixed provides the estimate of fixed cost.
To illustrate, let’s return to the CodeConnect example. For the month of May, the
cost of producing 2,000 units of the DX375 bar code reader was $265,000. Account
analysis would require a detailed analysis of the accounts that comprise the $265,000 of
production costs. Suppose the costs were as follows:
May
Production in units 2,000

Production cost
Component cost $130,600
Assembly labor 32,400
Utilities 7,100
Rent 22,000
Depreciation of assembly equipment 72,900
Total production cost $265,000
Using professional judgment, you may decide that component cost and assembly labor
are variable costs and all other items are fixed costs. In this case, variable and fixed
costs are estimated as in Illustration 4-7. Total production costs would be estimated as
$102,000 of fixed cost per month plus $81.50 of variable cost for each unit produced.
Illustration 4-7
Variable Cost Estimate
Estimate of variable and fixed
costs Component cost $130,600
Total $163,000 (a)
Production 2,000 (b)
Variable cost per unit $ 81.50 (a) ÷ (b)
Fixed Cost Estimate

Utilities $ 7,100
Rent 22,000
Depreciation 72,900
Total per month $102,000
Although Illustration 4-7 classifies each individual cost item as either 100 percent
fixed or 100 percent variable, the account analysis method does not require that this
be so. For example, there may be reason to believe that at least part of utilities is also
variable. In this case, the manager can use his or her judgment to refine estimates using
account analysis. Suppose the manager believes that approximately 50 percent of utilities
are variable. As indicated in Illustration 4-8, the revised estimate of total variable cost
would then amount to $166,550, or $83.28 per unit, whereas the revised estimate of fixed
costs per month would amount to $98,450.
Illustration 4-8
Variable Cost Estimate
Revised estimate of variable
and fixed costs Component cost $130,600
Utilities (50% of $7,100) 3,550
Total $166,550 (a)
Production 2,000 (b)
Variable cost per unit $ 83.28 (a) ÷ (b)
Fixed Cost Estimate

Utilities (50% of $7,100) $ 3,550
Rent 22,000
Depreciation 72,900
Total per month $ 98,450
With these estimates we can project what costs will be at various levels of production.
For example, how much cost can CodeConnect expect to incur if 2,500 units are produced?
With 2,500 units, variable costs are estimated as $208,200 and fixed costs per month are
estimated as $98,450. Therefore, total cost of $306,650 would be expected, as shown:
Expected Monthly Cost of 2,500 Units; DX375 Bar Code Reader

Variable cost (2,500 × $83.28) $208,200
Fixed cost per month 98,450
Total $306,650
The account analysis method is subjective in that different managers viewing the
same set of facts may reach different conclusions regarding which costs are fixed and
which costs are variable. Despite this limitation, most managers consider it an important
tool for estimating fixed and variable costs.
Scattergraphs
In some cases, you may have cost information from several reporting periods available in
order to estimate how costs change in response to changes in activity. Weekly, monthly, or
quarterly reports are particularly useful sources of cost information. In contrast, annual
reports are not as useful because the relation between costs and activity is generally not
consistent or stable over several years.
Suppose the monthly production and cost information provided in Illustration 4-9
is available for CodeConnect. We can gain insight into the relation between production
cost and activity by plotting these costs and activity levels. The plot of the data is referred
to as a scattergraph. The scattergraph for the data in Illustration 4-9 is presented in
Illustration 4-10.
Typically, as in Illustration 4-10, scattergraphs are prepared with costs measured on
the vertical axis and activity level measured on the horizontal axis. Each point on the
scattergraph represents one pair of cost and activity values. The graphical features in
®
spreadsheet programs such as Excel make the preparation of a scattergraph very easy.
Essentially, all you need to do is input the data, and then you can rely on the spreadsheet
to plot it accurately.
The methods we use to estimate cost behavior assume that costs are linear. In other
words, they assume that costs are well represented by straight lines. A scattergraph is
useful in assessing whether this assumption is reasonable. The plot in Illustration 4-10
suggests that a linear approximation is quite reasonable since the data points line up in
an approximately linear fashion. The scattergraph is also useful in assessing whether
there are any outliers. Outliers are data points that are markedly at odds with the trend
of other data points. Here there are no obvious outliers.
High-Low Method
With the same type of data as that described previously, we can estimate the fixed and
variable components of cost at various activity levels using the high-low method. This
Illustration 4-9
Monthly production cost Month Production Cost
information
January 750 $ 170,000
February 1,000 175,000
March 1,250 205,000
April 1,750 250,000
May 2,000 265,000
June 2,250 275,000
July 3,000 400,000
August 2,750 350,000
September 2,500 300,000
October 1,250 210,000
November 1,000 190,000
December 500 150,000
Total 20,000 $2,940,000

Scattergraph of cost and
production information $400,000
$350,000
Total production costs

$300,000
$250,000
$200,000
$150,000
$100,000
$50,000
0 500 1,000 1,500 2,000 2,500 3,000

Units produced (monthly)
method fits a straight line to the data points representing the highest and lowest levels of
activity. The slope of the line is the estimate of variable cost (because the slope measures
the change in cost per unit change in activity), and the intercept (where the line meets
the cost axis) is the estimate of fixed cost.
We’ll use the data in Illustration 4-9 to describe the high-low method. Note in
Illustration 4-9 that the highest level of activity is a production level of 3,000 units in July
with a corresponding cost of $400,000. The lowest level of activity is a production level
of 500 units in December with a corresponding cost of $150,000. Thus, a line connecting
these points looks like the one in Illustration 4-11.
We can calculate the slope of the line in Illustration 4-11 fairly easily. The slope is
equal to the change in cost divided by the change in activity. In moving from the lowest
level of activity to the highest level of activity, the cost changes by $250,000 and activity
changes by 2,500 units. Thus, the estimate of variable cost (the slope) is $100 per unit.
Estimate of Change in cost

=
variable cost Change in activity
Cost at highest Cost at lowest
−
Estimate of level of activity level of activity
=
variable cost Highest level Lowest level
of activity − of activity
Estimate of $400,000 − $150,000
=
variable cost 3,000 − 500
Estimate of $250,000
= = $100 per unit
variable cost 2,500
Once we obtain an estimate of variable cost, we can use it to calculate an estimate of fixed
cost (the intercept of the line). The fixed cost equals the difference between total cost and
estimated variable cost. For example, at the lowest level of activity (500 units), total cost

High-low estimate of production
costs $400,000
$350,000
$300,000
Production costs
$250,000
$200,000
$150,000
$100,000
$50,000
0 500 1,000 1,500 2,000 2,500 3,000

Monthly production
is $150,000. Since variable cost is $100 per unit, variable cost is $50,000 of the total cost.
Thus, the remaining cost of $100,000 must be the amount of fixed cost. As indicated in
the following calculation, we arrive at the same fixed cost amount ($100,000) whether
we work with the lowest or the highest level of activity.
Estimate Using Lowest ActivityEstimate Using Highest Activity
Total cost $150,000 Total cost $400,000

Less: Estimated variable Less: Estimated variable
cost (500 × $100) 50,000 cost (3,000 × $100) 300,000
Estimated fixed cost Estimated fixed cost
per month $100,000 per month $100,000
Be sure to note that because monthly data—the data from Illustration 4-9—are used in
this example, the fixed costs calculated are the fixed costs per month. If annual data were
used, the fixed costs calculated would be the fixed costs per year.
Refer to Illustration 4-11, which shows the high-low line for the cost and activity
data from Illustration 4-9. We can describe the total cost at any point along this line by
using the following equation:
Total cost = Fixed cost + (Variable cost per unit × Activity level in units)
Thus, we can use the equation to derive an estimate of total cost for a given activity level.
For example, at an activity level of 1,500 units, we would estimate that $250,000 of cost
would be incurred:
Total=cost
Total
Total cost = $100,000
cost
$100,000 + ($100
= $100,000
+ ($100 × 1,500)
×+ 1,500)
($100 × 1,500)
= $100,000
= $100,000
= $100,000 + $150,000
+ $150,000
+ $150,000
= $250,000
= $250,000
= $250,000
Looking at Illustration 4-11 should suggest a weakness of the high-low method.

Notice that the cost line passes through the high and low data points but the other data
points lie below the cost line. In other words, the estimate represented by the line does
not adequately fit the available data.
A significant weakness of the high-low method, then, is that it uses only two data
points. These two points may not be truly representative of the general relation between
cost and activity. The two points may represent unusually high and unusually low levels
of activity, and costs at these levels may also be unusual. For example, at the highest
level of activity, part-time workers may be used to supplement the normal workforce.
They may not work as efficiently as other workers, and costs may be unusually high.
Thus, when additional data are available, using more than two data points for estimates
is advisable.
T e st y o u r KNO W LE D GE
During the past year, Island Air flew 15,000 miles in August (its busiest month) and had
total costs of $300,000. In November (its least busy month), the company flew 5,000 miles
and had $200,000 of costs.
Using the high-low method, estimate the variable cost per mile and fixed cost per
month.
a. $20 of variable cost per mile and $100,000 of fixed costs per month.
b. $15 of variable cost per mile and $250,000 of fixed costs per month.
c. $10 of variable cost per mile and $150,000 of fixed costs per month.
d. $5 of variable cost per mile and $250,000 of fixed costs per month.
Correct answer is c ($300,000 − $200,000) ÷ (15,000 − 5,000) = $10; FC = $200,000 − (5,000 × $10) = $150,000.
Regression Analysis
Regression analysis is a statistical technique that uses all the available data points to esti-
mate the intercept and slope of a cost equation. The line fitted to the data by regression
is the best straight-line fit to the data. Software programs to perform regression analysis
are widely available and are included in spreadsheet programs like Excel. How to use
Excel to conduct regression analysis is explained in the appendix to this chapter. The
topic of regression analysis is covered in introductory statistics classes. For our purposes,
we simply note that application of regression analysis to the data in Illustration 4-9 yields
the following equation:
Total cost = Fixed cost + (Variable cost per unit × Activity level in units)
Total cost = $93,619 + ($90.83 × Activity level in units)

Thus, at a production level of 1,500 units, the amount of total cost estimated is $229,864:
Total cost = $93,619 of fixed cost + ($90.83 × 1,500)

= $229,864
This is less than the $250,000 estimated using the high-low cost equation.
A graph of the regression analysis estimate of cost is presented in Illustration 4-12.
Notice that the regression line fits the available data better than the line estimated

Regression analysis estimate of
production cost $400,000
$350,000
$300,000
$250,000
Cost
$200,000
$150,000
$100,000
$50,000
0 500 1,000 1,500 2,000 2,500 3,000

Production
with the high-low method. Because the regression line is more consistent with the
past data of the company, it probably will provide more accurate predictions of future
costs.
The Relevant Range and Cost Estimation

When working with estimates of fixed and variable costs, remember that they are valid
for only a limited range of activity which, you recall, we refer to as the relevant range.
Outside the relevant range, the estimates of fixed and variable costs may not be very
useful. Often managers are not confident using estimates of fixed and variable costs
when called upon to make predictions for activity levels that have not been encoun-
tered in the past. Since the activity levels have not been encountered in the past, past
relations between cost and activity may not be a useful basis for estimating costs in
this situation. For example, a manager at CodeConnect may not feel confident using
the regression estimates of $93,619 fixed cost and $90.83 variable cost per unit to
estimate total cost for a production level of 4,000 units. As indicated in Illustration 4-9,
the highest prior level of production was 3,000 units; thus, 4,000 units is outside the
relevant range.
In some cases, actual costs behave in a manner that is different from the com-
mon cost behavior patterns that we have discussed. All of those patterns imply linear
(straight-line) relations between cost and activity. In the real world, some costs are non-
linear. When companies produce unusually large quantities, for example, production
may not be efficient, resulting in costs increasing more rapidly than the rate implied by a
straight line. This may not be a serious limitation for a straight-line approach as long as
the predictions and estimates are restricted to the relevant range. Consider Illustration 4-13.
Note that although the relation between cost and activity is nonlinear, within the rel-
evant range, a straight line would closely approximate the relation between cost and
activity.
Illustration 4-13
Relevant range
Relevant
range
Cost
Activity
Last month, Venture Trucking logged 80,000 miles delivering goods for various customers.
Costs for the month were:
Fuel $30,000
Maintenance 10,000
Tires 4,000
Driver salaries 60,000
Insurance 5,000
Depreciation 10,000
Office expenses 6,000
Permits 3,000
Fuel, maintenance, tires, and driver salaries are considered to be variable costs while all
other costs are fixed. Using account analysis, what is variable cost per mile and fixed costs
per month?
Based on this information, what is cost of goods sold?
a. Variable = $1.30 per mile; fixed = $24,000 per month.
b. Variable = $1.20 per mile; fixed = $24,000 per month.
c. Variable = $1.50 per mile; fixed = $22,000 per month.
d. Variable = $1.40 per mile; fixed = $20,000 per month.
Learning COST-VOLUME-PROFIT ANALYSIS

Objective 2
Perform cost-volume- Once fixed and variable costs have been estimated, cost-volume-profit analysis (CVP)
profit analysis for single can be conducted. Basically, CVP analysis is any analysis that explores the relation among
and multiple products. costs, volume or activity levels, and profit.
C o s t - V o l u m e - P r o f i t A n a l y s i s 137
The Profit Equation

Fundamental to CVP analysis is the profit equation. The profit equation states that profit
is equal to revenue (selling price times quantity), minus variable cost (variable cost per
unit times quantity), minus total fixed cost:
Profit = SP( x ) − VC( x ) − tFC

where
x = Quantity of units produced and sold
SP = Selling price per unit
VC = Variable cost per unit
TFC = Total fixed cost
Break-Even Point
One of the primary uses of CVP analysis is to calculate the break-even point. The break-
even point is the number of units that must be sold for a company to break even—to
neither earn a profit nor incur a loss. The break-even point is shown in the profit graph
presented in Illustration 4-14. At the point where sales revenue equals total cost (com-
posed of fixed and variable costs), the company breaks even.
To calculate the break-even point, we simply set the profit equation equal to zero,
because by definition the break-even point is the point at which profit is zero. Then we
insert the appropriate selling price, variable cost, and fixed cost information and solve
for the quantity (x).
Let’s consider an example. Mary Stuart, the VP of operations at CodeConnect,
wants to know the break-even point for the company’s model DX375 bar code reader.
This will help her assess the possibility of incurring a loss for this product. Suppose
CodeConnect sells this model for $200 per unit. Mary uses account analysis and esti-
mates that variable production costs will be $81.50 per unit and fixed production costs
Illustration 4-14 $ Sales revenue

Profit graph and break-even
point
Profit
Total costs
Break-even
point in sales Variable costs
dollars
Loss
Fixed costs
Break-even point in units

Units produced and sold
Link to Practice
Breaking Even on a Golf Course Is Harder • Lower rates after 3 p.m.
than Making Par • Offer frequent player discount cards.
While most golfers dream of shooting a round of golf • Offer a senior discount.
below par, many golf course administrators dream of a • Use course marshals to improve the pace of play
year when profit is above break-even. Making a profit and eliminate waiting between holes. (No one likes
on a golf course is a difficult business, and recent years to wait!)
have seen more course closures than openings. What • Market to corporations that have golf outings.
can a manager do to increase the profitability of a golf • Develop a golf program for juniors.
course and ensure the break-even point is reached? The
key, not surprisingly, is to increase the number of rounds
played. Some ideas to increase rounds:
will be $102,000 per month. There are also $63,900 of fixed selling and administrative
costs each month. Thus, total fixed costs are $165,900.
Selling price per unit $ 200.00

Variable cost per unit 81.50
Fixed production cost per month $102,000.00
Fixed selling and administrative costs per month 63,900.00
Total fixed costs $165,900.00
How many units must be sold to break even in a given month? To answer this ques-
tion, we solve the profit equation for a particular value of x:
Profit = SP(x) - VC(x) - TFC
0 = $200(x) - $81.50(x) - $165,900
$118.50(x) = $165,900
(x) = 1,400 units
Solving for x yields a break-even quantity of 1,400 units. If management prefers to have
the break-even quantity expressed in dollars of sales rather than in units, the quantity is
simply multiplied by the selling price of $200 to yield $280,000.
Margin of Safety. Obviously, managers are very concerned that they have a level of
sales greater than break-even sales. To express how close they expect to be to the break-
even level, managers may calculate the margin of safety. The margin of safety is the
difference between the expected level of sales and break-even sales:
Margin of safety = Expected sales − Break-even sales
For example, the monthly break-even level of sales for Model DX375 is $280,000. If
management expects to have sales of $350,000, the margin of safety is $70,000 (i.e.,
$350,000 − $280,000). Given that the margin of safety is relatively high, Mary Stuart can
be reasonably confident that the Model DX375 will break even.
The margin of safety can also be expressed as a ratio called, not surprisingly, the
margin of safety ratio. This is equal to the margin of safety divided by expected sales.
For Model DX375, the margin of safety ratio is .20, indicating that sales would have
to drop more than 20 percent before the product would show a loss. Obviously, the
C o s t - V o l u m e - P r o f i t A n a l y s i s 139
higher the margin of safety ratio, the more likely that profit will exceed the break-
even level.
Margin of Margin of safety
=
safety ratio Expected sales
Margin of $70,000
= = .20
safety ratio $350,000
Contribution Margin
The profit equation can be rewritten by combining the terms containing x in them to
yield the contribution margin per unit—the difference between the selling price (SP)
and variable cost per unit (VC).
Profit = SP(x ) − VC(x ) − TFC
Profit = (SP − VC)( x ) − TFC
Profit = Contribution margin per unit(x ) − TFC
For CodeConnect’s model DX375 bar code reader, the selling price is $200.00 and the
variable cost is $81.50. Thus, the contribution margin is:
Selling price per unit $200.00

Variable cost per unit (81.50)
Contribution margin per unit $118.50
The contribution margin per unit measures the amount of incremental profit generated
by selling an additional unit. This may not be obvious at first glance, but consider what
happens when sales and production increase by one unit. The firm benefits from revenue
equal to the selling price, ($200.00) but it also incurs increased costs equal to the variable
cost per unit ($81.50). Fixed costs are unaffected by changes in volume, so they do not
affect the incremental profit associated with selling an additional unit. Thus, the net benefit
of producing and selling an incremental unit is $118.50 (i.e., $200.00 − $81.50). Note that
if we multiply the contribution margin per unit by the number of units sold, we obtain
the incremental profit related to the units sold.
For example, suppose Mary Stuart wanted to know how much incremental profit
would be generated by selling 100 more units. Multiplying the 100 units by the contri-
bution margin per unit ($118.50) indicates that the total incremental profit would be
$11,850:
Number of units sold 100.00

Contribution margin per unit × $118.50
Incremental profit related to selling 100 units $11,850
Units Needed to Achieve Profit Target. If we solve the profit equation for the sales
quantity in units (x), we get a handy formula for calculating the break-even level of sales
in units or for calculating the number of units needed to achieve a specified or target
level of profit.
TFC + Profit
Unit sales ( x ) needed to attain specified profit =
SP − VC
TFC + Profit
Unit sales ( x ) needed to attain specified profit =
Contribution margin per unit
For CodeConnect, the amount of fixed cost is $165,900 per month. With a selling
price of $200 and variable costs of $81.50, the contribution margin per unit is $118.50.
Using the formula implies that 1,400 units must be sold to break even each month.
$165,900 + 0 TFC + Profit
1,400 = =
$118.50 Contribution margin per unit
Now suppose that the management of CodeConnect wants to know how many units
must be sold to achieve a profit of $35,550 in a given month. Using the formula implies
that 1,700 units must be sold to achieve a profit of $35,550:
$165,900 + $35,550
1,700 =
$118.50
Contribution Margin Ratio

The contribution margin ratio measures the amount of incremental profit generated
by an additional dollar of sales. It is equal to the contribution margin per unit divided
by the selling price:
SP − VC
Contribution margin ratio =
SP
For the model DX375 bar code reader, the contribution margin ratio is:
$200.00 − $81.50
= .5925
$200.00
This indicates that the company earns an incremental $0.5925 for every dollar of
sales. Thus, if Mary Stuart wanted to know how much incremental profit would be gen-
erated by have sales increase by $10,000, the answer to her question is easily obtained by
multiplying the contribution margin ratio by sales, yielding $5,925:
.5925 × $10,000 = $5,925
Dollar Sales Needed to Achieve Profit Target. We can also solve the profit equation
to determine the dollar level of sales needed to break even or achieve a specified or target
level of profit. The formula ends up being equal to profit plus fixed cost divided by the
contribution margin ratio:
TFC + Profit
Dollar sales needed to attain specified profit =
Contribution margin ratio
Recall that the contribution margin ratio tells us how much incremental profit we earn
per dollar of sales. So if we divide this into the sum of profit plus fixed cost, we’ll get the
dollar level of sales needed to cover fixed costs and generate the specified profit.
Let’s apply the formula to calculate the amount of sales dollars needed to earn a profit
of $35,550 in a given month for CodeConnect. Its contribution margin ratio is .5925
(Contribution margin of $118.50 ÷ Selling price of $200). Thus, sales of $340,000 are needed:
$165,900 + $35,550
$340,000 =
.5925
“What If” Analysis

The profit equation also can show how profit will be affected by various options under
consideration by management. Such analysis is sometimes referred to as “what if ” analysis
because it examines what will happen if a particular action is taken.
M u l t i p r o d u c t A n a l y s i s 141
Change in Fixed and Variable Costs. Suppose CodeConnect is currently selling

3,000 units per month at a price of $200. Variable costs per unit are $81.50, and total fixed
costs are $165,900 per month. Management is considering a change in the production
process that will increase fixed costs per month by $50,000 to $215,900 but decrease
variable costs to only $80 per unit. How would this change affect monthly profit? Using
the profit equation, and assuming that there will be no change in the selling price or the
quantity sold, profit under the alternative will be equal to $144,100:
Profit = $200(3,000) − $80(3,000) − $215,900 = $144,100
Without the change, profit will equal $189,600:
Profit = $200(3,000) − $81.50(3,000) − $165,900 = $189,600
The change in the production process would actually lower profit, so it appears not to
be advisable.
Change in Selling Price. Any one of the variables in the profit equation can be con-
sidered in light of changes in the other variables. For example, suppose CodeConnect’s
management wants to know what the selling price would have to be to earn a profit of
$200,000 if 3,000 units are sold in a given month. To answer this question, all of the
relevant information is organized in terms of the profit equation, and then the equation
is solved for the selling price:
$200,000 = SP(3,000) − $81.50(3,000) − $165,900
SP(3,000) = $610,400
SP = $203.47
Matthews Consulting charges $300 per hour. It has fixed costs of $600,000 per month
and no variable costs. How many hours must the company work to earn a monthly profit
of $900,000?
a. 5,000. b. 2,000. c. 3,000. d. 6,000.
Correct answer is a ($600,000 + $900,000)/$300.
MULTIPRODUCT ANALYSIS
The previous examples illustrate CVP analysis for a single product. But CVP analysis can
be extended easily to cover multiple products. In the following sections, we examine the
use of the contribution margin and the contribution margin ratio in performing CVP
analysis for a company with multiple products.
Contribution Margin Approach

If the products a company sells are similar (e.g., various flavors of ice cream, various
types of calculators, various models of similar boats), the weighted average contribution
margin per unit can be used in CVP analysis. Let’s consider a simple example. Suppose
that Rohr Watch Company produces two model watches: Model A has an automatic
movement and displays the date as well as time. Model B displays the date, time, and
moon phase. Model A sells for $2,000 and requires $800 of variable cost per watch. Model B
sells for $3,000 and requires $1,200 of variable cost per watch. Further, Rohr typically
Illustration 4-15
Calculation of weighted Rohr Watch Company
average contribution margin
per unit Contribution Margin Contribution Margin
Model A Model B
Selling price $2,000 $3,000
Variable cost 800 1,200
Contribution margin $1,200 $1,800
2($1,200) + 1($1,800)
Weighted average contribution margin per unit =
3
= $1,400 per unit
sells two Model A watches for every Model B watch sold. To calculate the weighted aver-
age contribution margin per unit, the fact that twice as many A watches as B watches are
sold must be taken into account. Since two Model A watches are sold for each Model B,
the contribution margin of A is multiplied by 2 and the contribution margin of B is
multiplied by 1. The sum is then divided by 3 to yield the weighted average contribution
margin per unit of $1,400. (See Illustration 4-15.)
Now suppose the Rohr Watch Company has fixed costs equal to $3,500,000. How
many watches must be sold for the company to break even? Working with the weighted
average contribution margin, the break-even point is 2,500 watches.
Total fixed costs + Profit

Break-even sales in units =
Weighted average contribution margin per unit
$3,500,000 + 0
2,500 =
$1,400
These 2,500 units would be made up of the typical two-to-one mix. Thus, Rohr must
sell 1,667 Model A’s (two-thirds of 2,500) and 833 Model B’s (one-third of 2,500) to
break even.
Contribution Margin Ratio Approach

If the products that a company sells are substantially different, CVP analysis should be
performed using the contribution margin ratio. Consider a large store like Walmart,
which sells literally thousands of different products. In this setting, it does not make
sense to ask how many units must be sold to break even or how many units must be sold
to generate a profit of $100,000. Because the costs and selling prices of the various items
sold are considerably different, analyzing these types of questions in terms of number
of units is not useful. Instead, these questions are addressed in terms of sales dollars. It
is perfectly reasonable to ask how much sales must be to break even or how much sales
must be to generate a profit of $100,000. To answer these questions, the contribution
margin ratio rather than the contribution margin per unit is used.
Suppose Gilbert and Gibbs, a store that sells outdoor living products, is interested in
using CVP analysis to analyze its four product lines, which include garden tools, outdoor
furniture, barbecues, and patio entertainment items such as glasses, plates, and outdoor
lighting. The company is only 2 years old, and last year was the first time it performed
an analysis of fixed and variable costs and product-line profitability. The resulting report
is shown in Illustration 4-16.
M u l t i p r o d u c t A n a l y s i s 143
Illustration 4-16
Profitability analysis of product lines
Gilbert and Gibbs
Garden Outdoor Entertainment

Tools Furniture Barbecues Items Total
Sales $950,000 $2,500,000 $1,400,000 $1,600,000 $6,450,000
Less variable costs:

Cost of goods sold 665,000 1,800,000 910,000 640,000 4,015,000
Incentive compensation
tied to sales 95,000 250,000 140,000 160,000 645,000
Miscellaneous variable costs 12,000 13,000 11,000 10,000 46,000
Total variable costs 772,000 2,063,000 1,061,000 810,000 4,706,000
Contribution margin 178,000 437,000 339,000 790,000 1,744,000
Contribution margin ratio 0.1874 0.1748 0.2421 0.4938 0.2704
Less direct fixed costs:
Sales staff salaries 75,000 120,000 96,000 103,000 394,000
Product-line specific
advertising 20,000 35,000 25,000 10,000 90,000
Total direct fixed costs 95,000 155,000 121,000 113,000 484,000
Product-line profit $ 83,000 $ 282,000 $ 218,000 $ 677,000 $1,260,000
Less common fixed costs:

Advertising 220,000
Utilities 35,000
Rent 185,000
Management salaries 625,000
Other common fixed costs 55,000
Total common fixed costs 1,120,000
Profit $ 140,000
Let’s review it. From sales of each product line, the company subtracts variable costs
to identify the contribution margin. The contribution margin is then divided by sales to
identify the contribution margin ratio. The same procedure can be followed to identify
the contribution margin ratio for the entire company. Given the information in the
report, what is the break-even level of sales for Gilbert and Gibbs?
To answer this question, the total amount of fixed costs is divided by the contri-
bution margin ratio for the company. Total fixed costs are composed of the direct fixed
costs associated with the four product lines plus the common fixed costs. Common
fixed costs are related to resources that are shared but not directly traced to the product
lines. Examples are advertising, utilities, and salaries of managers. Because the contri-
bution margin of the company is .2704 and total fixed costs are $1,604,000 ($484,000 of
direct fixed costs and $1,120,000 of common fixed costs), the break-even level of sales
is $5,931,953:
Total fixed costs

Break-even sales =
Contribution margin ratio
$1,604,000
Break-even sales = = $5,931,953
.2704
We can also easily calculate the break-even point for the various product lines. For
example, the break-even level of sales for garden tools is $506,937:
$95,000
Break-even sales = = $506,937
.1874
Note that when we calculate the break-even level of sales for garden tools, we only
consider the direct fixed costs related to this product line ($95,000) since the common
fixed costs cannot be directly traced to it or any other product line.
The contribution margin ratio can also be used to analyze the effect on income
of a change in total company sales. Suppose in the coming year, management believes
that total company sales will increase by 20 percent and is interested in assessing the
effect of this increase in overall company profitability. A 20 percent increase in sales is
$1,290,000. The weighted average contribution margin ratio of .2704 indicates that the
company generates $0.2704 of incremental profit on each dollar of sales. Thus, income
will increase by $348,816:
.2704 × $1,290,000 = $348,816
Note that this approach makes one very important assumption: When overall sales
increase, sales of garden tools, outdoor furniture, barbecues, and entertainment items
will increase in the same proportion as the current mix. If this assumption is not war-
ranted, then the contribution margin ratios of the four product lines must be weighted
by their share of the increase. For example, suppose the company believes sales will
increase by $1,290,000 but expects the increase will be made up of a $258,000 increase
in garden tools, a $387,000 increase in outdoor furniture, a $516,000 increase in barbe-
cues, and a $129,000 increase in entertainment items. To calculate the effect on profit,
the contribution margin ratios of the specific product lines must be used. The expected
increase in profit is $304,621.
Increase in Contribution Increase

Product Line Sales Margin Ratio in Profit
Garden Tools $ 258,000 0.1874 $ 48,349
Outdoor Furniture 387,000 0.1748 67,648
Barbecues 516,000 0.2421 124,924
Entertainment Items 129,000 0.4938 63,700
$1,290,000 $304,621
Why did this analysis yield a smaller increase in profit compared to the preceding
analysis? The preceding analysis assumed the increase in sales would be proportionate
to the current mix of product-line sales ($6,450,000 × .20). With the current mix, enter-
tainment items make up approximately 25 percent of sales. Now we are assuming that
entertainment items are only 10 percent of sales ($129,000 ÷ $1,290,000), so relatively less
is being sold of the product line with the highest contribution margin ratio. If relatively
less of this high-margin line is sold, profit will be less.
Decision Making/ Before leaving the Gilbert and Gibbs example, let’s see how the contribution margin
Incremental ratio can help a manager make decisions that increase company profit. Suppose Sarah
Analysis Williams, the store manager, is considering ways to increase profit in the coming year.
Which product line do you think she should emphasize? As indicated in Illustration 4-16,
entertainment items have the highest contribution margin ratio. For this product line,
A s s u m p t i o n s i n C vp A n a l y s i s 145
the company earns $0.49 on every dollar of sales. The next highest line is barbecues,
which earns only $0.24 on a dollar of sales. The contribution margin ratio tells us that
if we can get a dollar of incremental sales by emphasizing a product, we definitely want
to emphasize entertainment items. But what does it mean to “emphasize” a product? A
critical aspect in retail is the positioning of products within the store, and the prime area
is usually near the entrance. Because many shoppers don’t make it halfway through the
store, Sarah needs to place the entertainment items where they will be seen. Also, she
may want to spend relatively more money making the display of entertainment items
particularly attractive. Remember, she makes almost 50 cents on each dollar of sales for
this product line.
You get what you If you refer to Illustration 4-16, you will see that under each product line, there is an
M e a s u r e expense for incentive compensation equal to 10 percent of sales. This is the incentive
compensation paid to the sales people in the product-line departments. Obviously, this
incentive encourages them to provide good service to customers and generate sales in
their respective departments. Sarah Williams, the store manager, currently does not
receive incentive compensation, but the owner of the company is considering such an
arrangement. Do you think Sarah’s incentive compensation should be tied to sales or to
the contribution margin?
Any answer to this question is bound to be subjective, but a good case can be made
for measuring and compensating Sarah’s performance based on the total contribution
margin generated by the store. We don’t want Sarah to get overly focused on sales, since
all sales dollars are not equal. Sales of entertainment items generate more profit per dollar
of sales than all other product lines, and sales of outdoor furniture generate less profit
per dollar of sales than all other product lines. If Sarah is evaluated with respect to the
contribution margin, she will pay close attention to how much contribution margin is
generated and come up with ideas to increase this measure. That’s exactly what the owner
of Gilbert and Gibbs would want Sarah to do.
Refer to the information in Illustration 4-16. What level of sales is needed to generate a profit
of $288,800 across the four product lines?
a. $6,000,000. b. $6,500,000. c. $7,000,000. d. $7,500,000.
Correct answer is c ($484,000 + $1,120,000 + $288,800) ÷ .2704.
ASSUMPTIONS IN CVP ANALYSIS

Whenever CVP analysis is performed, a number of assumptions are made that affect the
validity of the analysis. Perhaps the primary assumption is that costs can be accurately
separated into their fixed and variable components. In some companies, this is a very
difficult and costly task. A further assumption is that the fixed costs remain fixed and
the variable costs per unit do not change over the activity levels of interest. With large
changes in activity, this assumption may not be valid. When performing multiproduct
CVP analysis, an important assumption is that the mix remains constant. In spite of these
assumptions, most managers find CVP analysis to be a useful tool for exploring various
profit targets and for performing “what if ” analysis.
Link to Practice
Deciding to Use the Contribution Margin Sears
per Unit or the Contribution Margin Ratio A manager of a Sears store would focus on the weighted
Baskin-Robbins average contribution margin ratio, not the weighted
average contribution margin per unit. Unlike the units at
At an ice cream company like Baskin-Robbins, it
an ice cream store, the various units at a Sears store are
is very reasonable for managers to use either the
quite different. It doesn’t make sense to use a weighted
weighted average contribution margin per unit or
average contribution margin per unit when
the weighted average contribution mar-
the units are as diverse as refrigerators and
gin ratio in CVP analysis. For example, a
shirts. Instead, a manager of a Sears store
manager might want to know the effect
will focus on the weighted average contri-
on profit of a 1,000,000-gallon increase
bution margin ratio. It would be reasonable
in sales. Assuming the weighted average
for a manager at Sears to ask, “What is
contribution margin is $5 per gallon, profit
the weighted average contribution margin
is expected to increase by $5,000,000.
istockphoto/Getty Images, Inc. ratio for our store?” and use that number
A manager might also want to know the iStockphoto
to estimate the increase in profit if the store
effect on profit of a $1,000,000 increase
can increase sales by $20,000,000. Assuming the con-
in sales. Assuming a weighted average contribution
tribution margin ratio is .20, the expected increase would
margin ratio of $0.30, profit is expected to increase by
be $4,000,000.
$300,000.
CODECONNECT EXAMPLE REVISITED:

ANSWERING MARY’S QUESTIONS
Recall that at the beginning of the chapter, Mary Stuart of CodeConnect was faced with
several questions related to planning, control, and decision making. Let’s go back to these
questions and make sure we can answer them.
Planning. Last year, CodeConnect sold 20,000 bar code readers at $200 per unit.
The cost of manufacturing these items was $2,940,000, and selling and administra-
tive costs were $766,800. Total profit was $293,200. In the coming year, the company
expects to sell 25,000 units. What level of profit should be in the budget for the
coming year?
Assume that the $2,940,000 of production costs consist of variable production costs
of $81.50 per unit and fixed production costs of $1,224,000 per year. Further, assume
that all selling and administrative costs are fixed and equal to $766,800 per year. In this
case, expected profit is $805,822.
Selling price(x ) − Variable cost(x ) − Fixed production costs − Fixed selling and administration costs = Pro
Selling price(x ) − Variable cost(x ) − Fixed production costs − Fixed selling and administration costs = Profit
$200(25,000) − $81.50(25,000) − $1,224,000 − $766,800 = $971,700
Control. In April, production costs were $250,000. In May, costs increased to $260,000,
but production also increased from 1,750 units in April to 2,000 units in May. Did the
manager responsible for product costs do a good job of controlling costs in May?
C o d e C o n n e c t E x a m p l e R e v i s i t e d : A n s w e r i n g M a r y ’ s Q u e s t i o n s 147
Link to Practice
Which Firm Has the Higher Contribution Companies
Margin Ratio? McDonald’s versus United Airlines
The following list identifies six pairs of firms with different Ford Motor Company versus Kroger (a large grocery
contribution margin ratios (contribution margin per dollar chain)
of sales). For each pair, identify the firm with the higher Oracle (a large software company) versus Sears
contribution margin ratio. Nordstorm (a chain of clothing stores) versus E*Trade (an
online brokerage firm)
Coca-Cola versus Walmart
Answer: United Airlines; Ford Motor Company; Oracle; E*Trade; Coca-Cola
Assume that production costs are estimated to be $81.50 per unit of variable cost
and $102,000 of fixed costs per month. Then, the expected cost for producing 2,000 bar
code readers is $265,000:
Variable cost(x ) + Fixed cost = Total cost

$81.50(2,000) + $102,000 = $265,000
Because actual costs are slightly less than expected costs, it appears (based on this limited
analysis) that the manager responsible for product costs has done a reasonable job of
controlling them.
Decision Making/ Decision Making. The current price for a bar code reader is $200 per unit. If the price
Incremental is increased to $225 per unit, sales will drop from 20,000 to 17,000. Should the price be
Analysis increased?
Before answering this question, recall an idea we discussed in Chapter 1: All
decisions rely on incremental analysis. For the pricing decision, we can perform
an incremental analysis using the contribution margin. Currently, the contribution
margin per unit is $118.50 (i.e., $200 − $81.50). Thus, the total contribution margin is
20,000 units times $118.50, which equals $2,370,000. If the selling price increases to
$225, the contribution margin per unit will increase to $143.50 (i.e., $225 − $81.50).
Thus, the total contribution margin will increase to $143.50 times 17,000 units, which
is $2,439,500. The increase suggests that increasing the selling price is warranted
although the effect on profit will be relatively minor. Why aren’t fixed costs considered
in this analysis? The fixed costs in this decision don’t enter into the analysis because
they are not incremental costs. Irrespective of the price, the company will have the
same level of fixed costs.
Incremental Analysis
Total contribution margin = (Selling price − Variable cost) × Number of units
$2,370,000 = ($200 − $81.50) × 20,000Original price of $200
$2,439,500 = ($225 − $81.50) × 17,000New price of $225
$ 69,500 = Incremental profit with new price
Learning OPERATING LEVERAGE

Objective 3
We will cover two additional topics before concluding our discussion of CVP analysis.
Discuss the effect of First, we’ll discuss the concept of operating leverage, and then we’ll address constraints
operating leverage, and on output. Operating leverage relates to the level of fixed versus variable costs in a
use the contribution firm’s cost structure. Firms that have relatively high levels of fixed costs are said to
margin per unit of the have high operating leverage. To some extent, firms can control their level of operat-
constraint to analyze ing leverage. For example, a firm can invest in an automated production system using
situations involving a robotics, thus increasing its fixed costs while reducing labor, which is a variable cost.
resource constraint. The level of operating leverage is important because it affects the change in profit when
sales change. Consider two firms with the same level of profit but different mixes of
fixed and variable cost:
Firm 1 Firm 2
Sales $10,000,000 $10,000,000

Variable cost 5,000,000 7,000,000
Contribution margin 5,000,000 3,000,000
Fixed costs 3,000,000 1,000,000
Profit $ 2,000,000 $ 2,000,000
Suppose there is a 20 percent increase in sales. Which firm will have the greatest increase
in profit? If Firm 1 has a 20 percent increase in sales, its profit will increase by $1,000,000
(i.e., 20% × the contribution margin), which represents a 50 percent increase in profit.
Firm 2, however, will have a profit increase of only $600,000, or 30 percent. Now sup-
pose there is a 20 percent decrease in sales. Which firm will have the greatest decrease
in profit? Again, the answer is Firm 1. This is because it has relatively more fixed costs
(higher operating leverage).
Firms that have high operating leverage are generally thought to be more risky
because they tend to have large fluctuations in profit when sales fluctuate. However, sup-
pose you are very confident that your firm’s sales are going to increase. In that case you
would want high operating leverage because the large positive fluctuation in sales will
lead to a large positive fluctuation in profit. Unfortunately, many, if not most, managers
are not highly confident that their firm’s sales will only increase!
A final point on operating leverage: Because of fixed costs in the cost structure,
when sales increase by 10 percent, profit will increase by more than 10 percent. The only
Link to Practice
Impact of Operating Leverage at Vulcan Sales increased from $2.41 billion in 2012 to $2.63
Materials billion in 2013—an increase of 9 percent. Gross profit,
however, went from $334.0 million in 2012 to $426.9
Vulcan Materials is the largest producer of construc-
million in 2013—an increase of 28 percent! It’s important
tion aggregates (crushed stone, sand, and gravel) in
to remember that for firms that have high operating lever-
the U.S. Because of its reliance on heavy equipment,
age, while profit may increase dramatically when sales
the company has significant operating leverage. Thus,
increase, it is also the case that profit may decrease
when sales increase, profit is likely to increase at a
dramatically if sales decline.
higher rate.
C o n s t r a i n t s 149
Link to Practice
Fixed Costs Too High—Make Them incentive compensation equal to 1 percent of her
Variable! sales. If sales go up, you pay her more. If sales go
down, you pay her less. Now compensation that was
A company with high fixed costs is risky. If its sales
fixed is at least partially variable.
decline, profit will take a big hit. Firms, however, can take
2. Many companies outsource activities such as payroll
steps to reduce their fixed costs. In fact, they may be able
processing and customer call center services, to turn
to turn fixed costs into variable costs. Two strategies for
fixed costs into variable costs. For example, much of
doing this are incentive compensation and outsourcing:
the cost of processing payroll transactions is fixed
1. Offer employees incentive compensation in lieu of a (e.g., fixed wages, depreciation of office equipment
higher base. Suppose a senior sales executive makes and furniture, etc.). But if payroll is outsourced, a
$200,000 in annual base salary. That’s a fixed cost. company may pay a fee based on the number of pay-
But suppose you could get the executive to accept roll transactions. So with outsourcing, the fixed costs
a base salary of $100,000 and, in addition, receive become variable.
time that you expect profit to increase by the same percent as sales is when all costs are
variable. If all costs vary in proportion to sales (i.e., all costs are variable), then profit
will vary in proportion to sales.
CONSTRAINTS
In many cases (e.g., owing to shortages of space, equipment, or labor), there are con-
straints on how many items can be produced or how much service can be provided. Under
such constraints, the focus shifts from the contribution margin per unit to the contribution
margin per unit of the constraint. For example, suppose a company can produce either
Product A or Product B using the same equipment. The contribution margin of A is $200,
whereas the contribution margin of B is only $100. However, there are only 1,000 machine
hours available, and Product A requires 10 hours of machine time to produce one unit
while Product B requires only 2 hours per unit. In this simplified case, the company would
only produce Product B. Although its contribution margin is smaller ($100 versus $200),
it contributes $50 per machine hour, whereas Product A contributes only $20 per machine
hour. In total, with 1,000 available machine hours, Product A can generate $20,000 of
contribution margin while B can generate $50,000 of contribution margin.
Product A Product B
Selling price $500 $300

Variable cost 300 200
Contribution margin $200 $100
Time to produce 1 unit 10 hours 2 hours
Contribution margin per hour $20 $50
Contribution margin given
1,000 available hours $20,000 $50,000
Decision Making
In the chapter, we learned how to estimate fixed and variable costs using account
Insight analysis, the high-low method, and regression analysis. (This latter method is covered
in the appendix.) All of these methods make the assumption that prior costs are good
predictors of future costs. However, decisions that involve significant increases in
sales or production may cause prior “fixed” costs to jump to a higher level. This might
be due, for example, to the need to hire an additional supervisor.

Learning Objective 1 Identify common cost equation to determine the level of volume required to achieve
behavior patterns and estimate the relation between a certain level of profit. The number of units that must be sold
cost and activity using account analysis and the or the sales dollars needed to achieve a specified profit level can
high-low method. be determined using the following formulas:
Common cost behavior patterns include those involving

variable, fixed, mixed, and step costs. Variable costs are costs Fixed cost + Profit
Number of units =
that change in proportion to changes in volume or activity. Contribution margin
Fixed costs are constant across activity levels. Mixed costs Fixed cost + Profit
contain both a variable cost component and a fixed cost Sales dollars =
component. Step costs are fixed for a range of volume but Contribution margin ratio
increase to a higher level when the upper bound of the range
is exceeded. The case of multiple products is easily addressed by using the
Managers use account analysis, the high-low method, and weighted average contribution margin per unit or the weighted
regression analysis to estimate the relation between cost and average contribution margin ratio.
activity. Account analysis requires that the manager use his or
her judgment to classify costs as either fixed or variable. The Learning Objective 3 Discuss the effect of
high-low method fits a straight line to the costs at the highest operating leverage and use the contribution margin
and the lowest activity levels. Regression analysis provides the per unit of the constraint to analyze situations
best straight-line fit to prior cost/activity data. involving a resource constraint.
Operating leverage relates to the level of fixed versus variable
Learning Objective 2 Perform cost-volume-profit costs in a company’s cost structure. The higher the level of fixed
analysis for single and multiple products. costs, the greater the operating leverage. Also, the higher the
Once fixed and variable costs have been estimated, cost-volume- operating leverage, the greater the percentage change in profit
profit analysis can be performed. CVP analysis makes use of for a given percentage change in sales. Firms with high oper-
the profit equation: ating leverage are generally considered to be more risky than
firms with low operating leverage.
Profit = SP(x ) − VC(x ) − TFC When there is a constraint, the focus shifts from the contri-
bution margin per unit to the contribution margin per unit of
to perform “what if ” analysis. The effect of changing various the constraint. The product that has the highest contribution
components of the equation can be explored by solving the margin per unit of the constraint should be produced because
equation for the variable affected by the change. Specific exam- it will generate the greatest contribution to covering fixed costs
ples include solving for the break-even point or solving the and generating a profit.
Appendix
USING REGRESSION IN EXCEL TO ESTIMATE

FIXED AND VARIABLE COSTS
In this appendix, we will see how to use the Regression function in Excel to estimate fixed and
variable costs using the data for CodeConnect presented in Illustration 4-9. As you will see, the
spreadsheet program makes performing regression analysis very easy. However, it doesn’t make
understanding regression analysis easy! While we will discuss the interpretation of the output of
the regression program, it would be wise to consult the treatment of regression analysis in an
introductory statistics book before doing any real-world analysis.
Setting Up the Spreadsheet

Open a spreadsheet and enter the cost and production data from Illustration 4-7 in columns A
and B. (See Illustration A4-1.) Now click on the data tab and then click on Data Analysis. From
Data Analysis, select Regression. (Note: If you do not see Data Analysis in the data tab, click on
Add-Ins and install the Analysis ToolPak.)
U s i n g R e g r e s s i o n i n E x c e l t o E s t i m a t e F i x e d a n d V a r i a b l e C o s t s 151
Illustration A4-1
Selecting the regression
function
Once the Regression program opens, under Input Y, scroll down from A1 to A13. Note
that this includes the heading “Cost.” Under Input X, scroll down from B1 to B13. Note that
this includes the heading “Production.” Click Labels, which indicates that you have labels for
Production and Cost data columns.
Under Output Options, click New Worksheet and give the worksheet a name. Under Residuals,
click Line Fit Plot. This indicates that you want a plot of the data and the regression line. At this
point your spreadsheet should look like the one in Illustration A4-2. Now click OK, and the
Regression program will yield the output presented in Illustration A4-3.
Interpreting the Output of the Regression Program

Let’s interpret the most critical elements of the regression output.
The Plot. The plot of the data and the plot of the regression line indicate that the data line up quite
close to the regression line. This suggests that a straight-line fit to the data will be quite successful.
R Square. R Square is a statistical measure of how well the regression line fits the data.
Specifically, it measures the percent of variance in the dependent variable (cost in the current case)
explained by the independent variable (production). R Square ranges from a low of 0, indicating
that there is no linear relation between cost and production, to a high of 1, indicating that there is
a perfect linear relation between cost and production. In the current case, R Square is .96, which
is quite high. This reinforces our conclusion from looking at the plot of the data and the plot of
the regression line that there is a strong linear relation between cost and production.
Intercept and Slope of the Regression Line. The intercept of the regression line is inter-
preted as the estimate of fixed cost while the slope of the regression line is interpreted as the
variable cost per unit. The output from the regression indicates that the intercept is $93,618.78
Illustration A4-2
Input cost and production
values in the regression
program
Illustration A4-3
Viewing the output
while the coefficient on production (the slope of the regression line) is $90.83. Thus, the regression
line indicates that:
Cost = $93,618.78 + $90.83 (Production )
P-Value. The p-values corresponding to the intercept and the slope measure the probability of
observing values as large as the estimated coefficients when the true values are zero. In other words,
there is some probability that even when the true fixed cost is zero, we will observe an estimate
as large as $93,618.78. We would, of course, like this probability to be quite low (at least less than
.05). In the current case, the probability is very low (.00000579). Likewise, the probability that we
will observe an estimate as large as $90.83 when the true variable cost per unit is zero is also very
low (.0000000252). Thus, it seems highly unlikely that either the true fixed cost is zero or that the
true variable cost per unit is zero.
Review Problem 1
Potter Janitorial Services provides cleaning services to both homes and offices. In the past year,
income before taxes was $4,250, as follows:
Home Office Total
Revenue $250,000 $425,000 $675,000

Cleaning staff salaries 175,000 276,250 451,250
Supplies 30,000 42,500 72,500
Contribution margin $ 45,000 $106,250 151,250
Billing and accounting 25,000
Owner salary 90,000
Other miscellaneous
Common fixed costs 32,000
For the coming year, Janice Potter, the company owner, would like to perform CVP analysis. She
has asked you to help her address the following independent questions.
Req u i red
a. What are the contribution margin ratios of the Home and Office segments, and what is the
overall contribution margin ratio?
b. Assuming that the mix of home and office services does not change, what amount of rev-
enue will be needed for Janice to earn a salary of $125,000 and have income before taxes
of $4,000?
c. Suppose staff salaries increase by 20 percent. In this case, how will break-even sales in the
coming year compare to the prior year?
A n sw er
a. Contribution margin ratio for Home = $45,000 ÷ $250,000 = .18
Contribution margin ratio for Office = $106,250 ÷ $425,000 = .25
Overall contribution margin ratio = $151,250 ÷ $675,000 = .22407
b. ($25,000 + $125,000 + $32,000 + $4,000) ÷ .22407 = $830,097.73
c. Break-even in the prior year = ($25,000 + $90,000 + $32,000) ÷ .22407 = $656,045.
If staff salaries increase by 20 percent, then the contribution margin ratios will be as
follows:
Home Office Total
Revenue $250,000 $425,000 $675,000

Cleaning staff salaries 210,000 331,500 541,500
Supplies 30,000 42,500 72,500
Contribution margin 10,000 51,000 61,000
Contribution margin ratios 0.0400 0.1200 0.09037
In this case, the break-even level of sales will be = ($25,000 + $90,000 + $32,000) ÷ .09037 =
$1,626,646.01. Obviously, a 20 percent increase in staff salaries will have a very significant
impact on the break-even level of sales.
Review Problem 2
The Antibody Research Institute (ARI) is a biotechnology company that develops humanized
antibodies to treat various diseases. Antibodies are proteins that bind with a foreign substance,
such as a virus, and render it inactive. The company operates a research lab in Boston and currently
employs 23 scientists. Most of the company’s work involves development of humanized antibodies
for specific pharmaceutical companies. Revenue comes from this contract work and from royalties
on products that ultimately make use of ARI-developed antibodies.
In the coming year, the company expects to incur the following costs:
Expense Summary
Salaries of 23 research scientists $2,760,000

Administrative salaries 785,000
Depreciation of building and equipment 3,200,000
Laboratory supplies 765,000
Utilities and other miscellaneous (fixed) expenses 285,000
Total $7,795,000
Annual contract revenue is projected to be $4,000,000. The company also anticipates royalties
related to the sale of Oxacine, which is a product that will come to market next year. Oxacine
is marketed by Reach Pharmaceuticals and makes use of an antibody developed under contract
with ARI. The product is scheduled to sell for $120 per unit, and ARI will receive a royalty of
20 percent of sales. ARI, in turn, has a contractual commitment to pay 10 percent of royalties it
receives (i.e., 10 percent of the 20 percent) to the scientists who were on the team that developed
the antibody.
Req u i red
a. How many units of Oxacine must be sold for ARI to achieve its break-even point?
b. Reach Pharmaceuticals has projected annual sales of 180,000 units of Oxacine. Assuming
this level of sales, what will be the before-tax profit of ARI?
c. What if Reach Pharmaceuticals sells only 160,000 units of Oxacine? Assuming that the aver-
age salary of scientists is $120,000, how many scientists must be “downsized” to achieve the
break-even point?
d. Do you consider ARI to be high or low with respect to operating leverage? Explain.
An s w er
a. $4,000,000 + .20($120)(Q) − .10(.20)($120)(Q) − $7,795,000 = $–0–
$21.6(Q) = $3,795,000
Q = 175,694.44
b. $4,000,000 + .20($120)(180,000) − .10(.20)($120)(180,000) − $7,795,000 = $93,000
c. $4,000,000 + .20($120)(160,000) − .10(.20)($120)(160,000) − $7,795,000 = ($339,000)
Average salary = $2,760,000 ÷ 23 = $120,000
($339,000) ÷ $120,000 = (2.825)
This implies that approximately three scientists must be “downsized.”
d. ARI is extremely high with respect to operating leverage since costs other than royalty pay-
ments to scientists are generally fixed. The fact that the costs are fixed does not mean, how-
ever, that they cannot be cut. Some costs such as the salaries of the scientists are discretionary
fixed costs. Other costs such as depreciation are committed fixed costs.
Key Terms Account analysis (129) Fixed costs (125) Scattergraph (131)
Break-even point (137) High-low method (131) Semivariable costs (126)
Committed fixed costs (126) Margin of safety (138) Step costs (126)
Contribution margin (139) Mixed costs (126) Step fixed costs (127)
Contribution margin ratio (140) Operating leverage (148) Step variable costs (127)
Cost-volume-profit (CVP) Profit equation (137) Variable costs (124)
analysis (136) Regression analysis (134) “What if ” analysis (140)
Discretionary fixed costs (125) Relevant range (127)

1. At Branson Corporation, the selling price per unit is 2. At Branson Corporation, the selling price per unit is
$800 and variable cost per unit is $500. Fixed costs are $800 and variable cost per unit is $500. Fixed costs
$1,000,000 per year. In this case, the contribution mar- are $1,000,000 per year. Assuming sales of $3,000,000,
gin per unit is: profit will be:
a. $300. a. $125,000.
b. $0.375. b. $680,000.
c. 2,500 units. c. $750,000.
d. None of the answer choices is correct. d. None of the answer choices is correct.
Common Cost BehavioQ u east t ei or n s 155
r P
3. The contribution margin ratio measures: Drugs Cosmetics Housewares

a. Profit per unit. Sales $80,000 $40,000 $30,000
b. Contribution margin per dollar of sales. Variable cost 40,000 15,000 25,000
c. Profit per dollar of sales. Contribution
d. The ratio of variable to fixed costs. margin $40,000 $25,000 $ 5,000
4. In March, Octavius Company had the following costs Based on this information, estimate the increase in
related to producing 5,000 units: profit for a $10,000 increase in sales (assuming that the
sales mix stays the same).
a. $4,667.
Direct labor 20,000
Rent 5,000 b. $5,667.
Depreciation 4,000 c. $3,334.
Estimate variable cost per unit using account analysis. d. None of the answer choices is correct.
a. $17.80. 8. Consider the sales and variable cost information in
b. $4.00. Question 7. Assuming that total fixed costs at Fortesque
c. $5.80. Drug are $30,000 per month, what is the break-even
level of sales in dollars?
d. $16.00.
a. $86,326.
5. Using the following production/cost data, estimate
variable cost per unit using the high-low method: b. $45,876.
c. $72,284.
Month Production Cost d. $64,286.
January 2,000 $20,000 9. If a firm has relatively high operating leverage, it has:
February 2,500 $21,000 a. Relatively high variable costs.
March 3,000 $23,000 b. Relatively high fixed costs.
April 1,900 $18,500
c. Relatively low operating expenses.
a. $4.00. d. Relatively high operating expenses.
b. $3.70. 10. Product A has a contribution margin per unit of $500
c. $4.20. and requires 2 hours of machine time. Product B has
d. $4.09. a contribution margin per unit of $1,000 and requires
6. At Branson Corporation, the selling price per unit is 5 hours of machine time. How much of each product
$800 and variable cost per unit is $500. Fixed costs are should be produced, given there are 100 hours of available
$1,000,000 per year. In this case, the break-even point is machine time?
approximately: a. 50 units of A.
a. 3,333 units. b. 25 units of B.
b. 6,667 units. c. 50 units of A and 25 units of B.
c. 5,500 units. d. None of the answer choices is correct.
d. None of the answer choices is correct.
7. Consider the sales and variable cost information for the
1. a 2. a 3. b 4. d 5. d 6. a
three departments at Fortesque Drug in May:
7. a 8. d 9. b 10. a
QUESTIONS 1. Define the term mixed cost and provide an example of such a cost.
2. Distinguish between discretionary and committed fixed costs.
3. Provide two examples of costs that are likely to be variable costs.
4. Provide two examples of costs that are likely to be fixed costs.
5. Explain why total compensation paid to the sales force is likely to be a mixed cost.
6. Explain how to use account analysis to estimate fixed and variable costs.
7. Explain the concept of a relevant range.
8. What is the difference between the contribution margin and the contribution margin
ratio?
9. In a multiproduct setting, when would it not be appropriate to focus on a weighted average
contribution margin per unit?
10. Which company would have higher operating leverage: a software company that makes large
investments in research and development or a trucking company that relies on owner-operators
(i.e. individuals who own and drive their own truck). Why?
Exercises EXERCISE 4-1. Operating Leverage [LO 3] John Diaz is the president of Pacific Refrigeration.
The company has 2,000 employees and manufactures and sells a variety of refrigeration units for
commercial use. Recently, the company experienced large losses due to a downturn in the econ-
omy and a subsequent decline in sales. John thinks the losses were particularly large because his
company has too many fixed costs.
Req u i r ed
a. Expand on John’s thought. How are the large losses related to fixed costs?
b. Identify a way that John can turn potential fixed costs into variable costs.
EXERCISE 4-2. Contribution per Unit and Contribution Margin Ratio [LO 2] Consider two
companies, Oakland Hill Golf Course and Brooks Men’s Clothing.
Req u i r ed
Which company is more likely to focus on the contribution margin per unit, and which is more
likely to focus on the contribution margin ratio in cost-volume-profit analysis? Explain. (Note: A
unit at the Oakland Hills Golf Course is a round of golf. A unit at Brooks Men’s Clothing is an
article of apparel.)
EXERCISE 4-3. Cost-Volume-Profit Analysis [LO 2] Watson’s Fish Company buys whole salmon
from various fishermen at $4 per pound and sells the fish to restaurants for $6 per pound. Its fixed
costs are $20,000 per month.
Req u i r ed
How many pounds must be sold to break even, and how many pounds must be sold to earn a
profit of $10,000 per month?
EXERCISE 4-4. Cost Behavior [LO 1] Information for three costs incurred at Boole Manufactur-
ing in the first quarter follows:
Units
Month Cost Produced
Depreciation January $575,000 6,500

February $575,000 9,500
March $575,000 12,500
Direct labor January $234,000 6,500
February $342,000 9,500
March $450,000 12,500
Telecommunications January $249,000 6,500
February $327,000 9,500
March $405,000 12,500
Req u i r ed
Plot each cost, making the vertical axis cost and the horizontal axis units produced. Classify
each cost (depreciation, direct labor, and telecommunications) as either fixed, variable, or
mixed.
EXERCISE 4-5. High-Low Method [LO 1] Campus Copy & Printing wants to predict copy
machine repair expense at different levels of copying activity (number of copies made). The fol-
lowing data have been gathered:
Copy Machine
Month Repair Expense Copies Made
May $ 9,000 300,000

June 13,000 550,000
July 22,000 950,000
August 17,000 750,000
September 10,500 400,000
Req u ir ed
Determine the fixed and variable components of repair expense using the high-low method. Use
copies made as the measure of activity. Round cost per copy to two decimal places.
EXERCISE 4-6. High-Low Method [LO 1 and Appendix] Madrigal Theater Company is inter-
ested in estimating fixed and variable costs. The following data are available:
Cost No. of Tickets Sold
January $160,000 19,000

February 190,000 22,000
March 215,000 28,000
April 217,000 29,000
May 209,500 29,500
June 194,500 24,500
July 240,000 35,000
August 172,000 20,000
September 185,000 22,000
October 202,000 26,000
November 191,500 23,500
December 207,000 30,000
Req u ir ed
a. Use the high-low method to estimate fixed cost per month and variable costs per ticket sold [i.e.,
estimate a and b in the equation Cost = a + (b × # of tickets) using the high-low method].
b. Madrigal Theater Company is considering an advertising campaign that is expected to increase
annual sales by 15,000 tickets. Assume that the ticket selling price is $25. Ignoring the cost of
the advertising campaign, what is the expected increase in profit associated with the advertising
campaign?
c. (Optional) Repeat part a using regression analysis. In light of the result, how would you answer
part b? Round unit variable cost to five decimal places.
EXERCISE 4-7. Scattergraph [LO 1] Reef Office Supplies is interested in estimating the relation-
ship between customer service costs and sales. The following data are available:
Month Customer Service Cost Sales
May $9,740 $170,000

June $10,100 $210,000
July $10,690 $230,000
August $12,750 $255,000
September $13,830 $275,000
Req u i r ed
a. Prepare a scattergraph of customer service cost (vertical axis) and sales (horizontal axis).
b. Comment on whether there appears to be a linear relation between cost and sales and whether
any of the observations appear to be outliers.
EXERCISE 4-8. Account Analysis [LO 1] Reef Office Supplies is interested in estimating the cost
involved in hiring new employees. The following information is available regarding the costs of
operating the Human Resource department at Reef Office Supplies in May, when there were 60
new hires:
Human Resources Department
May
Staff wages $30,000
Manager salary 7,500
Office supplies 300
Depreciation of office equipment 500
Share of building cost (based on square feet
occupied by Human Resources) 2,000
Total $40,300
Req u i r ed
a. Use account analysis to determine fixed cost per month and variable cost per new hire. Assume
that only staff wages and office supplies are variable costs.
b. The company is planning to hire 75 employees in June. Estimate the total cost of Human
Resources for June.
c. What is the expected incremental cost associated with hiring 15 more employees than were
hired in May?
EXERCISE 4-9. Account Analysis [LO 1, 2] Madrigal Theater Company is interested in estimat-
ing fixed and variable costs. The following data are available for the month of December:
Number of Tickets Sold Cost
December 4,200 $365,400

Detail of Cost:
Author royalties/fees* $ 80,000
Wages (actors, ticket office, ushers, etc.) 165,000
Rent 60,000
Utilities 7,000
Food and beverages 29,400
Depreciation—theater equipment 14,000
Owner’s salary 10,000
Total $365,400
*Author royalties/fees are fixed because the theater pays for the right to put on the play; royalties and fees are
not paid based on the number of tickets sold.
Req u i r ed
a. Use account analysis to estimate fixed cost per month and variable cost per tickets sold [i.e.,
estimate a and b in the equation Cost = a + (b × Sales)]. Assume the only variable cost are in food
and beverages.
b. Assume that the selling price per ticket is $25. Additionally, on average each ticket holder
spends $10 on food and beverages. Based on your answer to part a, what is your estimate of the
contribution margin ratio at Madrigal Theater?
EXERCISE 4-10. Account Analysis [LO 1] Lopez Mfg. is interested in estimating fixed and vari-
able manufacturing costs using data from October. Based on judgment, the plant manager classi-
fied each manufacturing cost as fixed, variable, or part fixed and part variable:
Units
Produced Cost
October 1,500 $136,100

Detail of Cost: Cost Behavior
Material $ 63,000 Variable
Direct labor 24,000 Variable
Depreciation 8,000 Fixed
Phone 300 Fixed
Other utilities 4,500 20% Fixed
Supervisory salaries 25,200 75% Fixed
Equipment repair 6,500 20% Fixed
Indirect materials 600 Variable
Factory maintenance 4,000 80% Fixed
Total $136,100
Req u ir ed
a. Use account analysis to estimate fixed cost per month and variable cost per unit produced.
b. Based on your answer to part a, what is your estimate of the incremental cost of producing 500 units?
EXERCISE 4-11. CVP Analysis [LO 2] Gabby’s Wedding Cakes creates elaborate wedding cakes.
Each cake sells for $600. The variable cost of making the cakes is $250, and the fixed cost per
month is $8,750.
Req u ir ed
a. Calculate the break-even point for a month in units.
b. How many cakes must be sold to earn a monthly profit of $7,000?
EXERCISE 4-12. CVP Analysis, Profit Equation [LO 2] Lake Stevens Marina has estimated that
fixed costs per month are $350,000 and variable cost per dollar of sales is $0.30.
Req u ir ed
a. What is the break-even point per month in sales dollars?
b. What level of sales dollars is needed for a monthly profit of $70,000?
c. For the month of July, the marina anticipates sales of $1,000,000. What is the expected level of
profit?
EXERCISE 4-13. Contribution Margin [LO 2] Rhetorix, Inc., produces stereo speakers. The selling
price per pair of speakers is $1,000. The variable cost of production is $300 and the fixed cost per
month is $49,000.
Req u ir ed
a. Calculate the contribution margin associated with a pair of speakers.
b. In August, the company sold eight more pairs of speakers than planned. What is the expected
effect on profit of selling the additional speakers?
c. Calculate the contribution margin ratio for Rhetorix associated with a pair of speakers.
d. In October, the company had sales that were $10,000 higher than planned. What is the expected
effect on profit related to the additional sales?
EXERCISE 4-14. Margin of Safety [LO 2] Rhetorix, Inc. produces stereo speakers. The selling
month is $49,000. For November, the company expects to sell 125 pairs of speakers.
Req u i r ed
a. Calculate expected profit.
b. Calculate the margin of safety in dollars. (Round any percentage to two decimal places and
round dollar answers to the nearest dollar.)
EXERCISE 4-15. “What If” Analysis [LO 2] Rhetorix, Inc., produces stereo speakers. The selling
month is $49,000.
Req u i r ed
Calculate the expected profit for November, assuming that the company sells 125 pairs of speakers
as planned (see Exercise 4-14), but the selling price changes to $1,200.
EXERCISE 4-16. Multiproduct, Contribution Margin Ratio [LO 2] Wilde Home & Garden is
organized into three departments. The following sales and cost data are available for the prior year:
Sales $450,000 $600,000 $750,000 $1,800,000

Less variable costs 270,000 450,000 450,000 1,170,000
Contribution margin 180,000 150,000 300,000 630,000
Less fixed costs 70,000 90,000 100,000 260,000
Profit $110,000 $ 60,000 $200,000 $ 370,000
Req u i r ed
a. What is the weighted average contribution margin ratio?
b. What level of sales is needed to earn a profit of $440,000 assuming the current mix?
c. Wilde Home & Garden places an advertisement in the local paper each week. All else equal,
which two departments would you emphasize in the advertisement? Explain.
EXERCISE 4-17. Operating Leverage [LO 2, 3] Refer to the data in Exercise 4-16. (Round all
decimal answers to four places and all dollar answers to the nearest dollar.)
Req u i r ed
a. Calculate profit as a percent of sales in the prior year.
b. Suppose sales in the current year increase by 15 percent. Calculate profit as a percent of sales
for the new level of sales and explain why the percent is greater than the one calculated in part a.
EXERCISE 4-18. Constraints [LO 3] Dvorak Music produces two durable music stands:
Stand A Stand B
Selling price $110 $100

Less variable costs 50 64
Contribution margin $ 60 $ 36
Stand A requires 2 labor hours and stand B requires 1 labor hour. The company has only 350
available labor hours per week. Further, the company can sell all it can produce of either product.
P r o b l e m s 161
Req u i red
a. Which stand(s) should the company produce?
b. What would be the incremental benefit of obtaining 15 additional labor hours?
Problems PROBLEM 4-1. Cost Behavior [LO 1] The Hotel Majestic is interested in estimating fixed and
variable costs so that the company can make more accurate projections of costs and profit. The
hotel is in a resort area that is particularly busy from November through February. In July and
August, however, the hotel has only a 50 percent occupancy rate.
Req u ir ed
Classify each of the following costs as fixed (F), variable (V), or mixed (M) with respect to the
number of hotel guests per month:
______ a. Depreciation of the building
______ b. Salaries of restaurant staff
______ c. Salaries of administrative staff (hotel manager, desk clerks, accountants, etc.)
______ d. Soap, shampoo, and other toiletries in rooms
______ e. Laundry costs (cost of linens, cleaning products, depreciation of laundry equipment, etc.)
______ f. Food and beverage costs
______ g. Grounds maintenance
PROBLEM 4-2. Account Analysis [LO 1, 2] Lancer Audio produces a high-end DVD player that
sells for $1,300. Total operating expenses for July were as follows:
Units produced and sold 150
Component costs $ 71,000

Supplies 2,500
Rent 2,300
Supervisor salary 5,600
Electricity 350
Telephone 280
Gas 300
Shipping 2,000
Advertising 2,600
Administrative costs 15,000
Total $126,930
Req u ir ed
a. Use account analysis to determine fixed cost per month and variable cost per DVD player.
Assume assembly labor in a variable cost.
b. Project total cost for August, assuming production and sales of 175 units.
c. What is the contribution margin per DVD player?
d. Estimate total profit, assuming production and sales of 175 units.
e. Lancer Audio is considering an order for 120 DVD players, to be produced in the next 10
months, from a customer in Canada. The selling price will be $1,050 per unit (well under the
normal selling price). However, the Lancer Audio brand name will not be attached to the product.
What will be the impact on company profit associated with this order?
PROBLEM 4-3. High-Low, Break-Even [LO 1, 2] Lancer Audio produces a high-end DVD player
that sells for $1,300. Total operating expenses for the past 12 months are as follows:
Units Produced and Sold Cost
August 165 $140,345

September 130 116,990
October 150 130,650
November 145 127,670
January 170 143,910
February 140 123,520
March 150 130,950
April 145 127,385
May 150 129,865
June 140 122,720
July 135 120,255
Req u i r ed
a. Use the high-low method to estimate fixed and variable costs.

b. Based on these estimates, calculate the break-even level of sales in units. (Round to the nearest
whole unit.)
c. Calculate the margin of safety for the coming August assuming estimated sales of 175 units.
d. Estimate total profit assuming production and sales of 175 units.
e. Comment on the limitations of the high-low method in estimating costs for Lancer Audio.
PROBLEM 4-4. Regression Analysis (see Appendix) [LO 1 and Appendix] Lancer Audio pro-
duces a high-end DVD player that sells for $1,300. Total operating expenses for the past 12 months
are as follows:
Units Produced and Sold Cost
August 165 $140,345

October 150 130,650
November 145 127,670
January 170 143,910
February 140 123,520
March 150 130,950
April 145 127,385
May 150 129,865
June 140 122,720
July 135 120,255
Req u i r ed
a. Use regression analysis to estimate fixed and variable costs. Round to two decimal places.
b. Compare your estimates to those obtained using account analysis (Problem 4-2) and the high-
low method (Problem 4-3). Which method provides the best estimates of fixed and variable costs?
(Round all answers to the nearest dollar.)
PROBLEM 4-5. Break-Even, “What If” [LO 2] Michael Bordellet is the owner/pilot of Bordellet
Air Service. The company flies a daily round trip from Seattle’s Lake Union to a resort in Canada.
P r o b l e m s 163
In 2016, the company reported an annual income before taxes of $120,403, although that included
a deduction of $70,000, reflecting Michael’s salary:
Revenue ($360 × 1,560 passengers) $561,600

Less costs:
Pilot (owner’s salary) $ 70,000
Fuel (35,657 gallons × $4.15) 147,977
Maintenance (variable) 127,920
Depreciation of plane 25,000
Depreciation of office equipment 2,800
Rent expense 40,000
Insurance 20,000
Miscellaneous (fixed) 7,500 441,197
Income before taxes $120,403
Revenue of $561,600 reflects six round trips per week for 52 weeks with an average of five pas-
sengers paying $360 each per round trip (6 × 52 × 5 × $360 = $561,600). The flight to the resort is
400 miles one way. With 312 round trips (6 per week × 52 weeks), that amounts to 249,600 miles.
The plane averages 7 miles per gallon.
Req u i red (Round all monetary calculations to the nearest cent and all trips to the nearest
whole trip.)
a. How many round trips is Michael currently flying, and how many round trips are needed to
break even?
b. How many round trips are needed so that Michael can draw a salary of $110,000 and still not
show a loss?
c. What is the average before-tax profit of a round trip flight in 2016?
d. What is the incremental profit associated with adding a round-trip flight?
PROBLEM 4-6. Account Analysis, High-Low, Contribution Margin [LO 1, 2] Information on

occupancy and costs at the Light House Hotel for April, May, and June are indicated below:
April May June
Occupancy 1,700 1,850 1,950

Day manager salary $ 4,500 $ 4,500 $ 4,500
Night manager salary 3,900 3,900 3,900
Cleaning staff 15,960 16,275 16,590
Depreciation 12,500 12,500 12,500
Complimentary continental
breakfast: food and beverages 5,050 5,205 5,225
Total $41,910 $42,380 $42,715
Req u ir ed
a. Calculate the fixed costs per month and the variable cost per occupied room using account
analysis for April. Round to two decimal places.
b. Calculate the fixed costs per month and the variable cost per occupied room using the high-low
method.
c. Average room rates are $120 per night. What is the contribution margin per occupied room? In
answering this question, use your variable cost estimate from part b.
PROBLEM 4-7. Fixed and Variable Costs, the Profit Equation [LO 1, 2] Last year, Emily Sanford
had a booth at the three-day Indianapolis Craft Expo, where she sold a variety of silver jewelry
handcrafted in India. Her before-tax profit was as follows:

Sales $21,000
Less:
Cost of jewelry sold 11,550
Gross margin 9,450
Less other expenses:
Registration fee 1,800
Booth rental (6% sales) 1,260
Salary of Mindy Orwell 450
Before tax profit $ 5,940
Mindy Orwell is a friend who takes care of the booth for approximately 5 hours, from 9 a.m. until
2 p.m. Emily takes over from 2 p.m. until closing at 9 p.m. Emily has added several new designs
to her collection and anticipates that in the coming year, her sales will increase by 20 percent, to
$25,200. In light of this, she has forecasted before-tax profit as follows:
Before-tax profit in prior year $ 5,940 a
Sales in prior year 21,000 b
Before-tax profit per dollar of sales 0.2829 a÷b
Forecasted sales $25,200
Profit per dollar of sales 0.2829
Forecasted before-tax profit $ 7,129
Req u i red
a. What is the fundamental assumption that Emily is making, and why is it obviously wrong?
b. Prepare a more appropriate forecast of before-tax profit related to the Indianapolis Craft
Expo.
PROBLEM 4-8. The Profit Equation [LO 1, 2] Gaming Solutions is a small company that
assembles PCs to gamer customer specifications. The company buys all of its component parts
from Northern Oregon Computer Warehouse. In the past year, the company had the following
before-tax profit:
Sales $1,800,000
Less:
Cost of components $1,080,000
Staff salaries 280,000
Rent 40,000
Utilities 8,000
Advertising 7,000 1,415,000
Operating profit before bonuses 385,000
Less:
Staff bonuses 115,500
Profit before taxes and owner draw $ 269,500
The company, owned by Steven Rich, has seven full-time employees. These employees are each
paid a base salary of $40,000 per year. In addition, they receive a bonus equal to 30 percent of
operating profits before bonuses. Owner draw is the amount Steven pays himself out of company
profits.
The company is in the process of planning profit for the coming year. Northern Oregon Com-
puter Warehouse has agreed that their prices to Gaming Solutions will be reduced by 20 percent
on all purchases over $1,000,000.
R equ i r ed
Estimate profit before taxes and owner draw for five levels of sales: $1,600,000; $1,700,000;
$1,800,000; $1,900,000; and $2,000,000. (Round all calculations to the nearest dollar.)
P r o b l e m s 165
PROBLEM 4-9. High-Low, Profit Equation [LO 1] Crux, Inc., produces amplifiers. Each unit sells
for $900. Below is information on production/sales and costs for 2016:
Production and Production Selling and

Sales in Units Costs Admin. Costs
January 105 $ 88,860 $ 23,570

February 117 97,600 25,200
March 97 83,007 22,495
April 106 89,600 23,720
May 115 96,200 24,950
June 125 103,500 26,250
July 128 105,670 26,690
August 132 108,550 27,200
September 138 112,978 28,030
October 126 104,200 26,400
November 124 102,750 26,150
December 108 91,050 23,990
Total 1,421 $ 1,183,965 $ 304,645
Average cost per unit $833.19141 $214.38776
Req u i r ed
a. Use the high-low method to identify the fixed and variable cost components for both produc-
tion costs and selling and administrative costs.
b. The company estimates that production and sales in 2017 will be 1,650 units. Based on this
estimate, forecast income before taxes for 2017.
PROBLEM 4-10. High-Low Method, Scattergraph, Break-Even Analysis [LO 1, 2] FirstTown

Mortgage specializes in providing mortgage refinance loans. Each loan customer is charged a $500
loan processing fee by FirstTown when the loan is processed. FirstTown’s costs over the past year
associated with processing the loans follow:
Loans Processed Cost
January 190 $50,030

February 170 48,550
March 200 50,810
April 211 51,012
May 235 52,012
June 285 54,530
July 310 55,725
August 240 54,420
October 185 49,700
November 175 49,000
December 180 49,290
Req u i red
a. Use the high-low method to estimate fixed and variable costs.
b. Based on these estimates, calculate the number of loans that must be made to break even.
(Round to the nearest whole unit.)
c. Estimate total profit in a month when 275 loans are processed. (Round to the nearest dollar.)
d. Prepare a scattergraph of loan processing cost (vertical axis) and number of loans processed
(horizontal axis).
e. Comment on whether the high-low method produces a reasonable estimate of costs. Look at
whether the relationship between the number of loans processed and the cost is linear. Are there
any outliers? Does an outlier affect the high-low estimate?
PROBLEM 4-11. Break-Even Analysis, Margin of Safety, Increase in Profit [LO 2] Edison
Entrepreneur Services, Inc., is a legal services firm that files the paperwork to incorporate a
business. Edison charges $1,200 for the incorporation application package and plans to file 1,600
applications next year. The company’s projected income statement for the coming year is:
Sales $1,920,000
Less variable expenses 1,184,000
Contribution margin 736,000
Less fixed expenses 300,000
Operating income $ 436,000
Req u i r ed
a. Compute the contribution margin per application and calculate the break-even point in number
of applications. (Round to the nearest whole unit, since it is not possible to file a partial applica-
tion.) Calculate the contribution margin ratio (round to four decimal places) and the break-even
sales revenue (round to the nearest dollar).
b. What is the current margin of safety in terms of the number of units? What is the current mar-
gin of safety in terms of sales dollars?
c. If Edison wants to have operating income of $500,000 next year, how many applications must it
process? (Round to the nearest whole unit.) What dollar level of sales is required to achieve oper-
ating income of $500,000? (Round to the nearest dollar.)
d. The office manager for Edison has proposed that Edison increase advertising (a fixed cost) for
the upcoming year by $75,000; she feels that this increase in advertising will lead to an increase
in sales of $300,000. Prepare a new projected income statement for this proposal. Should Edison
increase its advertising to this new level?
PROBLEM 4-12. Multiproduct CVP [LO 2] Fidelity Multimedia sells audio and video equipment
and car stereo products. After performing a study of fixed and variable costs in the prior year, the
company prepared a product-line profit statement as follows:
Fidelity Multimedia
Profitability Analysis
Audio Video Car Total
Sales $3,250,000 $1,950,000 $1,300,000 $6,500,000
Cost of merchandise 1,920,000 1,374,000 617,000 3,911,000
Salary, part-time staff 192,500 108,000 59,000 359,500
Total variable costs 2,112,500 1,482,000 676,000 4,270,500
Contribution margin 1,137,500 468,000 624,000 2,229,500
Salary, full-time staff 325,000 240,000 220,000 785,000
Total $ 812,500 $ 228,000 $ 404,000 $1,444,500
Advertising 115,000
Utilities 25,000
Other administrative costs 570,000
Total common fixed costs 710,000
Profit $ 734,500
P r o b l e m s 167
Req u i red
a. Calculate the contribution margin ratios for the audio, video, and car product lines.
b. What would be the effect on profit of a $125,000 increase in sales of audio equipment com-
pared with a $125,000 increase in sales of video equipment or a $125,000 increase in sales of
car equipment? Based on this limited information, which product line would you recommend
expanding?
c. Calculate the break-even level of sales dollars for the company as a whole. (Round to the nearest
dollar.)
d. Calculate sales needed to achieve a profit of $1,800,000, assuming the current mix. (Round to
the nearest dollar.)
e. Determine the sales of audio, video, and car products in the total sales amount calculated for
part d. (Round to the nearest dollar.)
PROBLEM 4-13. Multiproduct, Contribution Margin Ratio [LO 2, 3] ComputerGuard offers

computer consulting, training, and repair services. For the most recent fiscal year, profit was
$328,100, as follows:
Consulting Training Repair Total
Sales $600,000 $525,000 $375,000 $1,500,000

Salaries 300,000 210,000 225,000 735,000
Supplies/parts 24,000 39,000 75,000 138,000
Other 1,200 2,700 5,000 8,900
Contribution margin $274,800 $273,300 $ 70,000 618,100
Rent 55,000
Utilities 13,000
Other 10,000
Profit $ 328,100
Req u ir ed
a. Linda O’Flaherty, the owner of ComputerGuard, believes that in the coming year, she can
increase sales by 15 percent. Assuming the current mix of services, what will be the percentage
increase in profit associated with a 15 percent increase in sales? Why will profit increase at a
greater percent than sales? Round contribution margin ratio to six decimal places, and increased
profit to nearest dollar.
b. If Linda were to focus on the contribution margin per unit (rather than the contribution margin
ratio), what would be a likely unit of service?
PROBLEM 4-14. Multiproduct, Contribution Margin [LO 2] National Tennis Racquet Co. pro-
duces and sells three models:
Smasher Basher Dinker Total
Units sold 2,000 3,000 3,000 8,000

Sales $150,000 $180,000 $120,000 $450,000
Less variable costs 80,000 75,000 35,000 190,000
Contribution margin $ 70,000 $105,000 $ 85,000 260,000
Less common fixed costs 140,000
Profit $120,000
Req u ir ed (Round all percentages to two decimal places and monetary calculations to the
nearest dollar.)
a. What is the weighted average contribution margin per unit?

b. Calculate the break-even point in units assuming the current mix.
c. What would be the number of Smashers, Bashers, and Dinkers in the break-even level of sales?
d. What is the weighted average contribution margin ratio?
e. What level of sales (in dollars) would be needed to earn a profit of $125,000, assuming the cur-
rent mix? Round to nearest dollar.
f. What would be the sales (in dollars) of Smashers, Bashers, and Dinkers for total sales calculated
in part e?
PROBLEM 4-15. Operating Leverage [LO 3] Equillion, Inc., and Storis, Inc., are two companies
in the pharmaceutical industry. Equillion has relatively high fixed costs related to research and
development. Storis, however, does little research and development. Instead, the company pays for
the right to produce and market drugs that have been developed by other companies. The amount
paid is a percent of sales. Thus, Storis has relatively high variable costs and relatively low fixed costs:
Equillion, Inc. Storis, Inc.
Sales $150,000,000 $150,000,000

Less variable costs 37,500,000 90,000,000
Less fixed costs 90,000,000 37,500,000
Profit $ 22,500,000 $ 22,500,000
Req u i r ed
a. Which company has the higher operating leverage?
b. Calculate the expected percentage change in profit for a 20 percent increase (and for a 20 per-
cent decrease) in sales for each company. (Round to the nearest percentage.)
c. Which company is more risky?
PROBLEM 4-16. Value of Loosening a Constraint [LO 3] For the past 3 years, Rhetorix, Inc.,
has produced the model X100 stereo speaker. The model is in high demand, and the com-
pany can sell as many pairs as it can produce. The selling price per pair is $900. Variable costs of
production are $300, and fixed costs per year are $720,000. Each pair of speakers requires 5 hours
of assembly time. Currently the company has five assembly workers who are highly skilled and
can work a total of 12,500 hours per year. With a tight labor market, the company finds it difficult
to hire additional assembly workers (at the current rate of $40 per hour) with the skill needed to
assemble the X100. Jurgis Rand, the owner of Rhetorix, is considering offering assembly workers
an overtime premium of $20 per hour (wages in excess of regular hourly wages) to get them to
work more than 12,500 hours per year. In thinking about how much to offer, Jurgis performed the
following calculation:
Sales (2,500 units × $900) $2,250,000

Less variable costs (2,500 × $300) 750,000
Less fixed costs 720,000
Profit $ 780,000
Profit/assembly hours $62.40 per assembly hour
($780,000 ÷ 12,500)
After seeing this calculation, Jurgis decided to offer an overtime premium of $20 per hour to his
assembly workers. Jurgis reasoned: “This is a great deal. The workers make an extra $20 per hour,
and I’ll still make an extra $42.40 per hour.” The $42.40 is equal to the profit per assembly hour
minus the extra labor cost ($62.40–$20.00).
Req u i r ed
a. How much would profit increase if 5 more assembly hours were available at the regular hourly
wage for assembly workers?
P r o b l e m s 169
b. Compare your answer in part a to the answer that Jurgis would provide to the question in part a
(i.e., $62.40 × 5 = $312). What is the flaw in Jurgis’s calculation of the value of additional assembly
time?
c. Suppose Jurgis pays assembly workers $20.00 per hour of overtime premium. On average, what
will be the incremental benefit to Jurgis of an hour of extra assembly time?
PROBLEM 4-17. Constraints [LO 3] Fleet Valley Shoes produces two models: the Nx100 (a shoe
aimed at competitive runners) and the Mx100 (a shoe aimed at fitness buffs). Sales and costs for
the most recent year are indicated:
Nx100 Mx100
Sales (pairs) 20,000 80,000

Sales $3,000,000 $8,800,000
Variable costs (700,000) (1,200,000)
Contribution margin 2,300,000 7,600,000
Fixed costs (20,000) (1,500,000)
Profit $2,280,000 $6,100,000
Assembly time per pair 3 hours 2 hours
Profit per assembly hour $38.00 $37.50
CM per assembly hour $38.33 $47.50
Req u i red
a. Suppose the company has 200,000 assembly hours available. Further, management believes that
at least 4,000 pairs of each model must be produced so that the company has a presence in both
market segments. How many pairs of each model should be produced in the coming year?
b. Suppose management decides that at least 6,000 pairs of each model must be produced. What is
the opportunity cost of this decision versus requiring only 4,000 pairs?
PROBLEM 4-18. Regression Analysis (see Appendix), Profit Equation [LO 1 and Appendix]
Cindy Havana is a vice president of finance for Captain Wesley’s Restaurant, a chain of 12 restaurants
on the East Coast, including five restaurants in Florida. The company is considering a plan whereby
customers will be mailed coupons in the month of their birthday, entitling them to 20 percent off
their total bill. The cost of the mailing (printing, paper, postage, etc.) is estimated to be $500,000.
Cindy estimates that the campaign will result in an annual increase in sales of $3,000,000 at nor-
mal prices ($2,400,000 after the 20 percent discount).
As part of her analysis of the financial impact of the plan, Cindy ran a regression of total
monthly operating costs on sales using data from the past year. The results of this analysis are
indicated in the Summary Output table (see next page):
Operating Costs Sales
January $ 3,809,720 $ 4,141,000

February 3,850,000 4,065,000
March 3,969,000 4,410,000
April 4,007,225 4,502,500
May 3,895,000 4,750,000
June 4,221,240 4,852,000
July 4,343,200 4,880,000
August 4,177,360 4,747,000
September 4,070,000 4,625,000
October 4,035,600 4,484,000
November 3,795,850 4,265,000
December 4,105,200 4,665,000
$48,279,395 $54,386,500
Summary Output
Regression Statistics
Multiple R 0.839596802
R Square 0.70492279
Adjusted R Square 0.675415069
Standard Error 97375.78793
Observations 12
Coefficients Standard Error t Stat P-value
Intercept 1617476.445 493020.2996 3.28075 0.00827844
Sales 0.530824334 0.108604516 4.887682 0.000634652
Req u i r ed
Based on the limited information provided, give Cindy an estimate of the net effect of the coupon
campaign on annual profit. (Ignore taxes.)
CASE
4-1 ROTHMUELLER MUSEUM [LO 1, 2]
In 1928, Francis P. Rothmueller, a Northwest railroad mag- 1. Estimated attendance is 10,000, and admission to the
nate, established an endowment to fund the Rothmueller exhibit is $15.
Museum in Minneapolis. The museum currently has a $30 2. Some photographs will come from the Rothmueller collec-
million endowment, but it also has substantial operating costs tion while others will be leased from other museums and
and continues to add to its eclectic collection that encompasses collectors.
paintings, photographs, drawings, and design objects post-1900. 3. Cost of packing and transportation to and from Rothmueller.
Annual earnings from the endowment (approximately $2,500,000
4. Insurance to cover photographs during the run of the
in 2016) are not sufficient to cover operations and acquisitions,
exhibition.
and the museum’s trustees and president are conscious of the
need to generate income from admissions, special exhibits, and 5. Twenty-five percent of annual salary for Alice Morgan,
museum store sales. head photography curator.
Alice Morgan, photographic curator, is in the process of plan- 6. Twenty-five percent of annual salary for William Jacob, as-
ning an exhibition of Ansel Adams photographs that will run sistant photography curator.
from September through November 2017. Below is a preliminary 7. Cost of guard service for exhibition.
budget, prepared by Alice, of revenue and costs associated with 8. Painting of exhibition room to off-white background.
the exhibition:
9. Advertising in newspapers and public radio.
Revenue (10,000 × $15) $150,000 1 10. Cost of programs describing the work of Ansel Adams and
Less: pictures at exhibition.
Lease of photographs from
other museums and A dditio nal Informatio n
collectors $100,000 2
Packing and transportation In preparing the budget, Alice assigned 25 percent of her and her
of photographs from other assistant’s annual salaries to the exhibition since they will each
museums and collectors 5,000 3 spend approximately 3 months on the project. An admission fee
Event insurance 4,000 4 of $6 is charged to enter the museum, and attendance at the exhi-
Alice Morgan salary (25%) 15,000 5 bition is an additional $15 per person. Approximately one-fifth of
William Jacob salary (25%) 13,000 6 the individuals who are estimated to attend the exhibition would
Guard service 12,000 7 have come to the museum whether the exhibition was being held
Installation costs 2,000 8 or not. (Alternatively, four-fifths of the individuals are coming
Advertising 7,000 9 specifically to attend the exhibition.)
Exhibition printed programs 4,000 162,000 10 Analysis of prior data indicates that 20 percent of individuals
make a purchase at the museum store, and the average purchase
Profit (loss) ($ 12,000)
price is $8. The store has a 30 percent gross margin (sales minus
C a s e 171
cost of sales) and profit (sales minus cost of sales minus staff sal- Does offering the exhibition appear to be a good decision from
aries and other operating costs) per dollar of sales of 5 percent. a financial standpoint?
b. How many people must attend the exhibition for its financial
R e q uir ed impact to be profit neutral (i.e., the museum will not be better
a. Prepare an analysis of the financial impact of the exhibition or worse off financially)?
on the Rothmueller Museum, assuming attendance is 10,000.
CASE
4-2 MAYFIELD SOFTWARE, CUSTOMER TRAINING [LO 2]
Marie Stefano is the group director of customer training and classes are cancelled if enrollment is fewer than 15 stu-
for Mayfield Software. In this capacity, she runs a center in dents. Classes typically are held Monday through Friday,
Kirkland, Washington, that provides training to employees of although some classes are held on Saturdays and Sundays.
companies that use Mayfield’s inventory control, customer man- 2. Rent relates to the training center in Kirkland, which is
agement, and accounting software products. Her group employs not part of Mayfield’s main campus located in Bellevue,
a receptionist and an office manager/bookkeeper, and she has Washington.
arrangements with several part-time trainers who are hired on 3. Advertising costs relate to the cost of monthly advertise-
an as-needed basis. (They are all retired employees of Mayfield ments in trade journals such as TechWorker and Inventory
Software.) Trainers are paid $4,000 per daylong class. Mayfield is a Management. These ads provide information on upcoming
decentralized company, and Marie is given considerable authority training sessions.
to advertise and conduct classes as she sees fit.
4. Operating manuals are provided to each participant.
5. Postage, envelopes, and paper costs relate primarily to bill-
Report of Operating Results, 2016 ing companies for employees who participate in classes.
This cost varies with the number of participants.
Revenue $6,120,000 6. Central charges are assigned to each group at Mayfield Soft-
Less operating costs: ware based on actual sales. The allocation relates to costs
Trainer costs $3,400,000 incurred for the benefit of the company as a whole, includ-
Director salary 180,000 ing salaries of the CEO and company president, legal costs,
Receptionist 60,000 costs related to the company’s central office building, brand
Office manager 80,000 advertising, and so on. The charge is 20 percent of revenue.
Utilities, phone, etc. 38,000
Lease expense related to
computers, servers, etc. 400,000 R eq uired
Rent 100,000 a. As indicated, the training group suffered a loss in 2016. Thus,
Operating manuals for unbeknownst to Marie, Mayfield management is considering
participants 510,000 shutting down the training center. Given the results of 2016,
Postage, envelopes, paper, etc. 12,750 what would be the effect on Mayfield Software’s total company
Advertising 160,000 profit in 2017 if the training center is closed at the start of the
Total operating costs 4,940,750 year?
Profit before central charges 1,179,250
b. Given the current room configuration and approach to allo-
Central charges 1,224,000
cation of central charges (20 percent of revenue), calculate the
Group profit ($ 44,750) number of classes that must be offered (with an average enroll-
ment of 20 students) for Marie’s group to break even on the
During 2016, the group conducted 850 day-long classes with Report of Operating Results.
an average enrollment of 20 students paying $360. The group’s c. Recalculate your answer to part b assuming Marie can lower
Report of Operating Results for 2016 is detailed above. the amount paid to instructors to $3,500 per class. Should
Marie seriously pursue this option?
Ad dit ion a l Fa c ts
d. Mayfield Software is releasing version 4.0 of CustomerTrack
1. All equipment is leased on a yearly basis. Costs include 100 in 2017. Marie believes that this will create a demand for 30
workstations for students (one workstation for every seat additional daylong classes with an average enrollment of 20 stu-
in each of the four 25-student classrooms), plus servers and dents per class. What effect will this have on “group profit” on
other miscellaneous equipment. While average class en- Marie’s Report of Operating Results? Assume that instructors
rollment is 20 students, some classes are full (25 students), will be paid $4,000 per class.
CASE
4-3 KROG’S METALFAB, INC. [LO 1, 2]
John Krog is president, chairman of the board, production sustained “lost profit”). The expenses in 2016 include excess op-
supervisor, and majority shareholder of Krog’s Metalfab, Inc. erating costs of $250,000. Krog has documentation supporting
He formed the company in 1991 to manufacture custom-built these items, which include overtime costs, hotel costs, meals, and
aluminum storm windows for sale to contractors in the greater such related to operating out of Moline. The insurance company
Chicago area. Since that time the company has experienced is quite willing to pay for these costs since they reduced potential
tremendous growth and currently operates two plants: one in lost profit.
Chicago, the main production facility, and a smaller plant in The chief accountant at Krog, Peter Newell, has e stimated
Moline, Illinois. The company now produces a wide variety of lost profit to be only $34,184. Thus, he does not feel that it’s
metal windows, framing materials, ladders, and other products worthwhile spending a lot of company resources trying to
related to the construction industry. Recently the company de- collect more than the $250,000. Peter arrived at his c alculation
veloped a new line of bronze-finished storm windows, and initial as follows:
buyer reaction has been quite favorable. The company’s future
seemed bright, but on January 3, 2016, a light fixture overheated Sales in 2015 $5,091,094
causing a fire that virtually destroyed the entire Chicago plant. Predicted sales in 2016, assuming
Three days later, Krog had moved 50 percent of his Chicago work- a 7% increase $5,447,471
force to the Moline plant. Workers were housed in hotels, paid Actual sales in 2016 3,857,499
overtime wages, and provided with bus transportation home on (A) Lost sales 1,589,972
weekends. Still, the company could not meet delivery schedules (B) Profit in 2015 as a percentage of 2015
because of reduced operating capacity, and total business began sales ($109,495 ÷ 5,091,094) .0215
to decline. At the end of 2016, Krog felt that the worst was over. Lost profit (A × B) $ 34,184
A new plant had been leased in Chicago, and the company was
almost back to normal. R eq uired
Finally, Krog could turn his attention to a matter of consid-
erable importance: settlement with the insurance company. The a. Mr. Krog is not convinced by Peter’s analysis and has turned
company’s policy stipulated that the building and equipment loss to you, an outside consultant, to provide a preliminary estimate
be calculated at replacement cost. This settlement had been fairly of lost profit. Using the limited information contained in the
straightforward, and the proceeds had aided the rapid rebuilding financial statements for 2015 and 2016, estimate lost profits.
of the company. A valued feature of the insurance policy was “lost (Hint: You can proceed as follows.)
profit” coverage. This coverage was to “compensate the company STEP 1. Determine the level of fixed and variable costs in 2015
for profits lost due to reduced operating capacity related to fire as a function of sales. You can use account analysis,
or flood damage.” The period of “lost profit” was limited to 12 the high-low method, or regression if you are f amiliar
months. Interpreting the exact nature of this coverage proved to with that technique. If you use account analysis,
be difficult. The insurance company agreed to reimburse Krog for assume that cost of goods sold and selling expense are
the overtime premium, transportation, and housing costs related variable costs and administrative expense is a fixed
to operating out of the Moline plant. These expenses obviously cost.
minimized the damages related to the 12 months of lost or re- STEP 2. Predict what sales would have been in 2016 if there
duced profits. But was the company entitled to any additional was no fire. Using this level of sales and the fixed and
compensation? variable cost information from Step 1, estimate what
Krog got out the latest edition of Construction Today. Accord- profit would have been in 2016.
ing to this respected trade journal, sales of products similar to
STEP 3. The difference between actual profit in 2016 and the
products produced by Krog’s Metalfab had increased by 7 percent
amount estimated in Step 2 is lost profit.
during 2016. Krog felt that were it not for the fire, his company
could also have increased sales by this percentage. b. Based on your preliminary analysis, do you recommend that
Income statement information is available for 2015 (the year Mr. Krog aggressively pursue a substantial claim for lost profit?
prior to the fire) and 2016 (the year during which the company c. What is the fundamental flaw in Peter Newell’s analysis?
C a s e 173
Krog’s Metalfab
Income from Operations, 2015 and 2016
2015 January February March April May June July August September October November December Total
Sales $501,260 $349,260 $361,250 $303,685 $435,650 $511,650 $561,625 $603,210 $421,210 $331,025 $330,009 $381,260 $5,091,094
Less:
Cost of goods
sold 392,036 441,570 334,030 321,131 371,140 406,065 422,007 440,620 370,434 332,255 333,134 354,053 4,518,475
Selling expense 21,200 15,720 15,535 13,300 18,425 21,472 23,590 25,020 17,795 14,383 14,301 16,383 217,124
Administrative
expense 20,500 20,500 20,500 20,500 20,500 20,500 20,500 20,500 20,500 20,500 20,500 20,500 246,000
Total expense 433,736 477,790 370,065 354,931 410,065 448,037 466,097 486,140 408,729 367,138 367,935 390,936 4,981,599
Income from
operations $ 67,524 ($128,530) ($ 8,815) ($ 51,246) $ 25,585 $ 63,613 $ 95,528 $117,070 $ 12,481 ($ 36,113) ($ 37,926) ($ 9,676) $ 109,495
2016 January February March April May June July August September October November December Total
Sales $447,252 $236,362 $291,370 $216,265 $278,165 $316,441 $357,662 $453,245 $363,772 $315,427 $264,273 $317,265 $3,857,499
Less:
Cost of goods
sold 395,445 311,800 330,720 301,232 327,776 343,590 357,880 395,442 362,254 340,732 320,800 343,583 4,131,254
Selling expense 19,340 10,900 13,110 10,105 12,582 14,112 15,760 19,583 16,005 14,072 12,026 14,149 171,744
Administrative
expense 22,300 23,515 23,910 24,650 23,745 24,790 23,745 23,522 23,670 22,791 22,709 22,990 282,337
Total expense 437,085 $346,215 $367,740 $335,987 $364,103 $382,492 397,385 438,547 401,929 377,595 355,535 380,722 4,585,335
Income from
operations $ 10,167 ($109,853) ($ 76,370) ($119,722) ($ 85,938) ($ 66,051) ($ 39,723) $ 14,698 ($ 38,157) ($ 62,168) ($ 91,262) ($ 63,457) ($ 727,836)
5
Variable Costing
In 2015, the all-tube amplifier produced by ClausenTube
received rave reviews and the company was able to sell
all 5,000 units it produced, generating company profit of
$3,500,000.
Based on these results, ClausenTube increased production to 6,000 units in the

subsequent year but was able to sell only 4,800 units. This performance, however,
was considered quite good given that the economy had slipped in the third and
fourth quarters.
In early January of 2017, Robert Clausen, company president and founder,
reviewed financial performance for 2016. Surprisingly, profit had actually increased
slightly to $3,528,000. Robert was confused and wasted no time calling Leslie
Anders, the company controller. “What’s going on?” Robert asked in a voice that
hinted at his irritation. “Sales are down, the production process and prices haven’t
changed, and yet profit is up! How confident are you in the income numbers? There
must be a significant error somewhere.”
“I know this result looks bizarre,” Leslie replied. “But it’s not due to an error in the
accounting department. It’s due to the fact that our financial statements are prepared
using what’s called full, or absorption, costing. That’s the method most companies
use for external reporting to shareholders and creditors. If your schedule permits,
let’s meet this afternoon and I’ll show you an analysis that explains what happened.
There’s a method called variable costing that we could use for internal reporting
purposes which wouldn’t produce such puzzling results. Maybe we should consider
adopting it. I really think it can help us do a better job managing the business.”
In this chapter, we will discuss the differences between full costing and variable
costing and gain an understanding of why profit is up at ClausenTube even though
sales are down. We will also see how a variable costing income statement can sup-
port accurate planning and good decision making, two activities that are jeopardized
if managers rely on full cost information.
jakkapan21/iStock/Getty Images Plus
Learning Objectives
1 Explain the difference between full (absorption) and variable costing and prepare an income
statement using variable costing.
2 Discuss the effect of production on full and variable costing income; explain the impact of
JIT (just-in-time) on the difference between full and variable costing income; and discuss the
benefits of variable costing for internal reporting purposes.
175
176 chapter 5 V a r i a b l e C o s t i n g
Learning Full (Absorption) and Variable Costing

Objective 1
Income statements of manufacturing firms prepared for external purposes use full costing
Explain the difference (also called absorption costing). In full costing, inventory costs include direct material,
between full (absorption) direct labor, and all manufacturing overhead. Direct material and direct labor are generally
and variable costing variable costs, but manufacturing overhead includes both variable and fixed cost elements.
and prepare an income Thus, fixed and variable costs are commingled, or combined, and it is very difficult to
statement using variable untangle the costs to perform “what if ” analysis that requires separating fixed and variable
costing. costs. An alternative to full costing for internal reporting purposes is variable costing. In
variable costing, only variable production costs are included in inventory costs. All fixed
production costs are treated as period costs and expensed in the period incurred.
As shown in Illustration 5-1, the only difference between the two methods is their
treatment of fixed manufacturing overhead. Under the full costing method, these costs
are included in inventory. They enter into the determination of expense only when the
inventory is sold. Under the variable costing method, fixed manufacturing costs enter
into the determination of expense in the same way as other, nonmanufacturing period
Illustration 5-1
Comparison of full and variable costing
Full Costing
Product Costs Period Costs
Variable Fixed
Direct Direct Manufacturing Manufacturing Selling Administrative
Material Labor Overhead Overhead Costs Costs
Inventory Cost of Goods Sold Expense
Variable Costing
Product Costs Period Costs
Variable Fixed
Direct Direct Manufacturing Manufacturing Selling Administrative
Material Labor Overhead Overhead Costs Costs
Variable
Inventory Expense
Cost of Goods Sold
F u l l ( A b s o r p t i o n ) a n d V a r i a b l e C o s t i n g 177
costs. Consider depreciation, which usually is a fixed cost component of manufacturing

overhead. Under full costing, some portion of depreciation for the period remains in end-
ing inventory when some of the items produced are not sold. Under the variable costing
method, however, the total amount of depreciation is treated as an expense of the period.
Variable Costing Income Statement

If variable costing is used, an income statement can be prepared that classifies all
expenses in terms of their cost behavior, either fixed or variable. With the variable
expenses separated from the fixed expenses, a contribution margin can be presented.
The contribution margin information will allow readers of the income statement to make
reasonable estimates of how much profit will change with a change in sales.
A comparison of a variable costing income statement and an income statement typ-
ical for a manufacturing firm using full costing is presented in Illustration 5-2. Suppose
sales of the Lee Dress Manufacturing Company are expected to increase by $10,000,000.
What is the expected increase in profit? This can’t be determined from the full costing
income statement because we don’t know which costs are fixed and which costs are
variable. However, using the variable costing income statement, we can easily calculate
the contribution margin ratio as the contribution margin divided by sales, which equals
65 percent. If sales increase by $10,000,000, profit is estimated to increase by $6,500,000:
Contribution Contribution margin

=
margin ratio Sales
Contribution $65,000
= = 0.65
margin ratio $100,000
Increase in sales $10,000,000

Contribution margin ratio × 0.65
Increase in contribution margin $ 6,500,000
Note that the full costing income statement at the top of Illustration 5-2 cannot be
used to estimate the increase in profit due to a $10,000,000 increase in sales. The reason
is that cost of goods sold includes both fixed and variable costs. Obviously, the fixed costs
won’t increase if sales increase, but the problem is that we don’t know how much of cost
of goods sold is fixed—or variable, for that matter—under full costing.
Also note that in the variable costing income statement, we assume that some of the
Lee Dress Manufacturing Company’s selling and administrative costs are fixed and some
are variable. Given this, it is important that we break out the fixed and variable compo-
nents of selling and administrative costs so that we can calculate the contribution margin
ratio. This ratio, as we just saw, allows us to do profit planning and answer questions like,
“By how much will profit increase if sales increase by $10,000,000?”
Link to Practice
German Companies More Likely to Use variable costing makes fixed overhead more visible. A
Variable Costing U.S. respondent who uses variable costing stated that
he prefers variable costing because, at his company, vol-
In a survey yielding responses from 148 German com-
umes vary a lot from period to period. If fixed costs were
panies and 130 U.S. firms, two accounting researchers
allocated to products, unit costs would be distorted.
found that German firms are much more likely than
American companies to use variable costing (52 percent Source: Kip Krumwiede and Augustin Suessmair, “Getting Down
versus 21 percent). One German respondent stated that to Specifics on RCA,” Strategic Finance, June 2007, pp. 50–55.
Illustration 5-2
Income Statement Prepared Using Full Costing
Comparison of income
Lee Dress Manufacturing Company
statements prepared using
full and variable costing
Income Statement
In Thousands
Sales $100,000
Less cost of goods sold 30,000
Gross margin 70,000
Less selling and administrative expense:
Selling expense $18,000
Administrative expense 12,000 30,000
Net income $ 40,000
Income Statement Prepared Using Variable Costing

Lee Dress Manufacturing Company
Income Statement
For the Year Ending December 31, 2017
In Thousands
Sales $100,000
Variable cost of goods sold $20,000
Variable selling expense 10,000
Variable administrative expense 5,000 35,000
Less fixed costs:
Fixed manufacturing expense 10,000
Fixed selling expense 8,000
Fixed administrative expense 7,000 25,000
Net income $ 40,000
Learning EFFECTS OF PRODUCTION ON INCOME

Objective 2
Discuss the effect of
FOR FULL VERSUS VARIABLE COSTING:
production on full and THE C LAUSENTUBE EXAMPLE
variable costing income; To examine in detail the differences between full and variable costing, let’s consider the case
explain the impact of of ClausenTube presented at the start of the chapter. The amplifiers produced by the company
JIT (just-in-time) on the sell for $2,000 per unit. The variable production costs of each unit include the following:
difference between full direct material (various tubes and other components), $600; direct labor, $225; and variable
and variable costing manufacturing overhead, $75. In addition, $1,200,000 of fixed manufacturing overhead is
income; and discuss incurred each year. Selling expense is composed of $40 per unit sold of variable expense
the benefits of variable and $100,000 of fixed expense. Administrative expenses are all fixed and equal to $500,000:
costing for internal
reporting purposes. Selling price per unit $2,000
Variable production costs per unit:
Direct material $600
Direct labor 225
Variable overhead 75 900
Variable selling expense per unit 40
Contribution margin per unit $1,060
Fixed manufacturing overhead $1,200,000
Fixed selling expense $100,000
Fixed administrative expense $500,000
E f f e c t s o f P r o d u c t i o n o n I n c o m e f o r F u l l V e r s u s V a r i a b l e C o s t i n g : T h e C l a u s e n T u b e E x a m p l e 179
LINK TO Practice
Overproduction to Avoid Showing a Loss per unit and cost of goods sold, since fixed costs are
spread over more units.
In a 2006 study, Sugata Roychowdhury found evidence
indicating firms that would have shown a loss were able Source: Sugata Roychowdhury, “Earnings Management
to increase earnings and avoid a loss by producing more Through Real Activities Manipulation,” Journal of Accounting
goods than necessary. Overproduction lowers the cost and Economics, 2006, pp. 335–370.
Quantity Produced Equals Quantity Sold

In 2017, there is no beginning inventory of finished goods; 5,000 units are produced, and
5,000 units are sold. Illustration 5-3 provides a comparison of full costing and variable
costing income statements for this situation. The full cost of production is $5,700,000. This
includes $4,500,000 of variable production cost ($900 × 5,000 units) and $1,200,000 of fixed
manufacturing overhead. With 5,000 units produced, this results in a unit cost of $1,140:
Variable Fixed
production + production
cost cost
= Unit cost under full costing
Units Produced
$4,500,000 + $1,200,000
= $1,140 per unit
5,000
Because 5,000 units are sold, cost of goods sold is $5,700,000 ($1,140 × 5,000 units).
Illustration 5-3
ClausenTube
Full versus variable costing Income Statements
when units produced equal
units sold
Full Costing
Sales ($2,000 × 5,000 units) $10,000,000
Cost of goods sold ($1,140 × 5,000 units) 5,700,000
Gross margin 4,300,000
Selling expense $ 300,000
Net income $ 3,500,000
Notes: Units produced and sold both equal 5,000.
Selling expense = $100,000 + ($40 × 5,000 units).
Variable Costing
Sales ($2,000 × 5,000 units) $10,000,000
Variable cost of goods sold ($900 × 5,000 units) $4,500,000
Variable selling costs ($40 × 5,000) 200,000 4,700,000
Contribution margin 5,300,000
Less fixed costs:
Fixed production costs 1,200,000
Fixed selling costs 100,000
Fixed administrative costs 500,000 1,800,000
Note: Units produced and sold both equal 5,000.
Selling expense is equal to $100,000 of fixed selling expense plus $40 per unit of
variable selling expense for a total of $300,000:
Variable selling expense ($40 × 5,000 units) $200,000

Total selling expense $300,000
Taking into account fixed administrative expense of $500,000, net income is $3,500,000.
Now let’s consider the variable costing income statement in Illustration 5-3. The vari-
able cost of production is only $900 per unit and variable selling expense is $40 per unit.
With 5,000 units sold, variable expenses are $4,700,000. Thus, as indicated in the illustra-
tion, the contribution margin is $5,300,000. With fixed production cost of $1,200,000, fixed
selling expense of $100,000, and fixed administrative expense of $500,000, net income is
equal to $3,500,000, which is the same as net income calculated using full costing.
Decision Making/ As we’ve just seen, when the quantity produced equals the quantity sold, there is no dif-
Incremental ference between net income calculated using full versus variable costing. Since all units
Analysis produced are sold, no fixed cost ends up in ending inventory. Thus, the only difference
between the two methods in this situation is that variable costing breaks out total costs
into both fixed and variable costs and provides a contribution margin. That, however, is
not a trivial difference since the contribution margin can be very helpful in planning and
decision making. Suppose, for example, that ClausenTube is considering an advertising
campaign that will cost $100,000 and is expected to increase sales by $200,000. What
will be the impact on income (a planning question), and should the company undertake
the marketing plan (a decision question)?
Using the variable costing income statement, we can easily calculate the contribution
margin ratio to be 0.53:
Contribution margin $5,300,000
= = 0.53
Sales $10,000,000
With this information, we can estimate that if sales increase by $200,000, incremental
profit will be $6,000:
Increase in sales $200,000

Contribution margin ratio × 0.53
Increase in contribution margin 106,000
Less increased marketing costs 100,000
Increase in profit $ 6,000
Given that the impact on profit is positive, deciding to undertake the marketing plan is
appropriate, and ClausenTube can update its financial plans accordingly.
Now suppose that the variable costing income statement is not available and
ClausenTube managers rely on the information in the full costing income statement. How
will they calculate the impact of the marketing plan? There are two assumptions they might
make—both of which are wrong! First, they might assume that the cost of goods sold is
entirely variable and, further, is the only variable cost. In this case, they will estimate that
profit will increase by $0.43 for every dollar of sales, which, as we know, is too low:
Gross margin $4,300,000
= = 0.43
Sales $10,000,000
Second, they might assume that all costs are variable, in which case net income is
equivalent to the contribution margin. In this case, they will estimate that profit will
increase by only $0.35 for every dollar of sales, which is also too low:
Net income $3,500,000

= = 0.35
Sales $10,000,000
The point is that having a variable costing income statement can be very useful for
planning and decision making. Not having one may lead managers to make assumptions
that are incorrect, leading to poor plans and poor decisions.
Quantity Produced Is Greater Than Quantity Sold

In the previous section, we saw that when the quantity produced is equal to the quantity
sold, there is no difference between income computed using full costing or using variable
costing. Such is not the case if the quantity produced is greater than the quantity sold. In
this case, income will be greater using full costing as opposed to variable costing. Let’s
see why this is the case.
Recall that in 2016, ClausenTube increased production to 6,000 units but sold only
4,800 due to a weakening economy. Illustration 5-4 provides a comparison of full costing
and variable costing income statements for this situation. The full cost of production is
$6,600,000. This includes $5,400,000 of variable production cost ($900 × 6,000 units) and
$1,200,000 of fixed manufacturing overhead. With 6,000 units produced, this results in
a unit cost of $1,100:
Variable Fixed
production + production
cost cost
= Unit cost under full costing
Units produced
$5,400,000 + $1,200,000
= $1,100 per unit
6,000
Q: If variable costing is so great for internal reporting purposes, why isn’t
it used for external reporting purposes? Don’t external users want useful
information?
A : Generally accepted accounting principles (GAAP) imply that variable costing is not
acceptable for external reporting purposes. Since it’s not allowed, it isn’t used! But that
leads one to wonder why this is the case. Shouldn’t GAAP be formulated to provide use-
ful information? Perhaps a better answer is that company managers may be concerned
that variable cost information will prove helpful to competitors who, with the variable cost
information, will have better insight into a rival company’s cost structure. Another reason
is that separating costs into fixed and variable components may be quite subjective. As
we saw in Chapter 4, the most common way of classifying costs as fixed and variable is
account analysis. In that method, costs are simply classified using management’s sub-
jective judgment.
Illustration 5-4
ClausenTube
Full versus variable costing
Income Statements
when units produced are
greater than units sold
Full costing
Sales ($2,000 × 4,800 units) $9,600,000
Notes: 6,000 units produced and 4,800 units sold.
Variable Costing
Sales ($2,000 × 4,800 units) $9,600,000
Variable cost of goods sold ($900 × 4,800 units) $4,320,000
Variable selling costs ($40 × 4,800) 192,000 4,512,000
Less fixed costs:
Note: 6,000 units produced and 4,800 units sold.
Full costing income is greater than variable
costing income $ 240,000
In the previous year, the unit cost was $1,140. Unit costs have decreased because pro-
duction has increased, spreading fixed costs out over more units. Because 4,800 units are
sold, cost of goods sold is $5,280,000. Net income amounts to $3,528,000.
Now let’s consider the variable costing income statement in Illustration 5-4. The vari-
able cost of production is only $900 per unit and variable selling costs are $40 per unit.
With 4,800 units sold, variable expenses are $4,512,000. Thus, as indicated in the illustra-
tion, the contribution margin is $5,088,000. With fixed production costs of $1,200,000,
fixed selling costs of $100,000, and fixed administrative costs of $500,000, net income is
equal to $3,288,000, which is $240,000 less than the income computed using full costing.
Let’s see why income is higher using full costing. Recall that the difference between
full and variable costing is that under full costing, inventory cost includes fixed man-
ufacturing overhead whereas under variable costing, fixed manufacturing overhead is
expensed as a period cost. Illustration 5-5 presents a comparison. Note that the $240,000
difference in ending inventory values completely accounts for the difference in income
under the two methods.
Quantity Produced Is Less Than Quantity Sold

We have just seen that if the quantity produced equals the quantity sold, then full and vari-
able costing yield the same reported income (see Illustration 5-3). If the quantity produced
is greater than the quantity sold, full costing yields a higher income, because some fixed
Illustration 5-5
Full Costing Inventory Value
Inventory cost under full
and variable costing Cost per Unit
Direct material per unit $ 600
Direct labor per unit 225
Variable manufacturing overhead 75
Fixed manufacturing overhead
($1,200,000 ÷ 6,000 units) 200
Total $1,100
Ending Inventory Value
($1,100 × 1,200 units) $1,320,000
Variable Costing Inventory Value
Cost per Unit
Direct material per unit $ 600 Difference of $240,000 due to
Direct labor per unit 225 $200 per unit of fixed manu-
Variable manufacturing overhead 75 facturing overhead in ending
Total $ 900 inventory under full costing
($200 × 1,200 units = $240,000)
Ending Inventory Value
($900 × 1,200 units) $1,080,000
manufacturing overhead is in ending inventory under full costing while the entire amount
is treated as a period expense under variable costing (see Illustrations 5-4 and 5-5). Now,
what is the case if the quantity produced is less than the quantity sold? To sell more than
produced, a company must have some beginning inventory. The recorded value of that
beginning inventory will be greater with full costing since full costing includes fixed man-
ufacturing overhead and variable costing does not. Thus, when the beginning inventory
is charged to cost of goods sold, the charge will be higher under full costing. The result:
Income is lower under full costing when the quantity produced is less than the quantity sold.
Suppose that in 2017, ClausenTube produces 6,000 units but sells 7,200 units. Recall
that 1,200 units are left over from the prior year. Now cost of goods sold under full cost-
ing includes 1,200 units at $1,100 per unit from beginning inventory and 6,000 units
at $1,100 from current-period production. As indicated in Illustration 5-6, total cost of
goods sold is equal to $7,920,000 under full costing.
The difference in incomes between full and variable costing is $240,000 ($5,832,000
under variable costing - $5,592,000 under full costing). This, as we’ve already said, is due
to the fact that beginning inventory includes fixed manufacturing overhead under full
costing while beginning inventory under variable costing does not.
Note that the difference between the beginning inventory values accounts for the
$240,000 difference in incomes:
Beginning inventory under full costing $1,320,000
Beginning inventory under variable costing 1,080,000
Difference $ 240,000
To summarize, here are the comparative effects of production on income for the
two methods:
Condition Result
Units produced equal units sold No difference in income
Units produced exceed units sold Full costing yields higher income
Units produced are less than units sold Variable costing yields higher income
Illustration 5-6
ClausenTube
Full versus variable costing Income Statements
when units produced are less For the Year Ended December 31, 2017
than units sold
Full Costing
Sales ($2,000 × 7,200 units) $14,400,000
Cost of goods sold
1,200 units × $1,100 $1,320,000
6,000 units × $1,100 6,600,000 7,920,000
Notes: 6,000 units produced and 7,200 sold.
Variable Costing
Sales ($2,000 × 7,200 units) $14,400,000
Variable cost of goods sold
1,200 units × $900 $1,080,000
6,000 units × $900 5,400,000 6,480,000
Variable selling costs ($40 × 7,200) 288,000
Less fixed costs:
Note: 6,000 units produced and 7,200 sold.
Variable costing income is greater than
full costing income $ 240,000
Explaining What Happened at ClausenTube

Recall the scenario at the start of the chapter. Robert Clausen had just called his controller
and asked her to explain why profit increased even though the company sold fewer units
in 2016 compared to 2015 and had not changed its price or its production processes. It is
hoped that the answer is now apparent. In 2016, the company produced a lot more units
than it sold. The high level of production reduced cost per unit because fixed manufactur-
ing overhead was spread out over more units. The low unit cost led to a low cost of goods
sold value, but the company ended up with a substantial ending inventory balance.
LINK TO Practice
Cut in Production at John Deere Likely are spread over fewer units. The end result is a likely
to Hurt Profit Margin decline in Deere’s profit margin (the ratio of gross profit
to sales).
At the start of 2015, John Deere forecasted a 20 per-
cent decline in agriculture and turf equipment sales. Source: Trefis Team, “Why 2015 Might Not Be a Good Year
That’s likely to increase cost per unit as fixed costs For Deere,” Forbes Online (January, 2, 2015).
B e n e f i t s o f V a r i a b l e C o s t i n g f o r I n t e r n a l R e p o r t i n g 185
If the company had been using variable costing, Robert Clausen would have seen
profit decline, just as he expected. Note that per Illustration 5-3, income under variable
costing in 2015 when sales were 5,000 units was $3,500,000. Per Illustration 5-4, income
under variable costing in 2016 when sales were only 4,800 units was only $3,288,000.
That’s because variable costing does not allow fixed manufacturing overhead to be
“buried” in ending inventory. Rather, with variable costing, the entire amount is treated
as a period expense.
Impact of JIT on the Income Effects

of Full versus Variable Costing
As discussed in Chapter 2, many companies have adopted just-in-time (JIT) inventory
management systems. Companies that use JIT may have very low inventory levels since
they don’t produce until they are ready to sell their products. The result is that the units
they produce are approximately equal to the units they sell. Thus, the difference between
variable costing income and full costing income is likely to be very small for companies
that use JIT.
T est y o u r K NO W LEDGE
Kincade Faucets produces a variety of faucets for residential and commercial use. At the
start of the year, the company had Finished Goods Inventory of $1,000,000. At the end
of the year, the company had Finished Goods Inventory of $1,400,000. During the year,
the company incurred $400,000 of depreciation expense on its manufacturing equipment.
How much depreciation expense will be in Finished Goods Inventory under variable
costing?
a. $285,714.
b. $0.00.
c. Neither of the answer
choices is correct.
Benefits of Variable Costing

for Internal Reporting
There are two primary benefits associated with using variable costing for internal report-
ing purposes. Both are discussed in this section.
Variable Costing Facilitates CVP Analysis

Variable costing separates fixed and variable costs, a necessary step in performing
cost-volume-profit (CVP) analysis and, relatedly, planning and decision making. We
discussed this point earlier, but it’s worth repeating. Managers simply can’t estimate
accurately the impact of changes in volume on cost and profit unless they know
which costs are fixed and which costs are variable. Consider the full costing income
statement in Illustration 5-4 and ask yourself, “What would be the impact on profit
of a $100,000 increase in sales?” Unfortunately, the question cannot be answered with
any assurance using the full cost information. We don’t know which costs are fixed
and which are variable so we don’t know which ones will increase with the increase
in sales.
Now consider the variable costing income statement. We can easily see that the con-
tribution margin ratio is .53 (i.e., $5,088,000 ÷ $9,600,000). Thus, we can easily estimate
a $53,000 increase in profit with a $100,000 increase in sales.
Variable Costing Limits Management

of Earnings via Production Volume
You get what you Because the performance of managers is often evaluated in relation to earnings, managers
M e a s u r e may have an incentive to artificially inflate profit by producing more units than they can
sell. Using variable costing to calculate earnings, however, limits this option. Suppose a
manager expects sales to be 1,000 units. The selling price is $100 per unit, variable produc-
tion costs are $50 per unit, and fixed production costs are $45,000. If the manager produced
1,000 units, profit would be equal to $5,000 (i.e., 1,000 × ($100 - $50) - $45,000) under
both the full costing method and the variable costing method. The manager may realize,
however, that if the full costing method is used, part of the fixed costs can be assigned to
ending inventory, thereby transferring the expense to a future period. Thus, if the manager
produces 2,000 units, profit will be $22,500 higher because half of the fixed costs will be
included in the 1,000 units remaining in ending inventory. Of course, this is a short-run
strategy, because eventually the inventory buildup will be noticed. However, the manager
may hope to be working for a different company by that time with a great track record
as a manager at the former company! Note that the strategy of producing more than you
can sell will not increase income under the variable costing method, because under that
method, none of the fixed costs can be included in ending inventory.
Decision Making
A variable costing income statement facilitates decision making by breaking out the
Insight
total contribution margin. If we divide the contribution margin by sales, we have the
contribution margin ratio, and we can use it to analyze the impact of changes in sales
on profit. Since many decisions affect sales, being able to estimate the impact of
changes in sales on profit greatly facilitates decision making.

Learning Objective 1 Explain the difference full and variable costing income; and discuss the ben-
between full (absorption) and variable costing and efits of variable costing for internal reporting purposes.
prepare an income statement using variable costing. If the quantity produced equals the quantity sold, there is no
In full costing, product costs include direct material, direct difference in income. If the quantity produced exceeds the
labor, and variable and fixed manufacturing overhead. In vari- quantity sold, full costing income is higher than variable costing
able costing, fixed manufacturing overhead is not included in income. If the quantity produced is less than the quantity sold,
product cost. Rather, it is treated as a period expense. full costing income is less than variable costing income.
In a variable costing income statement, variable and fixed With a JIT system, there is often little difference between the
costs are segregated. All variable expenses are deducted from quantity produced and the quantity sold. Thus, there is likely
sales to yield a contribution margin. Then fixed expenses are to be only a small difference between full and variable costing
deducted from the contribution margin to yield net income. income when companies use JIT.
Finally, remember that variable costing results in a contribu-
Learning Objective 2 Discuss the effect of production margin, which is useful in planning and decision making.
tion on full and variable costing income; explain the Also, variable costing income cannot be managed up (inflated)
impact of JIT (just-in-time) on the difference between by producing more units than needed.
Review Problem 1
Albert Pernelli, a well-known consultant, was hired to “turn around” Inlet Steel Plate. In the year
prior to his arrival, the company produced and sold 60,000 tons of steel plate for $800 per ton. The
company has $20,000,000 of fixed manufacturing costs and $400 per ton of variable manufacturing
costs. Selling and administrative costs are essentially fixed and amount to $9,000,000. At the end
of the year, the company had a loss of $5,000,000, as follows:
Sales (60,000 tons × $800) $48,000,000
Less cost of goods sold ($20,000,000 fixed + ($400 × 60,000 tons)) 44,000,000
Less selling and administrative costs 9,000,000
Net loss ($ 5,000,000)
Upon arriving at Inlet Steel Plate, Albert noted that the company was operating substantially below
capacity due to a weak market for steel plate. He decided that the company had to take advantage
of its capacity and ordered the company to increase production of steel plate to 90,000 tons. He
also cut advertising and laid off white-collar workers, saving the company $2,000,000. Although
sales remained at 60,000 tons, profit went from a loss of $5 million to a gain of $3,666,667! Albert
received a large fee and added to his reputation as a “turnaround genius.”
Req u i r ed
a. Assuming no changes in price or the company’s cost structure, show the calculation of
income under Albert’s “leadership.”
b. How much fixed cost is buried in ending inventory?
c. Did Albert really create value for the company?
A n sw er
a. Calculation of unit cost of production
Fixed cost $20,000,000
Variable costs
($400 × 90,000 tons) 36,000,000
Total $56,000,000
Number of tons ÷ 90,000
Cost per ton $ 622.2222 per ton
Calculation of net income:

Sales (60,000 tons × $800) $48,000,000
Less cost of goods sold
($622.2222 × 60,000 tons) $37,333,332
Less selling and administrative costs 7,000,000
b. Fixed cost buried in ending inventory

Amount of fixed cost $20,000,000
Production (tons) ÷ 90,000
Fixed cost per ton $ 222.2222
Tons in ending inventory
(90,000 - 60,000) × 30,000
Fixed cost in ending inventory
(30,000 × $222.2222) $ 6,666,666
c. It’s hard to see that Albert really created shareholder value. Most of the increase in profit is
due to burying $6.7 million of fixed costs in ending inventory. Albert did increase profit by
$2,000,000 due to cutting advertising and laying off white-collar workers, but this may be a
short-run savings. Indeed, cutting advertising may actually hurt long-run profitability.
Review Problem 2
Butler Manufacturing produces fireproof data storage containers that sell for $6,000 each. The
company has the following cost structure:
Manufacturing costs:
Direct material per unit $ 1,000
Direct labor per unit 2,000
Variable manufacturing overhead per unit 500
Total variable manufacturing costs per unit $ 3,500
Fixed manufacturing overhead per year $2,000,000
Selling costs:
Variable selling costs per dollar of sales $ 0.10
Fixed selling costs per year $ 600,000
Administrative costs:
Fixed administrative costs per year $ 800,000
At the start of 2017, there was no beginning inventory. During 2017, the company produced and
sold 2,000 units. During 2018, the company produced 2,500 units but still sold only 2,000 units.
Req u i r ed
a. Calculate the full manufacturing cost per unit for 2017 and 2018.
b. Prepare full costing income statements for 2017 and 2018.
c. Calculate the variable manufacturing cost per unit for 2017 and 2018.
d. Prepare variable costing income statements for 2017 and 2018.
e. Reconcile the difference in net income for 2018 between the full costing and the variable
costing approaches.
A n sw e r
a. Full Manufacturing Cost per Unit in 2017
Direct material per unit $1,000
Fixed manufacturing overhead per unit ($2,000,000 ÷ 2,000 units) 1,000
Total $4,500
Full Manufacturing Cost per Unit in 2018

Fixed manufacturing overhead per unit ($2,000,000 ÷ 2,500 units) 800
Total $4,300
b. Income for 2017 Using Full Costing
Sales ($6,000 × 2,000 units) $12,000,000
Selling expense ($600,000 + (.10 × $12,000,000)) $1,800,000
Administrative expense 800,000 2,600,000
Net income $ 400,000
Note: Units produced and sold both equal 2,000.
Income for 2018 Using Full Costing

Sales ($6,000 × 2,000 units) $12,000,000
Selling expense ($600,000 + (.10 × $12,000,000)) $1,800,000
Administrative expense 800,000 2,600,000
Note: 2,500 units produced and 2,000 units sold.
c. Variable Manufacturing Cost per Unit in 2017 and 2018

Total $3,500
d. Income for 2017 and 2018 Using Variable Costing

Sales ($6,000 × 2,000 units) $12,000,000
Variable cost of goods sold ($3,500 × 2,000 units) $7,000,000
Variable selling costs (.10 × $12,000,000) 1,200,000 8,200,000
Less fixed costs:
e. $800 of fixed manufacturing overhead per unit × 500 units in ending inventory = $400,000.
Key Terms Absorption costing (176) Full costing (176) Variable costing (176)

1. Full costing differs from variable costing in that: 3. Use of a just-in-time inventory management system is
a. Full costing excludes selling costs from likely to:
consideration. a. Increase the difference between variable and full
b. Full costing excludes administrative costs from costing income.
consideration. b. Decrease the difference between variable and full
c. Full costing includes variable manufacturing costing income.
overhead in inventory. c. Have no effect on the difference between variable
d. Full costing includes fixed manufacturing overhead and full costing income.
in inventory. 4. A benefit of variable costing for internal reporting
2. If units produced exceed units sold: purposes is that it:
a. Full costing yields a higher income than variable a. Facilitates CVP analysis.
costing. b. Limits the ability to inflate income by
b. Full costing yields a lower income than variable producing more units than needed for current
costing. sales.
c. Full costing and variable costing yield the same c. Allows management to manage net income.
income. d. Allows two of the answer choices.
190 c h a p t e r 5 V a r i a b l e C o s t i n g
5. If units produced are less than units sold: 7. Assume that Ajax produces 10,000 items and sells 8,000
a. Full costing yields a higher income than variable items. In this case, the variable costing value of ending
costing. inventory is:
b. Full costing yields a lower income than variable a. $70,000.
costing. b. $90,000.
c. Full costing and variable costing yield the same c. $130,000.
income. d. $140,000.
The following information applies to Questions 6–10. 8. Assume that Ajax produces 10,000 items and sells 8,000
items. In this case, the full costing value of cost of goods
Ajax Manufacturing has the following cost structure:
sold is:
Direct material $10
a. $360,000. b. $350,000. c. $300,000. d. $280,000.
Direct labor 20
Variable manufacturing overhead 5 9. Assume that Ajax produces 10,000 items and sells 8,000
items. In this case, the variable cost of goods sold is:
Total variable manufacturing costs per unit $35
a. $360,000. b. $350,000. c. $300,000. d. $280,000.
Fixed manufacturing overhead per year $100,000 10. Assume that Ajax produces 10,000 items and sells 8,000
Fixed selling and administrative expense per year $200,000 items. The selling price of Ajax’s product is $90 per unit.
6. Assume that Ajax produces 10,000 items and sells In this case, the contribution margin on the income
8,000 items. In this case, the full costing value of ending statement prepared using variable costing is:
inventory is: a. $350,000. b. $440,000. c. $550,000. d. $700,000.
a. $70,000.
b. $90,000.
c. $130,000. 1. d 2. a 3. b 4. d 5. b 6. b
7. a 8. a 9. d 10. b
d. $140,000.
QUESTIONS 1. Explain the difference between variable costing and full costing.
2. Explain why income computed under full costing will exceed income computed under vari-
able costing if production exceeds sales.
3. What are the benefits of variable costing for internal reporting purposes?
4. Why would the difference between income computed under full costing and income com-
puted under variable costing be relatively small if a company used a JIT inventory manage-
ment system?
5. Explain why the ending inventory balance (assuming it is not zero) computed under full cost-
ing will always be greater than the ending inventory balance computed under variable costing.
6. If a company produces 50,000 units and sells 46,000 units during a period, which method of
computing net income will result in the higher net income? Why?
7. If a company produces less than it sells (the extra units sold are from beginning inventory),
which method of computing net income will result in the higher net income? Why?
8. Explain how fixed manufacturing costs are treated under variable costing. How are fixed man-
ufacturing costs treated under full costing?
9. If fixed manufacturing overhead per unit under full costing is multiplied by the change units
in inventory between the beginning of the period and the end of the period, what does the
resulting number represent?
10. Explain how a manufacturing company can “bury” fixed production costs in ending inventory
under full costing.
C o m m o n C o s t B e h a v i o rEP e s 191
x ea rt ct ei sr n
Exercises EXERCISE 5-1. [LO 2] A key idea in this book is that decision making relies on incremental analysis.
Req u ir ed
Explain how the use of variable costing can support appropriate decisions using incremental analysis.
EXERCISE 5-2. [LO 2] In a normal year, Wilson Industries has $24,000,000 of fixed manufactur-
ing costs and produces 60,000 units. In the current year, demand for its product has decreased, and
it appears that the company will be able to sell only 50,000 units. Senior managers are concerned,
in part because their bonuses are tied to reported profit. In light of this, they are considering keep-
ing production at 60,000 units.
Req u i r ed
Write a paragraph explaining why increasing production beyond the quantity needed for current
sales will increase profit, and calculate the impact of producing 10,000 “extra” units. Is the man-
agers’ proposed action in the best interest of shareholders?
EXERCISE 5-3. [LO 1] Mendel Manufacturing produces composite window frames for airline
manufacturing companies. At the start of the year, the company had no beginning inventory.
During the year, the company manufactured 5,000 units and sold 4,000. Direct material costs were
$500,000, direct labor was $400,000, variable manufacturing overhead was $800,000, and fixed
manufacturing overhead was $1,000,000.
Req u i red
Calculate cost per unit under full costing and under variable costing.
The following information relates to Exercises 5-4 through 5-10:
Xenoc produces stereo speakers. The selling price per pair of speakers is $1,800. There is no
beginning inventory.
Costs involved in production are:

Direct material $ 150
Direct labor 200
Total variable manufacturing costs per unit $ 450
Fixed manufacturing overhead per year $600,000

In addition, the company has fixed selling and administrative costs:
Fixed selling costs per year $210,000
Fixed administrative costs per year $110,000
EXERCISE 5-4. [LO 1] During the year, Xenoc produces 1,500 pairs of speakers and sells 1,200 pairs.
Req u i r ed
What is the value of ending inventory using full costing?
Req u ir ed
What is the value of ending inventory using variable costing?
Req u ir ed
What is cost of goods sold using full costing?
Req u ir ed
What is cost of goods sold using variable costing?
Req u ir ed
What is net income using full costing?
Req u ir ed
What is net income using variable costing?
EXERCISE 5-10. [LO 1, 2] During the year, Xenoc produces 1,500 pairs of speakers and sells
1,200 pairs.
Req u ir ed
How much fixed manufacturing overhead is in ending inventory under full costing? Compare this
amount to the difference in the net incomes calculated in Exercises 5-8 and 5-9.
The following information relates to Exercises 5-11 through 5-18:
Summit Manufacturing produces snow shovels. The selling price per snow shovel is $30. There is
no beginning inventory.
Costs involved in production are:

Direct material $ 5
Direct labor 4
Total variable manufacturing costs per unit $ 12
Fixed manufacturing overhead per year $180,000
In addition, the company has fixed selling and administrative costs of $160,000 per year.
EXERCISE 5-11. [LO 1] During the year, Summit produces 50,000 snow shovels and sells 45,000
snow shovels.
R equ i r ed
What is the value of ending inventory using full costing?
snow shovels.
R equ i r ed
What is the value of ending inventory using variable costing?
EXERCISE 5-13. [LO 1, 2] During the year, Summit produces 50,000 snow shovels and sells 45,000
snow shovels.
Req u ir ed
Calculate the difference in full costing net income and variable costing net income without pre-
paring either income statement.
P r o b l e m s 193
snow shovels.
R equ i red
What is cost of goods sold using full costing?
snow shovels.
R equ i red
What is cost of goods sold using variable costing?
snow shovels.
R equ i red
What is net income using full costing?
snow shovels.
R equ i red
What is net income using variable costing?
EXERCISE 5-18. [LO 1, 2] During the year, Summit produces 50,000 snow shovels and sells 45,000
snow shovels.
Req u i r ed
How much fixed manufacturing overhead is in ending inventory under full costing? Compare this
amount to the difference in the net incomes calculated in Exercise 5-13.
Problems PROBLEM 5-1. Variable and Full Costing: Sales Constant but Production Fluctuates [LO 1, 2]
Spencer Electronics produces a wireless home lighting device that allows consumers to turn on
home lights from their cars and light a safe path into and through their homes. Information on the
first 3 years of business is as follows:
2017 2018 2019 Total
Units sold 20,000 20,000 20,000 60,000

Units produced 20,000 25,000 15,000 60,000
Fixed production costs $750,000 $750,000 $750,000
Variable production costs per unit $ 150 $ 150 $ 150
Selling price per unit $ 250 $ 250 $ 250
Fixed selling and administrative expense $220,000 $220,000 $220,000
Req u i red
a. Calculate profit and the value of ending inventory for each year using full costing.
b. Explain why profit fluctuates from year to year even though the number of units sold, the selling
price, and the cost structure remain constant.
c. Calculate profit and the value of ending inventory for each year using variable costing.
d. Explain why, using variable costing, profit does not fluctuate from year to year.
PROBLEM 5-2. Variable and Full Costing: Sales and Production Fluctuate [LO 1, 2] Hamilton
Stage Supplies is a manufacturer of a specialized type of light used in theaters. Information on the
first 3 years of business is as follows:
2017 2018 2019 Total
Units sold 5,000 5,000 5,000 15,000

Units produced 5,000 6,000 4,000 15,000
Fixed selling and administrative expenses $ 5,000 $ 5,000 $ 5,000
Req u i r ed
a. Calculate profit and the value of ending inventory for each year using full costing. Round cost
percent to two decimal places.
b. Explain why profit fluctuates from year to year even though the number of units sold, the selling
price, and the cost structure remain constant.
c. Calculate profit and the value of ending inventory for each year using variable costing.
d. Explain why, using variable costing, profit does not fluctuate from year to year.
PROBLEM 5-3. Variable and Full Costing: Earnings Management with Full Costing; Changes
in Production and Sales [LO 1, 2] Firemaster BBQ produces stainless steel propane gas grills.
The company has been in operation for 3 years, and sales have declined each year due to increased
competition. The following information is available:
2017 2018 2019 Total
Units sold 30,000 27,000 25,000 82,000

Units produced 30,000 30,000 22,000 82,000
Fixed production costs $30,000,000 $30,000,000 $30,000,000
Variable production costs per unit $ 1,000 $ 1,000 $ 1,000
Selling price per unit $ 2,500 $ 2,500 $ 2,500
Fixed selling and administrative expense $ 350,000 $ 350,000 $ 350,000
Req u i r ed
a. Calculate profit and the value of ending inventory for each year under full costing.
b. Calculate profit and the value of ending inventory for each year under variable costing.
c. Explain how management of Firemaster could manipulate earnings in 2018 by producing more
units than are actually needed to meet demand. Could this approach to earnings management be
repeated year after year?
PROBLEM 5-4. Variable and Full Costing: Earnings Management with Full Costing; Changes
in Production and Sales [LO 1, 2] Sampson Steel produces high-quality worktables. The company
has been in operation for 3 years, and sales have declined each year due to increased competition.
The following information is available:
2017 2018 2019 Total
Units sold 10,000 9,000 8,000 27,000

Units produced 10,000 10,000 7,000 27,000
Fixed selling and administrative expenses $300,000 $300,000 $300,000
P r o b l e m s 195
Req u i red
a. Calculate profit and the value of ending inventory for each year under full costing.
b. Calculate profit and the value of ending inventory for each year under variable costing.
c. Explain how management of Sampson could manipulate earnings in 2018 by producing more
units than are actually needed to meet demand. Could this approach to earnings management be
repeated year after year?
PROBLEM 5-5. Variable and Full Costing: Income Effect of Clearing Excess Inventory
[LO 1, 2] The following information is available for Skipper Pools, a manufacturer of above-
ground swimming pool kits:
2017 2018 Total
Units produced 12,000 8,000 20,000

Units sold 10,000 10,000 20,000
Selling price per unit $ 4,000 $ 4,000
Direct material per unit $ 800 $ 800
Direct labor per unit $ 1,500 $ 1,500
Variable manufacturing overhead
per unit $ 300 $ 300
Fixed manufacturing overhead
per year $2,400,000 $2,400,000
Fixed selling and administrative
expense per year $1,500,000 $1,500,000
In its first year of operation, the company produced 12,000 units but was able to sell only 10,000
units. In its second year, the company needed to get rid of excess inventory (the extra 2,000 units
produced but not sold in 2017), so it cut back production to 8,000 units.
Req u i red
a. Calculate profit for both years using full costing.
b. Note that profit has declined in 2018. Is company performance actually worse in 2018 compared
to 2017?
c. Calculate profit for both years using variable costing.
d. Does variable costing profit present a more realistic view of firm performance in the 2 years?
Explain.
PROBLEM 5-6. Variable and Full Costing: Income Effect of Clearing Excess Inventory
[LO 1, 2] The following information is available for Dunworth Canoes, a company that builds
inexpensive aluminum canoes:
2017 2018 Total
Units produced 21,000 15,000 36,000

Units sold 18,000 18,000 36,000
Selling price per unit $ 500 $ 500
Variable production costs per unit $ 200 $ 200
Direct material per unit $ 80 $ 80
Direct labor per unit $ 50 $ 50
Variable manufacturing overhead per unit $ 70 $ 70
Fixed manufacturing overhead per year $630,000 $630,000
Fixed selling and administrative expense per year $200,000 $200,000
In its first year of operation, the company produced 21,000 units but was able to sell only 18,000
units. In its second year, the company needed to get rid of excess inventory (the extra 3,000 units
produced but not sold in 2017) so it cut back production to 15,000 units.
Req u i red
a. Calculate profit for both years using full costing.
b. Note that profit has declined in 2018. Is company performance actually worse in 2018 compared
to 2017?
c. Calculate profit for both years using variable costing.
d. Does variable costing profit present a more realistic view of firm performance in the 2 years?
Explain.
PROBLEM 5-7. Reconciling Variable and Full Costing Income [LO 1] Miller Heating is a small
manufacturer of auxiliary heaters. The units sell for $300 each. In 2017, the company produced
1,000 units and sold 800 units. There was no beginning inventory. Below are variable and full
costing income statements for 2017.

Miller Heating Company
Income Statement
Sales $240,000
Variable selling expense 16,000 48,000
Less fixed costs:
Net income $ 92,000

Miller Heating Company
Income Statement
Sales $240,000
Gross margin 168,000
Less selling and administrative expenses:
Net income $102,000
Req u i r ed
Reconcile the difference in profit between the two income statements.
PROBLEM 5-8. Reconciling Variable and Full Costing Income [LO 1] The Octavius Company
produces a 10-inch chef knife used by commercial chefs. The knives sell for $50 each. In 2017, the
company produced 50,000 units and sold 45,000 units. There was no beginning inventory. Follow-
ing are variable and full costing income statements for 2017.
P r o b l e m s 197

Octavius Company
Income Statement
Sales $2,250,000
Variable selling expense 150,000 800,000
Less fixed costs:

Octavius Company
Income Statement
Sales $2,250,000
Less cost of goods sold 1,190,000
Less selling and administrative
expenses:
Req u ir ed
Reconcile the difference in profit between the two income statements.
PROBLEM 5-9. Using Information from a Variable Costing Income Statement to Make a
Decision [LO 1, 2] Below is a variable costing income statement for the Wilner Glass Company, a
maker of bottles for the beverage industry. For the coming year, the company is considering hiring
two additional sales representatives at $80,000 each for base salary. The company anticipates that
each sales representative will generate $900,000 of incremental sales.
Wilner Glass Company

Income Statement
Sales $20,000,000
Less:
Variable cost of goods sold $8,000,000
Variable selling expense 4,000,000 12,000,000
Less:
Fixed production expense 2,600,000
Fixed selling expense 1,800,000
Fixed administrative expense 3,000,000 7,400,000
Req u i red
a. Calculate the impact on profit of the proposed hiring decision. Should the company hire the two
additional sales representatives?
b. Consider the analysis of the decision performed by the company’s chief accountant and com-
pare it to your analysis in part a. What is the fundamental flaw in the chief accountant’s work?
Analysis by Chief Accountant

Incremental sales $1,800,000
Income per dollar of sales in 2017
($600,000 ÷ $20,000,000) 0.03
54,000
Less increase in base salary 160,000
Effect on profit ($ 106,000)
PROBLEM 5-10. Using Information from a Variable Costing Income Statement to Make a
Decision [LO 1, 2] Below is a variable costing income statement for Trio Office Supplies, a com-
pany well known for its quality high-volume automatic staplers. For the coming year, the company
is considering hiring three additional sales representatives at $150,000 each in base salary. The
company anticipates that each sales representative will generate $400,000 of incremental sales.
Trio Office Supplies

Income Statement
Sales $30,000,000
Less:
Variable cost of goods sold $15,000,000
Variable selling expense 3,000,000 18,000,000
Less:
Fixed production expense 2,000,000
Fixed selling expense 1,500,000
Fixed administrative expense 3,000,000 6,500,000
Req u i r ed
a. Calculate the impact on profit of the proposed hiring decision. Should the company hire the
three additional sales representatives?
b. Consider the analysis of the decision performed by the company’s chief accountant and compare
it to your analysis in part a. What is the fundamental flaw in the chief accountant’s work?
Analysis by Chief Accountant

Incremental sales $1,200,000
Income per dollar of sales in 2017:
($5,500,000 ÷ $30,000,000) .183
Net increase in income from sales 219,600
Less increase in base salary 450,000
Effect on profit ($ 230,400)
PROBLEM 5-11. Variable versus Full Costing Income and Earnings Management [LO 1, 2]
The Renton Tractor Company was formed at the start of 2015 and produces a small garden tractor.
The selling price is $4,800, variable production costs are $2,000 per unit, fixed production costs are
P r o b l e m s 199
$6,400,000 per year, and fixed selling and administrative costs are $3,600,000 per year. Data below
indicate net income for 2015–2017 under full costing.
In 2015 and 2016, Edward Vendon was the president of Renton Tractor. The board of directors
was generally pleased with the company’s performance under his leadership—the company hit the
break-even point in its first year of operation and had a modest profit in 2016. Edward quit at the
end of 2016 and went on to start an e-commerce company selling used cars on the Internet. His
replacement, Zac Dalton, was apparently not as successful as Ed. Zac argued that he was improving
the company by getting rid of excess inventory, but the board noted that the company showed a
$2,360,000 loss in the first year of his leadership.
2015 2016 2017
Production (units) 4,000 4,000 2,000

Sales (units) 3,000 3,300 3,700
Production cost per unit $ 3,600 $ 3,600 $ 5,200
Sales $14,400,000 $15,840,000 $17,760,000
Less cost of goods sold 10,800,000 11,880,000 16,520,000
Gross margin 3,600,000 3,960,000 1,240,000
Less selling and administrative expense 3,600,000 3,600,000 3,600,000
Net income (loss) $ –0– $ 360,000 ( $ 2,360,000)
Req u i red
a. Recalculate net income for all 3 years using variable costing.
b. Based on the limited information available, comment on the relative job performance of Ed
and Zac.
c. Note that under full costing, the company is showing a substantial loss in 2017. Based on
the limited information available, does it appear that the company should get out of the tractor
business?
PROBLEM 5-12. Variable versus Full Costing Income and Earnings Management [LO 1, 2]
Hawthorne Golf, the maker of a sought-after set of golf clubs, was formed in 2012. The selling
price for each golf club set is $1,700, variable production costs are $900 per unit, fixed production
costs are $2,100,000 per year, and fixed selling and administrative costs are $2,250,000 per year.
Data below indicate net income for 2015–2017 under full costing.
In 2015 and 2016, Milo Hawthorne, Jr., was the president of Hawthorne Golf. The board
of directors was generally pleased with the company’s performance under his leadership—the
company hit the break-even point in its first year of operation and had a modest profit in 2016.
Milo quit at the end of 2016 and went on to buy a golf course and open a pro shop. His replace-
ment, Daryl Selmer, was apparently not as successful as Milo. Daryl argued that he was improving
the company by getting rid of excess inventory, but the board noted that the company showed a
$350,000 loss in the first year of his leadership.
2015 2016 2017
Production (units) 7,000 7,000 2,500

Sales (units) 4,500 5,500 6,500
Production cost per unit (full cost) $ 1,200 $ 1,200 $ 1,740
Sales $7,650,000 $9,350,000 $11,050,000
Gross margin 2,250,000 2,750,000 1,900,000
Less selling and administrative expenses 2,250,000 2,250,000 2,250,000
Net income (loss) $ –0– $ 500,000 ($ 350,000)
Req u i red
a. Recalculate net income for all 3 years using variable costing.
b. Based on the limited information available, comment on the relative job performance of Milo
and Daryl.
c. Note that under full costing, the company is showing a substantial loss in 2017. Based on the lim-
ited information available, does it appear that the company should get out of the golf club business?
PROBLEM 5-13. Reconciling Variable and Full Costing Income [LO 1, 2] The following infor-
mation relates to Jarden Industries for fiscal 2017, the company’s first year of operation:
Units produced 150,000

Units sold 120,000
Units in ending inventory 30,000
Fixed manufacturing overhead $900,000
R equ i r ed
a. Calculate the amount of fixed manufacturing overhead that would be expensed in 2017 using
full costing.
b. Calculate the amount of fixed manufacturing overhead that would be expensed in 2017 using
variable costing.
c. Calculate the amount of fixed manufacturing overhead that would be included in ending inven-
tory under full costing and reconcile it to the difference between parts a and b.
PROBLEM 5-14. Reconciling Variable and Full Costing Income [LO 1, 2] The following infor-
mation relates to Sinclair Industries for fiscal 2017, the company’s first year of operation:

Units sold 450,000
Units in ending inventory 50,000
Fixed manufacturing overhead $1,500,000
R equ i r ed
a. Calculate the amount of fixed manufacturing overhead that would be expensed in 2017 using
full costing.
b. Calculate the amount of fixed manufacturing overhead that would be expensed in 2017 using
variable costing.
c. Calculate the amount of fixed manufacturing overhead that would be included in ending inven-
tory under full costing and reconcile it to the difference between parts a and b.
PROBLEM 5-15. Variable and Full Costing Income: Comprehensive Problem [LO 1, 2] The follow-
ing information relates to Porter Manufacturing for fiscal 2017, the company’s first year of operation:
Selling price per unit $ 150

Direct labor per unit $ 30
Variable manufacturing overhead per unit $ 5
Variable selling cost per dollar of sales $ 0.05
Annual fixed manufacturing overhead $2,750,000
Annual fixed selling expense $1,500,000
Annual fixed administrative expense $ 900,000
Units sold 230,000
P r o b l e m s 201
Req u i red
a. Prepare an income statement using full costing.
b. Prepare an income statement using variable costing.
c. Calculate the amount of fixed manufacturing overhead that will be included in ending inventory
under full costing and reconcile it to the difference between income computed under variable and
full costing.
PROBLEM 5-16. Variable and Full Costing Income: Comprehensive Problem [LO 1, 2] The
following information relates to Dorian Industrial for fiscal 2017, the company’s first year of
operation:

Units sold 400,000
Variable selling cost per unit $ 0.20
Annual fixed manufacturing overhead $1,260,000
Annual fixed selling expense $ 300,000
Annual fixed administrative expense $ 100,000
Req u i r ed
full costing.
PROBLEM 5-17. Variable and Full Costing Income: Comprehensive Problem [LO 1, 2] The
following information relates to Jorgensen Manufacturing for calendar year 2017, the company’s
first year of operation:

Units sold 7,000
Selling price per unit $ 4,500
Direct material per unit $ 2,000
Direct labor per unit $ 1,200
Variable selling cost per unit $ 225
Annual fixed manufacturing overhead $800,000
Annual fixed selling and administrative expense $400,000
Req u i r ed
full costing.
d. Suppose that the company sold 8,000 units during the year. What would the variable costing net
income have been? What would the full costing net income have been?
PROBLEM 5-18. Variable and Full Costing Income: Comprehensive Problem; Break-even
Calculation [LO 1, 2] The following information relates to Axar Products for calendar year 2017,
the company’s first year of operation:

Units sold 18,000
Variable selling cost per unit $ 3
Annual fixed manufacturing overhead $160,000
Annual fixed selling and administrative expense $ 80,000
Req u i red
c. Using the variable costing income statement, calculate the company’s break-even point in sales
dollars and in units. Can the break-even point be calculated easily using the full costing income
statement? Why or why not?
Case
5-1 MicroImage Technology, Inc. [LO 1, 2]
MicroImage Technology, Inc. produces miniature digital Warren:
color cameras that can be attached to endoscopes and I expected a net loss but not this big. And I certainly didn’t expect
other medical devices. The cameras sell for $215 per unit and a negative gross profit! It looks like the more we sell, the more
are disposed of after each use. For 2017, the company’s first full we’ll lose. I hope you come to the investor meeting next week with
some explanations and some better numbers.
year of operation, the company had sales of 80,000 units and a net
SP
loss of $9,810,000, as follows:
MicroImage Technology, Inc. In preparing for the meeting, Warren assembled the following in-
Income Statement formation based on results for 2017:
For the Year Ended December 31, 2017 Units sold 80,000
Sales $17,200,000
Selling price $ 215
Less cost of goods sold 18,360,000
Manufacturing costs:
Gross profit (loss) (1,160,000) Direct material costs $ 1,280,000
Less selling and Direct labor costs 1,200,000
administrative expenses:
Variable manufacturing overhead:
Selling expense $3,750,000
Equipment maintenance 160,000
Administrative expense 4,900,000 8,650,000
Inspection costs 400,000
Net loss ($ 9,810,000) Miscellaneous variable manufacturing overhead 320,000
Fixed manufacturing overhead:
The company is closely held, with six major inventors. Early in Rent 1,800,000
the first quarter of 2018, Warren Logan, company CFO, was pre- Depreciation 5,000,000
paring to meet with them to present profitability estimates for the Supervisory salaries 4,500,000
coming 2 years. He expected the meeting to be somewhat hos- Miscellaneous fixed manufacturing overhead 3,700,000
tile. Two days before, he had received an email from one of the
$18,360,000
investors, Sanjay Patel:
C a s e 203
Selling expenses b. Based on the previous information, calculate sales in dollars

Variable selling expense: and units needed to break even in 2018.
Shipping $ 280,000 c. Warren Logan, CFO, has developed assumptions that he
Commissions 800,000 believes are reasonable for 2018 and 2019. Using these assump-
Travel 120,000 tions, prepare budgeted income statements for 2018 and 2019
Fixed selling expense: using the variable costing method. Are the major investors
Salaries 1,900,000 likely to find forecasted profits encouraging?
Miscellaneous fixed
selling expense 650,000 Assumptions for 2018
1. The company will hire two additional sales managers at a base
$ 3,750,000
salary of $90,000 each.
Administrative expenses (all fixed) 2. R&D will be cut by $1,100,000.
Research and development $ 2,700,000 3. Unit sales will increase by 30 percent.
Administrative salaries not related to R&D 1,300,000
Assumptions for 2019
Miscellaneous administrative expense 900,000
1. The company will hire one additional sales manager at a base
$ 4,900,000 salary of $90,000.
2. R&D will be increased by $600,000 over 2018.
R e q uir ed 3. Unit sales will increase by 60 percent over 2018.
a. Recast the full costing income statement for 2017 into a vari-
able costing format. Does it appear, as Sanjay Patel contends,
that the more the company sells, the more it loses?
Case
5-2 Rainruler Stains [LO 1, 2]
RainRuler Stains produces a variety of exterior wood Gross profit per dollar of sales
stains that have excellent coverage and longevity. In 2017, ($1,350,000 ÷ $4,650,000) 0.2903
the company produced and sold 310,000 gallons of stain. There Incremental profit $243,852
was no beginning inventory. Income for the year was as follows:
Since the incremental profit was more than two times as large as
RainRuler Stains
current net income, most of the managers present at the meeting
Income Statement
expressed their hearty congratulations. Jennifer Jones, a sum-
mer intern and assistant to the company controller, Ed Flem-
Sales $4,650,000 ming, thought Reggie’s estimate was more than a little rough.
Less cost of goods sold 3,300,000 After the meeting, she approached her boss and expressed her
Gross profit 1,350,000 misgivings. “Ed, according to our previous discussions, fixed
Less selling and administrative expenses: production costs related to rent, depreciation, and other items
Selling expense $870,000 are about $1,362,500 per year. Reggie’s analysis assumes that
Administrative expense 360,000 1,230,000 there aren’t any fixed manufacturing overhead items. And I
Net income $ 120,000 know our shipping costs, which are included in selling expense,
are around $0.70 per gallon. Reggie’s analysis assumes all sell-
In the past, the company has marketed its product only to indepen- ing expense is fixed. It’s probably the case that almost all of our
dent hardware stores in Oregon, Washington, and Idaho. Recently, administrative expense is fixed, but that’s clearly not accurate
however, Reggie Sherman, VP of marketing, has negotiated deals for selling expense. How about if I recast our income statement
with several large construction companies. He estimates that these in a contribution margin format—you know, using variable
deals will increase annual sales by 70,000 gallons but at a reduced costing—and use that as a basis to estimate the impact of the
price of $12 per gallon. (The price in 2017 to hardware stores was new channel sales?” Ed quickly agreed to Jennifer’s proposal.
$15 per gallon, and this will not be affected by the new deals.)
At a recent meeting of the company’s senior management
team, Reggie presented a rough estimate of the financial impact R eq uired
of selling through the new channel:
Assume the role of Jennifer and prepare an income statement for
Additional sales (gallons) 70,000
2017 using variable costing. Then use information on that state-
Selling price per gallon $ 12.00
ment as a basis for estimating the annual impact on profit of sales
Incremental revenue $840,000 to construction companies.
6
Cost Allocation and
Activity-Based Costing
McMaster Screen Technologies produces a variety of
touch-screen displays used in phones, kiosks, automobile
navigation devices, and numerous other applications.
Approximately 80 percent of McMaster’s revenue comes from be directly traced to products or services, some means of assign-
producing screens in large numbers for touch-screen phones ing them must be developed. The process of assigning indirect
and automobile navigation devices. The other 20 percent is costs is referred to as cost allocation, which we first discussed
related to low-volume orders for kiosks, custom electronic in Chapter 2. Unfortunately, cost allocation frequently results
equipment, and military applications. in problems like the one faced by Michael Soma. To prepare
In recent months, Michael Soma, the CFO at McMaster, yourself to deal with them, you need a good understanding of
has become concerned about the apparent profitability of why and how costs are allocated. Providing you with that under-
several products. In particular, some high-volume products, standing is the purpose of this chapter. One of the key points of
such as the Model ND32 touch screen used in automobile the chapter is that costs are allocated for a variety of purposes;
navigation systems, are barely breaking even, while low- allocations that are adequate for one purpose may not be ade-
volume products, such as the Model MK420 touch screen quate for another purpose.
used in a military targeting device, are selling for much more Many managers have expressed concern that the way
than the cost of production. This surprised Michael because overhead is typically allocated may seriously distort product
the company has worked hard to reduce production ineffi- cost for manufacturing firms. The problem arises because
ciencies, and he thought that would translate into high-volume most product costing systems allocate overhead using
products that were quite profitable. On the other hand, the measures related to production volume. This is the case
company had just begun manufacturing for military applica- at McMaster Screen Technologies, where manufacturing
tions that required new production techniques to meet strin- overhead is allocated based on labor cost. However, many
gent quality standards. Hence he suspected that production overhead costs are not proportional to volume. Activity-based
inefficiencies would keep gross profit low for more than a year costing (ABC) is an approach to allocating overhead costs
for military-related products. that addresses this problem. We briefly discussed ABC in
Michael knows that manufacturing overhead is allocated Chapter 2. Here you will gain a better understanding of the
to products based on labor cost. The approach is simple, but general process of cost allocation, which allows for a more
he suspects it may be causing allocations of costs that are too detailed treatment of ABC.
high for the Model ND32 and too low for the Model MK420. In our discussion of ABC, we will build on the McMaster
Firms that produce more than one product or that provide Screen Technologies example. However, it is important to
more than one type of service invariably have indirect costs note that ABC is not restricted to manufacturing firms. Banks,
because resources are shared by the products or services hospitals, insurance companies, and other service firms find
(e.g., two different products may be manufactured using the that ABC provides insight into the costs of providing services
same piece of equipment). Various departments may also have to customers. Several of the problems and cases at the end
common or shared resources (e.g., the marketing and human of this chapter are in a service firm context and will provide
resources departments may share a high-speed copy machine). you with an opportunity to generalize the ideas of ABC to this
Because indirect costs associated with shared resources c annot important business setting.
Shironosov/iStock /Getty Images Plus
Learning Objectives
1 Explain why indirect costs are allocated, describe the cost allocation process, and discuss
allocation of service department costs.
2 Identify potential problems with cost allocation, discuss activity-based costing (ABC) and cost
drivers, and distinguish activity-based costing (ABC) from activity-based management (ABM).
205
206 chapte r 6 C o s t A l l o c a t i o n a n d A c t i v i t y - B a s e d C o s t i n g
Learning Purposes of Cost Allocation

Objective 1
Companies allocate costs to products, services, and departments for four major reasons:
Explain why indirect (1) to provide information needed to make appropriate decisions, (2) to reduce the friv-
costs are allocated, olous use of common resources, (3) to encourage managers to evaluate the efficiency of
describe the cost allo- internally provided services, and (4) to calculate the “full cost” of products for financial
cation process, and reporting purposes and for determining cost-based prices (see Illustration 6-1). We will
discuss allocation of now discuss each of these purposes.
service department
costs.
To Provide Information for Decision Making
When managers use a company resource and receive an allocation of its cost, they are,
in essence, receiving a charge for use. For example, when Malinda Smith, a product
manager at Mayfield Software, asks the art department to design a prototype box for a
product under development, she will likely receive an allocation, on her product-line
profit and loss statement, of costs incurred in the art department. The more artwork she
orders, the more cost she will receive, reducing the profit for which she is responsible.
But what is the appropriate allocation?
From a decision-making standpoint, the allocated cost should measure the oppor-
tunity cost of using a company resource. Let’s see why this is the case. Suppose the art
department has excess capacity and the design work does not create additional costs
other than very minor material cost. In this case, the opportunity cost is approximately
zero, and the appropriate allocation is also zero. Malinda’s company, after all, does not
want to discourage her from using the art department’s services since this use does not
lead to additional costs.
Suppose, however, the art department is extremely busy. If it takes on Malinda’s
job, other work will be delayed. In fact, a different product-line manager will be
forced to go outside the company to get artwork done on time, incurring a cost of
$5,000. In this case, Malinda’s use of a company resource has led to a $5,000 oppor-
tunity cost. Thus, $5,000 would be an appropriate allocation, or charge, to Malinda’s
operation. If she does not believe that the art department’s services represent a $5,000
benefit to her operation, then she will not demand these services, and the other
product manager can make use of them and avoid incurring $5,000 of costs outside
the company.
Although allocated costs should measure the opportunity cost of using a company
resource, in practice this is difficult to operationalize. One reason is that the opportunity
cost may quickly change. For example, on Wednesday, the art department may be dealing
with a rush job and working overtime. But by Friday, the rush job may be completed,
Illustration 6-1
To provide information
Reasons firms allocate costs
for decision making
To calculate the "full cost" of Why Firms To reduce frivolous use of

products for GAAP reporting Allocate Costs common resources
To encourage evaluation of
internally provided services
P u r p o s e s o f C o s t A l l o c a t i o n 207
and there may be excess capacity. Thus, the opportunity cost would be much higher on
Wednesday than on Friday.
Still, the opportunity cost idea is a useful benchmark. Whenever you are discussing
allocations of cost, you should ask yourself, “How close is this allocation to the oppor-
tunity cost of use?” The closer it is, the better the allocation.
To Reduce Frivolous Use of Common Resources

As already noted, allocated costs serve as charges, or fees, for use of internal resources
or services. Consider a company that runs a computer network used by all three of its
divisions. Almost all of the costs associated with running the network are fixed, and they
amount to $100,000 per year. Some accountants would argue that because these costs
are fixed, the divisions should not be charged for using the network since use creates
no incremental cost. However, if the three divisions do not incur any charge for using
the network, they may tend to use it for frivolous or nonessential purposes (e.g., playing
computer games, sending unnecessary e-mail, or accessing streaming video or otherwise
creating unnecessary loads on network traffic).
This situation may not seem to be that detrimental to the company’s welfare. After
all, the costs associated with the network are primarily fixed. If frivolous use does not
create additional costs, why discourage it? The reason is that frivolous use may have
hidden costs. The primary hidden cost in the example is slower service to departments
that need to use the network when it is being used unnecessarily by another department.
In other words, an opportunity cost is associated with the use of the network.
One way to eliminate frivolous use is to charge for the use of centrally provided
services. And one of the most common ways to charge for use is to allocate the cost of
the service. For example, suppose Division 1 plans to use the network for 1,000 hours per
year, Division 2 plans to use it for 1,000 hours, and Division 3 for 2,000 hours. A charge
of $25 per hour ($100,000 ÷ 4,000 hours) could be assessed. Note that this rate would
allocate the entire cost of the network ($100,000) among the three users, assuming that
their plans worked out as expected. Divisions 1 and 2 would each be charged $25,000,
and Division 3 would be charged $50,000. If division managers knew that this method
of cost allocation would be used, they would have an incentive to reduce their division’s
frivolous use of the network, because use of the network reduces the reported profit of
their division.
To Encourage Evaluation of Services

Cost allocation is also useful because it encourages managers to evaluate the services for
which they are being charged. If no costs are allocated to users of centrally administered
services, such as computer services or janitorial services, then the users of the services
do not have an incentive to evaluate these services carefully. After all, the services are
free. However, if the users are charged for the services (i.e., if they receive an allocation
of the cost of the services), then the users have a strong incentive to look critically at the
services and consider the possibility of lower-cost alternatives. If lower-cost alternatives
exist, the users will certainly bring them to the company’s attention. The company can
then evaluate whether the services are being provided in an efficient manner.
Let’s reconsider the example of Malinda Smith, a product manager at Mayfield
Software, who is being charged for using the company’s art department to design pack-
aging for a product she manages. Suppose she receives a charge of $5,000 and believes
that if she purchased the service outside the company, the cost would be only $2,000.
In this case, she is likely to bring this matter to the attention of higher-level company
officials who will encourage the manager of the art department to lower that operation’s
costs, perhaps by reducing head count or replacing staff who are inefficient. If the costs
of the art department cannot be lowered, the company may consider shutting down the
service and using an independent design firm.
To Provide “Full Cost” Information

As we have mentioned, GAAP requires full costing for external reporting purposes.
Indirect production costs must be allocated to goods produced to meet this requirement.
In addition, full cost information is required when a company has an agreement whereby
the amount of revenue received depends on the amount of cost incurred. For example,
defense contractors with the federal government often have contracts that specify they
will be paid the cost of production as well as some fixed amount or percentage of cost.
Such contracts are commonly called “cost-plus” contracts. An interesting feature of these
contracts is that the cost of production specified often includes not only manufacturing
costs but also a share of general and administrative costs. Thus, a substantial amount of
cost allocation is required to assign indirect manufacturing costs and indirect general
and administrative costs to the contract work.
A major problem with cost-plus contracts is that they create an incentive to allocate
as much cost as possible to the goods produced on a cost-plus basis and little cost to
goods that are not produced on a cost-plus basis. The more cost allocated to cost-plus
contracts, the higher the amount paid to the company.
In spite of this limitation, cost-plus contracts serve a useful purpose. Without the
assurance that they will be reimbursed for their costs and that they will earn some profit,
many manufacturers would not be willing to bear the financial risks associated with
producing state-of-the-art products for the government, using untried technologies. For
example, not many companies would be willing to develop a new fighter aircraft without
assurance that they would be reimbursed for all costs incurred in its development.
Link to Practice
Cost-plus Contracts Create Incentive properly should be charged to their non-government
to Misallocate Costs contracts. The reason—the more costs they allocate to
government contracts, the higher their reimbursement.
Government contracts issued by the Department of
To thwart this fraudulent practice, the government
Defense are often so-called cost-plus contracts. Under
passed the False Claims Act, which allows whistleblow-
such contracts, companies that supply the Department
ers (informants) to receive 15 to 30 percent of any
of Defense are reimbursed for their direct costs as well as
recovery. Since informants may collect millions of dollars,
reasonable overhead (their costs), and they also receive an
the Act is generally considered to be quite effective in
amount for profit (the “plus” part of the cost-plus contract).
bringing fraud to light!
These contracts create an incentive for suppliers
to allocate costs to government contracts that more
T est y ou r K NO W LE D GE
Indirect costs are allocated to products, services, and departments in order to:
a. Improve decision making.
b. Reduce frivolous use of resources.
c. Encourage evaluation of services.
d. Provide “full cost” information.
e. All of these answer choices are correct.
Correct answer is e.
P r o c e s s o f C o s t A l l o c a t i o n 209
Illustration 6-2
Allocation
The cost allocation process Cost pool Cost objective
base
PROCESS OF COST ALLOCATION

We have seen that cost allocation is often necessary. But how is it achieved? The cost
allocation process has three steps: (1) identify the cost objectives, (2) form cost pools,
and (3) select an allocation base to relate the cost pools to the cost objectives. The three
steps are shown in Illustration 6-2.
Determining the Cost Objective

The first step in the cost allocation process is to determine the product, service, or depart-
ment that is to receive the allocation. The object of the allocation is referred to as the cost
objective. For example, if a company allocates depreciation of a drilling press to products
such as flanges and brackets, the products are the cost objectives. If computer-processing
costs are allocated to the contracts worked on by a computer-aided design group, the
contracts are the cost objectives. If a bank allocates general and administrative costs to
product lines (e.g., loan services and estate-planning services), the product lines are the
cost objectives (see Illustration 6-3).
Forming Cost Pools

The second step in the cost allocation process is to form cost pools. A cost pool is a
grouping of individual costs whose total is allocated using one allocation base. For
example, all of the costs in the maintenance department could be treated as a cost
pool. In this case, the cost pool would include the wages of workers in the m
aintenance
Illustration 6-3 Cost to Be Allocated Cost Objectives

Cost objectives
Model 2b flange
Depreciation of drilling press
Model 36k bracket
CT
Contract 1 CONTRA
Computer processing costs
Contract 2
Lo
Agreeamn
ent
Loan services
General and administrative costs PLAN
Estate planning
department, supplies, small tools, and a variety of additional cost items. Cost pools
are often formed along departmental lines (e.g., maintenance department costs in one
cost pool and personnel department costs in another cost pool). They may also be
formed according to major activities. For example, costs related to equipment setups,
a major activity in most manufacturing firms, are in one cost pool, and costs related
to inspecting products for defects, another major activity, are in another cost pool.
The overriding concern in forming a cost pool is to ensure that the costs in the
pool are homogeneous, or similar. One way to determine whether these costs are homo-
geneous is to compare the allocations with the allocations that result from breaking
the pool up into smaller pools and using a variety of allocation bases. If there is not a
substantial difference in the allocations, then, for practical purposes, the costs in the pool
are considered to be homogeneous.
Some manufacturing companies include all manufacturing overhead (power costs,
computing costs, material handling costs, etc.) in a single cost pool. However, alloca-
tions from a large pool containing costs related to very different activities are not likely
to provide useful information. (We discuss this problem later in the chapter.) Although
use of a single cost pool for overhead seems too broad, exactly how many cost pools are
appropriate is not clear. Managers must make a cost-benefit decision. More pools involve
more analysis and record keeping, which is costly. However, more pools also result in
the benefit of more accurate information.
Selecting an Allocation Base

The third step in the allocation process is to select an allocation base that relates the
cost pool to the cost objectives. The allocation base must be some characteristic that is
common to all of the cost objectives. If the cost objectives are manufactured products,
then direct labor hours, direct labor cost, and machine hours are examples of character-
istics that could be used as allocation bases. If the cost objectives are the divisions of a
multidivisional firm, then sales dollars, total assets, and divisional profit are examples of
characteristics that could be used as allocation bases.
Deciding which of the possible allocation bases to use is not an easy matter. Ideally,
the allocation base selected should relate costs to cost objectives that caused the costs
to be incurred. In this case, the allocation is based on a cause-and-effect relationship.
For example, if additional activity in a production department causes an increase in
the costs incurred by the maintenance department, then the allocation base selected
should result in the additional costs being allocated to the production department when
there is additional activity. Direct labor hours, direct labor cost, or machine hours in
the production department would be likely choices for the allocation base because they
represent the increase in activity that leads to the increase in cost in the maintenance
department. However, it would be difficult to argue that one of these allocation bases
is better than another on cause-and-effect grounds. As we will see next, this is one of
the problems of cost allocation. A number of allocation bases may appear to be equally
valid, but they may result in substantially different costs being assigned to the cost
objectives.
Let’s consider an example. The Watts Equipment Company has two producing
departments, assembly and finishing, that receive allocations of indirect costs from the
maintenance department. In the coming year, the maintenance department expects to
incur variable costs of $200,000. These costs are related to both the labor hours and
the machine hours incurred in the producing departments. The quantities of labor and
machine hours are indicated here. With labor hours as the allocation base, the allocation
rate is $4 per labor hour, and the assembly department receives an $80,000 allocation of
cost from the maintenance department. However, with machine hours as the allocation
base, the allocation rate is $10 per machine hour, and the assembly department receives a
P r o c e s s o f C o s t A l l o c a t i o n 211
$110,000 allocation of cost from the maintenance department. The $30,000 difference in
the allocations occurs even though both labor hours and machine hours are reasonable
allocation bases to use.
Labor Hours Allocations Machine Hours Allocations
Assembly 20,000 $ 80,000 11,000 $110,000

Finishing 30,000 120,000 9,000 90,000
Total 50,000 $200,000 20,000 $200,000
Allocation rate $4 per labor hour $10 per machine hour
When indirect costs are fixed, establishing cause-and-effect relationships between

costs and cost objectives is not feasible. In these cases, accountants turn to other criteria,
such as relative benefits, ability to bear costs, and equity. Unfortunately, these terms are
rather vague and difficult to implement in an unambiguous manner.
The relative benefits approach to allocation suggests that the base should result
in more costs being allocated to the cost objectives that benefit most from incurring
the cost. This might suggest, for example, that computer costs should be allocated to
departments based on time spent using the computer, since greater use implies greater
benefit. However, this could result in fixed computer cost being allocated to departments
that did not exist when the computer was acquired (and so could not have caused the
cost of the computer to be incurred).
The ability to bear costs notion suggests that the allocation base should result in
more costs being allocated to products, services, or departments that are more profit-
able. Because they are more profitable, they can bear the increased costs from the higher
allocations.
The equity approach to allocation suggests that the base should result in allocations
that are perceived to be fair or equitable. Obviously, this is a difficult criterion to apply,
because different individuals have different perceptions of what is equitable.
Link to PRACTICE
Basis for Allocating Costs to Federal • The cost of computer equipment is allocated based
Grants and Contracts on the number of hours used for each project.
Medical researchers at the University of Washington • The cost of personality tests is allocated based on the
frequently share lab space, supplies, support staff, and number of clients served.
other resources while working on various federal grants • The cost of renting space is allocated based on the
and contracts. Because of this, they must allocate costs number of full-time equivalent researchers working on
to the specific grants and contracts. each project.
For example, syringes may be used in a variety of • The cost of lab supplies is allocated based on the
experiments related to various grants but, due to cost, relative time the principal investigator spends on each
the lab does not directly trace individual syringes to project.
specific grants. Instead, the cost of syringes is allocated
based on the relative number of experiments conducted Source: Grant and Contract Accounting, Cost Allocation
under each grant. Here are some additional examples of Policy, University of Washington, Office of Financial
allocation bases used to allocate costs to grants: Management, October 12, 2006.
ALLOCATING SERVICE DEPARTMENT COSTS

The organizational units in most manufacturing firms can be classified as either pro-
duction departments or service departments. Production departments engage in direct
manufacturing activity, whereas service departments provide indirect support. For
example, in a furniture manufacturing company, the assembly and finishing departments
are production departments, whereas maintenance, janitorial, personnel, cafeteria, cost
accounting, and power are service departments. Cost pools are often formed by service
departments, and these costs are allocated to production departments—the cost objec-
tives. Ultimately, production departments allocate their costs to specific products.
Direct Method of Allocating Service Department Costs

The method of allocating service department costs that we cover is called the direct
method. In the direct method of allocating cost, service department costs are allocated
to production departments but not to other service departments.1 Thus, even though the
janitorial department provides a service to the personnel department, under the direct
method no janitorial costs are allocated to the personnel department. The process is
diagrammed in Illustration 6-4. The illustration includes no arrow between janitorial
costs and personnel costs because there is no allocation of costs between the janitorial
service department and the personnel department.
We’ll consider an example involving the Mason Furniture Company. Suppose the
company’s janitorial costs are $100,000. The company decides to allocate these costs to
assembly and finishing based on the number of square feet in each production depart-
ment. Since assembly has 20,000 square feet and finishing has 30,000 square feet, the
allocation rate is $2 per square foot ($100,000 ÷ 50,000 square feet). Assembly receives
an allocation of $40,000 (20,000 square feet × $2), and finishing receives an allocation
of $60,000 (30,000 square feet × $2).
Now suppose the personnel costs at Mason are $200,000. These costs are allocated based
on the number of employees in each production department. The assembly department has
60 employees, and the finishing department has 40 employees. Thus, the allocation rate for
personnel costs is $2,000 per employee ($200,000 ÷ 100 employees). The assembly depart-
ment receives an allocation of $120,000 (60 × $2,000), and the finishing department receives
an allocation of $80,000 (40 × $2,000). The allocations are presented in Illustration 6-5.
Illustration 6-4 Service Departments Production Departments Products

Allocating service department
costs with the direct method
Janitorial Assembly
costs
Product A
Personnel Finishing
costs
Product B
1
Alternatives to the direct method that recognize that service departments make use of each other’s resources
(such as the sequential and the reciprocal methods) are covered in cost accounting texts.
P r o b l e m s w i t h C o s t A l l o c a t i o n 213
Illustration 6-5 Service Departments Allocations Production Departments

Direct allocations of
service department costs Janitorial dept. Assembly dept.
for Mason Furniture cost of $100,000 20,000 square feet
allocated on the 60 employees
$40,000
basis of square
feet of space in
production
departments 00
0,0
$12
$60
,00
0
Personnel dept.
cost of $200,000
allocated on the $80,000
basis of number of
employees in Finishing dept.
production 30,000 square feet
departments 40 employees
Allocating Budgeted and Actual Service

Department Costs
It is generally a good idea to allocate budgeted rather than actual service department
costs. If budgeted costs are allocated, service departments cannot pass on the cost of
inefficiencies and waste. For example, suppose at the start of the year, budgeted costs in
the janitorial department are $100,000, and the accounting department informs assembly
and finishing that they will receive allocations of $2 per square foot ($100,000 ÷ 50,000
square feet).
But suppose that the janitorial department actually incurs $130,000 of cost ($30,000
more than planned) due to a lack of good cost control. If actual costs are allocated, the
janitorial department can pass the extra costs on to the production departments by allo-
cating $2.60 per square foot ($130,000 ÷ 50,000 square feet). The managers of assembly
and finishing would strongly resist the higher charge. Obviously, they would not want
their costs to be increased simply because some other department was not performing its
job efficiently. This problem is avoided if only budgeted costs are allocated; in that case,
the janitorial department must stick to the allocation of $2 per square foot.
Learning PROBLEMS WITH COST ALLOCATION

Objective 2
Our discussion so far has focused on ideas about how costs should be allocated. In
Identify potential practice, when costs are allocated, a number of problems may arise. Here we discuss
problems with cost problems brought about by: (1) allocations of costs that are not controllable, (2) arbitrary
allocation, discuss allocations, (3) allocations of fixed costs that make the fixed costs appear to be variable
activity-based costing costs, (4) allocations of manufacturing overhead to products using too few overhead cost
(ABC) and cost drivers, pools, and (5) use of only volume-related allocation bases.
and distinguish activity-
based costing (ABC)
from activity-based Responsibility Accounting and Controllable Costs
management (ABM). In Chapter 1 we learned that one of the primary uses of managerial accounting is to eval-
uate the performance of managers and the operations under their control. Performance
evaluation is facilitated by a system of accounting that traces revenues and costs to orga-
nizational units (e.g., departments and divisions) and individuals (e.g., plant manager,
supervisor of assembly workers, vice president of operation), with related responsibility

for generating revenue and controlling costs. Such a system is referred to as a responsi-
bility accounting system.
Consider a company that produces tennis racquets and tennis clothes in two
separate plants. The company could prepare monthly production cost reports that list the
total amount of material, labor, and overhead cost for the two plants combined. However,
this would not be consistent with responsibility accounting because the reports would
not trace the production costs to the plants responsible for controlling them. A respon-
sibility accounting system would require not only that the costs of producing the tennis
racquets and tennis clothes be traced to their respective plants but also that the costs in
each plant be traced to the departments or other units responsible for those costs. For
example, within the plant producing the tennis racquets, labor costs should be traced
to each foreman responsible for an identifiable group or team of workers (e.g., assembly
workers and finishing workers).
Cost allocation is generally required in a responsibility accounting system because
one organizational unit often is responsible for the costs incurred by another organiza-
tional unit. For example, activity in a production department increases the costs incurred
in the machine repair department. Because the production department is responsible for
the incurrence of costs in the machine repair department, the production department’s
performance reports should reflect some share of the machine repair department cost.
This can be achieved by allocating machine repair department costs to the production
department.
Some allocations of costs, however, are not consistent with a responsibility account-
ing system. Most accountants believe that managers should be held responsible only for
costs they can control. These costs, called controllable costs, are affected by the manag-
er’s decisions. Allocating the cost of a building to the performance report of a supervisor
responsible for controlling labor costs is not appropriate because the supervisor cannot
control building costs.
If allocated costs beyond the manager’s control appear on his or her performance
reports, they may cause considerable frustration. Managers want their performance
evaluations to reflect their own strengths and weaknesses. In some cases, managers are
allocated costs beyond their control simply to make them aware that the costs exist and
must be covered by the firm’s revenue. In such situations, the costs should be clearly
labeled noncontrollable, indicating to the manager that company officials are aware
that the items are not affected by his or her decisions. This should minimize possible
resentment.
Arbitrary Allocations
In practice, cost allocations are the topic of numerous and often heated discussions.
Managers may feel that their departments receive unnecessarily large allocations of
indirect costs, causing the departments to appear less profitable. Governmental agencies
that have cost-plus contracts may feel that products produced by contractors on a cost-
plus basis receive allocations of indirect costs that are unfairly high. Unfortunately, such
discussions are likely to continue in the future. The reason is that allocations of costs are
to a great extent inherently arbitrary.
In almost all cost allocation situations, determining the one “true,” “correct,” or
“valid” allocation is not possible. As noted earlier in the chapter, various allocation bases
(e.g., labor hours, labor cost, and machine hours) may be equally justifiable but may
result in substantially different allocations. These situations naturally lead managers to
support the allocation that makes their performance look best and reject allocations that
cast an unfavorable light on their performance.
Link to PRACTICE
Disputes over Allocations not Limited department. Baldwin observed, “This cost allocation sys-
to the Private Sector tem has run amok.” Seemingly an easy solution would be
to allocate the attorney’s salary based on the time spent
Disputes over allocations of cost are not limited to the
working on issues related to individual departments.
private sector. In Brooksville County, Florida, a civic
But what if the utilities department has money to cover
activist, Janey Baldwin, questioned allocations of costs
its allocation but the allocation and planning and zoning
to county enterprise funds. These funds are set up much
does not? Then, a “political” solution might be sought in
like a private business and provide services that are
which the cost is simply charged to the department with
financed through user fees.
the largest budget. That solution, while simple, is likely
Baldwin questioned why 100 percent of the assistant
to lead to a cost allocation dispute.
county attorney’s salary was allocated to the utilities
department (an enterprise fund operation) when the Source: Michael Bates, “County to Examine Cost Allocations,”
attorney also worked for the county planning and zoning Hernado Today, June 4, 2008.
Unitized Fixed Costs and Lump-Sum Allocations

One of the most significant problems associated with cost allocation is due to the fact
that the allocation process may make fixed costs appear to be variable costs. This happens
when fixed costs are unitized—that is, stated on a per unit basis. To illustrate the prob-
lem, consider the Smith Tool Company, which has two divisions. At the start of each year,
the company estimates the amount of general and administrative costs that are incurred
centrally on behalf of the operations of both divisions. Such costs include administrative
salaries, clerical costs, central accounting costs, and a variety of others, all of which are
essentially fixed in the short run. In the current year, these costs are expected to amount
to $2,000,000. Smith has decided that it would be useful for the divisions to know that
these costs are being incurred on their behalf. Therefore, it allocates the costs among the
divisions based on their relative sales. In the current year, divisional sales are expected to
be $50,000,000. Thus, Smith has decided to allocate general and administrative costs to
the divisions at a rate of $0.04 per dollar of sales (i.e., $2,000,000 ÷ $50,000,000).
We have said that the general and administrative costs are essentially fixed, but how
will they appear to the division managers? Let’s look, for instance, at Bob Gallegos, the
manager of the Carpenter Division, which produces a variety of carpenter tools (e.g.,
hammers, saws, and drills). Bob observes that as divisional revenue increases, the allocated
costs increase. Thus, to him, the costs appear to be variable. This may lead Bob to make
decisions that are not in the best interest of the company as a whole but that appear to
maximize divisional profitability. For example, suppose the Carpenter Division is consid-
ering producing a new hammer that will sell for $20. At this price, the division expects
to sell 100,000 units. Production of the hammer will require $12 of direct material cost,
$6 of direct labor cost, and an increase in manufacturing overhead costs of $130,000. An
analysis of the effect on the profit of the Carpenter Division is presented in Illustration 6-6.
Illustration 6-6
Sales of hammers (100,000 × $20) $2,000,000
Problem of unitized fixed costs
Less: additional costs
Direct material (100,000 × $12) $1,200,000
Direct labor (100,000 × $6) 600,000
Additional manufacturing overhead cost 130,000 1,930,000
Real increase in profit $ 70,000
Less: allocated fixed costs
($2,000,000 increase in sales × $.04) 80,000
Perceived loss on sale of hammers ($ 10,000)
As indicated in the illustration, sales of the hammer are expected to result in an increase
of $2,000,000 in sales. There will also be a $1,800,000 increase in variable costs (direct material
and direct labor) and a $130,000 increase in manufacturing overhead cost. Thus, production
and sale of the hammer will result in a $70,000 increase in profit. From this information, the
hammer appears to be a profitable addition to the product line of the division. However, will
the manager of the division be motivated to produce the hammer? Probably not.
The reason is that, with the increase in sales, the division will receive a larger alloca-
tion of central general and administrative costs. With an allocation rate of $.04 per dollar
of sales and an expected increase in sales of $2,000,000, the division would expect its allo-
cated costs to increase by $80,000. To the manager of the division, the additional allocated
costs appear to be variable even though, in fact, they are fixed (i.e., central administration
salaries, clerical costs, and accounting costs will not increase if the hammer is produced).
The result is that the manager of the division would expect production of the hammer
to result in a loss of $10,000 ($70,000 - $80,000) for the division.
To remedy this problem, allocations of fixed costs must be made in such a way that
they appear fixed to the managers whose departments receive the allocations. This is
achieved by lump-sum allocations of fixed costs. A lump-sum allocation is an allocation
of a predetermined amount that is not affected by changes in the activity level of the orga-
nizational unit receiving the allocation. Resources are acquired taking into account the
long-run needs of users. Thus, allocations of fixed costs should be based on the projected
long-run needs that lead managers to incur the costs. For example, suppose the Smith
Tool Company purchases a computer to serve each of its two divisions. Purchase of the
computer results in annual fixed costs of $40,000. In deciding what type of computer to
purchase, management estimated that the Carpenter Division would use the computer
for 2,000 hours per year and the Specialty Tools Division would use the computer for
3,000 hours per year. Thus, allocating $16,000 to the Carpenter Division ($40,000 × 2/5)
and $24,000 to the Specialty Tools Division ($40,000 × 3/5) is appropriate.
Lump-sum allocations generally should remain the same year after year, even though,
over time, the activity of the organizational units involved may deviate from expectations.
Suppose, for example, that the Carpenter Division expanded and required 3,000 hours of
computer time per year, whereas the Specialty Tools Division lost business and required
only 2,000 hours. Should the lump-sum allocations of the two divisions be reversed?
Probably not. Reversing the allocations would make it appear to the managers of the two
divisions that their allocations do indeed depend on their activity levels. In other words,
the fixed costs would again appear to be variable. If lump-sum allocations of fixed costs
are to appear fixed, the amount of the allocation must not depend on changes in activity.
It follows that, with lump-sum allocations, the allocations of a division do not depend
on the activity level of other divisions. Suppose the activity of the Carpenter Division stayed
at 2,000 hours, but the activity level of the Specialty Tools Division decreased from 3,000
hours to 2,000 hours. If the cost of the computer were allocated based on current activity lev-
els, the amount allocated to the Carpenter Division would increase from $16,000 to $20,000,
in spite of the fact that its use of the computer had not changed. Obviously, this could cause
considerable dissatisfaction on the part of the manager of the Carpenter Division. It could
also make planning more difficult, because the costs of the division would depend on the
activity of other divisions. This is not the case with a lump-sum allocation. Once the amount
of the lump sum is determined, it does not vary in response to changes in activity.
How can lump sum allocations improve a manager’s decisions? Refer back to the
decision Bob Gallegos at the Carpenter Division of the Smith Tool Company faced
regarding sale of a new hammer. If the general and administrative costs at Smith Tool
Company are allocated on a lump-sum basis and the amount allocated to the Carpenter
Division is $700,000 regardless of its activity, then Bob will perceive that general and
administrative costs are indeed fixed. Thus, he will correctly determine that, in the
interest of maximizing divisional profit, the hammer should be produced because it
contributes $70,000 toward covering the allocated costs that will be incurred whether
or not the hammer is produced.
The Problem of Too Few Cost Pools

Some companies assign overhead to products using only one or two overhead cost pools.
Although the approach has the benefit of being simple and easy to use, product costs may
be seriously distorted when only a small number of cost pools are used.
Consider the problem in the context of the Reed Manufacturing company, which
manufactures products in two departments: assembly and finishing. Reed has total man-
ufacturing overhead of $1,000,000 and each year the company incurs 50,000 labor hours.
If the company includes all overhead in one cost pool and allocates overhead using labor
hours, the overhead rate will be $20 per labor hour ($1,000,000 ÷ 50,000 labor hours).
Now suppose that of the $1,000,000 of overhead, $600,000 is incurred in assembly and
$400,000 is incurred in finishing. Furthermore, assembly requires 40,000 labor hours and
finishing requires only 10,000 labor hours. You can see that overhead per labor hour is
much less expensive in the assembly department: $15 per labor hour in assembly versus
$40 per labor hour in finishing (see Illustration 6-7).
Now assume that Reed produces two products (A and B). Each product requires
25,000 labor hours. However, Product A requires 16,000 hours of assembly time and 9,000
hours of finishing time whereas Product B requires 24,000 hours of assembly time and
1,000 hours of finishing time. How much overhead will be allocated to each product if all
overhead is included in a single cost pool and allocated on the basis of labor hours? The
answer is that both products will receive the same allocation. They both require a total
of 25,000 of total labor hours, and use of a single cost pool allocates the average cost per
labor hour. Both will be allocated $500,000 of overhead ($20 per hour × 25,000 hours).
Which product is being undercosted and which product is being overcosted when
using a single cost pool? Product A is undercosted because it requires relatively more
production time in finishing, which is a high-cost department in terms of overhead cost
(but it receives the average overhead allocation of $20 per hour). Product B is overcosted
because it requires relatively more production time in assembly, which is a relatively
Illustration 6-7
One cost pool
Overhead rates and product
costs using one versus two Total overhead $1,000,000
cost pools = = $20 per labor hour
Total labor hours 50,000
Overhead allocated to Product A = $20 × 25,000 labor hours = $500,000
Overhead allocated to Product B = $20 × 25,000 labor hours = $500,000
Two cost pools
Assembly overhead $600,000 $15 per assembly
= =
Assembly labor hours 40,000 labor hour
Finishing overhead $400,000 $40 per finishing

= =
Finishing labor hours 10,000 labor hour
Overhead allocated to Product A

$15 per assembly labor hour × 16,000 assembly hours = $240,000
$600,000
$40 per finishing labor hour × 9,000 assembly hours = $360,000
Overhead allocated to Product B
$15 per assembly labor hour × 24,000 assembly hours = $360,000
$400,000
$40 per finishing labor hour × 1,000 assembly hours = $40,000
cheap department in terms of overhead (but it receives the average overhead allocation
of $20 per hour).
Reed’s problem is easily solved by setting up separate cost pools for overhead in each
department. Note that when two cost pools are used, Product A receives an allocation of
$600,00 versus only $500,000 when a single cost pool is used (see Illustration 6-7.) And
when two cost pools are used, Product B’s allocation is reduced from $500,000 to $400,000.
Generally speaking, using more cost pools will result in more accurate allocations of costs.
Using Only Volume-Related Allocation Bases

We now turn to a final problem involved in cost allocations. Some manufacturing
companies allocate manufacturing overhead to products using only measures of pro-
duction volume (e.g., direct labor or machine hours) as allocation bases. However, not
all overhead costs vary with volume. We discuss this issue in the next section along with
activity-based costing (ABC), because ABC solves the problem.
ACTIVITY-BASED COSTING
Activity-based costing (ABC) is a relatively recent development in managerial account-
ing, and it has received a tremendous amount of attention from both academics and
practitioners interested in improving managerial accounting information.2 We introduced
ABC in Chapter 2, dealing with job-order costing. Now we discuss it in more detail.
The Problem of Using Only Measures of Production Volume

to Allocate Overhead
Manufacturing companies commonly use direct labor hours, direct labor cost, and
machine hours as allocation bases when assigning overhead to products. Each of these
items is a measure of production volume. Because most companies continue to allocate
overhead using only measures of production volume as allocation bases, we refer to this
approach as the traditional approach. The problem with the traditional approach is that it
assumes that all overhead costs are proportional to production volume. By proportional,
we mean that, for example, when volume increases by 20 percent, overhead increases by
20 percent; when volume increases by 50 percent, overhead increases by 50 percent; and
so forth. However, many overhead costs (such as the cost of setting up equipment for a
production run, the cost of inspecting raw materials, and the cost of handling materials)
are not proportional to volume. In fact, many overhead costs are affected by product
complexity rather than volume. The result is that simple high-volume products are often
overcosted whereas complex low-volume products are undercosted.
Consider the overhead costs created by starting up a production line. Both a
high-volume product (which is associated with a large amount of labor and machine
time) and a low-volume product (which is associated with a small amount of labor and
machine time) may require the same amount of setup time and setup cost. However,
since setup costs (along with all other overhead) are allocated only on the basis of pro-
duction volume, the high-volume product will receive a larger allocation of setup cost.
Thus, the high-volume product is overcosted. Let’s see how the ABC approach avoids
this problem.
2
Credit for developing activity-based costing is usually given to Robin Cooper and Robert Kaplan. See R.
Cooper, “The Rise of Activity-Based Costing—Part One: What Is an Activity-Based Cost System?” Journal of
Cost Management, Summer 1988, pp. 45–54, and R. Cooper and R. Kaplan, “How Cost Accounting Distorts
Product Costs,” Management Accounting, April 1988, pp. 20–27.
A c t i v i t y - B a s e d C o s t i n g 219
Which of the following is not a volume-related cost driver?
a. Direct labor hours.
b. Direct labor cost.
c. Machine time.
d. Time to set up a production run.
The ABC Approach

In the ABC approach, companies identify the major activities that cause overhead costs
to be incurred. Some of these activities are related to production volume, but others are
not. The costs of the resources consumed performing these activities are grouped into
cost pools. Finally, the costs are assigned to products using a measure of activity referred
to as a cost driver (an allocation base in an ABC system). The steps involved in the ABC
approach, then, are:
Step 1 Identify major activities.
Step 2 Group costs of activities into cost pools.
Step 3 Identify measures of activities—the cost drivers.
Step 4 Relate costs to products using the cost drivers.
Some common activities and associated cost drivers are listed in Illustration 6-8.
Note that some of the cost drivers are volume related; machine hours and assembly labor
hours are examples. Other cost drivers are not related to production volume; one exam-
ple is the number of inspections. Some low-volume products that involve complex or
fragile parts may need a large number of inspections, whereas some high-volume prod-
ucts that involve simple or rugged parts may need relatively few inspections. Number
of setups, as suggested earlier, is another cost driver that may not be related to volume.
Both low-volume and high-volume products may require the same number of setups.
Each firm must decide how many separate activities (and related cost pools and cost
drivers) to identify. If too many activities are identified, the system will be unnecessarily costly
and confusing. For example, consider a company that produces 200 products and identifies
100 key activities. This company must account for 20,000 (200 × 100) product-activity rela-
tions. On the other hand, if too few activities are used, the ABC system is not likely to produce
accurate data. Most companies that design ABC systems use 25 to 100 distinct activities.3
3
See R. Cooper, R. Kaplan, L. Maisel, E. Morrissey, and R. Oehm, “Implementing Activity-Based Cost
Management: Moving from Analysis to Action,” Institute of Management Accountants, October 1993, p. 13.
Illustration 6-8
Common activities and associated cost drivers
Hierarchy of Activities Major Activities Associated Costs Cost Driver
Unit Level Handling materials Labor cost for workers handling Number of material
and parts material and parts; depreciation of requisitions
equipment used to move material
and parts (e.g., depreciation of
forklifts); fuel to run material
handling equipment; etc.
Producing goods using Labor costs for individuals operating Number of
manufacturing machinery; depreciation of machine hours
equipment machines; energy used to run
machines; machine maintenance;
insurance for machinery; etc.
Packing customer orders Labor cost for packing workers; cost Number of boxes
of packing materials; etc. shipped
Batch Level Processing purchase orders Labor cost for workers determining Number of
for materials and parts order quantities, contracting with purchase orders
vendors, and preparing purchase
orders; forms; amortization of
software and computer equipment
used in order processing; etc.
Setting up machines and Labor cost for workers involved in Number of setups
workstations setups; depreciation of tools used
to adjust machines and measure
tolerances; etc.
Inspecting products for Labor costs for inspectors; Number of
quality control depreciation of equipment used to inspections
test whether items meet customer
specifications; etc.
Product Level Product design Salary of designers; depreciation Number of hours
of equipment used by designers; worked by
miscellaneous supplies used by designers
designers
Facility Level Factory administration Salary of plant manager; salary of This is likely to be
assistant to the plant manager arbiitrary
depreciation of office equipment
Hierarchy of Activities. Sometimes managers classify activities into a hierarchy of unit-

level activities, batch-level activities, product-level activities, and facility-level activities.
Unit-level activities are activities that are required to produce an incremental unit
of product. In Illustration 6-8, handling materials and parts would likely be a unit-
level activity since, to produce more units, more materials and parts must be handled.
Producing goods using manufacturing equipment and packing customer orders would
also be unit level activities (assuming that each unit is packed in an individual box).
Batch-level activities are activities that are required to produce another batch of a
product, regardless of how many units are in the batch. In Illustration 6-8, process-
ing purchase orders and setting up machines are examples of batch-level activities.
Inspecting products would also be a batch-level activity, assuming that inspections are
performed on a small sample of a batch. If every unit were inspected, then inspection
would be a unit-level activity.
Product-level activities are activities that are required to initiate production of product,
regardless of the number of units or batches. In Illustration 6-8, product design would
be an example of a product-level activity.
Facility-level activities are activities that support all other activities. Factory adminis-
tration is an example in Illustration 6-8. In most, if not all, cases, charging the cost of
facility-level activities to products is arbitrary, with no real cause-and-effect relationship.
Thus, some companies do not assign the cost of facility-level activities to products.
Relating Cost Pools to Products Using Cost Drivers

Let’s take a moment to look at the last step in the ABC approach: relating cost pools
to products using cost drivers as the allocation bases. Understanding how this step is
accomplished will allow us to move on to a comprehensive example.
Kim Electronics produces a variety of electronic products ranging from simple
handheld calculators to hard disk drives. Inspection to ensure that products are of high
quality is a major activity at Kim. In the coming year, the company expects to incur
inspection costs of $2,500,000. Forty workers are employed in the inspection process,
and they are expected to perform 1,000,000 product inspections in the coming year.
Using inspection cost as a cost pool and the number of inspections as a cost driver, the
company arrives at a rate of $2.50 per inspection for purposes of allocating inspection
costs to products.
Kim produces 20,000 Model ZX disk drives. Each drive is inspected three times
during the production process, and various functions are tested for conformance with
rigorous standards set by the company. How much of the total $2,500,000 inspection
cost will be allocated to the Model ZX? With 20,000 disk drives and three inspections
per drive, a total of 60,000 inspections will be performed. A rate of $2.50 per inspection
implies that $7.50 of inspection cost will be allocated to each disk drive ($2.50 rate × 3
inspections) for a total of $150,000 ($7.50 × 20,000). A similar approach will be taken to
determine the amount of inspection cost to be allocated to the other products produced
by Kim.
Budgeted inspection cost $2,500,000

Divided by budgeted number of inspections 1,000,000
Cost per inspection $2.50
Times number of inspections per unit for the
Model ZX disk drive 3
Inspection cost per unit for Model ZX $7.50
The ABC Approach at McMaster Screen Technologies:

A Comprehensive Example
Our comprehensive example of the ABC approach uses the situation faced by McMaster
Screen Technologies presented at the start of the chapter. As you read through the
example, make sure you can explain why using the ABC approach reduces the cost of
the high-volume product (the Model ND32 touch screen used in automobile navigation
devices) and increases the cost of the low-volume product (the MK420 touch screen used
in a military targeting device).
McMaster’s Costs under the Traditional Approach. For product costing purposes,
McMaster traces labor and material costs directly to products produced. Manufacturing
overhead is allocated to products based on labor cost. At the start of 2016, estimated
manufacturing overhead was $100,000,000 and estimated labor cost was $25,000,000.
Thus, the overhead allocation rate was $4 per dollar of labor.
For 2016, the following costs and revenues are expected from sale of the Model
ND32 and the Model MX420:
Model ND32 Model MX420

Touch Screen for Touch Screen for
Auto Navigation System Military Targeting Device
Number of Units 45,000 50

Sales revenue $21,375,000 $112,500
Less:
Direct labor 2,025,000 2,600
Direct material 9,450,000 16,500
Overhead ($4 × direct labor) 8,100,000 10,400
Total cost 19,575,000 29,500
Gross profit $ 1,800,000 $ 83,000
Selling price per unit $ 475 $2,250
Cost per unit (435) (590)
Gross profit per unit $ 40 $ 1,660
Gross profit as a % of sales 8.42% 73.78%
Note that the overhead allocated to the Model ND32 Display, $8,100,000, is equal to
the overhead rate of $4 per dollar of labor times the $2,025,000 of direct labor incurred
in production of the display used in an automobile navigation system. Also recall that
Michael Soma, the CFO at McMaster Screen Technologies, suspects that the relatively
low gross profit (less than 10 percent of sales) may be due to problems with the costing
system in use. Furthermore, he is somewhat surprised that the company is able to earn
such a high gross profit on the display used in a military targeting device (more than
70 percent of sales). While this product has a relatively high selling price, the low-volume
product required new production techniques to meet stringent quality standards and he
suspected that production inefficiencies would keep gross profit low for more than a year.
McMaster’s Costs under the ABC Approach. The CFO is right to be concerned
about the product costing system at McMaster. The company’s approach to allocating
overhead assumes that all overhead is proportional to a single measure of production
volume—labor cost. However, overhead is likely caused by several key activities.
Suppose the CFO authorizes a study of how the costs of the Model ND32 touch
screen and the Model MX420 touch screen will change if an ABC approach is taken.
The study determines that the $100,000,000 of overhead cost is related to the seven
cost drivers identified in Illustration 6-9. As indicated in the illustration, setup costs are
related to the number of setups, material ordering costs are related to the number of
purchase orders, material handling costs are related to the number of material requisi-
tions, machinery costs are related to the number of machine hours, inspection costs are
related to the number of inspections, and design costs are related to the number of design
hours. All other overhead is categorized in a cost pool simply referred to as “Other.”
McMaster has decided that “manufacturing complexity” is a major factor contributing
to the incurrence of other overhead costs. The cost driver for complexity is the number
of workstations required to produce a product. Products that require more workstations
to produce are more complex and cause more overhead.
Illustration 6-9
Overhead cost items and cost drivers
Estimated Cost per

Major Activities Annual Cost Cost Driver Annual Activity Driver Unit
Setting up production line $10,000,000 Number of setups 1,000 $10,000 per setup
Ordering materials $ 4,000,000 Number of purchase orders 24,242 $165 per purchase order
Handling materials $ 5,000,000 Number of material requisitions 14,286 $350 per requisition
Running machines $45,000,000 Number of machine hours 30,000 $1,500 per machine hour
Inspection $18,000,000 Number of inspections 40,000 $450 per inspection
Design $15,000,000 Number of design hours 176,471 $85 per design hour
Other $ 3,000,000 Number of workstations used
across all products 1,000 $3,000 per workstation
Note that in constructing the table in Illustration 6-9, we are following the steps in
the ABC process that we previously discussed. We start by identifying major activities
(Step 1). We then group associated costs into cost pools (Step 2), and we identify measures
of the activities—the cost drivers (Step 3). Now we’ll turn to relating the costs to specific
products using the cost drivers (Step 4). This last step is shown in Illustration 6-11.
Manufacturing the Model ND32 touch screen used in an automotive navigation
system requires 20 setups, 250 purchase orders, 180 material requisitions, 500 machine
hours, 450 inspections, 60 design hours, and 20 workstations. Manufacturing the Model
MX420 touch screen used in a military targeting device requires 2 setups, 30 purchase
orders, 5 material requisitions, 8 machine hours, 50 inspections, 325 design hours, and
30 workstations. This information is summarized in Illustration 6-10.
Using this information, we can calculate the cost per unit of the Model ND32 and
the Model MX420 touch screens assuming the company changes to an ABC system. The
calculations are presented in Illustration 6-11. With the ABC approach, the cost of the
Model ND32 used in an automobile navigation system drops from $435.00 to $284.37
per unit, whereas the cost of the Model MX420 used in a military targeting device
increases from $590.00 to $3,958.50 per unit:

Auto Navigation Military Targeting Device
Cost per unit using traditional $435.00 $ 590.00

approach to allocating overhead
Cost per unit using ABC approach $284.37 $3,958.50
Illustration 6-10
Production information for
45,000 Model ND32 displays
and 50 Model MX420 displays
Auto Navigation Military Targeting Device
Number of setups 20 2

Number of purchase orders 250 30
Number of material requisitions 180 5
Number of machine hours 500 8
Number of inspections 450 50
Number of design hours 60 325
Number of workstations used
in production 20 30
Illustration 6-11
Costs of Model ND32 and Model MX420 using an ABC approach
Auto Navigation System Military Targeting Device
Number of Units 45,000 Number of Units 50

Direct labor $ 2,025,000 Direct labor $ 2,600
Direct material 9,450,000 Direct material 16,500
Overhead: Overhead:
Setup cost (20 × $10,000) 200,000 Setup cost (2 × $10,000) 20,000
Material ordering cost Material ordering cost
(250 × $165) 41,250 (30 × $165) 4,950
Material handling cost Material handling cost
(180 × $350) 63,000 (5 × $350) 1,750
Machine costs (500 × $1,500) 750,000 Machine costs (8 × $1,500) 12,000
Inspection costs (450 × $450) 202,500 Inspection costs (50 × $450) 22,500
Design costs (60 × $85) 5,100 Design costs (325 × $85) 27,625
Other (20 × $3,000) 60,000 Other (30 × $3,000) 90,000
Total overhead 1,321,850 Total overhead 178,825
Total cost $12,796,850 Total costs $ 197,925
Selling price per unit $ 475.00 Selling price per unit $ 2,250.00
Cost per unit 284.37 Cost per unit 3,958.50
Gross profit per unit $ 190.63 Gross profit (loss) per unit ($1,708.50)
Gross profit as a % of sales 40% Gross profit (loss) as a % of sales (76%)
Recall that the Model ND32 sells for $475 per unit. The ABC approach reveals that
this high-volume product is very profitable. However, even though the Model MX420 sells
for $2,250 per unit, the ABC approach revels that the selling price does not come close to
covering the full cost of this low-volume product.4 The CFO’s intuition that the traditional
product costing system at McMaster might be providing misleading information was
correct. Because the traditional system only allocated costs using a volume-related alloca-
tion base (direct labor cost), the high-volume product (touch screen used in automobile
navigation systems) was overcosted and did not appear to be particularly profitable. The
low-volume product (touch screen used in military targeting device) was undercosted and
appeared to be highly profitable when, in fact, it was not covering its full cost.
Compared to a traditional cost allocation system that allocates costs to products based on
labor hours, an ABC system is likely to:
a. Allocate more costs to high-versus low-volume products.
b. Allocate less costs to high-versus low-volume products.
c. Allocate the same amount of costs to high-and low-volume products.
d. Allocate less costs to highly specialized products.
4
The fact that costs exceed revenue for the Model MX420 does not necessarily imply that the product should be
dropped immediately. Some of the costs included in the cost of this product (e.g., depreciation) will exist whether the
model is produced or not. See the discussion in Chapter 7 dealing with cost information and management decisions.
Pros and Cons of ABC

Although, as you can see, ABC offers some real advantages, it is not without problems.
This section describes two major benefits of ABC and two major limitations.
Link to PRACTICE
Avoiding a Disastrous Decision neering ratio, the big special gears required less labor than
by Using ABC the standard gearboxes. The accounting system shifted
a large chunk of the big special gears’
Mike Paris is a principal at Paris
PhotoDisc, Inc./Getty Images

overhead costs for engineering, sales, and
Consultants, a Hinsdale, Illinois, firm tooling onto the standard products because
that performs ABC consulting. Here’s they used more total direct labor.
one of his war stories on how ABC saved This led management to believe the
a client from a potentially disastrous standard gears lost money when the truth
decision: was they were very profitable. The big
gears lost money. The company almost
A gear maker produces standard indus sold the profitable part of its business to
trial gearboxes and very large specially focus on specials that were killing them. Until we pointed
engineered ring gears for ships and mining machinery. The out the unintended cross-subsidy, no one perceived the
special-gear business employed 86 engineers and a tech
competitive advantages and disadvantages.
nically trained sales force, which ran up lots of sales-related
travel costs. The standard gearboxes, however, required
just four engineers, and sales expenses were minimal since Source: Michael Paris and Dan Brassard, “Reading
most sales were to distributors and by catalog. Between the Numbers,” Strategic Finance, December 2004,
pp. 41–45. Copyright © 2004 by the Institute of Management
The indirect costs averaged a worrisome 40 percent and Accountants. Used with permission from Strategic Finance,
were badly skewed. Burden rates were allocated on the published by the IMA, Montvale, NJ, USA, www.imanet.org,
basis of direct labor hours worked. Despite the 86:4 engi www.strategicfinancemag.com.
Benefits. ABC is less likely than traditional costing systems to undercost complex,
low-volume products and overcost simple, high-volume products. This follows because
ABC uses more cost drivers to assign costs and the drivers are not necessarily volume
related.
A second benefit is that ABC may lead to improvements in cost control. With ABC,
managers see costs broken out by a number of activities rather than buried in one or
two overhead cost pools. Unless managers know the costs of setups, inspections, order
taking, stocking, moving inventory, and other key activities, they are not likely to see a
need to improve efficiency and reduce these costs.
Recall that under its traditional overhead allocation system, managers at McMaster
Screen Technologies knew that overhead was $100,000,000 in total. What they didn’t
know was the cost of the key activities that determine total overhead. With the ABC
system, however, they now know that: (1) setup costs are $10,000,000 in total or
$10,000 per setup; (2) material ordering costs are $4,000,000 or $165 per purchase
order; (3) material handling costs are $5,000,000 in total or $350 per requisition;
(4) machine-related costs are $45,000,000 or $1,500 per machine hour; (5) inspection
costs are $18,000,000 in total or $450 per inspection; (6) design costs are $15,000,000
in total or $85 per design hour; and (7) other overhead is $3,000,000 in total or $3,000
per workstation. One can easily imagine a manager saying, “Wow, I had no idea we were
spending $5 million on material handling. We’ve got to be able to get this cost down
below $275 per requisition. Let’s take a look at the steps involved in material handling
and cost them out. Now that I think of it, we have 15 people working the receiving dock,
and they don’t seem that busy. Maybe that’s a place to start.”
Limitations. A major disadvantage of ABC is its expense; an ABC system is more costly
to develop and maintain than a traditional costing system. Consider an ABC system with
20 cost pools applied to 100 different products. Assigning costs to each of the 20 pools
will be costly, and then 2,000 allocations will have to be made (20 pools × 100 products)
to assign costs to products.
Decision Making/ Perhaps the major limitation of ABC is that, in practice, it is used to develop the full cost
Incremental of products. Because full costs include allocations of costs that are fixed (e.g., deprecia-
Analysis tion of plant and equipment and supervisory salaries), the cost per unit generated by the
ABC system does not measure the incremental costs needed to produce an item. And
incremental information is what is needed to make decisions. (Remember that Chapter 1
made this point: Decision making relies on incremental analysis.)
Consider the example of the Model MX420 touch screen produced by McMaster
Screen Technologies analyzed in the previous section. The ABC system indicated that the
cost per unit was $3,658.50 and that the selling price was only $2,250.00. However, will
McMaster’s costs really increase by $3,068.50 if another screen is produced? The answer
is no. Much of the cost of producing the screen relates to depreciation on equipment that
has already been incurred. This cost is not just fixed, it’s also sunk, and sunk costs are
not relevant for decisions since they’re not incremental. Thus, in many cases, ABC does
not provide clear-cut information applicable to decision making. Do the disadvantages
of ABC outweigh the advantages? After assessing the pros and cons, we can reasonably
conclude that, for companies that don’t use the information in an overly simplistic way
(i.e., treat the full cost information as if it were incremental cost information), an ABC
system is likely to be quite beneficial.
Q: According to this book, a major limitation of ABC is that it doesn’t distinguish
between fixed and variable costs. Isn’t there a simple fix to this problem? Just
separate fixed costs and variable costs in each cost pool and allocate the variable
costs per unit of each cost driver to products, but don’t allocate the fixed costs
on a per unit basis.
A: Your idea is a good one. Most likely, managers would find the variable cost per setup,
the variable cost per material requisition, the variable cost per inspection, and so forth, to be
very useful information. Unfortunately, the simple fix you suggest isn’t common in practice.
Perhaps this is due to the fact that, in practice, the fix isn’t all that simple—a great deal of
analysis would be needed to separate fixed and variable costs in each overhead cost pool.
ACTIVITY-BASED MANAGEMENT
Activity-based management (ABM) is a management tool that involves analyzing and
costing activities with the goal of improving efficiency and effectiveness. As you would
expect, ABM is closely related to ABC, but the two schemes differ in their primary goals.
Whereas ABC focuses on activities with the goal of measuring the costs of products and
services produced by them, ABM focuses on activities with the goal of managing the
activities themselves. This difference is shown graphically in Illustration 6-12.
To clarify the difference, consider activities involved in setting up equipment for
a production run. ABC seeks to measure the cost of setups and then assign a cost to
products based on how many setups each product requires. The goal of ABM, however,
A c t i v i t y - B a s e d M a n a g e m e n t 227
is to improve the efficiency and effectiveness of the activities. Thus, for example, ABM
would focus on ways to improve the setup process and ways to eliminate the demand
for setup activity (thus reducing setup cost).
Managers using ABM want to know the costs of activities because this information
may provide insight into how well the activities are being performed. For example, by
knowing the cost of setups, managers can benchmark performance by comparing setup
costs at one plant to setup costs at another plant. If the costs per setup are much higher
at Plant A than at Plant B (and the plants are producing similar items), there is a good
chance that costs are out of control in Plant A. In essence, ABM supports the manage-
ment dictum that you can’t manage what you can’t measure. In other words, you need
to know the costs of activities before you can do a good job managing them. ABM is
discussed in more detail in the appendix to this chapter.
Link to PRACTICE
Banks and Other Service Companies bank, which has 47 outlets, is analyzing the processing
Use ABM of checks and the handling of loan applications.
To help, accomplish this task, the company uses
Although ABC and ABM were initially implemented at
activity analysis software. According to the bank’s senior
manufacturing firms, service companies have jumped on
accountant, the ABM analysis has identified a number
the bandwagon. Recall that a previous Link to Practice
of processes that can be reengineered to improve effi-
noted a healthcare organization’s use of ABC. Banks
ciency, and related savings have already justified the
and other service firms also are using ABM. Consider
investment in the software.
Allied Irish Banks. In 2006, the company used ABM in
its money transmission and lending operation to gain Source: Christian Annesley, “Bank Tracks Costs by Activity
insights into the cost structure of its processes. The Tool,” Computer Weekly, January 24, 2006, p. 5.
Illustration 6-12 ABC focus is better costing of products and services.

Comparison of ABC Resources are traced to activities to facilitate costing of products and services.
and ABM
Resources Activities Costing of products and services
ABM focus is improvement of efficiency and effectiveness of activities.

Resources are traced to activities to facilitate evaluation of activities.
Resources Activities Evaluation of activities
Link to PRACTICE
ABC Points to Process Improvement ncouraged the company to streamline material handling
e
and Cost Control by reducing the distance from storage to the manufactur-
ing floor. The feasibility of an automatic material handling
When AIRCO, a manufacturer of industrial air condition-
system was also considered.
ing units, conducted an ABC study, it identified eight
cost pools and associated cost drivers. With overhead
Source: Heather Nactmann and Mohammad Hani Al-Rifai,
broken out by key activities, the company gained an “An Application of Activity-Based Costing in the Air
important insight—material handling activities accounted Conditioner Manufacturing Industry,” Engineering Economist
for 55 percent of total overhead expenditures. This 49, 2004, pp. 221–236.
Remember—You Get What You Measure!

You get what you Before concluding our discussion of cost allocation, let’s return to one of the key points
M e a s u r e raised in Chapter 1: You get what you measure! How does this point relate to cost allo-
cation? Allocations affect the profit that managers have reported on their performance
reports. Thus, managers pay attention to controlling the allocation base, since more use
of the allocation base results in higher costs and lower profit.
Consider two companies that are initially identical. Company A allocates produc-
tion overhead based on labor hours, whereas Company B allocates production overhead
based on machine hours. Managers at both companies must make decisions about how
much labor and equipment to use in their production processes. All else being equal, the
managers at Company A will view labor as more expensive because when they use more
labor to make products, the products receive higher allocations of overhead. Managers
at Company B will view equipment as more expensive because when they use more
machine time to produce products, the products receive higher allocations of overhead.
Thus, over time, we might expect the managers of Company A to increase use of equip-
ment and the managers of Company B to increase use of labor to produce their products.
Similarly, if you calculate overhead using the number of setups as the allocation base,
managers are likely to want to reduce the number of setups. If you calculate overhead
using the number of inspections as the allocation base, managers are likely to want to
reduce the number of inspections. And if you calculate overhead using labor costs as the
allocation base, managers are likely to want to reduce labor costs. These actions, which
are driven by the way companies measure profit, are not necessarily good or bad. For
example, it may be useful to reduce the number of inspections in order to reduce cost, but
it might also be useful to increase the number of inspections in order to increase product
quality. The point is not that the number of setups, the number of inspections, or labor
costs are or are not good allocation bases. The point is that the choice of an allocation
base affects other management decisions in ways that may not be obvious.
Decision Making
Decision making relies on incremental analysis. A potential problem with cost
Insight allocation is that it may make a fixed cost appear to be a variable cost and, therefore,
incremental. Suppose, for example, that fixed costs are allocated based on sales
dollars. This makes it appear that if sales increase, the costs will increase. When
making decisions using cost information that involves allocation, beware!

Learning Objective 1 Explain why indirect costs
difficult to operationalize in practice, since opportunity costs
are allocated, describe the cost allocation process, often change quickly.
and discuss allocation of service department costs. The cost allocation process has three steps: (1) identify the
Indirect costs are allocated to provide information for decision cost objectives, (2) form cost pools, and (3) select an allocation
making, to calculate the full cost of products, to reduce the base to relate the costs to the cost objectives.
frivolous use of common resources, and to encourage managers Service department costs are allocated to production depart-
to evaluate the efficiency of internally provided services. From a ments, which in turn allocate these costs to products. The
decision-making standpoint, the allocation should measure the direct method allocates service department costs to production
opportunity cost of using a company resource. However, this is departments but not to other service departments.
Comm
A co tni vC t aBseehda vMi oarn aPgaet tme er nnst 229
i t oy -sB
Learning Objective 2 Identify potential prob- Activity-based costing (ABC) is a costing method that rec-
lems with cost allocation, discuss activity-based ognizes that costs are caused by activities. Measures of the key
costing (ABC) and cost drivers, and distinguish activities that cause costs to be incurred are referred to as cost
activity-based costing (ABC) from activity-based drivers. The cost drivers are used as the allocation bases to relate
indirect costs to products. Unlike traditional systems, ABC does
management (ABM).
not focus solely on volume-related cost drivers.
A number of problems are associated with cost allocation in Whereas ABC focuses on the costs of activities in order to
practice: (1) the allocated costs may not be controllable by develop the cost of goods and services produced by the activ-
the manager receiving the allocation; (2) allocations may be ities, ABM focuses on the costs of activities in order to help
arbitrary; (3) allocations may make fixed costs appear to be manage the activities themselves (you can’t manage what you
variable; (4) allocations may be made using too few cost pools; can’t measure).
and (5) allocation may be made using only volume-related
allocation bases.
Appendix
Learning Activity-Based Management

Objective A1
Activity-based management is a method of activity analysis aimed at improving the efficiency and
Understand the four effectiveness of business processes. Let’s look at two process improvement examples that will help
steps involved in an make the goal of ABM more concrete. Then we’ll discuss a four-step approach to conducting an
ABM study. ABM study.
Consider the activity shipping goods to stores conducted by a large retailer with multiple stores.
This activity involves having suppliers unload deliveries at the company’s warehouse. Subsequently,
goods are moved from the warehouse to the company’s trucks and sent to stores. How could this
process be improved? Walmart uses cross-docking, whereby deliveries from suppliers are loaded
directly from suppliers’ trucks onto Walmart trucks and then sent to stores. With this approach,
there is no need to move products into and around a warehouse.
As another example, consider the activity checking into a hotel. A number of hotels have
improved this process using computer technology. Based on information obtained from initial
visits, a computerized database knows customer preferences for room location and for a smoking
versus nonsmoking room. Credit card information, addresses, and phone numbers are also in the
database. With this information readily available, hotel workers at the registration desk can check
customers in more rapidly and in a way that recognizes their individual preferences, leading to
gains in customer loyalty.
Hopefully, these two examples have provided some insight into the goal of an ABM study:
process improvement. Now let’s discuss a four-step process for conducting one. In our discussion,
we’ll consider the case of Mattress Warehouse, a discount store that sells beds and mattresses. The
company has a single warehouse and 15 stores in the Dallas/Fort Worth area. Stores do not hold
inventory except for display. Thus, all shipments originate from the warehouse. The company offers
free delivery within 100 miles of any store and, for the first time in its 25-year history, has decided
to study the delivery process to determine its cost and identify potential improvements. Solutions
Analysis, a consulting firm, has been hired to undertake the study.
Step 1: Determine Major Activities

The first step in the ABM study is to determine major activities. This is usually accomplished
through interviews and observation. Solutions Analysis has determined that the key activities are:
a. Determine customer locations, determine availability of stock, and prepare delivery schedules.
b. Pick orders from warehouse.
c. Load trucks.
d. Deliver merchandise.
e. Return merchandise to stock if not acceptable to customer or customer not home to receive
delivery.
f. Wash delivery trucks (performed each night).
g. Schedule trucks for routine service (e.g., oil change) and nonroutine repairs.
Step 2: Identify Resources Used by Each Activity

The second step is to identify the resources used by each activity. Let’s consider the resources used
by activities (e) and (f).
Return Merchandise to Stock If Not Acceptable to Customer or Customer Not

Home to Receive Delivery. Solutions Analysis has determined that in a typical month,
25 orders are returned because customers receive a slightly different mattress or box spring than
expected. For example, a customer may have picked out a mattress in the store with blue stitching,
but the one delivered has red stitching. Or the model name on the mattress delivered is different
(due to a change by the manufacturer) from the model name on the mattress in the store, although
items are identical in all other respects. Additionally, 40 orders are returned each month due to
customers not being home to receive delivery. The monthly cost of this activity is $2,050.
Wash Delivery Trucks. Solutions Analysis has determined that each of the 15 delivery trucks
is washed each night. Costs include the salaries of three employees, supplies, depreciation, water,
and other miscellaneous costs. The total cost is $8,450 each month.
Monthly Cost of Returning Merchandise to Stock When

Not Acceptable to Customer or Customer Is Not
Home to Receive Delivery
Salaries related to returning merchandise to

stock (15 hours × $20) $ 300
Costs to process paperwork for corrected
shipment 250
Salaries to re-pick shipment (10 hours × $20) 200
Transportation cost to re-ship order (in-
cludes fuel, repair cost, and driver salary) 1,300
Total $2,050
Monthly Cost to Wash 15 Delivery Trucks
Monthly salaries (three full-time employees) $7,500

Supplies 450
Depreciation of equipment 300
Water and other miscellaneous costs 200
Total $8,450
Step 3: Evaluate the Performance of the Activities

Once Solutions Analysis has determined the cost of key activities, it can turn its attention to an
evaluation of them. This is the third step in an ABM study. One way the company can do this is by
benchmarking the activities against similar activities performed by other clients it has dealt with.
For example, Solutions Analysis now knows that it costs the company $101,400 a year ($8,450 × 12
months) to wash its 15 trucks. That’s $6,760 per truck. From its work with other retail companies
that perform delivery services, it has calculated an average cost of under $3,000 per truck. Thus,
the cost of this activity to Mattress Warehouse appears to be too high.
Illustration A6-1
• Ask the sales force to discuss the possibility of minor variations in stitching color with
Possible process
customers. If customers have a strong preference, confirm current colors with warehouse
improvements for
before shipping. This should reduce returns.
Mattress Warehouse
• Have a clerk call customers the day before a delivery to confirm that the customers will be
home. This should reduce the problem of customers not being home to accept deliveries.
• Reduce staffing in the wash operation from three full-time employees to two full-time
employees. This will save approximately $2,500 per month. Alternatively, consider outsourcing
the wash operation.
Step 4: Identify Ways to Improve the Efficiency and/or

Effectiveness of the Activities
The most satisfying part of the ABM process is identifying ways to improve the efficiency and/
or effectiveness of activities, the fourth and last step of the ABM process. Pause for a minute and
consider the two activities analyzed. Can you suggest any process improvements?
To identify process improvements, the consultants at Solutions Analysis would think about
best practices they’ve identified at other clients, they would brainstorm with each other, and they
would solicit input from managers at Mattress Warehouse. Possible improvements are listed in
Illustration A6-1.
CONCLUSION
It is hoped that this brief treatment of ABM has provided you with insight into the nature
of an ABM study.5 Unlike ABC, which is focused on better costing of goods and services,
ABM is focused on process improvements. Still, ABM, like ABC, requires costing activities.
Once activities are costed, a manager conducting an ABM study can identify the so-called
low-hanging fruit. That is, the manager can identify activities whose costs are large and
apparently out of line. These are the activities that deserve immediate management attention.
One reason ABM studies have become so popular is that they often generate very
substantial financial returns. Consider the case of Mattress Warehouse. If it turns out
that eliminating one employee from the wash operation is appropriate, the company will
save $2,500 per month, or $30,000 per year. Over 5 years, that’s $150,000. To analyze the
wash operation, a consultant from Solutions Analysis likely spent less than eight hours
and billed Mattress Warehouse less than $4,000.
5
These books will provide you with additional information on activity-based management: Judith J. Baker, Activity-
Based Costing and Activity-Based Management for Health Care, Gaithersburg, MD: Aspen Publishers (1998); James
A. Brimson and John Antos, Activity-Based Management, New York: John Wiley and Sons (1994); and Robin
Cooper, Robert Kaplan, Lawrence Maisel, Eileen Morrissey, and Ronald Oehm, Implementing Activity-Based Cost
Management: Moving from Analysis to Action, Montvale, NJ: Institute of Management Accountants (1992).
Review Problem 1
Wilton International is a large conglomerate with divisions that produce chemicals, tires, specialty
metals, and pharmaceuticals. Two years ago, the chief financial officer noted that the company
paid consultants more than $6,000,000 per year to help solve problems related to manufactur-
ing efficiency, employee motivation, investment decisions, and a variety of other matters. The
$6,000,000 in charges reflect average fees of approximately $240 per hour. The CFO decided that
substantial funds could be saved by setting up an internal consulting group. Accordingly, five
senior consultants from a respected firm were hired to run an internal consulting group at an
average salary of $300,000 per year. These new managers hired 15 staff consultants at an average
232 c h a p t e r 6 C o s t A l l o c a t i o n a n d A c t i v i t y - B a s e d C o s t i n g
salary of $100,000 per year. Thus, the company had 20 full-time internal consultants at a yearly
cost of only $3,000,000. The 20 individuals can work approximately 37,974 hours per year in total.
In the first year of the consulting group, the CFO sent out a notice to all divisions that they would
no longer be allowed to hire outside consultants for work that could be performed by the internal
group. Further, each division was to be charged a flat annual fee for use of the consultants based
on their relative size (measured in sales dollars) over the past four years. With this approach, the
allocation was as follows:
Allocation
Chemicals $ 300,000
Tires 600,000
Specialty metals 900,000
Pharmaceuticals 1,200,000
Total $3,000,000
With this allocation, the division managers made frequent demands for the services of the con-
sultants. Indeed, because of the demand for the services of the internal consultants, there were
frequent delays, often exceeding one month.
The following year, the CFO changed the method of allocation to a charge for hours worked.
Since costs were $3,000,000 and 38,000 hours were available, the charge was $79 per hour. With
this charge, demand for consulting services declined drastically. In fact, the average consultant was
only charging 70 percent of available hours. Further, all requests for service were easily answered
within a day or two.
Req u i r ed
a. Explain the difference in demand under the two allocation schemes.
b. Is the current charge of $79 per hour more or less than the opportunity cost of providing
consulting services?
c. Because, at a charge equal to the actual hourly wage paid to consultants, demand is less than
internal consulting capacity, the CFO is considering closing the internal consulting depart-
ment. Based on the limited information provided, what would you advise?
Answer
a. The initial allocation is a lump-sum allocation to each division based on average sales over the
past 4 years. This appears to be an ability to bear allocation. The result: excess demand and
delays resulting in an opportunity cost that exceeds the zero incremental charge for use. Excess
demand isn’t surprising when the incremental charge for service is zero. “Does your office
chair squeak? If so, call a consultant to fix it!” “Would you like to have someone do market
research for a product that you think has a low probability of market acceptance? Call in the
consultants—it won’t cost anything so you might as well get more information!”
b. The new allocation is $79 per hour, which was calculated as the $3,000,000 annual cost di-
vided by 37,974 hours. With this allocation, there is a drastic decline in requests and only
70 percent of available consulting time is used. This suggests that the opportunity cost of use
is less than $79. (If there was a need for consulting time with a benefit exceeding $79, then,
presumably, the manager with the need would call on the consultants.)
c. In the past, the company used only 25,000 hours of outside consultant time ($6,000,000 ÷
$240 per hour). Perhaps the company just hired too many internal consultants. In this case,
the company should downsize consulting to, say, 25,000 hours.
Alternatively, one could argue that the situation is just right. At many firms, consultants don’t
work more than 70 percent of their available time on billable projects because they need time for
training, and they need some slack or they won’t be able to respond on a timely basis when a new
project comes along.
Perhaps the company shouldn’t worry too much about the fact that only 70 percent of consultant
time is being used. After all, the company is saving $3,000,000 per year. The key question should be:
Common Cost R
Is their service of high quality? The CFO should have a meeting with representatives from the
divisions and get their feedback on the quality of the services provided by the internal consultants.
Review Problem 2
Bender Electric Motors produces electric motors used by home appliance and other manufacturing
companies. Each motor is built to customer specifications although the number of units requested
may vary from 1 to as many as 2,000.
Bender has recently adopted an activity-based costing system with the following overhead costs
and drivers.
Cost Pool Annual Amount Annual Activity Cost Driver
Direct labor related $ 400,000 $1,000,000 Direct labor cost

Material ordering 100,000 5,000 Purchase orders
Material inspection 600,000 4,000 Receiving reports
Equipment setup 200,000 1,000 Setups
Quality control 400,000 2,000 Inspections of motors
Machine related 800,000 40,000 Machine hours
Miscellaneous 400,000 $4,000,000 Product costs other
Total overhead $2,900,000 than miscellaneous
overhead
Recently the company received an order from Kromer’s Department Stores for 10 identical motors
for use in a holiday display. Bender estimates the following costs and activities related to the order:
Material cost $500

Labor cost $200
Purchase orders 2
Receiving reports 2
Setups 1
Inspections 1
Machine hours 10
Note that the costs indicated are for all 10 motors—they are not per motor.
Req u ir ed
a. Calculate the cost of the Kromer job using the new ABC system.
b. Calculate the cost of the Kromer job assuming the company used a traditional costing sys-
tem with labor cost as the only allocation base.
c. Briefly explain why costs are higher or lower using the ABC system in part a compared to the
traditional system in part b.
A n s we r
a.
Cost Pool Overhead Rate
Direct labor related $ 0.40 per direct labor dollar

Material ordering $ 20.00 per purchase order
Material inspection $150.00 per receiving report
Equipment setup $200.00 per setup
Quality control $200.00 per inspection
Machine related $ 20.00 per machine hour
Miscellaneous $ 0.10 per dollar of product costs other than misc.
ABC Cost of Kromer Job
Material $ 500
Labor 200
Overhead:
Labor related ($0.40 × $200) $ 80
Material ordering ($20 × 2) 40 Cost other than
Material inspection ($150 × 2) 300 misc. = $1,720
Setup ($200 × 1) 200
Quality control ($200 × 1) 200
Machine related ($20 × 10) 200
Miscellaneous (.10 × cost other than misc.) 172
Total overhead 1,192
Total cost $1,892
b. Traditional Overhead Rate
Total overhead $2,900,000

Total labor cost $1,000,000
Rate $2.90 per labor dollar
Traditional Cost of Kromer Job
Material $ 500
Labor $ 200
Overhead ($2.90 × $200) $ 580
Total cost $1,280

c. Costs are higher with ABC because the Kromer job is relatively small and makes use of a
number of activities whose costs are not proportionate to volume.
Key Terms Ability to bear costs (211) Cost allocation (204) Lump-sum allocations (216)
Activity-based costing (ABC) Cost driver (219) Product-level activities (221)
(218) Cost objective (209) Relative benefits approach to
Activity-based management Cost pool (209) allocation (211)
(ABM) (226) Direct method of allocating cost Responsibility accounting system
Batch-level activities (220) (212) (214)
Cause-and-effect relationship Equity approach to allocation Unitized (215)
(210) (211) Unit-level activities (220)
Controllable costs (214) Facility-level activities (221)

1. Costs are allocated: 2. An important concern in forming a cost pool is to:
a. To provide information useful for decision making. a. Avoid placing similar costs in the same pool.
b. To reduce frivolous use of resources. b. Limit the number of costs that make up the
c. To encourage evaluation of internally provided pool.
services. c. Ensure that the costs in the pool are homogeneous,
d. To calculate the “full cost” of products/services for or similar.
GAAP reporting. d. None of these answer choices is correct.
e. All of these answer choices are correct.
Q u e s t i o n s 235
3. In the cost allocation process, an allocation base: c. All costs related to Department A’s final product.
a. Must be some characteristic that is common to all d. All of these answer choices are correct.
of the cost objectives. 8. In allocating costs to products, more accurate costing is
b. Ideally should result in cost being allocated based generally obtained by:
on a cause-and-effect relationship. a. Allocating costs using labor hours as the allocation
c. Selection is not an easy matter. base.
d. All of these answer choices are correct. b. Having more than one cost pool.
4. The direct method of allocating costs: c. Always using allocation bases that are based on
a. Allocates service department costs to other service production volume.
departments. d. None of these answer choices is correct.
b. Allocates only direct costs. 9. Cost drivers in activity-based costing:
c. Allocates service department costs to producing a. Are always related to production volume.
departments only. b. Are workers who influence cost control.
d. None of these answer choices is correct. c. Often assign more costs to low-volume products
5. When fixed costs are stated on a per unit basis: than traditional allocation methods.
a. They are called “lump sum” allocations.
b. Fixed costs may appear to be variable to managers 10. Most companies that use an activity-based costing
receiving allocations. system use:
c. Decision making is greatly improved. a. No cost pools.
d. All of these answer choices are correct. b. One or two cost pools.
c. Two to five cost pools.
6. One way to avoid the problems associated with unitized
fixed costs is to: d. More than five cost pools.
a. Not allocate fixed costs.

b. Use a lump-sum method of allocating fixed costs.
1. e 2. c 3. d 4. c 5. b 6. b 7. b 8. b 9. c 10. d
c. Combine fixed and variable costs in a single cost pool.
7. Controllable costs for the manager of Production
Department A include:
a. Costs of the finance department.
b. Costs of material and labor used in Department A.
Questions 1. Is the following statement true: “Cost allocation refers to the process of assigning direct costs”?
Discuss.
2. Explain what a cost objective is and give two examples.
3. Explain one possible advantage to having two cost pools for each service department: one for
variable costs and one for fixed costs.
4. If a company is allocating cafeteria costs to all departments within the company, what alloca-
tion base might result in a cause-and-effect relationship?
5. Why is it generally a good idea to allocate budgeted, rather than actual, service department
costs?
6. What is a responsibility accounting system?
7. Why might noncontrollable costs be allocated to a department?
8. Briefly explain how traditional methods of allocating overhead to products might underallo-
cate costs to low-production-volume products.
9. How does activity-based costing differ from the traditional costing approach?
10. When would activity-based costing give more relevant costs than traditional costing systems?
EXERCISES EXERCISE 6-1. [LO 2] Explain how the allocation process can make a fixed cost appear variable,
leading to a poor decision.
EXERCISE 6-2. [LO 2] Mansard Hotels has five luxury hotels located in Boston, New York,
Chicago, San Francisco, and Los Angeles. For internal reporting purposes, each hotel has an
income statement showing its revenue and direct expenses. Additionally, the company allo-
cates to each hotel a share of general administrative and advertising costs (e.g., salary of the
company president, salary of the company CFO, hotel chain advertising, etc.) based on relative
revenue.
R equ i r ed
Write a paragraph explaining why the allocation of general administrative and advertising costs
to the specific hotels is potentially useful or potentially harmful.
EXERCISE 6-3. [LO 1] The provost at San Francisco University is considering allocating the cost
of campus security to the university’s various colleges (Arts and Science, Business, Engineering,
Nursing, etc.). In this regard, she is considering three allocation bases:
1. College expenses as a percent of total expenses summed across all colleges.
2. Number of college majors as a percent of the total number of students.
3. Square feet of space occupied by the college as a percent of the total square feet summed
across all colleges.
R equ i r ed
Suppose that the allocation will be subtracted from each college’s annual budget and the amount
returned to the provost to fund campus police. Explain why the deans of the various colleges are
not likely to be in agreement as to which is the “best” allocation.
EXERCISE 6-4. Reasons for Allocating Indirect Costs [LO 1] The Warner Development Com-
pany has a security department that provides security services to other departments within the
company. Department managers are responsible for working with the head of security to ensure
that their departments are protected.
R equ i r ed
Explain why Warner might want to allocate security department costs to other departments.
EXERCISE 6-5. Choice of Allocation Base (Cost Driver) for Service Departments [LO 1]
Auburn Banking and Loan Company has six service departments:
1. Human Resources (hires employees and manages benefits)
2. Duplicating (performs copy services)
3. Janitorial (provides routine cleaning services)
4. Accounting (provides accounting services)
5. Graphic Design (designs forms)
6. Food Services (provides free breakfast and lunch to employees)
The services are used by the company’s two subsidiaries, Auburn Personal Banking and Auburn
Business Banking.
R equ i r ed
a. Suggest allocation bases to be used in allocating the service department costs to the two
subsidiaries.
b. Food services are used by employees in the human resources department. Would a share of food
service costs be allocated to human resources under the direct method of allocation?
EXERCISE 6-6. Cost Allocation Process [LO 1] The Apex Company’s copy department, which
does almost all of the photocopying for the sales department and the administrative department,
budgets the following costs for the year, based on the expected activity of 5,000,000 copies:
Salaries (fixed) $100,000

Employee benefits (fixed) 12,500
Depreciation of copy machines (fixed) 10,000
Utilities (fixed) 5,000
Paper (variable, 1 cent per copy) 50,000
Toner (variable, 1 cent per copy) 50,000
The costs are assigned to two cost pools, one for fixed and one for variable costs. The costs are
then assigned to the sales department and the administrative department. Fixed costs are assigned
on a lump-sum basis, 40 percent to sales and 60 percent to administration. The variable costs are
assigned at a rate of 2 cents per copy.
Req u i red
Assuming 4,800,000 copies were made during the year, 2,500,000 for sales and 2,300,000 for
administration, calculate the copy department costs allocated to sales and administration.
EXERCISE 6-7. Allocation of Service Department Costs [LO 1] The building maintenance
department for the Taylor Manufacturing Company budgets annual costs of $5,250,000 based
on the expected operating level for the coming year. The costs are allocated to two production
departments. Taylor is considering two allocation bases for assignment of costs to departments:
(1) square footage and (2) direct labor hours. The following data relate to the potential allocation
bases:
Production Dept. 1 Production Dept. 2
Square footage 30,000 40,000

Direct labor hours 40,000 30,000
Req u i red
Calculate the costs allocated to the production departments using each allocation base. Comment
on which allocation base is preferable.
EXERCISE 6-8. Allocation of Service Department Costs [LO 1] The Marvin Company has three
service departments, S1, S2, and S3, and two production departments, P1 and P2. The following
data relate to Marvin’s allocation of service department costs:
Budgeted Costs Number of Employees
S1 $4,500,000 90
S2 3,000,000 60
S3 2,700,000 40
P1 200
P2 300
Service department costs are allocated by the direct method. The number of employees is used as
the allocation base for all service department costs.
Req u i red
a. Allocate service department costs to production departments.
b. Calculate the total service department cost allocated to each production department.
EXERCISE 6-9. Problems Associated with Cost Allocation [LO 2] Custom Metal Works r eceived
an offer from a big-box retail company to purchase 3,000 metal outdoor tables for $220 each.
Custom Metal Works accountants determine that the following costs apply to the tables:
Direct material $125

Direct labor 50
Manufacturing overhead 70
Total $245
Of the $70 of overhead, $14 is variable and $56 relates to fixed costs. The $56 of fixed overhead is
allocated as $1.12 per direct labor dollar.
R equ i r ed
a. What will be the real effect on profit if the order is accepted?
b. Explain why managers who focus on reported cost per unit may be inclined to turn down the order.
EXERCISE 6-10. Responsibility Accounting, Controllable Costs [LO 1, 2] Vance Mason, the
manager of the service department at the Proton Electronics Company, is evaluated based on
the profit performance of his department. The profit of the department is down this year because
the service department’s share of allocated general and administrative costs (allocated based on
relative sales dollars) is much higher than last year. In the current year, service revenue has in-
creased slightly while sales of handheld electronic game devices, the company’s major product,
have decreased substantially.
R equ i r ed
a. Explain why the allocation of general and administrative costs to the service department is
higher in the current year.
b. Discuss how this situation relates to a responsibility accounting system and controllable costs.
EXERCISE 6-11. Problems with Cost Allocation [LO 1, 2] Auburn Banking and Loan Com-
pany has six service departments—human resources, duplicating, janitorial, accounting, graphic
design, and food services—whose costs are allocated to the company’s two subsidiaries, Auburn
Personal Banking and Auburn Business Banking, on the basis of their relative sales.
R equ i red
a. Suppose you are the president of Auburn Business Banking. Will you perceive the allocated
service department costs to be fixed costs, variable costs, or mixed costs?
b. In performing incremental analysis related to expanding or contracting her business, will the
president of Auburn Business Banking tend to overestimate or underestimate incremental costs?
Explain.
EXERCISE 6-12. Problems Associated with Too Few Cost Pools [LO 2] Morton Manufactur-
ing allocates factory overhead using one cost pool with direct labor hours as the allocation base.
Morton has two production departments, P1 and P2. The new accountant at Morton estimates that
next year, the total factory overhead costs will be $5,000,000, and approximately 500,000 direct
labor hours will be worked. The accountant also estimates that P1 will use 200,000 direct labor
hours, and there will be about $3,000,000 in overhead costs in P1. P2 will use 300,000 direct labor
hours, and there will be $2,000,000 in overhead costs in P2. Morton has two products, A1 and B1.
It takes two direct labor hours in P1 and three direct labor hours in P2 to complete one unit of A1.
It takes one direct labor hour in P1 and four direct labor hours in P2 to complete one unit of B1.
R equ i r ed
Which product will be undercosted and which will be overcosted with the one-cost-pool system?
Support your answer with appropriate calculations. Round all amounts 2 decimal places.
EXERCISE 6-13. Cost Allocation and Opportunity Cost [LO 1] Auburn Banking and Loan Com-
pany has a graphic design department that designs loan forms and other documents used by the
company’s two subsidiaries, Auburn Personal Banking and Auburn Business Banking. For prac-
tical purposes, the costs of the graphic design department are primarily fixed and relate to the
salaries of the department’s two employees.
R equ ir ed
Analyze the following four independent cases:
a. Assume there is no allocation of graphic design costs to the subsidiaries. Jobs requested by the
subsidiaries are completed promptly (generally by the next business day). How does the allocation
(which is zero) compare to the opportunity cost of using design services?
b. Assume there is no allocation of graphic design costs to the subsidiaries. Jobs requested by the
subsidiaries generally take weeks to complete; the subsidiaries often go outside the company for
design services. How does the allocation (which is zero) compare to the opportunity cost of using
design services?
c. Assume subsidiaries receive an allocation of $60 per design hour. Jobs requested by the subsid-
iaries generally take weeks to complete; the subsidiaries often go outside the company for design
services rather than wait for jobs to be completed. They generally pay $80 per hour outside the
company. How does the allocation ($60 per design hour) compare to the opportunity cost of using
design services?
d. Assume subsidiaries receive an allocation of $60 per design hour. Although the graphic design
department is busy, jobs requested by the subsidiaries are completed promptly (generally by the
next business day). How does the allocation ($60 per design hour) compare to the opportunity
cost of using design services?
EXERCISE 6-14. Activity-Based Costing [LO 2] The following are six cost pools established for a
company using activity-based costing. The pools are related to the company’s products using cost
drivers.
Cost pools:
1. Inspection of raw materials
2. Production equipment repairs and maintenance
3. Raw materials storage
4. Plant heat, light, water, and power
5. Finished product quality control
6. Production line setups
R equ ir ed
For each of the preceding cost pools, identify a possible cost driver.
EXERCISE 6-15. Relating Cost Pools to Products Using Cost Drivers [LO 1, 2] Power Electron-
ics manufactures portable power supply units. Power has recently decided to use an activity-based
approach to cost its products. Production line setups is a major activity at Power. Next year Power
expects to perform 2,000 setups at a total cost of $4,200,000. Power plans to produce 800 units of
product EP150, which will require two setups.
Req u ir ed
How much setup cost will be allocated to each unit of EP150 produced?
EXERCISE 6-16. Relating Cost Pools to Products Using Cost Drivers [LO 1, 2] Classic Attire
is the designer and manufacturer of prom dresses. The president of Classic wants to switch to an
activity-based approach in the upcoming year to assign prices to the gowns. Production line setups
are a major activity at Classic. Next year Classic expects to perform 1,500 setups at a total cost of
$105,000. Classic plans to produce 325 dresses of the A128 design, which will require three setups.
Req u i red
How much setup cost will be allocated to each dress of the A128 design that is produced?
EXERCISE 6-17. Activity-Based Management [LO 2] The Eldon Company has two production
plants. Recently, the company conducted an ABM study to determine the cost of activities in-
volved in processing orders for parts at each of the plants.
R equ i r ed
How might an operations manager use this information to manage the cost of processing orders?
EXERCISE 6-18. Activity-Based Management [LO 2] Hearthstone Appliances supplies parts for
laundry and kitchen appliances. Customer orders are placed over the Internet and are generally
filled in 1 or 2 days using express mail services.
Angela Farnsworth, a consultant with ABM Services, has been asked to conduct an ABM
study of inventory management at Hearthstone Appliances. In this regard she has determined that
the cost of filling customer orders in the past year consisted primarily of $300,000 of salary expense
related to five workers who pick parts from the warehouse and $450,000 of salary expense related to
six workers who pack the orders for shipment. In the past year, the company filled 125,000 orders.
Based on work performed for a very large chain of auto supply stores, Angela has determined a
benchmark cost of $4.50 per order.
Req u ir ed
a. Comment on the advisability of comparing the costs at Hearthstone Appliances to those at an
auto supply chain store.
b. Angela has observed the following: Workers go to a box that contains individual customer order
sheets. They take the bottom order (the oldest) and go into the warehouse with a handcart and
a box. They then fill the order and carry the parts to a packing station. Can you suggest ways of
improving this process?
Problems PROBLEM 6-1. Number of Cost Pools [LO 1] Icon.com sells software and provides consulting
services to companies that conduct business over the Internet. The company is organized into two
lines of business (software and consulting), and profit statements are prepared as follows:
Software Consulting
Sales $15,000,000 $8,000,000

Less direct costs 6,000,000 4,000,000
Less allocated costs 5,250,000 1,750,000
Income before taxes $ 3,750,000 $2,250,000
Direct costs include costs that are easily associated with each line of business. For software, this
includes the salary of programmers, the cost of computers used by programmers, and the cost
of software manuals sold to customers. For consulting, direct costs include consultant salaries,
computer costs, and travel costs. Allocated costs include costs that are not directly traced to the
business units. These costs include employee benefits, rent, telecommunications costs, and general
and administrative costs, such as the salary of the CEO of Icon.com.
At the start of 2017, allocated costs were estimated as follows:
Employee benefits $2,500,000

Rent 1,000,000
Telecommunications 500,000
General and administrative costs 3,000,000
Total $7,000,000
P r o b l e m s 241
In the past, allocations have been based on headcount (the number of employees in each busi-
ness unit). Software had 375 employees and consulting had 125 employees. The new controller of
Icon.com believes that the key driver of employee benefits and telecommunications costs is head-
count. However, rent is driven by space occupied, and general and administrative costs are driven
by relative sales. Icon.com rents 40,000 square feet; approximately 20,000 is occupied by software
employees and 20,000 by consulting personnel.
Req u i red
a. Prepare profit reports for software and consulting assuming the company allocates costs using
headcount, space occupied, and sales as allocation bases. Compare the new levels of profit to the
levels that result using a single allocation base (headcount). Round to six decimal places.
b. Which provides the best information on profitability: a single overhead cost pool with head-
count as the allocation base, or multiple cost pools using headcount, sales, and space occupied?
PROBLEM 6-2. Number of Cost Pools [LO 1] The Kiddo Company manufactures and ships
children’s stuffed animals across the nation. The following are profit statements for the company’s
two lines of business:
Stock Stuffed Animals Custom Stuffed Animals
Sales $7,500,000 $5,000,000

Less direct costs 2,500,000 4,000,000
Less allocated costs 3,375,000 1,125,000
Income (loss) before taxes $1,625,000 ($ 125,000)
Costs that are easily associated with each line of business are included in the direct costs.
Allocated costs include costs that are not directly traced to the business units. These costs include
employee benefits, rent, telecommunications costs, and general and administrative costs, such as
the salary of the CEO of Kiddo.
At the start of 2017, allocated costs were estimated as follows:
Employee benefits $1,500,000

Rent 1,500,000
Telecommunications 500,000
General and administrative costs 1,000,000
Total $4,500,000
In the past, allocations have been based on headcount (the number of employees in each
business unit). There were 240 employees in Stock and 80 employees in Custom. The new con-
troller of Kiddo believes that the key driver of employee benefits and telecommunications costs is
headcount. However, rent is driven by space occupied, and general and administrative costs are
driven by relative sales. Kiddo rents 20,000 square feet; approximately 10,000 is occupied by Stock
employees and 10,000 by Custom personnel.
Req u i red
a. Prepare profit reports for Stock and Custom, assuming the company allocates costs using head-
count, space occupied, and sales as allocation bases. Compare the new levels of profit to the levels
that result using a single allocation base (headcount). Round to two decimal places.
b. Which provides the best information on profitability: a single overhead cost pool with head-
count as the allocation base, or multiple cost pools using headcount, sales, and space occupied?
PROBLEM 6-3. Allocated Cost and Opportunity Cost [LO 1] Binder Manufacturing pro-
duces small electric motors used by appliance manufacturers. In the past year, the company has
experienced severe excess capacity due to competition from a foreign company that has entered
Binder’s market. The company is currently bidding on a potential order from Dacon Appliances
for 6,000 Model 350 motors. The estimated cost of each motor is $45, as follows:
Direct material $25

Direct labor 5
Overhead 15
Total $45
The predetermined overhead rate is $3 per direct labor dollar. This was estimated by divid-
ing estimated annual overhead ($15,000,000) by estimated annual direct labor ($5,000,000). The
$15,000,000 of overhead is composed of $6,000,000 of variable costs and $9,000,000 of fixed costs.
The largest fixed cost relates to depreciation of plant and equipment.
Req u i red
a. With respect to overhead, what is the opportunity cost of producing a Model 350 motor?
b. Suppose Binder can win the Dacon business by bidding a price of $39 per motor (but no higher
price will result in a winning bid). Should Binder bid $39?
c. Discuss how an allocation of overhead based on opportunity cost would facilitate an appropriate
bidding decision.
PROBLEM 6-4. Allocated Cost and Opportunity Cost [LO 1] Brennen produces a mint syrup
used by gum and candy companies. Recently, the company has had excess capacity due to a for-
eign supplier entering its market. Brennen is currently bidding on a potential order from Quality
Candy for 5,000 cases of syrup. The estimated cost of each case is $23, as follows:
Direct material $ 9

Direct labor 5
Overhead 9
Total $23
The predetermined overhead rate is $1.80 per direct labor dollar. This was estimated by di-
viding estimated annual overhead ($1,080,000) by estimated annual direct labor ($600,000). The
$1,080,000 of overhead is composed of $270,000 of variable costs and $810,000 of fixed costs. The
largest fixed cost relates to depreciation of plant and equipment.
Req u i red
a. With respect to overhead, what is the opportunity cost of producing a case of syrup?
b. Suppose Brennen can win the Quality Candy business by bidding a price of $19 per case (but no
higher price will result in a winning bid). Should Brennen bid $19?
c. Discuss how an allocation of overhead based on opportunity cost would facilitate an appropriate
bidding decision.
PROBLEM 6-5. Cost-Plus Contracts, Allocations, and Ethics [LO 1] Pelton Instruments man-
ufactures a variety of electronic instruments that are used in military and civilian applications.
Sales to the military are generally on a cost-plus-profit basis with profit equal to 10 percent of
cost. Instruments used in military applications require more direct labor time because “fail-safe”
devices must be installed. (These devices are generally omitted in civilian applications.)
At the start of the year, Pelton estimates that the company will incur $75,000,000 of overhead,
$7,500,000 of direct labor, and 750,000 machine hours. Consider the Model KV10 gauge that is
produced for both civilian and military uses:
Civilian Military

Direct labor $ 900 $1,200
Machine hours 100 100
P r o b l e m s 243
Req u i red
a. Calculate the cost of civilian and military versions of Model KV10 using both direct labor dol-
lars and machine hours as alternative allocation bases.
b. Explain why Pelton Instruments may decide to use direct labor as an overhead allocation
base.
c. Is it ethical for Pelton to select an allocation base that tends to allocate more of overhead costs
to government contracts? Explain.
PROBLEM 6-6. Allocating Service Department Costs [LO 1] World Airlines has three service
departments: (1) ticketing, (2) baggage handling, and (3) engine maintenance. The service depart-
ment costs are estimated for separate cost pools formed by department and are allocated to two
revenue-producing departments: (1) domestic flights and (2) international flights. World does not
differentiate between fixed and variable costs in making allocations. The following data relate to
the allocations:
Budgeted Data
Costs Air Miles
Ticketing $4,000,000
Baggage handling $2,000,000
Engine maintenance $9,000,000
Domestic flights 7,500,000
International flights 22,500,000
Req u ir ed
a. Allocate the service department costs to the revenue-producing departments using air miles as
the allocation base.
b. Evaluate the cause-and-effect relationship resulting from the use of air miles as the allocation
base. In which of the cost pools do you think the cause-and-effect relationship is the strongest?
Suggest alternative allocation bases for the two remaining cost pools with the weakest cause-and-
effect relationship.
PROBLEM 6-7. Allocating Service Department Costs [LO 1] Armstrong Industries produces
electronic equipment for the marine industry. Armstrong has two service departments (main-
tenance and computing) and two production departments (assembly and testing). Maintenance
costs are allocated on the basis of square footage occupied, and computing costs are allocated on
the basis of the number of computer terminals. The following data relate to allocations of service
department costs:
Maintenance Computing Assembly Testing
Service department costs $700,000 $900,000

Terminals 6 14
Req u i r ed
Allocate the service department costs to production departments using the direct method.
PROBLEM 6-8. Allocating Service Department Costs [LO 1] Snowcap Electronics is a manu-
facturer of data storage devices. Snowcap consists of two service departments (maintenance and
computing) and two production departments (assembly and testing). Maintenance costs are allo-
cated on the basis of square footage occupied, and computing costs are allocated on the basis of
244 c h a p t e r 6 C o s t A l l o c a t i o n a n d A c t i v i t y - B a s e d C o s t i n g
the number of computer terminals. The following data relate to allocations of service department
costs:
Maintenance Computing Assembly Testing
Service department costs $600,000 $1,000,000

Terminals 30 60
Req u i r ed
Allocate the service department costs to production departments using the direct method. Round
to two decimal places.
PROBLEM 6-9. Choice of Allocation Base, Problems with Cost Allocation [LO 1] Tilden
inancial Services has two divisions, Financial Planning and Business Consulting. The firm’s
F
accountants are in the process of selecting an allocation base to allocate centrally provided per-
sonnel costs to the divisions. Two allocation bases have been proposed: salary and headcount
(number of employees). Personnel costs are expected to be $1,500,000. The following data relate
to the allocation:
Financial Planning Business Consulting
Salaries $15,000,000 $5,000,000

Headcount 200 50
Req u i r ed
a. Prepare a schedule showing the allocations to the two divisions using each allocation base.
b. Referring to your answer to part a, explain why allocations are sometimes considered arbitrary.
PROBLEM 6-10. Cost Allocation and Apparent Profitability [LO 1] Simon Products manufac-
tures jewelry settings and sells them to retail stores. In the past, most settings were made by hand,
and the overhead allocation rate in the prior year was $12 per labor hour ($2,700,000 overhead ÷
225,000 labor hours). In the current year, overhead increased by $800,000 due to acquisition of
equipment. Labor, however, decreased by 50,000 hours because the equipment allows rapid cre-
ation of the settings. One of the company’s many customers is a local jewelry store, Jasmine’s Fine
Jewelry. This store is relatively small, and the time to make an order of jewelry pieces is typically
less than 10 labor hours. On such jobs (less than 10 labor hours), the new equipment is not used,
and thus the jobs are relatively labor intensive.
Req u i r ed
a. Assume that in the current year, the company continues to allocate overhead based on labor
hours. What would be the overhead cost of a 10-labor-hour job requested by Jasmine’s Fine
Jewelry? How does this compare to the overhead cost charged to such a job in the prior year?
b. Assume that the price charged for small jobs does not change in the current year. Are small jobs
less profitable than they were in the past?
PROBLEM 6-11. Activity-Based Costing [LO 2] The Summit Manufacturing Company produces
two products. One is a recreational whitewater kayak molded from plastic and designed to per-
form as a durable whitewater play boat. The other product is a high-performance competition
kayak molded with high-tech fiberglass materials that are very light. The recreation kayak is uni-
form in its dimensions and style. However, the competition kayak is custom designed to fit the
individual (e.g., rocker and cockpit size are adjusted).
Most of the sales come from the recreation kayaks, but recently sales of the competition
kayaks have been increasing. The following information is related to the products for the most
recent year:
P r o b l e m s 245
Recreation Kayak Competition Kayak
Sales and production (number of kayaks) 1,000 200

Sales price per kayak $650 $800
Unit costs:
Direct materials 175 225
Direct labor 125 125
Overhead* 175 175
Total unit cost 475 525
Gross profit $ 175 $275
Overhead* costs:
Building depreciation $ 35,000
Equipment depreciation 35,000
Materials ordering 25,000
Quality control 20,000
Maintenance and security 20,000
Setup and drafting 35,000
Supervision 40,000
Total overhead $210,000
Overhead rate based on direct labor dollars:
Total overhead $210,000
Total labor ($125 × 1,000) + ($125 × 200) $150,000
* Overhead rate = $1.40 per direct labor dollar.
Victoria Mason, the president of Summit Manufacturing, is concerned that the traditional cost
system used by Summit may not be providing accurate cost information and that the sales price of
the competition kayak might not be enough to cover its true cost.
Req u ired
a. The traditional system that Summit is using assigns 83 percent of the $210,000 total overhead to
the recreational kayak because 83 percent of the direct labor dollars are spent on the recreational
kayaks. Discuss why this might not be an accurate way to assign overhead to kayaks.
b. Discuss how Summit might be able to improve cost allocation by using an ABC system.
c. Assume that Summit retains a consultant to create an activity-based costing system, and the
consultant develops the following data:
Driver Activity
Recreational Competition
Cost Pool Amount Driver Kayaks Kayaks
Building $ 35,000 Square footage 8,000 2,000

Equipment 35,000 Machine hours 4,250 750
Materials ordering 25,000 Number of orders 200 100
Quality control 20,000 Number of inspections 300 150
Maintenance and security 20,000 Square footage 8,000 2,000
Setup and drafting 35,000 Number of setups 30 60
Supervision 40,000 Direct labor cost $125,000 $25,000
$210,000
Determine the overhead allocation to each line of kayaks using an activity-based costing approach,
and compute the total unit costs for each model kayaks. Round to three decimal places.
d. Discuss why activity-based allocations are different from those generated by the traditional
allocation method used by Summit.
PROBLEM 6-12. Activity-Based Costing [LO 2] The Cheesecake Shoppe is a national bakery that
is known for its strawberry cheesecake. It makes 12 different kinds of cheesecake as well as many
other types of bakery items. It has recently adopted an activity-based costing system to assign
manufacturing overhead to products. The following data relate to its strawberry cheesecake and
the ABC cost pools:
Strawberry Cheesecake:
Annual production 19,500 units

Direct materials per unit $10
Direct labor per unit $2
Cost Pool Cost Cost Driver
Materials ordering $ 72,000 Number of purchase orders

Materials inspection 75,000 Number of receiving reports
Equipment setup 105,000 Number of setups
Quality control 69,000 Number of inspections
Other 100,000 Direct labor cost
Total manufacturing overhead $421,000
Annual activity information related to cost drivers:
Strawberry
Cost Pool All Products Cheesecake
Materials ordering 8,000 orders 100

Materials inspection 375 receiving reports 60
Equipment setup 3,000 setups 30
Quality control 3,000 inspections 150
Other $2,000,000 direct labor $39,000
Req u i r ed
a. Calculate the overhead rate per unit of activity for each of the five cost pools.
b. Calculate the total overhead assigned to the production of the strawberry cheesecake.
c. Calculate the overhead cost per unit for the strawberry cheesecake. Round to three decimal
places.
d. Calculate the total unit cost for the strawberry cheesecake. Round to three decimal places.
e. Suppose that the Cheesecake Shoppe allocates overhead by a traditional production v olume-based
method using direct labor dollars as the allocation base and one cost pool. Determine the over-
head rate per direct labor dollar and the per unit overhead assigned to the strawberry cheesecake.
Discuss the difference in cost allocations between the traditional method and the activity-based
costing approach. Round to three decimal places.
PROBLEM 6-13. Activity-Based Costing at a Service Company [LO 2] Tannhauser Financial is

a banking services company that offers many different types of checking accounts. It has recently
adopted an activity-based costing system to assign costs to various types of checking accounts. The
following data relate to one type of checking account, the money market checking account, and
the ABC cost pools:
P r o b l e m s 247
Total Number of Checking Accounts 221,750

Number of Money Market Checking Accounts 70,000
Checking account cost pools:
Returned check costs $3,000,000 Number of returned checks

Checking account Number of account
reconciliation costs 60,000 reconciliation requests
New account setup 780,000 Number of new accounts
Copies of cancelled checks 300,000 Number of cancelled check
copy requests
Web site maintenance Per product group (type of
(for online banking) 225,000 checking account)
Total checking account costs $4,365,000
Money
Cost Pool All Products Market Checking
Returned checks 200,000 returned checks 18,000

Check reconciliation costs 3,000 checking account reconciliations 420
New accounts 60,000 new accounts 20,000
Cancelled check copy requests 80,000 cancelled check copy requests 50,000
Web site costs 10 types of checking accounts 1
Req u ir ed
a. Calculate the cost rate per cost driver activity for each of the five cost pools. Round to two
decimal places.
b. Calculate the total cost assigned to the money market checking account. Round to two decimal
places.
c. Suppose that Tannhauser Financial allocates overhead using the number of checking accounts
as the allocation base and one cost pool. Determine the cost rate per checking account and the
per account cost assigned to the money market checking account. Discuss the difference in cost
allocations between this method and the activity-based costing approach.
PROBLEM 6-14. Traditional Allocation versus ABC Allocation of Manufacturing Overhead

Costs [LO 1, 2] TriTech Company has been allocating overhead to individual product lines based
on each line’s relative shares of direct labor hours. For the upcoming year, the company estimated
that manufacturing overhead will be $1,800,000 and estimated direct labor hours will be 120,000.
The company also has the following estimates:
Total Total Amount

Cost Pool Cost Driver Amount of Activity
Maintenance costs Direct labor hours $ 700,000 120,000

Setup costs Number of setups 500,000 200
Engineering costs Number of design changes 600,000 400
$1,800,000
Among many other products, TriTech has two switches, Standard and Elite switches. Standard
switches are a high-volume product that the company makes in large batches, while Elite switches
are a specialty product that is fairly low in sales volume.
Information about Standard and Elite usage of the different activities follows:
Standard Elite
Direct labor hours 3,000 300

Number of setups 1 14
Number of design changes 2 20
Req u i r ed
a. Calculate the predetermined overhead rate based on direct labor hours (traditional allocation).
Use this predetermined overhead rate to calculate the amount of overhead to apply to Standard
and Elite switches, based on their usage of direct labor hours.
b. Calculate the individual ABC pool rates by taking the total amount of overhead for each cost
pool and dividing that total by the total amount of activity for that pool. Allocate overhead to each
of the two products using these three activity rates.
c. Compare the overhead calculated in part a to that calculated in part b. Why are they different?
Which allocation method (traditional or ABC) most likely results in a better estimate of product cost?
PROBLEM 6-15. Activity-Based Costing—Comprehensive Problem [LO 2] The Riverdale

Printing Company prints limited edition art books with production runs of 15,000 to 100,000. It
has recently adopted an activity-based costing system to assign manufacturing overhead to prod-
ucts. The following data relate to one product, Art of Design, and the ABC cost pools:
Art of Design:
Annual production 40,000 units

Direct materials per unit $37
Direct labor per unit $8
Manufacturing overhead cost pools:
Materials ordering $ 840,000 Number of purchase orders

Materials inspection 525,000 Number of receiving reports
Equipment setup 2,500,000 Number of setups
Quality control 1,000,000 Number of inspections
Other 25,000,000 Direct labor cost
Total manufacturing overhead $29,865,000
Cost Pool All Books Art of Design
Materials ordering 120,000 orders 1,200

Materials inspection 2,100 receiving reports 315
Equipment setup 125 setups 1
Quality control 5,000 inspections 500
Other $12,500,000 direct labor $320,000
Req u i r ed
a. Calculate the overhead rate per unit of activity for each of the five cost pools.
b. Calculate the total overhead assigned to the production of the Art of Design. Round to two
decimal places.
P r o b l e m s 249
c. Calculate the overhead cost per unit for the Art of Design.
d. Calculate the total unit cost for the Art of Design.
e. Suppose that Riverdale Printing allocates overhead by a traditional production volume-based
method using direct labor dollars as the allocation base and one cost pool. Determine the over-
head rate per direct labor dollar and the per unit overhead assigned to the Art of Design. Discuss
the difference in cost allocations between the traditional method and the activity-based costing
approach.
PROBLEM 6-16. (Appendix) Activity-Based Management [LO 2] Talbot Partners is a consulting

firm with clients across the nation. Within the company is a travel group that arranges flights
and hotel accommodations for its over 2,000 consultants. The cost of operating the travel group
(excluding the costs associated with actual travel such as hotel cost and air fare) amounts to
approximately $1,500,000.
Recently, Talbot Partners conducted an ABM study that has determined the following:
1. Each consultant takes approximately 15 business trips per year.

2. On average, 30 percent of trips are rescheduled due to conflicts and poor planning.
3. The travel group employs 15 individuals at $50,000 each to book travel. In addition, there
is a travel manager and an assistant travel manager.
4. Benchmarking with a Talbot Partners’ client indicates that the client incurs $35 cost per
completed trip to book travel.
Req u i red
a. Evaluate the cost incurred by Talbot Partners compared to the benchmark cost.
b. Talbot Partners is planning a process improvement initiative aimed at reducing scheduling con-
flicts. What would be the savings if rescheduling could be reduced by 50 percent? Assume that the
only variable cost in travel services is the wages paid to employees who book travel.
PROBLEM 6-17. (Appendix) Activity-Based Management [LO 2] Primary Savings and Loan of
Denver is conducting an ABM study of its teller operations. In this regard, the company has iden-
tified the following major activities performed by bank tellers:
1. Process deposits

2. Process withdrawals
3. Process requests for certificates of deposit
4. Answer customer questions related to balances, overdrafts, interest rates, etc.
5. Print out customer activity statements
6. Provide access to safe deposit boxes
7. Reconcile cash drawer
The company benchmarked its operations against banks in other cities and has found that it has
many more tellers in comparison to banks of similar size. Further, the company has a relatively
unsophisticated Web site and call center.
Req u ir ed
a. How do the company’s Web site and call center affect the demand for teller activities and the
cost of teller services?
b. Identify two or three ways that technology can be used to reduce the cost of teller services.
PROBLEM 6-18. (Appendix) Activity-Based Management [LO 2] Each month, senior managers
at Vermont Wireless Technologies review cost reports for the company’s various departments. The
report for the human resource (HR) group for April is as follows:
Human Resources
April 2017
Salaries and benefits $80,000

Supplies 2,400
Total $84,100
Jason Fox, the new vice president of operations, expressed his dissatisfaction with the report at a
meeting with the company president, CFO, and controller. “This report is garbage,” he began. “It shows
that $80,000 is being spent on salaries in HR, but it doesn’t provide any information on what we’re
paying for. We need to know the activities of HR and what they cost. How are we supposed to man-
age the activities without that information? At my previous company, we routinely did activity-based
management studies, and they really helped us get a handle on operations and our costs.”
Maxwell Davies, the controller, responded that he’d get to work on ABM studies right away.
Two weeks later, his staff had developed the following information for the HR operation:
Activities in HR Monthly Cost
General administration of department

Salary of HR head $10,000
Salary of assistant to HR head 5,000
Supplies 200
$15,500
Benefits administration
Salary of administrator $ 8,000
Supplies 400
$ 8,650
HR Web site development/maintenance
One half-time staff person $ 4,000
Supplies 200
$ 4,700
Operations
Salary of five clerks who process paperwork
related to hiring, retirements, terminations $18,000
Supplies 500
$19,200
Training
Salary of six staff members who train new
employees on company policies $35,000
Supplies 400
$36,050
Total $84,100
Additional Information: The company has approximately 6,000 employees and annual employee
turnover of approximately 15 percent. New employee training is a half day session and 2 hours are
required to process paperwork for new hires and terminations.
C a s e 251
Req u i red
Comment on the insights provided by the ABM study to date. Where’s the low-hanging fruit? In
other words, what activities appear to be good candidates for further study and significant cost
savings?
Case
6-1 Eastside Medical Testing [LO 2]
Eastside Medical Testing performs five different tests Before responding to Worth’s letter, Emmet reviewed the reve-
(T1–T5) to detect drug use. Most clients are referred to the nue and cost data presented in the table below. As indicated, T1
company by potential employers who pay for the tests. Revenue produced a profit of $5.90 per test, which was much higher than
and costs related to the tests, for the most recent fiscal year, are the profit per test of any of the other procedures. However, since
detailed in the table below. taking a day-long continuing education course at City College
Setting up equipment to conduct a test is the responsibility of (titled ABC and Managing by the Right Numbers!), Emmet has
three highly skilled technicians, one of whom is Emmet Wilson, wondered whether the profitability of tests is being distorted by
founder and owner of the company. Tests T2 to T5 are high- the company’s simple approach to allocating overhead—overhead
volume tests that are conducted in batches of 100 tests per batch. allocation is based on direct labor cost. Direct labor consists of
Thus, for example, T5 is run approximately three times a day to wages and benefits paid to relatively unskilled technicians who
annually process 92,000 tests in 920 batches. T1 is a test with rela- prepare samples for testing. This cost, $325,650, is only 9.6 percent
tively low demand. However, it is run almost every day (350 runs of total overhead. With help from his bookkeeper, Emmet began
per year), so that results can be quickly communicated to employ- to analyze overhead costs in an attempt to calculate the ABC cost
ers. This fast turnaround represents a significant competitive ad- of the five tests. In the past year, overhead amounted to $3,386,760,
vantage for the company. as follows:
Nuclear Systems, Inc., is one of the few companies that requires
Overhead Costs
T1. Indeed, it accounted for almost half of the 3,500 T1 tests con-
ducted in the past year. Recently, Ron Worth, vice president of op- Setup labor $ 925,760
erations at Nuclear Systems, questioned the relatively high price Equipment 1,476,000
being charged for T1. In a letter to Emmet Wilson he noted: Rent 390,000
We pay $35 for each T1 test, which is about 40% higher than your Billing 235,000
next most expensive test. Is this charge warranted? Frankly, this Clerical 160,000
isn’t just a matter of dollars and cents. We believe that we are be- Other 200,000
ing taken advantage of because we are one of the few companies Total $3,386,760
that requires the test, and you are one of the few companies that
provide it. If we believed that the high price was justified in terms Emmet’s analysis of these six overhead cost categories was as
of significantly higher costs, we would not be writing this letter. follows:
Profitability of Tests for the Fiscal Year Ending December 31, 2017
T1 T2 T3 T4 T5 Total
Number of tests per year 3,500 52,000 72,000 80,000 92,000 299,500
Number of runs 350 520 720 800 920 3,310
Price per test $ 35.00 $ 26.00 $ 22.00 $ 21.00 $ 20.00
Less:
Material cost 12.00 10.50 7.50 7.35 5.85
Direct labor at $18 per hour 1.50 1.00 1.10 1.10 1.10
Overhead at $10.40 per labor hour 15.60 10.40 11.44 11.44 11.44
Total cost 29.10 21.90 20.04 19.89 18.39
Profit per test $ 5.90 $ 4.10 $ 1.96 $ 1.11 $ 1.62
Total profit $20,650 $ 213,200 $141,120 $ 88,800 $ 148,120 $ 611,890
Total overhead $54,600 $540,8000 $823,680 $915,200 $1,052,480 $3,386,760
Total labor $ 5,250 $ 52,000 $ 79,200 $ 88,000 $ 101,200 $ 325,650
Setup labor ($925,760). This amount is essentially the salary and Clerical ($160,000). This amount is the annual salary and benefits
benefits paid to Emmet and the two other skilled technicians who of two general clerical employees who process orders for supplies,
set up equipment for testing batches of T1 to T5. Emmet believes file records, and so on. Emmet believes that the number of tests
that the number of runs (batches of tests) is a valid driver for this (299,500 in the prior year) is a valid driver for this cost pool since
cost pool. In the past year, there were 3,310 runs. each test benefits equally from the incurrence of clerical expense.
Equipment ($1,476,000). This amount is depreciation on equip- Other ($200,000). This amount includes the salary and benefits
ment used to process the tests. All of the major pieces of equip- of the bookkeeper, depreciation on office equipment, utilities, and
ment are used in each test. (In other words, no major piece of so on. Emmet believes that the number of tests (299,500 in the
equipment is used exclusively for any individual test.) Emmet be- prior year) is a valid driver for this cost pool since each test bene-
lieves that the amount of direct labor cost is a valid driver for this fits equally from the incurrence of these expenses.
cost pool. This follows because equipment hours vary with direct
labor hours and direct labor cost. In the past year, total direct labor R eq uired
was $325,650.
a. Based on Emmet’s assumptions, calculate the ABC cost per
Rent ($390,000). This amount is the annual rent on the facility unit and profit per unit of each test. Round to 4 decimal places.
occupied by Eastside Medical Testing. Emmet believes that the
number of tests (299,500 in the prior year) is a valid driver for this b. Should Emmet lower the price of the T1 test, or keep the
cost pool since each test benefits equally from the incurrence of current price and risk losing the business of Nuclear Systems?
rent expense. c. Assume that Emmet, based on his ABC analysis, decides
Billing ($235,000). This amount is the annual salary and bene- not to lower the price of the T1 test. What will be the effect
fits of two billing clerks as well as a variety of other charges (e.g., on annual company profit if the company loses the business of
billing software costs). Emmet believes that the number of tests Nuclear Systems (i.e., T1 tests decrease by 1,750)?
(299,500 in the prior year) is a valid driver for this cost pool since
each test requires a separate billing charge.
CASE
6-2 quantumTM [LO 2]
QuantumTM manufactures electronic testing and mea- device and an order for 1 harmonic analyzer. The costs and prices
surement instruments. Many products are custom-designed charged were as follows:
with recent orders for function generators, harmonic analyzers,
Temperature Harmonic
logic analyzers, temperature measurement instruments, and
Monitor Analyzer
data-logging instruments. The company prices its instruments
at 30 percent over estimated cost (excluding administrative and Component cost per unit $ 250 $2,500
selling costs). Direct labor per unit 25 500
Recently, senior management has noted that its product mix Overhead per unit 120 2,500
has changed. Specifically, the company is receiving fewer large
Cost per unit 395 5,500
orders for instruments that are relatively simple to produce, and
Markup at 30% 119 1,650
customers are saying that the company is not price competi-
tive. The company is, however, receiving more small orders for Price per unit $ 514 $7,150
complex instruments, and customers appear quite happy to pay Number of units 900 1
QuantumTM’s price. This situation was discussed at a weekly Value of order $462,600 $7,150
management meeting. Jason Norton, VP of operations, blamed
the company’s antiquated cost accounting system. “Look,” he said, In the current system, overhead is applied based on an estimate of
“if you have bad cost information, you’re going to have bad prices, $50,000,000 of annual overhead and $10,000,000 of direct labor
and we’re still doing product costing the way companies did it in cost. The consultants have broken the $50,000,000 of annual over-
the 1930s. I’ve been reading articles about activity-based costing, head down into six cost pools and identified related cost drivers
and they indicate that out-of-date costing systems make simple as indicated in Exhibit 1. The consultants have also found that the
products look too costly and complex products too cheap. If that’s monitor and analyzer make use of the cost drivers as indicated in
true, it would explain why we’re not price competitive for simple Exhibit 2.
products.”
The meeting ended with a decision to hire a consultant to con-
R eq uired
duct a preliminary ABC study to determine how a switch to ABC
would affect product cost. The consulting firm selected two recent a. Based on the consultants’ work to date, calculate the ABC cost
orders for study: a 900-unit order for a temperature-monitoring per unit of each product.
C a s e 253
b. The consultants have completed their job, and QuantumTM c. Suppose QuantumTM meets its competitor’s price and gets
has adopted an ABC system as indicated in Exhibit 1. Recently, the job. What will be the impact on company profit? In answer-
the company received an order for a unique data-logging device. ing this question, make the following assumptions:
The device will require $9,000 of components and $3,000 of
1. 40 percent of design costs are fixed, and 60 percent vary
direct labor along with the following requirements:
with design hours.
2. 30 percent of material ordering and handling costs are
Use related to a data logging device: fixed, and 70 percent vary with the number of unique parts.
Number of design hours 27 3. 50 percent of inspection costs are fixed, and 50 percent
Number of unique parts 17 are variable.
Number of inspections 12 4. 80 percent of setup costs are fixed, and 20 percent are
Number of setups 1 variable.
Machine hours 10 5. 20 percent of labor-related costs are fixed, and 80 percent
are variable.
The customer has indicated that it currently has a low bid 6. Prices charged to this customer or other customers in the
from another company of $22,000. Calculate the ABC cost of the future will not be impacted by the current deal. This fol-
data-logging device. lows because each order is unique.
Exhibit 1 Cost Pools Annual Cost Annual Driver Value

Cost pools and drivers
Product design $ 8,000,000 160,000 design hours
Material ordering and handling 10,000,000 125,000 unique part’s
Inspection 3,500,000 560,000 inspections
Setup 2,500,000 80,000 setups
Labor-related overhead 8,000,000 $10,000,000 direct labor
Depreciation of plant and equipment 18,000,000 225,000 machine hours
$50,000,000
Exhibit 2 The following values relate to the entire order The following values relate to the order for
Use of cost driver of 900 monitors (this is not per monitor): 1 analyzer:
Number of design hours 47 Number of design hours 110
Number of unique parts 17 Number of unique parts 25
Number of inspections 225 Number of inspections 20
Number of setups 1 Number of setups 1
Machine hours 112 Machine hours 7
7
The Use of Cost Information in
Management Decision Making
Jon Jensen is the owner/operator of Jensen’s Rapid Copy,
a large copy center located near Eastern State University.
Currently, Jensen’s Rapid Copy is open from 6 a.m. until 8 p.m. 7 days per week.
However, Jon is considering two alternatives: (1) staying open until midnight or
(2) staying open 24 hours a day.
To properly make this decision, Jon should perform incremental analysis. We
touched on this topic in Chapter 1 and in subsequent chapters. Now we discuss it
in more detail.
©Photoraldz/Shutterstock
Learning Objectives
1 Explain the role of incremental analysis (analysis of incremental costs and revenues) in manage-
ment decisions, and define sunk cost, avoidable cost, and opportunity cost and understand
how to use these concepts in analyzing decisions.
2 Analyze decisions involving joint costs, and discuss the importance of qualitative considerations
in management decisions.
255
256 chapter 7 T h e U s e o f C o s t I n f o r m a t i o n i n M a n a g e m e n t D e c i s i o n M a k i n g
INCREMENTAL ANALYSIS
Decision Making/ All decisions involve a choice among alternative courses of action. In Chapter 1, we
Incremental learned that the solution to all business problems involves incremental analysis—the
Analysis analysis of the incremental revenue and the incremental costs incurred when one deci-
sion alternative is chosen over another. Incremental revenue is the additional revenue
received as a result of selecting one decision alternative over another. Incremental cost is
the additional cost incurred as a result of selecting one decision alternative over another.
If an alternative yields an incremental profit (the difference between incremental reve-
nue and incremental cost), then it should be selected. Incremental costs sometimes are
referred to as relevant costs, because they are the only costs that are relevant to consider
when analyzing decision alternatives. They are also referred to as differential costs,
because they are the costs that differ between decision alternatives.
Learning Let’s go over an example of incremental analysis to ensure that the approach is under-
Objective 1 stood. The example we’ll consider is the decision faced by Jon Jensen at Rapid Copy. Later
Explain the role of we’ll apply incremental analysis to somewhat more complicated decisions.
incremental analysis Currently, Jensen’s Rapid Copy is open from 6 a.m. until 8 p.m. Let’s compare this to
(analysis of incremental the alternative of extending hours until midnight. In this case, there is a choice between
costs and revenues) in two alternatives: closing at 8 p.m., which is the status quo, or closing at midnight.
management decisions, Incremental analysis of this decision is presented in Illustration 7-1. Note that there are
and define sunk cost, three columns. In the first column, we show the revenue and costs associated with the
avoidable cost, and status quo (decision alternative 1) for a one-year time horizon. In the second column,
opportunity cost and we show the revenue and costs associated with the decision to stay open until midnight
understand how to (decision alternative 2). In the third column, we show the difference in the revenue
use these concepts in and costs between the two decision alternatives. This is the incremental revenue and
analyzing decisions. incremental costs associated with the decision to stay open later. Since we are using a
one-year time horizon, this is obviously the incremental revenue and costs associated
with that time period. We could also perform the analysis for multiple years. However,
when multiple years are considered, it is generally important to consider the time value
Illustration 7-1
Incremental
Incremental analysis of
Revenue
decision to extend hours of
operation until midnight
and Costs
Alternative 1 Alternative 2 (Alternative 2
Current Extend Hours minus
Hours to Midnight Alternative 1)
Revenue $3,600,000 $3,888,000 $288,000

Less:
Labor 576,000 604,800 28,800
Paper, toner, and other supplies 2,520,000 2,721,600 201,600
Utilities 26,640 28,771 2,131
Insurance 7,800 8,250 450
Depreciation 60,000 60,000 –0–
Rent 55,000 55,000 –0–
Other fixed costs 3,000 3,000 –0–
Total expense 3,248,440 3,481,421 232,981
Profit $ 351,560 $ 406,579 $ 55,019
I n c r e m e n t a l A n a l y s i s 257
of money. That is, we need to take into account the fact that a dollar today is worth more
than a dollar in the future. We’ll go into that topic in Chapter 9.
As indicated in Illustration 7-1, if hours are extended, revenue will increase by
$288,000. This is the incremental revenue. However, labor, paper, toner and other sup-
plies, utilities, and insurance will increase. The total increase in expense is $232,981. This
is the incremental cost of extending hours. Incremental profit, the difference between
incremental revenue and incremental cost, is $55,019. Since incremental profit is posi-
tive, the second alternative (extending hours) should be selected.
Note that depreciation, rent, and other fixed costs are not incremental in this
decision, since none of these costs changed. Thus, they are not relevant to the decision
at hand. This is not to say that a fixed cost is never incremental. As we will see in later
examples, sometimes decisions have a major impact on operations and cause costs that
are normally considered to be fixed to change. For example, suppose expanded oper-
ations required Jon Jensen to rent additional space to store supplies. In this case, rent
(which is normally considered to be a fixed cost) would, in fact, be an incremental cost.
Incremental analysis can also be extended beyond two decision alternatives. Recall
that Jon is also considering the option of keeping the copy center open 24 hours per
day. Now there are three choices: close at 8 p.m., close at midnight, or stay open 24
hours. There are several ways we can deal with the third choice. We can compare it to
the status quo and see if it yields an incremental profit greater than the incremental
profit associated with staying open until midnight, which is $55,019; if so, it is preferred
to the midnight alternative. Or we can compare the all-day alternative directly to the
midnight option, which, as we know, dominates the status quo. Let’s do the latter. The
analysis is presented in Illustration 7-2. As indicated, the incremental revenue associated
with staying open 24 hours is $36,000. However, the incremental cost is $69,717. Thus,
if Jon were to stay open 24 hours, he would lose $33,717 compared to staying open until
midnight. Another way of saying this is: “The incremental profit of alternative 2 over
alternative 3 is $33,717.” Jon’s best decision of the three alternatives, therefore, is to stay
open until midnight.
A third way to determine the best alternative is to calculate the profit under each of
the three alternatives. In that approach, the best alternative is the one with the highest
profit, and the difference between its profit and the profit of any other alternative is its
Illustration 7-2
Incremental
Incremental analysis of the
Revenue
decision to stay open 24 hours
versus staying open until and Costs
midnight Alternative 2 Alternative 3 (Alternative 3
Stay Open Stay Open minus
until Midnight 24 Hours Alternative 2)
Revenue $3,888,000 $3,924,000 $36,000

Less:
Labor 604,800 648,800 44,000
Paper, toner, and other supplies 2,721,600 2,746,800 25,200
Utilities 28,771 29,038 267
Insurance 8,250 8,500 250
Depreciation 60,000 60,000 –0–
Rent 55,000 55,000 –0–
Other fixed costs 3,000 3,000 –0–
Total expense 3,481,421 3,551,138 69,717
Profit $ 406,579 $ 372,862 ($33,717)
Illustration 7-3
Alternative 1 Alternative 2 Alternative 3
Incremental analysis of three
Current Stay Open Stay Open
alternatives: status quo, open
until midnight, and open
Hours until Midnight 24 Hours
24 hours
Revenue $3,600,000 $3,888,000 $3,924,000
Less:
Labor 576,000 604,800 648,800
Paper, toner, and other supplies 2,520,000 2,721,600 2,746,800
Utilities 26,640 28,771 29,038
Insurance 7,800 8,250 8,500
Depreciation 60,000 60,000 60,000
Rent 55,000 55,000 55,000
Other fixed costs 3,000 3,000 3,000
Total expense 3,248,440 3,481,421 3,551,138
Profit $ 351,560 $ 406,579 $ 372,862
Incremental profit of alternative 2

over alternatives 1 and 3 $55,019 $33,717
Alternative 1 – Alternative 2 Alternative 2 – Alternative 3
incremental profit. This is the approach presented in Illustration 7-3. Note that alter-
native 2 has the highest profit, and its incremental profit compared to alternative 1 is
$55,019, which is what we calculated in Illustration 7-1. Its incremental profit compared
to alternative 3 is $33,717, which is what we calculated in Illustration 7-2.
Q : The focus on incremental analysis makes it seem like decisions are pretty cut
and dry and based just on “running the numbers.” I’ve talked to business people
who say that “gut feel” plays a very important role in the major decisions they make.
A : When making an important business decision, it’s always a good idea to perform
incremental analysis. But often there are important incremental benefits and incremental
costs that are difficult, if not impossible, to quantify. Managers shouldn’t ignore them, and
that’s where “gut feel” plays a role. We’ll discuss this in a bit more detail at the end of the
chapter, in the section Qualitative Considerations in Decision Analysis.
When Your Boss Asks, “What Does This Product (Service)

Cost?” You Should Say, “Why Do You Want to Know?”
If you’re ever in a situation where your boss asks you how much a product or service
costs, you should reply: “Why do you want to know?” While that reply may seem a bit
rude, it makes an important point about incremental analysis. There is no single cost
number that is relevant for all decisions. Thus, you need to know what decision your
boss is planning to make so you can identify the incremental cost information that is
applicable to the decision. Suppose your boss is trying to decide whether to accept a
special order for a particular product. In this case, your boss wants to know whether
the incremental cost of producing the order will exceed the incremental revenue from
accepting it. Some costs, such as the salary of a production supervisor, will not change
as a result of accepting the order and should not be considered as an incremental cost.
A n a l y s i s o f D e c i s i o n s F a c e d b y M a n a g e r s 259
However, your boss may be considering dropping the product. If the product is
dropped, the supervisor may be laid off, and the cost savings related to the supervisor’s
salary are incremental. Thus, whether supervisory salary is an incremental cost and
relevant to a decision depends on the decision being made. So, whenever, you’re asked
what a product or service costs, you need to respond: “Why do you want to know?”
T est y o ur K N O W L E D GE
Which of the following is likely to be an incremental cost associated with increasing a
planned production run of 1,000 units to 1,010 units?
a. Setup costs.
b. Depreciation of equipment.
c. Inspection costs.
d. Material costs.
Analysis of Decisions Faced by Managers

Now that we know how to apply incremental analysis, let’s practice the approach in the
context of three decisions that managers frequently face:1
1. The decision to engage in additional processing of a product
2. The decision to make or buy a product
3. The decision to drop a product line
Additional Processing Decision

Occasionally manufacturers must decide whether to sell a product in a partially com-
pleted stage or incur the additional processing costs required to complete the product.
As an example, consider Bridge Computer, a manufacturer of personal computers. Bridge
Computer has already decided to discontinue its Model 250 computer. Currently, it has
5,000 partially completed units on hand. To date, the company has spent $800 per unit, or
$4,000,000, to bring these computers to their current stage of completion. The company
estimates that costs of $400 per unit must be incurred to complete the computers. The
costs are summarized below:
Bridge Computer
Costs of Model 250 Computer
Costs per Unit Costs per Unit
Incurred to Date to Complete
Material $300 $200

Labor 200 100
Variable overhead 100 100
Fixed overhead 200 –
$800 $400
1
Another decision that managers frequently face is the pricing of special orders. This decision is presented in
Chapter 8.
Because the company has announced that the Model 250 is going to be discontin-
ued, the price of the computer has fallen. If the units are completed, they can be sold for
only $1,000 per unit. That is less than the total cost of producing the computers—$1,200
per unit ($800 cost to date plus $400 of additional cost). An alternative to finishing the
units is to sell them as they are. A small computer assembly company in another state
is willing to buy the units in their current partial state of completion for $500 per unit.
Which action should be taken? Should the computers be sold in their current state
of completion, or should the additional processing costs be incurred? Without a thor-
ough understanding of accounting information and incremental analysis, a manager at
Bridge Computer might conclude that further processing is not appropriate. After all,
with further processing, total costs will amount to $1,200 per unit, which is more than
the selling price of $1,000 per unit.
The error of this conclusion is revealed by incremental analysis. The facts for our
analysis are presented in Illustration 7-4. Note that the illustration contains three col-
umns. The first column lists the revenue and costs related to selling the computers in
their current state of completion (Alternative 1). The second column lists the revenue
and costs related to selling completed computers (Alternative 2). The third column lists
the incremental revenue and costs that will be incurred by completing the computers.
Illustration 7-4
Incremental analysis of additional processing decision
Bridge Computer
Incremental Analysis of Additional Processing
Incremental
Revenue
and Costs Incremental revenue
Sell in Current Complete (Alternative 2 associated with
State of Completion Processing minus Alternative 2
(Alternative 1) (Alternative 2) Alternative 1)
Revenue $500 $1,000 $500

Less:
Prior production costs
Material 300 300 0
Labor 200 200 0
Variable overhead 100 100 0
Fixed overhead 200 200 0
800 800 0
Additional processing costs
Material 0 200 200 Incremental cost
Labor 0 100 100 associated with
Variable overhead 0 100 100 Alternative 2
0 400 400
Gain (loss) per unit ($300) ($ 200) $100
Incremental profit
associated with
Alternative 2
We’ll begin by examining incremental revenue. Recall that incremental revenue is

simply the difference in revenue between two alternatives. Bridge Computer can sell
completed units for $1,000 each, whereas it can sell the units in their current state of
completion for $500 each. Thus, incremental revenue of $500 per unit is associated with
choosing Alternative 2 and completing processing.
Now let’s turn to incremental cost. Before going any further, we need to recall
another cost term from Chapter 1—sunk costs, or costs incurred in the past. Sunk costs
are not incremental costs. Since they’ve already been incurred, they won’t increase or
decrease with the choice of one alternative over another. In the case of Bridge Computer,
the prior production costs are sunk costs, not incremental costs. Thus, they do not enter
our analysis.
What, then, are the incremental costs for Bridge Computer? An incremental cost,
remember, is the difference in cost between two alternatives. The $400 cost of complet-
ing the units ($200 material, $100 labor, and $100 variable overhead) will be incurred if
the units are completed; thus, $400 is the incremental cost associated with completing
processing.
You can see that by choosing Alternative 2, the company will be better off by $100
per unit ($500 incremental revenue - $400 incremental cost). In total, the incremental
profit of completing the units is $500,000 (100 × 5,000 units). As we noted earlier, if an
alternative yields an incremental profit, it should be selected.
LINK TO Practice
Sell Partially Completed Superyacht? could be completed for $30 million and a fully completed
similar yacht would cost $60 million. In this case, buying
Here’s an interesting “additional processing” decision
the partially completed yacht is a “good deal!” The total
from the buyer’s (rather than the seller’s perspective).
cost would only be $54.9 million versus $60 million for a
Available in 2014 in Whangarei, New Zealand is project
yacht that’s already completed.
U77, a “superyacht” with 10 staterooms for 20 guests.
It’s for sale of $24.9 million, but the problem is it’s only
50 percent finished. A potential buyer must calculate
Source: Partially-built superyacht project U77 for sale at
the incremental cost of completing the yacht, add that Fraser Yachts and Burgess. http://www.boatinternational.
to the purchase price and compare the total to the cost com/2014/06/04/partially-built-superyacht-project-u77-for-
of buying a completed yacht. Let’s suppose the yacht sale-at-fraser-yachts-and-burgess/
Make-or-Buy Decisions: The General

Refrigeration Example
Most manufactured goods are made up of numerous components. In some cases,
a company may purchase one or more of the components from another company.
This may lead to considerable savings if the outside supplier is particularly efficient
at manufacturing the component and can offer it at a reasonable price. Two decision
alternatives arise in this situation: make or buy the component. No incremental
revenues are involved. Therefore, the analysis of this decision concentrates solely on
incremental costs.
Consider the situation faced by Wendy Grant, manager of the Tennessee plant of
General Refrigeration, a company that manufactures and sells refrigeration units used by
food processors and grocery stores. One of the main components of a refrigeration unit is
a compressor. Recently, Wendy received an offer from Dillard Compressor Corporation
to supply 50,000 compressors at $310 per unit. Last year, when her plant produced 50,000
compressors, the following costs were incurred:
Cost of Manufacturing 50,000 Compressors
Variable costs:
Direct material ($100 per unit) $ 5,000,000
Direct labor ($120 per unit) 6,000,000
Variable overhead ($80 per unit) 4,000,000
Total variable cost 15,000,000
Fixed costs:
Depreciation of building 600,000
Supervisory salaries 500,000
Other 350,000
Total fixed cost 2,250,000
Total cost $17,250,000
Cost per unit $ 345
Additional analysis reveals the following: (1) The market value of the machinery
used to produce the compressors is approximately zero. (2) Five of the six production
supervisors will be fired if production of compressors is discontinued. However, one
of the supervisors, who has more than 10 years of service, is protected by a clause in a
labor contract and will be reassigned to other duties, although his services are not really
needed. His salary is $110,000.
At first, you might assume that General should buy the compressors rather than
manufacture the units internally since the company can buy the units for $310 each,
whereas the cost of manufacturing them is $345 each ($17,250,000 ÷ 50,000 units).
However, careful consideration of the incremental costs reveals that it is cheaper to
manufacture the compressors internally.
Link to PRACTICE
Boeing’s Global Outsourcing Strategy Airplanes Chief Jim Albaugh conceded, “We spent a lot
Blamed for 3-Year Delay in 787 more money in trying to recover than we ever would have
spent if we’d tried to keep the key technologies closer
In developing the 787 Dreamliner, Boeing set up a large
to home.” Some analysts estimate that the outsourcing
and complex global supply chain with strategic partners
decision ended up costing Boeing $12 to $18 billion on
in China, Japan, Italy, Sweden, South Korea, and other
top of what Boeing had planned to spend. As of 2011,
countries. The plane has 30 percent international con-
Boeing was 3 years late in delivering a plane that is
tent, which is more than any other plane the company
critical to the long-run success of the company.
has produced.
Outsourcing key technologies and components Source: “A Prescient Warning to Boeing on 787 Trouble,”
turned out to be disastrous. Boeing Commercial The Seattle Times, February 6, 2011, p. D-1.
To demonstrate, we’ll work through an incremental analysis, which is presented in

Illustration 7-5. Like previous examples, Illustration 7-5 uses a three-column format. The
first two columns present the costs of the two alternatives, while the third column presents
the incremental costs. Another option is to use a single-column format that concentrates
Illustration 7-5
Incremental Cost Analysis
Incremental analysis of
make-or-buy decision Cost of Cost of Buying
Manufacturing 50,000 Incremental
50,000 Compressors Compressors Cost (Savings)
Variable costs:
Direct material $ 5,000,000 –0– ($ 5,000,000)
Direct labor 6,000,000 –0– (6,000,000)
Variable overhead 4,000,000 –0– (4,000,000)
Total variable cost 15,000,000 –0– (15,000,000)
Fixed costs:
Depreciation of building 600,000 600,000 –0–
Depreciation of equipment 800,000 800,000 –0–
Supervisory salaries 500,000 110,000 (390,000)
Other 350,000 350,000 –0–
Total fixed costs 2,250,000 1,860,000 (390,000)
Cost of buying compressors –0– 15,500,000 15,500,000
Total $17,250,000 $17,360,000 $ 110,000
only on the incremental costs and benefits. A single-column analysis of the make-or-buy
decision faced by the General Refrigeration Company is presented in Illustration 7-6.
A key issue in our analysis involves determining which of the costs listed earlier are,
in fact, incremental costs. Clearly, none of the $15,000,000 of variable manufacturing
costs will be incurred if the compressors are purchased outside the company. Thus, this
is an incremental cost savings between the two alternatives.
What about the fixed costs? Let’s consider them item by item. The fixed costs associ-
ated with depreciation on the building and equipment do not represent a cost savings. The
costs of purchasing the building and equipment were incurred in prior periods. Remember
that the approach to analyzing decisions requires consideration of only the incremental
revenues and costs of decision alternatives. The sunk costs related to purchasing the build-
ing and the pieces of equipment are not incremental costs because they have already been
incurred and will not change no matter which decision alternative is selected.
The example assumes that fixed costs classified as “other” are also irrelevant sunk costs.
But note that not all fixed costs are irrelevant sunk costs. Some fixed costs are avoidable
costs—costs that can be avoided if a particular action is undertaken. In our example, if
compressors are purchased outside the company, the salaries of five production supervisors
will be saved. The saving totals $390,000 (total supervisory salaries of $500,000 less the
$110,000 that must still be paid to the supervisor who will be retained). In other words,
supervisory salaries of $390,000 represent an avoidable cost and thus an incremental cost.
Illustration 7-6
Single-column format for
incremental analysis Cost of buying compressors outside
(50,000 units @ $310) $15,500,000
Cost savings (avoidable if compressors
purchased outside):
Variable costs $15,000,000
Supervisory salaries
(salaries of 5 of 6 supervisors) 390,000 (15,390,000)
Excess cost of buying compressors outside $ 110,000
Link to PRACTICE
PACCAR Decides to Make as Well as Buy! costs. Thus, the company built a $400 million engine
factory in Columbus, Mississippi.
PACCAR is one of the largest truck manufacturers in the
One of the benefits of making its own engines is
United States and Europe. Its Kenworth and Peterbilt
that the company can work more closely with dealers to
trucks, which are sold primarily in North America,
ensure timely delivery of parts when trucks come in for
were powered by engines made by either Cummins or
repair. That’s not too often, however. PACCAR trucks typ-
Caterpillar. Apparently, the company performed incre-
ically run for over a million miles, and engine overhauls
mental analysis and determined that the incremental ben-
may not be needed for 800,000 miles.
efits of making its own engines outweigh the incremental
We can see, then, that $15,000,000 of variable costs and $390,000 of fixed costs can
be eliminated if the compressors are purchased from Dillard Compressor Corporation,
for a total cost savings of $15,390,000. But the cost of purchasing the compressors from
Dillard is $15,500,000 (50,000 units × $310). The difference is $110,000 ($15,500,000 pur-
chase price - $15,390,000 cost saving), and the General Refrigeration Company would
be $110,000 worse off if it decided to buy rather than make the compressors. Before a
final decision is reached, however, qualitative factors should be considered. We’ll discuss
these factors later in the chapter.
A cost that must be considered in decision making is an opportunity cost. An
opportunity cost is the value of benefits forgone by selecting one decision alternative
over another. For example, if you chose to purchase a $1,000 stereo system rather than
investing in a certificate of deposit (CD), the potential interest that could have been
earned on the CD is an opportunity cost associated with buying the stereo. Since oppor-
tunity costs differ depending on which decision alternative is selected, they are also
incremental costs and are relevant in evaluating decision alternatives.
Suppose that the Tennessee plant is currently spending $500,000 per year to rent
space for manufacturing metal shelving, which is used in the refrigeration units. If pro-
duction of compressors is discontinued, the company will move the shelving operation
to space currently occupied by the compressor operation. Thus, in continuing to p roduce
the compressors, the company gives up rent savings of $500,000. The forgone rent
savings represents an opportunity cost. An analysis that includes this opportunity cost
Link to PRACTICE
Indian Wireless Company Outsources To manage the tremendous growth, Bharti Airtel
to U.S. and European Firms! outsourced its entire network to Sweden’s Ericsson,
Germany’s Siemens, and Finland’s Nokia. The result is
The make-or-buy decision that we just analyzed for
that the company no longer needs to worry about buying
General Refrigeration is often referred to as an outsourc-
and maintaining equipment. Instead, it pays a fee based
ing decision. That’s because the component under con-
on traffic and customer service. Bharti Airtel also signed
sideration may be sourced from outside the company.
a 10-year, $750 million contract with IBM. Now IBM
Outsourcing isn’t just for components, however. Services
handles the company’s information technology, billing,
may also be outsourced. Consider the actions taken by
and management of customer accounts. This was an
Bharti Airtel, the largest wireless company in India. In
interesting development since we often think of U.S.
2003, the company was ramping up from 3 million to
firms outsourcing to Indian companies rather than Indian
more than 25 million subscribers. The company realized
companies outsourcing to U.S. and European firms.
that it couldn’t build its network fast enough to take on
this volume. Source: Clay Chandler, “Wireless Wonder,” Fortune, January
22, 2007, pp. 131–132.
Illustration 7-7
Make-or-buy analysis with
opportunity costs considered Cost of buying compressors outside
(50,000 units @ $310) $15,500,000
Cost savings (avoidable if compressors
purchased outside) $15,000,000
Variable costs
Supervisory salaries
(salaries of 5 or 6 supervisors) 390,000
Opportunity cost of using the
plant to produce compressors
(forgone rent savings) 500,000 (15,890,000)
Net savings resulting from buying the
compressors outside ($ 390,000)
is presented in Illustration 7-7. According to this analysis, purchasing the compressors

outside is the best alternative because it results in a net annual cost saving of $390,000.
Dropping a Product Line

Dropping a product line is a very significant decision and one that receives a great deal of
attention. The proper approach to analyzing the problem is to calculate the change in income
that will result from dropping the product line. If income will increase, the product line
should be dropped. If income will decrease, the product line should be kept. This amounts
to comparing the incremental revenues and costs that result from dropping the product line.
Let’s consider an example involving a retailer. Mercer Hardware sells three product lines:
tools, hardware supplies, and garden supplies. Illustration 7-8 presents a product line income
statement for the prior year. To arrive at net income for each product line, both direct fixed
costs and allocated fixed costs are deducted from each product line’s contribution margin.
Direct fixed costs are fixed costs that are directly traceable to a product line. For
example, the salary of a worker who spends 100 percent of his or her time working in
the tool section of the hardware store is a direct fixed cost to the tool product line.
Allocated fixed costs are those fixed costs that are not directly traceable to an indi-
vidual product line. These costs are also referred to as common costs because they are
incurred for the common benefit of all product lines. An example of an allocated fixed
Illustration 7-8
Mercer Hardware
Product line income
Product Line Income Statement
statement for Mercer
Hardware For the Year Ended December 31, 2017
Hardware Garden
Tools Supplies Supplies Total
Sales $120,000 $200,000 $80,000 $400,000

Cost of goods sold 81,000 90,000 60,000 231,000
Gross margin 39,000 110,000 20,000 169,000
Other variable costs 2,000 4,000 1,000 7,000
Contribution margin 37,000 106,000 19,000 162,000
Direct fixed costs 8,000 5,000 3,500 16,500
Allocated fixed costs 24,000 40,000 16,000 80,000
Total fixed costs 32,000 45,000 19,500 96,500
Net income (loss) $ 5,000 $ 61,000 ($ 500) $ 65,500
Illustration 7-9
Effect of dropping garden supplies at Mercer Hardware
Income without
Income with Garden Supplies Garden Supplies Difference
Hardware Garden Hardware

Tools Supplies Supplies Total Tools Supplies Total
Sales $120,000 $200,000 $80,000 $400,000 $120,000 $200,000 $320,000 ($80,000)

Cost of goods sold 81,000 90,000 60,000 231,000 81,000 90,000 171,000 (60,000)
Gross margin 39,000 110,000 20,000 169,000 39,000 110,000 149,000 (20,000)
Other variable costs 2,000 4,000 1,000 7,000 2,000 4,000 6,000 (1,000)
Contribution margin 37,000 106,000 19,000 162,000 37,000 106,000 143,000 (19,000)
Direct fixed costs 8,000 5,000 3,500 16,500 8,000 5,000 13,000 (3,500)
Allocated fixed costs 24,000 40,000 16,000 80,000 30,000 50,000 80,000 –
Total fixed costs 32,000 45,000 19,500 96,500 38,000 55,000 93,000 (3,500)
Net income $ 5,000 $ 61,000 ($ 500) $ 65,500 ($ 1,000) $ 51,000 $ 50,000 ($15,500)
cost is the salary of the owner/manager of the hardware store. Mercer Hardware allocates
common fixed costs to product lines based on their relative sales revenues. For example,
sales of tools are 30 percent of sales ($120,000 tool sales ÷ $400,000 total sales). Thus, of
the $80,000 of common costs, $24,000 (30% of $80,000) is allocated to tools.
In examining the product line income statement, the owner of Mercer Hardware
observes that the garden supplies line is currently showing a loss of $500. Would drop-
ping this product line increase the profitability of the hardware store? To answer this
question, we turn again to incremental analysis. As indicated in Illustration 7-9, sales
revenue will decline by $80,000 if garden supplies are dropped. However, some costs
will decrease or be eliminated altogether. Cost of goods sold will decrease by $60,000,
and other variable costs will decrease by $1,000. Whether the direct fixed costs will
decrease depends on the nature of these costs. For purposes of this example, assume
that the direct fixed cost of $3,500 for garden supplies represents the wages paid to a
part-time employee. If the garden supplies product line is dropped, this employee will
not be retained by the store. In this case, the direct fixed cost of $3,500 is avoidable and
represents a cost savings achieved by dropping garden supplies.
LINK TO PRACTICE
Spike TV Drops Impact Wrestling WWE (World Wrestling Entertainment), and Spike doesn’t
want a product that can’t grow.
For TV stations, each show is a product, and in 2015,
Spike TV dropped a product called “Total Nonstop Action Source: TNA News: The Real Reason Spike TV Decided To Drop
(TNA) Impact Wrestling.” Speculation is that Spike’s Impact Wrestling Finally Revealed. http://www.inquisitr.com/
leadership believes that TNA can’t grow its brand against 1529412/the-real-reason-spike-tv-is-dropping-tna-wrestling/
Allocated common fixed costs are generally not avoidable. Thus, no cost savings will
be achieved with respect to the $16,000 of fixed costs allocated to garden supplies. For
example, one component of the allocated fixed cost is rent of the hardware store. The
rent will not decrease simply because one of the product lines is eliminated. Another
allocated fixed cost is the cost of electricity. This cost is also unlikely to decrease if garden
supplies are eliminated, because the store will still need approximately the same amount
of heat and light. If garden supplies are eliminated, the share of fixed costs allocated to
tools and hardware supplies will simply increase.
To summarize, the analysis of incremental costs and revenues indicates that income
of $15,500 will be lost if garden supplies are dropped:
Incremental Analysis
Dropping Garden Supplies
Lost sales ($80,000)

Cost savings:
Cost of goods sold 60,000
Other variable costs 1,000
Direct fixed costs 3,500
Total cost savings 64,500
Net loss from dropping ($15,500)
Beware of the Cost Allocation Death Spiral!

Whenever you analyze a decision involving dropping a product or service, remember
that common fixed costs are not incremental. This will allow you to avoid what is some-
times referred to as the cost allocation death spiral. In many cases, products or services
may not appear to be profitable because they receive allocations of common fixed costs.
But what will happen to the common costs if the product or service is dropped? They’ll
be allocated over the remaining products and services. That may result in another prod-
uct or service appearing to be unprofitable.
Consider Mercer Hardware as an example. If the company had decided to drop
garden supplies, the $80,000 of common fixed costs would have been allocated over tools
and hardware supplies. The new allocation would be $6,000 higher for tools, and it no
longer would appear profitable—it would show a $1,000 loss. But what will happen to
the common costs if it’s dropped? That’s right, they’ll be allocated to hardware supplies.
Before long, the store (which is currently profitable) would be out of business!
Summary of Incremental, Avoidable,

Sunk, and Opportunity Costs
A number of costs terms have been used earlier, and in this section we briefly review
them. Recall that the basic approach to decision making is to compare decision alterna-
tives in terms of costs and revenues that are incremental. Costs that can be avoided by
taking a particular course of action are always incremental costs and, therefore, relevant
to the analysis of a decision. Costs that are sunk (i.e., already incurred and not reversible)
are never incremental costs because they do not differ among the decision alternatives.
Therefore, they are not relevant in making a decision.
Students of managerial accounting often assume that fixed costs are equivalent to
sunk costs and are thus irrelevant (i.e., are not incremental costs), but this is not always
the case. Fixed costs may be sunk and, therefore, irrelevant. Fixed costs may not be sunk
but still irrelevant. Finally, fixed costs may not be sunk and may be relevant. Examples
of these three possibilities are presented in Illustration 7-10.
Finally, opportunity costs represent the benefit forgone by selecting a particular
decision alternative over another. By their nature, they are always incremental costs,
and they must be considered when making a decision. To illustrate opportunity costs,
consider the Mercer Hardware example presented earlier. In this example, the company
is considering dropping the garden supplies product line. Suppose that if garden supplies
are dropped, more space can be devoted to selling tools, sales of tools will increase, and
the contribution margin associated with tools will increase by $20,000. In this case, there
is a $20,000 opportunity cost associated with the decision to keep the garden supplies
268 c h a p t e r 7 T h e U s e o f C o s t I n f o r m a t i o n i n M a n a g e m e n t D e c i s i o n M a k i n g
Illustration 7-10
Fixed Costs Classification
Fixed costs and decision
relevance Depreciation on equipment already Sunk and irrelevant (not incremental)
purchased
President’s salary, which will not change Not sunk but still irrelevant (not
for both action A and action B incremental)
Salary of supervisor who will be Not sunk and relevant (incremental)
retained if action A is taken and
fired if action B is taken
product line. This opportunity cost would make dropping the product line desirable
rather than undesirable. Recall that our previous analysis indicated a $15,500 decrease in
income from dropping the product line. However, considering the $20,000 opportunity
cost due to forgone sales of tools, it appears that the store will be better off by $4,500
(i.e., $20,000 - $15,500) if garden supplies are dropped.
Link to PRACTICE
Ronald H. Coase’s Contribution costs are relevant to every decision because they are
to Incremental Analysis incremental costs.
While Coase thought his ideas where somewhat
Ronald H. Coase was one of the early academics to
obvious (especially to academics), he had critics. Indeed,
state that the approach to solving all business problems
S. W. Rowland, the head of the accounting department at
involves incremental analysis. In 1938, while he was on
the London School of Economics, gave his colleague a
the faculty of the London School of Economics, Coase
public rebuke in an address where he criticized Coase’s
wrote a series of 12 articles published in the Accountant
emphasis on opportunity costs. As Coase wrote in a
titled “Business Organization and the Accountant.” In
1989 article published in the Journal of Accounting and
the articles, Coase laid out his thinking on incremental
Economics (“Accounting and the Theory of the Firm”),
analysis and decision making. (A shortened version of
Rowland “opened his reference to my articles with the
these articles is available at www.econlib.org/library/
following sentences: ‘If I particularize I do so with pure
NPDBooks/Thirlby/bcthLS5.html.)
objectivity. I notice cases where the impact of economic
In the series of articles, Coase wrote, “The first
studies on accounting lays greater emphasis on the
point that needs to be made and strongly emphasized
speculative element than on experiences.’ He then pro-
is that attention must be concentrated on the variations
ceeded to ridicule the opportunity cost concept after
which will result if a particular decision is
completely misunderstanding what I had
taken, and the variations that are relevant
said.”
to business decisions are those in costs
Later in his career, Coase received
and/or receipts.” In other words, the
wide recognition for his research, espe-
costs and incremental revenues relevant
cially his work on transaction costs and
to business decisions are incremental
property rights, and in 1991 he was
costs and incremental revenues. Coase
awarded the Nobel Prize in Economics.
also went on to clarify that opportunity ©AP/Wide World Photos
T e s t y o u r K NO W L E D G E
Which of the following is true?
a. Opportunity costs are never incremental costs.
b. Opportunity costs are always incremental costs.
D e c i s i o n s I n v o l v i n g J o i n t C o s t s 269
Learning Decisions Involving Joint Costs

Objective 2
When two or more products always result from common inputs, they are known as joint
Analyze decisions
products. The costs of the common inputs are referred to as joint costs. Joint costs are
involving joint costs,
common in the food processing, extractive, and chemical industries. For example, in the
and discuss the
dairy processing business, the common input of raw milk is converted into cream, skim
importance of qualitative
milk, and whole milk. For lumber companies, the common input of a log is converted
considerations in
into various grades of lumber. For fuel companies, the common input of crude oil is
management decisions.
converted into a variety of fuels and lubricants.
A graphical treatment of a joint products and joint costs problem is presented in
Illustration 7-11. In the illustration, joint costs are incurred, leading to two joint prod-
ucts. The stage of production at which individual products are identified is referred to
as the split-off point. Beyond this point, each product may undergo further separate
processing and may incur additional costs.
Allocation of Joint Costs

For financial reporting purposes, the cost of the common inputs must be allocated to the
joint products. However, care must be taken to ensure that the resulting information does
not mislead managers about the profitability of the joint products. For example, suppose
a lumber company spends $600 for an oak log and $20 to saw the log into two grades of
lumber. The process results in 500 board feet of grade A lumber that sells for $1 per board
foot and 500 board feet of grade B lumber that sells for $0.50 per board foot. How should
the $620 joint cost be allocated to the joint products? One approach might be to allocate
the cost based on the physical quantity of output. Since the production process results in
equal quantities of physical output, it might seem reasonable to allocate an equal share of
the joint cost to each of the grades of lumber. In this case, both the grade A lumber and the
grade B lumber would show a cost of $310. This allocation could lead managers to think
that grade B lumber is not profitable and should be scrapped—after all, its cost is $310,
while revenue from its sale is only $250. But this logic is faulty. If the grade B lumber were
scrapped, the company would lose $250 that helped cover the joint cost of $620.
It is important to realize that the total joint cost will be incurred no matter what the
company does with the joint products beyond the split-off point. Because the joint cost
Illustration 7-11 Further
Joint costs and joint products Processing Cost
(Separate Input Process)
Split-off
Point
Wo o d
P reser vat i v
Grade B Grade B
Lumber Treated with preservative
Grade A
Joint Cost Lumber
(Common Input
Process)
is not incremental to production of an individual joint product, it is irrelevant to any

decision regarding an individual joint product. However, the joint cost is relevant to deci-
sions involving the joint products as a group. If the total revenue from the sale of the joint
products is less than the joint cost, production of all of the joint products should cease.
A better way of allocating the joint cost is to use the relative sales value method.
With this method, the amount of joint cost allocated to products depends on the relative
sales values of the products at the split-off point:
Joint cost allocated Sales value of A

= × Joint cost
to product A Sales value of A + Sales value of B
Joint cost allocated Sales value of B

= × Joint cost
to product B Sales value of A + Sales value of B
In the previous example, the grade A lumber would receive an allocation of $413.33
[i.e., $620 × ($500 ÷ $750)]. The grade B lumber would receive an allocation of $206.67
[i.e., $620 × ($250 ÷ $750)]. A good feature of this method is that the amount of joint
cost allocated to a product cannot exceed its sales value at the split-off point (unless
the amount of joint cost is greater than the sales value of the joint products, in which
case they should not be produced). Thus, products that make a positive contribution to
covering joint cost will not look unprofitable.
The costs allocated to the two grades of lumber using the physical quantity and the
relative sales value approaches are compared in Illustration 7-12. In particular, note that
for grade B lumber, the physical quantity approach yields a negative gross margin of
$60, whereas the relative sales value approach yields a positive gross margin of $43.33.
Link to PRACTICE
The Sunk Cost Effect Wisconsin ski trip are for the same weekend! It’s too late to
sell either ticket, and you cannot return either one. You must
When managers make decisions, they need to be careful use one ticket and not the other. Which trip will you go on?
that they are not influenced by sunk costs. That’s difficult
because, psychologically, people are predisposed to More than half of the respondents chose the Michigan trip,
take sunk costs into account. Psychologists refer to this even though the Wisconsin trip was identified as more
“irrational” economic behavior as the sunk cost effect. enjoyable. Based on this result and other experiments, Arkes
Consider an immensely expensive waterway project that and Blumer suggest that the psychological justification for
was scheduled for congressional review. Proponents the irrational behavior is a desire not to appear wasteful.
of the project suggested that its elimination would be Arkes and Blumer also presented the question
inappropriate because so much money had already been above to a group of students enrolled in an economics
spent on its completion. That is, proponents rationalized course where they had studied the concept of sunk cost.
continuation of the project in terms of sunk costs! Even in this group, about a third favored the Michigan
Two psychologists, Hal Arkes and Catherine Blumer, trip. Apparently, training in economics does not greatly
have investigated the sunk cost effect. In a research lessen the sunk cost effect. However, I gave the question
study, they presented 61 college students in Ohio and to a group of students who had studied sunk cost in
Oregon with the following question: their managerial accounting course. Almost none of the
students selected the Michigan trip. Maybe accounting
Assume that you have spent $100 on a ticket for a weekend instructors are effective in getting across the message—
ski trip to Michigan. Several weeks later you buy a $50 ticket
Beware of sunk costs when making decisions!
for a weekend ski trip to Wisconsin. You think you will enjoy
the Wisconsin ski trip more than the Michigan ski trip. As Source: H. R. Arkes and C. Blumer, “The Psychology of Sunk
you are putting your just-purchased Wisconsin ski trip ticket Cost,” Organizational Behavior and Human Decision Processes
in your wallet, you notice that the Michigan ski trip and the 35, 1985, pp. 124–140. Reprinted by permission of Elsevier.
Q u a l i t a t i v e C o n s i d e r a t i o n s i n D e c i s i o n A n a l y s i s 271
Illustration 7-12
Joint cost:
Comparison of physical
quantity and relative sales
Cost of log $600.00
value approaches to Cost of sawing 20.00
allocation of joint costs Total $620.00
Joint process yields:
500 board feet of grade A lumber selling for $1.00 per board foot
500 board feet of grade B lumber selling for $.50 per board foot
Results using physical quantities to allocate joint costs:
Grade A Grade B
Sales revenue
500 b.f. × $1.00 $500.00
500 b.f. × $.50 $250.00
Cost
$620 × (500 b.f. ÷ 1.000 b.f.) 310.00
$620 × (500 b.f. ÷ 1.000 b.f.) 310.00
Gross margin $190.00 ($ 60.00)
Results using relative sales values to allocate joint costs:

Grade A Grade B
Sales revenue
500 b.f. × $1.00 $500.00
500 b.f. × $.50 $250.00
Cost
$620 × ($500 ÷ $750) 413.33
$620 × ($250 ÷ $750) 206.67
Gross margin $ 86.67 $ 43.33
Additional Processing Decisions and Joint Costs

Suppose the manager of a lumber company is considering whether to pressure treat grade B
lumber so that it will be resistant to rot. The additional processing costs per board foot will be
$0.20. The pressure-treated lumber can be sold for $0.75 per board foot, compared with $0.50
for untreated lumber. Should the additional processing be undertaken? Ask yourself, “What
will be the incremental revenue and the incremental costs?” The incremental revenue will be
$0.25 per board foot (i.e., $0.75 - $0.50). The incremental cost will be $0.20. Therefore, the
incremental profit will be $0.05, indicating that the further processing is warranted.
Where do the joint costs enter into this decision? They don’t, because they are not
incremental! Whether further processing will take place or not, the company must obtain
a log and cut it into grade A and grade B lumber (unless the company wants to get out
of the business of producing both grades of lumber).
Qualitative Considerations
in D ecision Analysis
The solutions to the problems just presented have focused on the quantitative features of the
decision situations. In particular, we have concentrated on quantitative differences in costs
and revenues among decision alternatives. However, most important problems have one or
more features that are very difficult, if not impossible, to quantify. These qualitative aspects
of the problem must receive the same careful attention as the quantitative components.
The importance of qualitative considerations can be illustrated in the context of the
make-or-buy decision discussed earlier. Recall that the Tennessee plant of the General
Refrigeration Company was considering whether to continue producing compressors or
purchase them from another firm. The goal of our analysis was to determine whether
Link to PRACTICE
Qualitative Considerations ocean freight is generally the preferred means of deliv-
in Outsourcing to China ering goods. This can add 4 to 6 weeks to delivery
time compared to shipments by truck and rail inside
Labor rates in China are about 10 percent of those in the
the United States. Because of this long delivery time,
United States, and raw material costs may also be much
high-volume shipments are the norm.
lower. Therefore, it’s not surprising that many U.S. com-
This, however, leads to higher inventory holding
panies have outsourced manufacturing to China even
costs. And the U.S. buyer faces a risk that inventory may
though transportation costs back to the United States
become obsolete before all of it is sold. Also, consider
may be significant.
the risk of a manufacturing defect in the shipment. That’s
However, companies that are considering out-
obviously a much greater problem when the volume is
sourcing should give careful consideration to qualitative
20,000 units as opposed to 500.
factors (those factors that are very difficult or impossible
to quantify). For example, it may be that the items pro- Source: Adapted and reprinted with permission from “The
duced in China are of somewhat lower quality, which China Syndrome” by Mitchell Quint and Dermot Shorten
could damage a U.S. company’s reputation. Other from the Spring 2005 issue of Strategy & Business magazine,
published by Booz & Comp. Inc, Copyright © 2005 All rights
problems may arise because, when buying from China, reserved www.strategy-business.com.
it would cost General Refrigeration more to produce the compressors or to buy them
from an outside supplier. However, our analysis only considered the easily quantifiable
differences in costs between the two decision alternatives. In addition, there are qualita-
tive benefits and costs associated with using an outside supplier.
Perhaps the primary benefit of using an outside supplier is that the adverse effect
of a downturn in business is less severe. Suppose there is a temporary downturn in the
demand for refrigeration units. In this case, General Refrigeration can simply order fewer
compressors from its outside supplier, thus avoiding a major cost. In contrast, if General
Refrigeration continues to manufacture the compressors and a temporary downturn in
business is experienced, it is much more difficult to eliminate some of the fixed costs
associated with manufacturing the compressors. For example, the company probably
cannot eliminate the fixed costs of supervisors if the downturn is thought to be only
temporary. Experienced supervisors are difficult to find, and they cannot be hired and
fired based on temporary fluctuations in business.
A disadvantage of using an outside supplier is the associated loss of control over
the production process. Purchased items may not be of sufficiently high quality, and
delivery schedules may not be honored. Furthermore, knowing that it would be costly
for the company to restart internal production, the outside supplier may believe that it
has the company over a barrel and that it can raise prices significantly in the future. Also,
employee morale may suffer when a company decides to purchase a component outside
and employees are fired or transferred as a result. The cost to the firm of reduced morale
is difficult to quantify, but it may have a significant effect on the quantity and quality of
the products produced by remaining employees.
Decision Making
Throughout the book, and in particular in this chapter, we’ve stressed the idea that
Insight
decision making relies on incremental analysis. A problem with implementing this
approach, however, is that some incremental costs and incremental benefits are very
difficult to quantify. What if a decision has a negative impact on employee morale?
How will we quantify this as an incremental cost? Or what if a decision has a positive
impact on customer satisfaction? How do we go from knowledge of this qualitative
benefit to an estimate of incremental revenue? Whenever you make a decision,
carefully think about items that are difficult to quantify. These so-called qualitative
factors may be the most important aspect of the decision.
A p p e n d i x 273

Learning Objective 1 Explain the role of incremental Learning Objective 2 Analyze decisions involv-
analysis (analysis of incremental costs and revenues) ing joint costs, and discuss the importance of quali-
in management decisions, and define sunk cost, tative considerations in management decisions.
avoidable cost, and opportunity cost and understand Joint costs are the costs of common inputs that result in two or
how to use these concepts in analyzing decisions. more joint products. Joint costs are not relevant to analyzing
Decisions involve a choice between two or more alternatives. decisions that involve only one of the joint products, because
The best decision can be determined by comparing alternatives they are only incremental to producing all of the joint products.
in terms of the costs and revenue items that differ between In analyzing decisions related to further processing beyond the
them. These costs and revenues are referred to as incremental split-off point, consider only the incremental revenue (the extra
costs and revenues. revenue related to further processing) and incremental costs
Sunk costs are costs that have been incurred in the past and are (the costs incurred beyond the split-off point).
irrelevant to present and future decisions. Avoidable costs are costs A variety of qualitative factors (e.g., quality of goods,
that can be avoided by taking a particular action. The term oppor- employee morale, and customer service) need to be considered
tunity cost refers to the benefit forgone by selecting a particular in making a decision. Qualitative factors are often even more
decision alternative over another. Avoidable costs and opportunity important than costs and benefits that are easy to quantify.
costs are always incremental and relevant in decision analysis.
Appendix
Learning The Theory of Constraints

Objective A1
In this chapter, we focused on the general approach to decision making: incremental analysis.
Understand the five-step Here we discuss decisions related to constraints and show how large increases in profit can be
approach to the Theory achieved by elimination of bottlenecks in production processes. Specifically, we will focus on the
of Constraints (TOC). Theory of Constraints (TOC), which is an approach to production and constraint management
developed by Eli Goldratt.2
To facilitate our discussion, let’s consider the production process of Dwyer Electronics, a
producer of electronic measurement instruments. Production takes place in four departments,
as indicated in Illustration A7-1. Subassemblies are produced in Departments 1 and 2. The sub-
assemblies are transferred to Department 3, which makes and tests connections and installs the
subassemblies in housing units. Units are then transferred to Department 4, which completes final
testing and packages units for shipping.
THE FIVE-STEP PROCESS OF TOC

Goldratt specifies a five-step process for dealing with constraints. In this section, we discuss the
steps.
Step 1: Identify the Binding Constraint

The first step in the TOC process is to identify the bottleneck or binding constraint. This is the
process that limits throughput. (Throughput is the amount of inventory produced in a period.)
Every manufacturing company has a binding constraint unless capacity in all departments exceeds
2
For additional information on TOC, see E. Goldratt and J. Cox, The Goal (Croton-on-Hudson, NY:
North River Press, 1984). Also see D. Smith, The Measurement Nightmare, How the Theory of Constraints
Can Resolve Conflicting Strategies, Policies, and Measures (Boca Raton, FL: St. Lucie Press/APICS Series on
Constraints Management, 2000).
Illustration A7-1 Department 1

Production flow at Dwyer
Electronics Produce subassembly
Department 3 Department 4
Make and test Test,

connections, install package,
housing units and ship
Department 2
Produce subassembly
demand for the company’s product. And in this case, demand is the binding constraint. For Dwyer
Electronics, let’s assume that Department 3 is the bottleneck. Management has identified this
department as the bottleneck since production from Departments 1 and 2 is stacking up in front
of the Department 3 work area.
In the TOC, the department that is the bottleneck is equated to a drum since it “beats a
rhythm” that coordinates the production in other departments. At Dwyer Electronics, the pro-
duction in Departments 1 and 2 should be tied to the needs of Department 3. Even though they
can produce more than Department 3, there is no need for them to do so. Production beyond the
needs of Department 3 just ties up company funds in excess work-in-process inventory.
Step 2: Optimize Use of the Constraint

The second step is to optimize use of the constraint. This requires that the company use the
constraint to produce products with the highest contribution margin per unit of the constraint.3
Consider the following two testing instruments produced by Dwyer:
Model A70 Model B90
Selling price per unit $1,000 $2,000

Variable costs per unit:
Direct materials 400 900
Direct labor 200 300
Contribution margin per unit 400 800
Fixed costs per unit 100 300
Profit per unit $ 300 $ 500
Time to complete 1 unit in Dept. 3 .1 hour .3 hour
Contribution margin per hour in Dept. 3 $4,000 $2,667
($400 ÷ .1 hour) ($800 ÷ .3 hour)
Which product optimizes use of the constraint, Model A70 or Model B90? The answer
is Model A70. Note that its contribution margin is $400 per unit but it only takes .1 hour to
produce a unit in Department 3, which is the constrained department. Thus, each hour this
product generates $4,000 of incremental profit. So if managers of Dwyer face a choice between
using scarce time in Department 3 to produce Model A70 or Model B90, they should definitely
choose Model A70.
3
Goldratt takes the somewhat extreme position that the only variable cost is material. While this is
undoubtedly true in some situations, it is also undoubtedly true that in other situations, additional cost
elements are variable. For example, in the production of aluminum, which requires a great deal of electricity,
power is clearly a variable cost.
A p p e n d i x 275
Step 3: Subordinate Everything Else to the Constraint

The third step is to subordinate everything else to the constraint. This means that managers of
Dwyer should focus their attention on trying to loosen the constraint and not concentrate on
process improvements in other departments. Why, for example, should managers work to improve
processes 1, 2, or 4 if they are not limiting production? Only the binding constraint limits produc-
tion, and attention should be focused completely on this department.
There are a number of things that managers can do to loosen the constraint in Department 3.
For example, suppose the workers in Department 3 all take their breaks at the same time. Capacity
could be gained by staggering breaks. And note that this would generate substantial sums of money.
Product Model A70 generates $4,000 per hour. If breaks are staggered and the company gains an
hour a day of additional capacity in Department 3, then it is generating an additional $20,000 of
profit per week (5 hours × $4,000 per hour).
Step 4: Break the Constraint

The fourth step in the TOC process is to break the constraint. This can be accomplished in many
ways. Here are some examples:
• Cross-train workers in Departments 1 and 2 so they can help out in Department 3.
• Outsource some of Department 3’s work.
• Purchase additional equipment for Department 3.
• Hire additional workers for Department 3.
• Train workers in Department 3 so that they can perform their jobs more efficiently.
Step 5: Identify a New Binding Constraint

The final step is to identify a new binding constraint. Once the constraint is broken in Department 3,
either Department 1, 2, or 4 will become the bottleneck. Or, if the company has excess capacity in
all departments, it should focus its attention on building demand.
IMPLICATIONS OF TOC FOR INSPECTIONS, BATCH

SIZES, AND ACROSS-THE-BOARD CUTS
TOC has implications for a number of decisions faced by managers. Here we’ll discuss three:
implications for inspections, batch sizes, and across-the-board cuts.
Inspections. Time in a constrained department should never be wasted. Thus, whenever

possible, inspections should take place before work is transferred to a constrained department.
That way, the valuable time of the constrained department will not be wasted working on
defective items.
Batch Sizes. In recent years, many companies have gone to small batch sizes to gain flexi-
bility in responding to new orders and to avoid producing large quantities of defective items
if a process goes out of control. However, when a production process is a binding constraint,
it may be better to have large batch sizes. The reason is that then the valuable time of the
constrained department is not wasted setting up equipment for numerous small batches of
production.
Across-the-Board Cuts. The decision to have across-the-board cuts is completely at odds with
TOC. Cuts in nonbottleneck departments may make sense, but across-the-board cuts, even to
the department that is the binding constraint, can have a severe, negative impact on profit. Recall
that at Dwyer Electronics, each hour gained in Department 3 results in $4,000 of incremental
profit if the time is spent producing Model A70. Likewise, each hour lost reduces profit by $4,000.
If an across-the-board cut reduced capacity by the equivalent of just an hour a day, more than
a $1 million of profit would be lost in a year (1 hour × 5 days per week × 52 weeks × $4,000 per
hour = $1,040,000).
276 c h a p t e r 7 T h e U s e o f C o s t I n f o r m a t i o n i n M a n a g e m e n t D e c i s i o n M a k i n g
You get what you You Get What You Measure and TOC
M e a s u r e
As you know, a major theme of this book is: “You get what you measure!” In other words, per-
formance measures drive the behavior of managers. TOC points out that performance measures
related to production volume (e.g., units produced per hour) can have a negative impact on share-
holder value when they are applied to nonbottleneck departments. Suppose at Dwyer Electronics, the
company measures and rewards Departments 1 and 2 for units produced per hour. In this case, the
departments have an incentive to produce more items than Department 3 can deal with since it is
a bottleneck. The result will be large levels of work-in-process inventory accumulating in front of
Department 3. That excess inventory is an investment of shareholder funds, but shareholders will
not receive a reasonable return on the investment since it serves no useful purpose. Remember: Be
careful of performance measures that encourage overproduction in nonbottleneck departments!
Review Problem 1
Bainbridge Harbor Service currently operates a walk-on ferry service between Bainbridge Island
and downtown Seattle. Five days per week, the schedule is as follows:
Morning
7 a.m. Ferry departs Bainbridge, arrives in Seattle at 7:30 a.m. Returns empty to
Bainbridge.
8:15 a.m. Ferry departs Bainbridge, arrives in Seattle at 8:45 a.m.
Evening
5:15 p.m. Ferry departs Seattle, arrives in Bainbridge at 5:45 p.m. Returns empty to Seattle.
6:30 p.m. Ferry departs Seattle, arrives in Bainbridge at 7:00 p.m.
The cost of a round-trip ticket is $30, and only round-trip tickets are sold.
Profit last year was as follows:
Revenue (40 round-trip fares per

day × $30 × 52 weeks × 5 days) $312,000
Depreciation 20,000
Dock rental 12,000
Fuel 62,400
Captain 90,000
Mate 55,000
Bookkeeping 15,000
Miscellaneous 10,400 264,800
Profit $ 47,200
The distance between Bainbridge and Seattle is 5 miles, the boat’s fuel efficiency is 1 mile per gallon,
and the cost of a gallon of fuel is estimated at $4. Bookkeeping costs are fixed, as is the annual
rental of dock space on both sides. Miscellaneous costs vary with miles.
The company is now considering offering a 10 a.m. trip to Seattle on Saturday morning with
a return trip at 3 p.m., on Saturday afternoon. The round-trip fare will remain at $30, and the
company estimates 15 fares per day. A captain will be paid $300 per day, and a mate will be paid
$150 per day.
Req u i r ed
What is the annual incremental profit (loss) associated with the Saturday trips?
Common Cost R
A n sw er
Incremental revenue:
(15 round-trip fares per day × $30 × 52 weeks) $23,400
Incremental costs:
Fuel (5 miles per crossing × 2 × $4 per gallon × 52 weeks) 2,080
Captain ($300 × 52) 15,600
Mate ($150 × 52) 7,800
Miscellaneous (see below) 693
26,173
Incremental loss: ($ 2,773)
Given that there is an incremental loss, the Saturday
trips should not be undertaken.
Current miles per year:

6 crossings per day × 5 miles per crossing × 5 days per week × 52 weeks = 7,800 miles per year.
$10,400 annual miscellaneous ÷ 7,800 miles = $1.3333 per mile.
Miles for Saturday trips = 2 crossings per day × 5 miles per crossing × 52 weeks = 520 miles.
520 miles × $1.3333 = $693.
Review Problem 2
Mayfield Software has a 2,000-square-foot cafeteria located on the lower level of Building 3, the
company’s largest building. The vice president of operations for Mayfield insists that meal prices
be reasonable so workers will stay on campus and avoid wasting time driving to restaurants with
slow service. Employees at Mayfield are generally happy with the quality of food and the level of
service in the cafeteria. Still, Mayfield is considering outsourcing to Regal Food Service. Mayfield
is expanding and realizes that the future success of the company will require increased focus on
its core competencies (and food service is not a core competency!).
A cafeteria profit report for 2017 follows. In the report, the cafeteria is charged $20 per
year per square foot for space and 3 percent of sales for general overhead (to cover the centrally
administered costs of Mayfield Software, such as legal, brand advertising, salary of the CFO, etc.).
All business units receive the same 3 percent charge.
Cafeteria Profit Report for 2017
Sales $1,095,000
Less expenses:
Cost of food and supplies $657,000
Salaries 342,000
Space charge 40,000
General overhead charge 32,850 1,077,850
Cafeteria profit $ 17,150
The terms of the agreement with Regal (which has not yet been signed) call for Regal to provide
similar-quality meals and service at the same prices that were charged in 2017. Regal will use
the current cafeteria space and existing equipment without cost. Regal will keep 96 percent of
sales revenue and remit 4 percent of sales revenue back to Mayfield. Regal will pay for all food
and supplies and hire and pay the salaries of all staff including the cafeteria manager, cooks,
and servers.
Req u ir ed
Evaluate the annual financial impact of the outsourcing decision assuming sales in the coming
year, under Regal, will be the same as in 2017.
An s w er
Incremental Revenue and Costs
Lost sales ($1,095,000)

4% payment from Regal 43,800
Food savings 657,000
Salary savings 342,000
Net effect ($ 52,200)
Food services should not be outsourced since the effect is to reduce profit by $52,200. Note that
the general overhead charge is not included in the analysis because these costs will not actually
change due to the outsourcing decision. Thus, they are not incremental costs.
Key Terms Avoidable costs (263) Incremental cost (256) Opportunity cost (264)
Common costs (265) Incremental revenue (256) Relative sales value method (270)
Differential costs (256) Joint costs (269) Relevant costs (256)
Incremental analysis (256) Joint products (269) Split-off point (269)

1. Differential costs are sometimes referred to as c. Should be allocated based on physical attributes only.
________________ costs. d. None of these answer choices is correct.
2. Which of the following costs should not be taken into 8. A joint product’s cost is $18, which includes $6 of allo-
consideration when making a decision? cated joint cost. Its sales price is $16. In this case:
a. Opportunity costs. c. Relevant costs. a. Profit will improve if the company discontinues
b. Sunk costs. d. Differential costs. production of the product.
b. The company should sell as few of the items as pos-
3. Which of the following is often not a differential cost?
sible to minimize the loss on sales.
a. Material.
c. The data are misleading because the $6 allocated
b. Labor.
joint cost will be incurred even if the product is
c. Variable overhead. discontinued.
d. Fixed overhead. d. All of these answer choices are correct.
4. True or false? Fixed costs are never incremental costs. 9. (Appendix) According to the Theory of Constraints,
5. Which of the following is not relevant when consider- optimizing use of a constraint requires:
ing whether or not to drop a product? a. Production of the product with the highest profit
a. The contribution margin. per unit.
b. Qualitative factors. b. Production of the product with the shortest produc-
tion time.
c. The potential impact on demand for other products.
c. Production of the product with the highest contri-
d. Allocated common costs.
bution margin.
6. Opportunity costs are: d. Production of the product with the highest contri-
a. Never incremental costs. bution margin per unit of the constrained resource.
b. Always incremental costs. 10. (Appendix) True or false? Generally, parts should be
c. Sometimes sunk costs. inspected prior to being sent to a department that is a
d. None of these answer choices is correct. bottleneck.
7. The joint costs incurred in a joint product situation: Answers to Self-Assessment

a. Are incurred before the split-off point. 1. relevant 2. b 3. d 4. false 5. d
b. Are incurred after the split-off point. 6. b 7. a 8. c 9. d 10. true
QUESTIONS 1. What are differential costs and revenues?

2. Why are sunk costs irrelevant in decision making?
3. What are avoidable costs?
4. Why are opportunity costs relevant when making decisions?
5. What is the proper approach to analyzing whether a product line should be dropped?
6. Give an example of a fixed cost that is not sunk but is still irrelevant.
7. What is a qualitative advantage of making rather than buying a component?
8. Why is the relative sales value a more logical basis for allocating joint costs than physical
quantity?
9. (Appendix) Why are batch sizes generally larger in bottleneck departments?
10. (Appendix) Why is the bottleneck department referred to as a drum in the Theory of Con-
straints?
Exercises EXERCISE 7-1. [LO 1] Describe a decision and provide an example of a fixed cost that is incre-
mental in the context of the decision. Then provide an example of a fixed cost that is not incremen-
tal in the context of the decision.
EXERCISE 7-2. [LO 1] Jordan Walken owns and operates an electronics store in Seattle,
ashington. Her accountant has prepared a product line income statement that is reproduced
W
below. (Jordan’s two lines are music devices and accessories.) In preparing the income statement,
the accountant allocated all common costs, including rent, Jordan’s salary and the salary of her two
assistants, utilities, and other common costs based on relative sales (rounded to thousands). Her
reason: “Each product line needs to cover its share of common costs.”
In light of this report, Jordan is considering eliminating accessories and concentrating solely
on the sale of music devices (although, she does not expect an increase in music device sales).
Music Devices Accessories Total
Sales $970,000 $150,000 $1,120,000

Cost of merchandise 705,000 120,000 825,000
Gross margin 265,000 30,000 295,000
Rent 43,000 7,000 50,000
Salaries 198,000 32,000 230,000
Utilities 6,000 1,000 7,000
Other 5,000 1,000 6,000
Total 252,000 41,000 293,000
Income before taxes $ 13,000 ($ 11,000) $ 2,000
Req u i red
Analyze the effect on profit of dropping accessories. Then write a paragraph explaining the role of
common costs in your analysis and how allocation of common costs can lead to the cost allocation
death spiral.
EXERCISE 7-3. [LO 1] Go to the financial glossary Investorwords.com at www.investorwords.

com and look up the phrases sunk cost and opportunity cost.
Req u i red
Why are sunk costs never relevant to a decision whereas opportunity costs are always relevant?
EXERCISE 7-4. Incremental Analysis [LO 1] Rustic Interiors, an interior design company, has
experienced a drop in business due to an increase in interest rates and a corresponding slow-
down in remodeling projects. To stimulate business, the company is considering exhibiting at the
Middleton Home and Garden Expo. The exhibit will cost the company $15,000 for space. At the
show, Rustic Interiors will present a slide show on a laptop, pass out brochures that were printed
previously (the company printed more than needed), and show its portfolio of previous jobs.
The company estimates that revenue will increase by $40,000 over the next year as a result of
the exhibit. For the previous year, profit was as follows:
Revenue $212,500
Less:
Design supplies $18,000
Salary of Samantha Spade (owner) 82,000
Salary of Kim Bridesdale (full-time employee) 56,000
Rent 19,000
Utilities 7,000
Printing of advertising materials 800
Advertising in Middleton Journal 3,000
Travel expenses other than depreciation of autos 3,000
Depreciation of company cars 10,000 202,800
Net income $ 9,700
Req u i r ed
Calculate the impact of the exhibit on company profit. Should the company exhibit at the home show?
EXERCISE 7-5. Incremental Analysis [LO 1] Each year, Knight Motors surveys 7,600 former and
prospective customers regarding satisfaction and brand awareness. For the current year, the com-
pany is considering outsourcing the survey to RBG Associates, which has offered to conduct the
survey and summarize results for $35,000. Craig Knight, the president of Knight Motors, believes
that RBG will do a higher-quality job than his company has been doing but is unwilling to spend
more than $10,000 above current costs. The head of bookkeeping for Knight has prepared the
following summary of costs related to the survey in the prior year:
Mailing $17,500
Printing (done by Lester Print Shop) 6,000
Salary of Pat Fisher, part-time employee
who stuffed envelopes and summarized
data when surveys were returned
(130 hours × $16) 2,080
Share of depreciation of computer and
software used to track survey responses
and summarize results 1,200
Share of electricity/phone/etc. based on
square feet of space occupied by Pat
Fisher vs. entire company 600
Total $27,380
Req u i r ed
What is the incremental cost of going outside vs. conducting the survey as in the past? Will Craig
Knight accept the RBG offer?
EXERCISE 7-6. Incremental Analysis and Opportunity Costs [LO 1, 2] Finn’s Seafood Restaurant
has been approached by New England Investments, which wants to hold an employee recognition
dinner next month. Lillian Sumner, a manager of the restaurant, agreed to a charge of $72 per
person, for food, wine, and dessert, for 175 people. She estimates that the cost of unprepared food
will be $36 per person and beverages will be $14 per person.
To be able to accommodate the group, Lillian will have to close the restaurant for dinner that
night. Typically, she would have served 190 people with an average bill of $56 per person. On a
typical night, the cost of unprepared food is $20 per person and beverages are $17 per person. No
additional staff will need to be hired to accommodate the group from New England Investments.
Req u i red
a. Calculate the incremental profit or loss associated with accepting the New England Investments
group.
b. What was the opportunity cost of accepting the New England Investments group?
c. Should Lillian have considered any qualitative factors in her decision? Explain.
EXERCISE 7-7. Make-or-Buy Decision: Relevant Costs [LO 1] The Tufanzi Furniture Company
manufactures leather furniture. The manufacturing process uses a variety of metal pieces, such
as brackets, braces, and casters. Carla Reid, the resource officer of Tufanzi, has been asked to
determine whether it is advisable to purchase these pieces rather than make them internally (the
current practice). Identify which of the following items are relevant to her decision.
a. The original cost of equipment currently used to make metal pieces.
b. The market value of equipment currently used to make metal pieces.
c. The cost of buying metal pieces from suppliers.
d. The space freed up if metal pieces are not made internally.
e. The salary of the president of Tufanzi Furniture.
f. The quality of the metal pieces made internally.
g. The quality of the metal pieces purchased from suppliers.
h. Depreciation on equipment used to make metal pieces (ignore taxes).
i. The labor contract with production workers.
j. The selling prices of furniture pieces.
EXERCISE 7-8. Make-or-Buy Decision [LO 1] The Howell Corporation produces an executive jet
for which it currently manufactures a fuel valve; the cost of the valve is indicated below:
Cost per Unit
Variable costs
Direct material $ 950
Direct labor 650
Variable overhead 300
Total variable costs $1,900
Fixed costs
Depreciation of building 200
Supervisory salaries 300
Total fixed costs 1,000
Total cost $2,900
The company has an offer from Duvall Valves to produce the part for $2,100 per unit and supply
1,000 valves (the number needed in the coming year). If the company accepts this offer and shuts
down production of valves, production workers and supervisors will be reassigned to other areas
where, unfortunately, they really are not needed. The equipment cannot be used elsewhere in the
company, and it has no market value. However, the space occupied by the production of the valve
can be used by another production group that is currently leasing space for $55,000 per year.
Req u i red
Should the company make or buy the valve?
EXERCISE 7-9. Sunk, Avoidable, and Opportunity Costs [LO 1] Consider the information in
Exercise 7-8 and identify the following statements as true or false.
a. Supervisory salary is an avoidable cost if the company decides to buy the valves.
b. Depreciation of building is an avoidable cost if the company decides to buy the valves.
c. The $55,000 cost of leasing space is an opportunity cost associated with continuing production
of the valve.
d. The depreciation of equipment is an opportunity cost associated with continuing production
of the valve.
e. Depreciation of building is a sunk cost even if the company continues with production of the
valve.
f. Supervisory salary is a sunk cost even if the company continues with production of the valve.
EXERCISE 7-10. Dropping a Product: Relevant Costs [LO 1] E-Teller manufactures ATM ma-
chines. Recently the company has begun manufacturing and marketing a machine that can rec-
ognize customer fingerprints. Demand for this machine is very strong, and the chief executive
officer of E-Teller is considering dropping production of the company’s original model, which
relies on bankcards and passwords. This will give the company increased capacity to devote to the
new model. Which of the following items are relevant to the CEO’s decision to drop the old model
machine?
a. The original cost of equipment used to manufacture the old model.
b. Depreciation of the equipment used to manufacture the old model (ignore taxes).
c. The CEO’s salary.
d. The time it takes to manufacture each model.
e. The production manager’s salary.
f. The selling price of the new model.
g. The variable cost of producing the new model.
h. The cost of retraining personnel to make the newer model.
i. Depreciation of the factory building allocated to the old model.
EXERCISE 7-11. Additional Processing Decision [LO 1] DataPoint, Inc. has decided to discon-
tinue manufacturing its Quantum model personal organizer. Currently the company has a num-
ber of partially completed personal organizers on hand. The company has spent $110 per unit to
manufacture these organizers. To complete each unit, costs of $14 for material and $16 for direct
labor will be incurred. In addition, $10 of variable overhead and $32 of allocated fixed overhead
(relating primarily to depreciation of plant and equipment) will be added per unit.
If the DataPoint Company completes the organizers, it can sell them for $130 per unit.
Another manufacturer is interested in purchasing the partially completed organizers for $107 per
unit and converting them into inventory tracking devices.
Determine whether DataPoint should complete the personal organizers or sell them in their
current state.
EXERCISE 7-12. Make-or-Buy Decision [LO 1, 2] Imperial produces whirlpool tubs. Currently
the company uses internally manufactured pumps to power water jets. Imperial has found that
40 percent of the pumps have failed within their 12-month warranty period, causing huge war-
ranty costs. Because of the company’s inability to manufacture high-quality pumps, manage-
ment is considering buying pumps from a reputable manufacturer that also will bear any related
arranty costs. Imperial’s unit cost of manufacturing pumps is $80 per unit, which includes $18 of
w
allocated fixed overhead (primarily depreciation of plant and equipment). Also, the company has
spent an average of $20 (labor and parts) repairing each pump returned. Imperial can purchase
pumps for $85 per pump.
Req u i red
During 2017, Imperial plans to sell 15,000 whirlpools (requiring 15,000 pumps). Determine
whether the company should make or buy the pumps and the amount of cost savings related to
the better alternative. What qualitative factors should be considered in the outsourcing decision?
EXERCISE 7-13. Dropping a Product Line [LO 1] Computer Village sells computer equipment
and home office furniture. Currently the furniture product line takes up approximately 50 per-
cent of the company’s retail floor space. The president of Computer Village is trying to decide
whether the company should continue offering furniture or concentrate on computer equipment.
Below is a product line income statement for the company. If furniture is dropped, salaries and
other direct fixed costs can be avoided. In addition, sales of computer equipment can increase
by 13 percent without affecting direct fixed costs. Allocated fixed costs are assigned based on
relative sales.
Computer Home Office

Equipment Furniture Total
Sales $1,400,000 $1,100,000 $2,500,000

Less cost of goods sold 900,000 800,000 1,700,000
Contribution margin 500,000 300,000 800,000
Salaries 175,000 175,000 350,000
Other 60,000 60,000 120,000
Less allocated fixed costs:
Rent 13,440 10,560 24,000
Insurance 3,360 2,640 6,000
Cleaning 3,920 3,080 7,000
President’s salary 72,800 57,200 130,000
Other 6,720 5,280 12,000
Net income $ 164,760 ($ 13,760) $ 151,000
Req u ir ed
Determine whether Computer Village should discontinue the furniture line and the financial
benefit (cost) of dropping it.
EXERCISE 7-14. Qualitative Factors in Decision Making [LO 2] For each of the following situa-
tions, indicate a qualitative factor that should be considered prior to making a decision:
a. A company that produces and sells bottled water is considering outsourcing its bottling opera-
tion. The company will still source the water and deliver it to bottling companies.
b. A wine producer is considering dropping its premium brand wine and concentrating exclusively
on less costly wines.
c. A software company currently has a large facility for producing videos used in games and adver-
tisements. The company is considering shutting down the facility and using resources provided
by other companies.
EXERCISE 7-15. Joint Cost Allocation with Physical Quantity of Output [LO 2] Bailey Products
produces two joint products (A and B). Prior to the split-off point, the company incurs costs of
$6,000. Product A weighs 30 pounds, and Product B weighs 120 pounds. Product A sells for $100
per pound, and Product B sells for $35 per pound.
Req u i red
a. Based on a physical measure of output, allocate joint costs to Products A and B.
b. Compare the costs to the selling prices. Should the company sell products whose selling price is
less than the allocated joint cost?
EXERCISE 7-16. Joint Cost Allocation with Relative Sales Values [LO 2] Bailey Products pro-
duces two joint products (A and B). Prior to the split-off point, the company incurs costs of $6,000.
Product A weighs 30 pounds, and Product B weighs 120 pounds. Product A sells for $100 per
pound, and Product B sells for $35 per pound.
Req u ir ed
a. Based on relative sales values at the split-off point, allocate joint costs to Products A and B.
b. Under what condition would the cost allocated using relative sales values be greater than the
selling price of a joint product?
EXERCISE 7-17. Allocating Joint Costs [LO 2] The American Produce Company purchased
a truckload of cantaloupes (weighing 4,000 pounds) for $900. American Produce separated the
cantaloupes into two grades: superior and economy. The superior-grade cantaloupes had a to-
tal weight of 3,200 pounds, and the economy-grade cantaloupes totaled 800 pounds. American
Produce sells the superior-grade cantaloupes at $0.50 per pound, and the economy-grade ones at
$0.20 per pound.
Req u ir ed
Allocate the $900 cost of the truckload to the superior-grade and economy-grade cantaloupes
using the physical quantity method and the relative sales value method.
EXERCISE 7-18. (Appendix) Calculating the Value of Loosening a Constraint [LO A1] At RM
Sharpton, the engraving department is a bottleneck, and the company is considering hiring an
extra worker, whose salary will be $55,000 per year, to mitigate the problem.
With the extra worker, the company will be able to produce and sell 7,000 more units per
year. The selling price per unit is $14. Cost per unit currently is $8 as follows:
Direct material $2.75

Direct labor 1.00
Variable overhead .25
Fixed overhead (primarily depreciation of equipment) 4.00
Total $8.00
R equ i r ed
Calculate the annual financial impact of hiring the extra worker.
Problems PROBLEM 7-1. Decision Making and Ethics [LO 1, Ethics] Joan Paxton, VP of marketing
for Supertone Recording Equipment, has developed a marketing plan for presentation to the
company’s president. The plan calls for television ads, something the company has never used.
As part of her presentation, she will indicate the impact of the TV ads on company profit as
follows:
Incremental sales from increased exposure $9,600,000

Less:
Incremental cost of goods sold $4,200,000
Cost of TV ads 3,100,000 7,300,000
Incremental profit $2,300,000
P r o b l e m s 285
While Joan is quite confident in the cost of the ads and the incremental cost of goods sold if sales
are $9,600,000, she is quite uncertain about the sales increase. In fact, she believes that her estimate
is on the high side. However, she also believes that if she puts in a more conservative estimate, such
as $7,000,000, the president will not go along with the TV ads even though they still will generate
substantial profits at $7,000,000 of incremental sales.
Req u i red
Is it unethical of Joan to bias her estimate of incremental sales on the high side, given that she
believes the ultimate outcome is in the best interest of the company?
PROBLEM 7-2. Incremental Analysis of Outsourcing Decision [LO 1, 2] Oakland College is con-
sidering outsourcing grounds maintenance. In this regard, Oakland has received a bid from High-
line Grounds Maintenance for $300,000 per year. Highline states that its bid will cover all services
and planting materials required to “keep Oakland’s grounds in a condition comparable to prior
years.” Oakland’s cost for grounds maintenance in the preceding year were $309,000, as follows:
Salary of three full-time gardeners $195,000

Plant materials 80,000
Fertilizer 10,000
Fuel 12,000
Depreciation of tractor, mowers, and other
miscellaneous equipment 12,000
Total $309,000
If Oakland College outsources maintenance, it will be able to sell equipment for $30,000, and the
three gardeners will be laid off.
Req u ir ed
a. Analyze the 1-year financial impact of outsourcing grounds maintenance.
b. How will savings in the second year differ from those in year 1?
c. Discuss qualitative factors that should be considered in the decision.
PROBLEM 7-3. Incremental Analysis of Outsourcing Decision [LO 1, 2] Selzer & Hollinger, a
legal services firm, is considering outsourcing its payroll function. It has received a bid from ABC
Payroll Services for $22,000 per year. ABC Payroll will provide all payroll processing, including
employee checks and payroll tax reporting. Selzer & Hollinger’s costs for payroll processing in-
house over the past year were as follows:
Cost Amount
Payroll clerk (part time) $12,000

Annual cost of payroll processing software updates 1,000
Human resources manager’s salary 80,000
Depreciation of computers used in payroll processing 2,000
Annual payroll tax update seminar costs for one employee 1,500
Currently the payroll clerk works only on payroll processing, and will be laid off if payroll is out-
sourced. The human resources manager spends 25 percent of her time currently on payroll-related
issues. The computers would remain and be used for other tasks if payroll is outsourced.
Req u ir ed
a. What is the annual impact of outsourcing payroll? Will the company save money or spend extra
money if payroll is outsourced?
b. What qualitative factors should be considered in this decision?
PROBLEM 7-4. Make-or-Buy Decision [LO 1] For most construction projects, Bradley Heating
and Cooling buys sheet metal and forms the metal into heating/cooling ducts as needed. The
company estimates the costs of making and installing ductwork for the Kerry Park shopping mall
to be as follows:
Materials $35,000
Labor to form ductwork 4,000
Labor to install ductwork 10,000
Miscellaneous variable costs 1,500
Fixed costs allocated based on labor hours 3,000
Total cost $53,500
The fixed costs relate to the company’s building, equipment, and office staff. The company plans to
bill the Kerry Park developer $68,000 for services. Bradley is currently behind schedule on other
projects and is paying a late penalty of $1,200 per day. Walt Bradley, the owner of Bradley Heating
and Cooling, is considering ordering prefabricated ductwork for the Kerry Park job. The prefabri-
cated ductwork will cost $42,000 (including the cost of sheet metal). If Walt buys the prefabricated
ductwork, he’ll be able to reassign workers to another project and avoid five days of late fees.
R equ i r ed
Should Bradley make the ductwork or buy it prefabricated?
PROBLEM 7-5. Keep-or-Buy Decision, Sunk Costs [LO 1, 2] Susan Crossing purchased a used Ford
Focus for $12,000. Since purchasing the car, she has spent the following amounts on parts and labor:
New stereo system $1,500
New paint job 2,500
New tires 1,200
New muffler 250
Total $5,450
Unfortunately, the car needs a few major repairs now; among other things, the brake rotors and
pads must be replaced, and the radiator has sprung a leak. (A new radiator is needed.) The repairs
are estimated to cost $2,500.
Susan has looked around at other used cars and has found a used Honda Civic for $10,500
that is in very good condition and is approximately the same age as the Ford Focus. Susan can sell
the Ford Focus “as is” for $8,500.
R equ i red
a. In trying to decide whether to repair the Ford Focus or buy the Honda Civic, Susan is upset
because she has already spent $17,450 on the Focus. The car seems like it costs too much to sell at
such a large loss. How would you react to her dilemma?
b. Assuming that Susan would be equally happy with either the Ford Focus or the Honda Civic,
should she buy the Civic or repair the Focus? Explain your answer.
c. Are there any qualitative factors that might enter into this decision? Explain.
PROBLEM 7-6. Make-or-Buy Decision [LO 1] The Curtis Corporation is beginning production
of Mighty Mint, a new mouthwash in a small spray container. The product will be sold to whole-
salers and large drugstore chains in packages of 30 containers for $20 per package. Management
allocates $225,000 of fixed manufacturing overhead costs to Mighty Mint. The manufacturing cost
per package of 30 containers for expected production of 100,000 packages is as follows:
Direct material $ 8.00
Direct labor 3.50
Overhead (fixed and variable) 3.50
Total $15.00
P r o b l e m s 287
The company has contacted a number of packaging suppliers to determine whether it is better to
buy or manufacture the spray containers. The lowest quote for the containers is $1.90 per 30 units.
It is estimated that purchasing the containers from a supplier will save 10 percent of direct mate-
rials, 20 percent of direct labor, and 15 percent of variable overhead. Curtis’s manufacturing space
is highly constrained. By purchasing the spray containers, the company will not have to lease
additional manufacturing space, which is estimated to cost $17,000 per year. If the containers are
purchased, one supervisory position can be eliminated. Salary plus benefits for this position are
$72,000 per year.
Req u i red
Should Curtis make or buy the containers? What is the incremental cost (benefit) of buying the
containers as opposed to making them?
PROBLEM 7-7. Additional Processing Decision and Qualitative Factors [LO 1, 2] Mulan
Carpet produced 1,200 yards of its economy-grade carpet. In the coloring process, there was
a pigment defect, and the resulting color appeared to be faded. The carpet normally sells for
$15 per yard: $7 of variable cost per yard and $6 of fixed cost per yard have been assigned to
the carpet.
The company realizes that it cannot sell the carpet for $15 per yard through its normal chan-
nels, unless the coloring process is repeated. The incremental cost of the process is $2 per yard.
However, Practical Home Solutions is willing to buy the carpet in its current faded condition for
$9 per yard.
R equ ired
a. Should Mulan repeat the coloring process or sell the carpet to Practical Home Solutions?
b. Suppose Practical Home Solutions is willing to buy the carpet for $14 per yard if Mulan’s brand
is associated with the carpet by means of a tag indicating the carpet was produced by Mulan (a
highly regarded producer). Would you accept Practical Home Solutions’s offer if you were the
president of Mulan?
PROBLEM 7-8. Additional Processing Decision with a Production Constraint [LO 1] Mega
Chemical Company produces ZylexA and a related product called ZylexB. ZylexB, which sells for
$17.00 per gallon, is made from a base of ZylexA plus additional ingredients. It takes 25 minutes to
manufacture a gallon of ZylexA and an additional 10 minutes to manufacture a gallon of ZylexB.
ZylexA sells for $11.00 per gallon. The cost per gallon of manufacturing ZylexA and the additional
costs to convert it into ZylexB are:
Additional Cost to Convert

ZylexA ZylexA into ZylexB
Material $2.00 $1.75

Labor 2.50 0.50
Variable overhead 2.25 1.10
Both products have been successful, and demand for both products is strong and beyond the
company’s capacity. Since it takes additional time to manufacture ZylexB, the vice president of
production is trying to determine whether ZylexB should be produced.
Req u i red
Which product makes the largest contribution to company profit, given a capacity constraint mea-
sured in terms of production time?
PROBLEM 7-9. Dropping a Product Line [LO 1, 2] Pantheon Gaming, a computer enhance-
ment company, has three product lines: audio enhancers, video enhancers, and connection-speed
a ccelerators. Common costs are allocated based on relative sales. A product line income statement
follows:
Pantheon Gaming
Income Statement
Audio Video Accelerators Total
Sales $1,200,000 $2,450,000 $2,400,000 $6,050,000

Less cost of goods sold 730,000 1,435,000 2,070,000 4,235,000
Gross margin 470,000 1,015,000 330,000 1,815,000
Less other variable costs 53,000 69,000 20,000 142,000
Contribution margin 417,000 946,000 310,000 1,673,000
Less direct salaries 155,000 175,000 65,000 395,000
Rent 11,970 25,830 25,200 63,000
Utilities 4,370 9,430 9,200 23,000
Depreciation 5,890 12,710 12,400 31,000
Other administrative costs 79,230 170,970 166,800 417,000
Net income $ 160,540 $ 552,060 $ 31,400 $ 744,000
Since the profit for accelerator devices is relatively low, the company is considering dropping this
product line.
Req u i r ed
a. Determine the annual impact on profit of dropping accelerator products.
b. Discuss the potential qualitative effects of discontinuing the sale of accelerator products.
PROBLEM 7-10. Drop a Product/Opportunity Cost [LO 1] Midwestern Sod produces two prod-
ucts, fescue grass and Bermuda grass:
Fescue Grass Bermuda Grass
Selling price per square yard $3.00 $3.85

Variable cost per square yard
(water, fertilizer, maintenance) .85 1.57
The company has 130,000 square yards of growing space available. In the past year, the com-
pany dedicated 65,000 square yards to fescue and 65,000 square yards to Bermuda grass.
Annual fixed costs are $130,000, which the company allocates to products based on relative
growing space.
Martha Lopez, the chief financial officer of Midwestern Sod, has suggested that in the com-
ing year, all 130,000 square yards should be devoted to Bermuda grass. The president vetoed her
suggestion, saying, “I know that right now home construction is booming in our area, and we can
sell all the grass we can produce, irrespective of what type. But you know a lot of developers really
like that fescue grass, and I’d hate to disappoint them by not offering it.”
Req u i r ed
What is the opportunity cost of the president’s decision to stick with both types of grass?
PROBLEM 7-11. Drop a Product Decision [LO 1] Lennon Fans manufactures three model fans
for industrial use. The standard selling price and cost of each fan follow:
P r o b l e m s 289
Model 501 Model 541 Model 599
Selling price $6,300 $12,000 $15,200

Unit cost:
Material 1,650 5,450 7,050
Direct labor 850 2,700 4,900
Overhead 880 3,518 7,036
Unit profit (loss) $2,920 $ 332 ($ 3,786)
Essentially, all overhead costs are fixed. Some of the fixed overhead costs are direct costs to partic-
ular models, and others are common fixed costs.
Estimated Total Overhead
Model 501 Model 541 Model 599 Total
Direct fixed $5,000,000 $2,000,000 $1,000,000 $ 8,000,000

Common fixed 5,000,000
Total $13,000,000
Lennon allocates overhead costs to products using a single overhead rate developed as follows.
Estimated total overhead is divided by estimated direct labor cost. This results in an overhead rate
per labor dollar. This rate is used to assign standard overhead to products.
Below are estimates of sales and direct labor. These values imply an overhead rate of $1.3146
per labor dollar ($13,000,000 ÷ $9,889,000).
Model 501 Model 541 Model 599 Total
Estimated unit sales 1,100 2,300 560 3,960

Estimated labor $935,000 $6,210,000 $2,744,000 $9,889,000
Req u i red
a. Because Model 599 is showing a loss, the controller of Lennon has asked you to analyze whether
it should be dropped. You should assume that direct fixed costs will be avoided if a model is
dropped but common fixed costs will not be avoided if the model is dropped.
b. Explain why the method used to allocate costs at Lennon results in unreasonably high charges
to the Model 599 fan.
PROBLEM 7-12. Cost Allocation Death Spiral [LO 1] Carpets Unlimited produces and sells three
lines of carpet: economy, standard, and deluxe. Jeff Choi, the chief financial officer of the company,
has prepared the following report on the profitability in the past year. In the report, fixed costs are
allocated based on yards of carpet.
Economy Standard Deluxe Total
Yards of carpet 30,000 45,000 75,000 150,000

Sales $325,000 $700,000 $1,525,000 $2,550,000
Less variable costs
(dye, yarn, labor, etc.) 175,000 430,000 925,000 1,530,000
Less fixed costs (depreciation,
supervisory salaries, etc.) 162,000 243,000 405,000 810,000
Profit (loss) ($ 12,000) $ 27,000 $ 195,000 $ 210,000
Upon seeing the report, Matt Williams, the president of Carpets Unlimited, suggested that the
company should consider dropping the economy grade and concentrate on the two other lines. Jeff
replied, however, that would lead to the cost allocation death spiral.
Req u i red
a. Revise the report assuming the company drops the economy grade.
b. If either the standard or the deluxe grades is reporting a loss in part a, revise the report assuming
that it is also dropped.
c. Explain what Jeff means by the “cost allocation death spiral.”
PROBLEM 7-13. Joint Costs and Decision Making [LO 2] Sylvan Wood Products purchases
a lder logs for $100 per log. After the bark is stripped, the log is spun on a veneer cutter, which peels
thin layers of wood (referred to as veneer) that are sold to furniture manufacturers for $150 per
3′ × 30′ sheet of veneer. The peeled log (referred to as a peeler) is sold for $50 to companies that use
the logs to construct outdoor play equipment. On average, each alder log yields one 3′ × 30′ sheet
of veneer and (obviously) one peeled log. The cost of processing each log into a sheet of veneer and
a peeled log is $35 in addition to the $100 cost of the alder log. On average, a peeled log weighs
60 pounds, and an average 3′ × 30′ sheet of veneer weighs 10 pounds.
R equ i r ed
a. Suppose Sylvan were to allocate all joint costs based on the weight of the joint products. Calcu-
late expected profit per sheet of veneer and per peeler.
b. The profit per peeler in part a is negative. Does this imply that the company should not sell them?
c. Suppose Sylvan were to allocate all joint costs based on the relative sales values of the joint prod-
ucts. Calculate expected profit per sheet of veneer and per peeler.
d. Briefly explain why the relative sales value approach is the preferred method for allocating joint
costs.
PROBLEM 7-14. Joint Costs and Additional Processing [LO 2] Good Earth Products produces
orange juice and candied orange peels. A 1,000-pound batch of oranges, costing $500, is trans-
formed using labor of $50 into 100 pounds of orange peels and 300 pints of juice. The company
has determined that the sales value of 100 pounds of peels at the split-off point is $350, and the
value of a pint of juice (not pasteurized or bottled) is $0.40. Beyond the split-off point, the cost of
sugar-coating and packaging the 100 pounds of peels is $60. The cost of pasteurizing and packag-
ing the 300 pints of juice is $250. A 100-pound box of candied peels is sold to commercial baking
companies for $600. Each pint of juice is sold for $1.75.
Req u i red
a. Allocate joint costs using the relative sales values at the split-off point, and calculate the profit
per 100-pound box of sugar-coated peels and the profit per pint of juice. Round to the nearest
dollar.
b. What is the incremental benefit (cost) to the company of sugar-coating the peels rather than
selling them in their condition at the split-off point?
c. What is the incremental benefit (cost) to the company of pasteurizing and packaging a pint of
juice rather than selling the juice at the split-off point?
PROBLEM 7-15. Joint Costs [LO 2] Gavin West is a commercial fisherman, and he has just
returned from a trip off the coast of Maine. He has calculated the cost of his catch as follows:
Wages of deckhands $35,000

Gavin’s wage 18,000
Food, medical supplies, etc. 7,000
Depreciation of netting and other equipment 5,400
Depreciation of boat 12,600
Fuel 18,000
Total $96,000
P r o b l e m s 291
Gavin’s nets yielded a catch of 15,000 pounds of salmon, 23,000 pounds of halibut, and 37,000 pounds
of flounder. Salmon sells for $9 per pound, halibut for $6 per pound, and flounder for $3 per pound.
Req u i red
a. Allocate joint costs based on weight. With these costs, what is the profit associated with each
type of fish?
b. Allocate joint costs based on relative sales values. With these costs, what is the profit associated
with each type of fish? (Note: Round percentages to 3 decimal places.)
c. Gavin is considering turning the flounder into fish paste. The incremental cost of this operation
is $10,000. Each pound of flounder yields 1/2 pound of paste, and the paste sells for $6 per pound.
Will Gavin be better off selling the flounder or turning it into paste? What role does the allocated
joint cost play in this decision?
PROBLEM 7-16. Joint Costs [LO 2] Northwest Minerals operates a mine. During July, the com-
pany obtained 500 tons of ore, which yielded 250 pounds of gold and 62,500 pounds of copper.
The joint cost related to the operation was $500,000. Gold sells for $950 per ounce, and copper
sells for $2.50 per pound.
R equ ir ed
a. Allocate the joint costs using relative weight (rounded to 4 decimal places). With these costs,
what is the profit associated with each mineral? What is the drawback of this approach?
b. Allocate the joint costs using the relative sales values (rounded to 4 decimal places). With these
costs, what is the profit associated with each mineral?
c. With the relative sales value approach to allocation, what is the smallest value of joint cost that
would result in copper showing a loss? What is the smallest value of joint cost that would result in
gold showing a loss?
PROBLEM 7-17. (Appendix) Batch Size Decision and Constraints [LO A1] At Dalton Play-
ground Equipment, the powder-coating process is a bottleneck. Typically, it takes approximately
2 hours to switch between jobs. The time is spent cleaning nozzles and paint tanks and recalibrat-
ing equipment. Currently the company runs relatively small batch sizes through the process but is
considering increasing them to reduce setup time.
With small batch sizes, powder coating can process approximately 2,000 units per 8-hour
shift, and products have an average contribution margin of $60. With large batch sizes, powder
coating can process approximately 2,300 units per 8-hour shift.
R equ ir ed
a. Calculate the additional profit associated with running larger batch sizes through the
powder-coating process.
b. What potential problems are created by the larger batch sizes?
PROBLEM 7-18. (Appendix) Managing Constraints [LO 1, A1] Reece Herbal Supplements pur-
chases, in bulk, a variety of dietary supplements that the company bottles, packages, and ships to
health-food stores and drugstores around the country. The company has a good reputation, and its
products are in high demand. Last year the company purchased mechanical packaging equipment
for $300,000 and reduced its shipping department by two people, eliminating an annual salary
expense of $120,000. When it works, the equipment packages product 20 percent faster than the
previous manual system. Unfortunately, the equipment has broken down on many occasions for
up to four hours. Normally (when the packaging equipment is working), the company packages
2,500 bottles per hour, and the average contribution margin per bottle is $0.60. The general man-
ager of operations has suggested that the company rehire the two packaging workers as backup
for the new packaging system. The company president doesn’t think this is a good idea, since the
workers will be “sitting around doing nothing for 30 hours per week!”
Req u i r ed
Comment on the general manager’s suggestion and the president’s reaction. Support your answer
with an estimate of the financial impact of rehiring the two workers.
CASE
7-1 Primus Consulting Group [LO 1, 2]
Primus is a firm of consultants that focuses on process Overhead (computer costs, rent, utilities, paper, copying, etc.) is
reengineering and quality improvement initiatives. North- determined at the start of the year by dividing estimated annual
wood Industries has asked Primus to conduct a study aimed at overhead costs ($2,400,000) by total estimated nonpartner hours
improving on-time delivery. Normal practice for Primus is to (80,000 hours). Approximately 20 percent of the total amount is
bill for consultant time at standard rates plus actual travel costs variable costs. All Primus employees receive a fixed wage (i.e.,
and estimated overhead. However, Northwood has offered a flat there is no compensation for overtime). Annual compensation in
$75,000 for the job. Currently, Primus has excess capacity so it the previous year amounted to the following:
can take on the Northwood job without turning down other
business and without hiring additional staff. If normal practices Per Hour
were followed, the bill would be:
Partner $250
Senior consultant $150
Classification Hours Rate Amount
Staff consultant $ 80
Partner 90 $260 $23,400
Senior consultant 125 $160 20,000 R eq uired
Staff consultant 160 $ 90 14,400
Travel costs 21,000 What will be the effect on company profit related to accept-
Overhead at $30 per nonpartner hour 8,550 ing the Northwood Industries job? What qualitative factors
should be considered in the decision whether to accept the
Total $87,350
job or not?
CASE
7-2 Five Star Tools [LO A1]
(Note: This case relates to the appendix on the Theory of and Betty Spence, vice president of marketing, discussed the
Constraints.) situation. “We’ve got to do something,” Betty began. “If we don’t
Five Star Tools is a small family-owned firm that man- think we can meet a customer’s order deadline, we should turn
ufactures diamond-coated cutting tools (chisels and down the business. We can’t simply keep customers waiting for
saws) used by jewelers. Production involves three major pro- product or we’ll develop a reputation as an unreliable supplier.
cesses. First, steel “blanks” (tools without the diamond coating) You know as well as I do that this would be devastating to our
are cut to size. Second, the blanks are sent to a chemical bath that business.”
prepares the tools for the coating process. In the third major pro- “I think there may be another approach, Betty,” replied Max.
cess, the blanks are coated with diamond chips in a proprietary “Some of our products are exceptionally profitable. Maybe we
process that simultaneously coats and sharpens the blade of each should concentrate on them and drop some of the less profitable
tool. Following the coating process, each tool is inspected and de- ones. That would free up our production resources. Or maybe we
fects are repaired or scrapped. can figure out a way to run more product through the coating
In the past 2 years, the company has experienced significant process. If we could just loosen that constraint, I know we could
growth and growing pains. The company is at capacity in the coat- improve our response time and profitability. I’ll tell you what I’ll
ing and sharpening process, which requires highly skilled workers do. I’ll get the accounting department to prepare an analysis of
and expensive equipment. Because of the bottleneck created by product profitability. That should help us figure out which prod-
this operation, the company has missed deadlines on orders from ucts to concentrate on. And I’ll get the production people think-
several important customers. ing about how to free up some time in coating. We’ll meet early
Maxfield Turner, the son of Frederick Turner, founder of next month and try to get a handle on how to deal with our pro-
Five Star Tools, is the president of the company. Over lunch he duction constraints.”
C a s e 293
R e q uir ed estimates that this action will free up 240 hours in coating and
sharpening ([an average of 5 minutes per hour × 8 hours per
a. What steps can be taken to loosen the constraint in coating
day × 360 operating days per year]/60). Management has calcu-
and sharpening?
lated that the average contribution margin per unit for its prod-
b. Consider Model C210 and Model D400 chisels. Which ucts is $300. The average contribution margin per hour spent in
product should be emphasized if the constraint in coating and coating and sharpening is $850.
sharpening cannot be loosened? Based on this information, estimate the incremental profit per
c. Focusing only on the Model C210 chisel and the model D400 year associated with adding the new inspection station.
chisel, what would be the benefit to the firm of gaining one
more hour of production time in coating and sharpening? Model C210 Model D400
d. In coating and sharpening, the operator begins by inspecting Chisel Chisel
items that have arrived from the chemical bath. If rough edges
or blemishes are detected, the operator smooths and/or buffs the Selling price $500 $850
items before actual coating or sharpening takes place. (Note that Less variable costs:
this process is in addition to the inspection that takes place at a Direct labor $ 85 $180
separate inspection station following coating and sharpening.) Direct material 150 180
Variable overhead 15 250 60 420
In order to save valuable time in coating and sharpening, man- Contribution margin 250 430
agement is considering forming a separate inspection station Less allocated fixed costs 185 230
before the coating and sharpening process. The inspection station
Profit per unit $ 65 $200
can utilize existing smoothing and buffing equipment, and it can
be staffed on an as-needed basis by an employee who normally Time in coating and
works in the chemical bath area, which has excess capacity (so sharpening to
the employee will not be missed for brief periods). Management produce 1 unit .2 hours .8 hours
8
Pricing Decisions, Customer
Profitability Analysis, and
Activity-Based Pricing
Nancy Sanchez, vice president of marketing for Priced Right
Office Supplies, recently attended a management training
seminar where the instructor made the following point:
All customers are not the same—some are highly profitable and some are marginally
profitable at best. To be successful, companies need to analyze the profitability of cus-
tomers. Marginally profitable customers should be charged increased prices or their
business should be dropped. The highly profitable customers—those are the ones you
want to focus on. Direct your marketing campaigns toward them and you’ll be on your
way to achieving major increases in shareholder value!
Driving home from the seminar, Nancy thought about what she had learned and changes
that needed to be made at Priced Right. In particular, she thought about her company’s
approach to pricing. Currently, the company charges all customers a 10 percent markup
over the cost of products ordered. But some customers are much more difficult to deal
with than others. In particular, some customers want frequent deliveries of relatively small
orders. This means that relatively more time is spent picking and packing their orders,
and delivery costs are higher. “What we need to do,” Nancy decided, “is determine the
profitability of our various customers and then come up with a more rational approach to
pricing. First thing tomorrow, I’ll set up a team with members from distribution, marketing,
and accounting to work on customer profitability, measurement, and pricing.”
Pricing decisions are often the most difficult decisions that managers face, and in
this chapter we will examine them in some detail. We begin by discussing the profit-
maximizing price from the standpoint of economic theory. Then we discuss pricing
special orders and prices set by marking up costs as well as determining the target
cost for a new product. We conclude the chapter with a discussion of measuring
customer profitability and activity-based pricing—two topics that relate directly to the
problem Nancy Sanchez is facing at Priced Right Office Supplies.
Antonprado/iStockphoto
Learning Objectives
1 Compute the profit-maximizing price for a product or service, and perform incremental analysis
related to pricing a special order.
2 Explain the cost-plus approach to pricing and why it is inherently circular for manufacturing
firms. Also, explain the target costing process for a new product.
3 Analyze customer profitability, and explain the activity-based pricing approach.
295
296 c h apter 8 P r i c i n g D e c i s i o n s , C u s t o m e r P r o f i t a b i l i t y A n a l y s i s , a n d A c t i v i t y - B a s e d P r i c i n g
Learning The Profit-Maximizing Price

Objective 1
Economic theory suggests that the quantity demanded of a product or service is a func-
Compute the profit- tion of the price that is charged and that generally, the higher the price, the lower the
maximizing price for a quantity demanded. If managers can estimate the quantity demanded at various prices
product or service, and (admittedly a difficult but not an impossible task), determining the optimal price is
perform incremental relatively straightforward. Simply subtract variable costs from price to obtain the con-
analysis related to tribution margin, multiply the contribution margin by the quantity demanded, subtract
pricing a special order. fixed costs, and estimate profit. The price with the highest profit should be selected. This
is much simpler than it sounds. Consider the following example.
Next month, Test Technologies will begin to market a new electronic testing device
called the Model TM20. The variable costs of producing and marketing the device are
$1,500 per unit, and fixed costs are $7,000,000 per year. The market research team at
Test Technologies estimate demand at various prices as indicated in Illustration 8-1.
Note that with a price of $6,000 per unit, the quantity demanded is only 1,000 units
whereas demand increases to 19,000 units if the price is dropped to $2,500 per unit. By
subtracting the variable cost of $1,500 per unit from each price we obtain the contri-
bution margin per unit, which we multiply by the quantity demanded to estimate the
total contribution margin. From the total contribution margin, we subtract fixed costs of
$7,000,000 to obtain a measure of profit. In this case, the optimal price would be $3,500
per unit, because this price yields the highest total profit ($17,000,000 per year).1
The most difficult part of determining the profit-maximizing price is determining
the demand function, which is the relation between price and the quantity demanded.
While this is as much art as science, a number of approaches can be used. For example,
Test Technologies could ask sales managers in various regions to estimate the quantities
they can sell at various prices and then sum their responses to estimate the total quan-
tity demanded at various prices. Or the company could test-market the product with a
number of potential customers and experiment with various prices. From this experi-
ence, the company would extrapolate to the entire market for the product. Still, it must
be admitted that estimating the demand function is quite challenging, and that’s why
Illustration 8-1
Estimating the profit-maximizing price
A B C D=A-C E=B×D F G=E-F
Variable Contribution Total

Price Quantity Cost Margin Contribution
per Unit Demanded per Unit per Unit Margin Fixed Costs Profit
$6,000 1,000 $1,500 $4,500 $ 4,500,000 $7,000,000 ($ 2,500,000)
5,500 2,000 1,500 4,000 8,000,000 7,000,000 1,000,000
5,000 4,000 1,500 3,500 14,000,000 7,000,000 7,000,000
4,500 6,000 1,500 3,000 18,000,000 7,000,000 11,000,000
4,000 9,000 1,500 2,500 22,500,000 7,000,000 15,500,000
3,500 12,000 1,500 2,000 24,000,000 7,000,000 17,000,000
3,000 15,000 1,500 1,500 22,500,000 7,000,000 15,500,000
2,500 19,000 1,500 1,000 19,000,000 7,000,000 12,000,000
1
The approach to pricing in Illustration 8-1 is equivalent to an approach you may have learned in economics;
namely, select a price such that marginal revenue equals marginal cost.
T h e P r o f i t - M a x i m i z i n g P r i c e 297
Link to PRACTICE
Pricing Strategy: Apple’s Approach According to an article in Techpinions, Apple has
to Pricing added a twist to the skimming strategy. It introduces
products at a high price point, but then defends the
While economic theory plays an important role in pricing
price (rather than lowering it to gain penetration) by
decisions, so too does strategy. Two strategic approaches
updating them in future iterations. As an example, the
to pricing are skimming and market penetration. With a
average price of the iPhone remained quite stable for
skimming strategy, the initial price of a product is set higher
6 years.
than competing products. With skimming, a company can
The strategy seems to be working. In 2012, for
take advantage of consumers willing to pay a high price to
example, Apple had 69 percent of all the total profit in
be first to have an exciting new product. This segment is
the mobile phone market. And it obtained this level of
often referred to as early adopters. After introduction, the
performance with only 8 percent market share!
price is lowered to capture additional customers at a lower
price point. With a market penetration strategy, price is Source: John Kirk, “Android’s Penetration vs. Apple’s
set lower than competing products. The idea is to rapidly Skimming Marketing Strategies,” Techpinions (March 21,
achieve high volume and economies of scale. 2013).
© EdStock/iStockphoto
some companies turn to a simple approach: cost-plus pricing, which we discuss later in
the chapter. Now let’s turn to the pricing of special orders and return to a concept we’ve
stressed throughout the book: incremental analysis.
Pricing Special Orders

Companies occasionally receive what are called special orders. These are orders for
goods or services that are not considered part of a company’s normal business. The price
charged for a special order is not expected to affect prices charged in the normal course
of business, and, thus, the price may deviate substantially from what is common. Indeed,
as we’ll see, a company may be better off charging a price that is actually below full cost.
Link to PRACTICE
Pricing Power More Important usiness to a competitor, you’ve got a very good business.
b
Than Management And if you have to have a prayer session before raising the
price by 10 percent, then you’ve got a terrible business.”
Warren Buffett, the widely respected and frequently quoted
Buffett also believes that truly great businesses don’t
CEO of Berkshire Hathaway, has bought or invested in hun
require good management, and he sometimes doesn’t even
dreds of companies. Along the way, he’s become one of
consider who’s in charge when he makes an investment!
the wealthiest individuals in the world. So what does Buffett
look for when he considers an investment opportunity? He Source: Andrew Frye and Dakin Campbell, “Buffett: Not
looks at the company’s pricing power. According to Buffett, Much Stock in Who Runs Company,” The Seattle Times,
“If you’ve got the power to raise prices without losing February 19, 2011, p. A 15.
Decision Making/ Consider a situation faced by Premier Lens Company, which manufactures camera
Incremental lenses. Its lenses are sold through camera shops with a variety of mounting adapters to
Analysis fit most popular 35-millimeter digital cameras. Recently, Blix Camera has asked Premier
to produce 20,000 lenses for its compact 35-millimeter digital camera. The lens is iden-
tical to the Model A lens that Premier currently sells for $85. However, the model to
be produced will substitute the Blix name for the Premier name stamped on the lens.
In the past year, Premier sold 280,000 units of the Model A. However, the company has
been operating at only 75 percent of practical capacity and can easily accommodate pro-
duction of the 20,000 additional units. The standard cost of producing the Model A is $75.
Model A Lens Standard Unit Cost
Direct material $30.00

Direct labor 15.00
Variable overhead 10.00
Fixed overhead 20.00
Total $75.00
Blix Camera has offered to buy the 20,000 lenses for $73 each. Since the total stan-
dard cost is $75, it appears that the special order should be turned down. However, the
incremental analysis presented in Illustration 8-2 indicates that the special order will
make a substantial contribution to company income.
The special-order decision presents two alternatives: accept or reject the special
order. Since the income from the main business is the same under both alternatives, it is
not incremental and need not be considered in the decision. The most obvious incremen-
tal item is the revenue associated with the special order. If Premier accepts the order, its
revenue will increase by $1,460,000. In addition, direct material, direct labor, and variable
overhead will increase by $1,100,000 if the special order is accepted. These costs are
incremental, because they will be incurred if the special order is accepted and they will
not be incurred if the special order is not accepted. Since incremental revenue exceeds
incremental cost by $360,000, it appears to be quite beneficial to accept the special order.
Illustration 8-2
Incremental revenue (20,000 × $73) $1,460,000
Incremental analysis
of special lens order Less incremental costs:
Direct material (20,000 × $30) $600,000
Direct labor (20,000 × $15) 300,000
Variable overhead (20,000 × $10) 200,000 1,100,000
Net benefit of special order $ 360,000
C o s t - P l u s P r i c i n g 299
Note that in the calculation of the net benefit of accepting the special order, none of the
fixed costs of production is considered to be incremental costs. This is because these costs will
be incurred whether the special order is accepted or not. This assumption seems reasonable
given that the Premier Lens Company has excess capacity. However, suppose the manage-
ment of Premier anticipates some increase in fixed costs if the special order is accepted.
By how much could fixed costs increase before acceptance of the special order would be
inadvisable? As long as fixed costs increase by less than $360,000, the excess of incremental
revenue over incremental cost, acceptance of the special order will increase company income.
T est y o u r K NO W L EDGE
Which of the following is true?
a. In pricing special orders, fixed costs typically are not relevant.
b. In pricing special orders, fixed costs typically are relevant.
Learning Cost-Plus Pricing

Objective 2
Perhaps in part because of the difficulty of estimating demand functions, many com-
Explain the cost-plus
panies use so-called cost-plus pricing. With a cost-plus approach, the company starts
approach to pricing and
with an estimate of product cost (typically excluding any selling or adminstrative costs)
why it is inherently cir-
and adds a markup to arrive at a price that allows for a reasonable level of profit. To
cular for manufacturing
illustrate cost-plus pricing, suppose the Chicago Pump Company produces a variety of
firms. Also, explain the
pumps used in the mining industry. The company has recently introduced the Model
target costing process
L50 pump. To produce the pump, the company must incur $1,000,000 of annual fixed
for a new product.
costs and variable costs of $200 per unit. The company estimates that it can sell 10,000
pumps annually and marks up cost by 30 percent. In this case, as indicated in the top
section of Illustration 8-3, the price will be $390 per unit, which includes total cost of
$300 and markup of $90.
The obvious advantage of a cost-plus pricing approach is that it is simple to apply.
Also, if a sufficient quantity can be sold at the specified price, the company will earn a
reasonable profit. However, the approach also has limitations.
Illustration 8-3
Estimated quantity demanded in units 10,000
Cost-plus pricing for
Model L50 pump Total fixed costs $1,000,000
Fixed costs per unit ($1,000,000 ÷ 10,000) $100
Variable costs per unit 200
Total cost per unit 300
Markup at 30% 90
Price $390
Suppose the actual quantity demanded is less (say 9,000 units) 9,000
Total fixed costs $1,000,000
Fixed costs per unit ($1,000,000 ÷ 9,000) $111
Variable costs per unit 200
Total cost per unit 311
Markup at 30% 93
Price $404
An obvious difficulty is choosing what markup percent to use. Is 30 percent an appro-

priate markup, or should 10 percent, 20 percent, or 40 percent be used? Determination
of an appropriate markup requires considerable judgment, and experimentation with
different markups may be necessary before a final decision is reached.
Another problem is that cost-plus pricing is inherently circular for manufacturing
firms.2 You must estimate demand to determine fixed manufacturing cost per unit so
that you can mark up cost to obtain a price. However, the price affects the quantity
demanded; the higher the price, the lower the quantity demanded for most products.
What would happen if demand for the Model L50 pump produced by Chicago Pump
actually turned out to be 9,000 units? In this case, the cost per pump, as indicated in
the bottom half of Illustration 8-3, would increase (because fixed costs would be spread
over fewer units) and the price would be increased to $404. But what will happen to the
quantity demanded when the price is increased? That’s right, fewer units will be pur-
chased, the cost per unit will go up, and the cost-plus price will be increased, resulting
in lower demand! This circular process (increased price, decreased demand, increased
cost per unit, increased price) is obviously not a strategy used by successful companies.
Q: When I was shopping at an office supply store the other day, I noticed that
many product prices end in 99. For example, printer paper sold for $39.99 a case,
ballpoint pens were $7.99 per dozen, and message books were $4.99 each. Why
the focus on 99?
A : Most managers believe that human nature has a significant impact on purchase deci-
sions. And human nature, some believe, makes consumers treat certain digits as extrane-
ous information. Take the case of the paper selling for $39.99 a case. Conventional wisdom
is that although the price is very close to $40 per case, consumers will ignore the 99 and
simply classify the price as being in the $30 range. Alternatively, some managers think that
a price ending in 99 makes a product look like it’s on sale and, therefore, more attractive
to consumers.
LINK TO PRACTICE
Pricing Treasure Hunt Items at Costco Costco, consumers recognize that a Coach handbag (a
treasure hunt type item) selling for $159 is a great deal
Costco has around 4,000 items at each warehouse
since it would be $300 at a department store. Treasure
store. Generally, 3,000 are there every day and 1,000
hunt items keep customers coming back and create a
are referred to as “treasure hunt” items. These items are
positive buzz among consumers.
constantly changing and lead consumers to think they’d
better buy them while they’re shopping or they’ll miss out Source: Brendan Byrnes, “Jim Sinegal on Costco’s Pricing
on a great deal. According to Jim Sinegal, past CEO of Magic,” The Motley Fool (August 8, 2013).
2
Cost-plus pricing is not inherently circular for retail firms. Such firms typically mark up the cost of
merchandise from suppliers, which is a variable cost. They do not mark up fixed cost per unit, which would
require an estimate of the quantity demanded before setting price.
T a r g e t C o s t i n g 301
Target Costing
Manufacturing companies are always searching for ways to cut costs. Unfortunately, once
a new product is designed (the product’s features are specified, detailed engineering plans
are made, and manufacturing of the product is ready to commence), it is very difficult to
make changes that will reduce costs. In fact, it is commonly accepted that 80 percent of
a product’s costs cannot be reduced once it is designed. The primary reason for this state
of affairs is that product features drive costs. Consider the case of KC Home Appliances.
The company is bringing a new coffeemaker to market designed with an automatic burr
grinder, a water filter, and a stainless steel carafe that keeps coffee warm for 6 hours.
These features will largely determine the cost of manufacturing the coffeepot, and it
will be very difficult to reduce them once the coffeepot is being produced. Indeed, costs
related to purchases of equipment to produce the grinders, filters, and carafes are sunk
costs and cannot be changed.
To confront this difficulty, a number of companies have turned to target costing,
which is an integrated approach to determining product features, product price, product
cost, and product design that helps ensure a company will earn a reasonable profit on
new products. The target costing process is presented in Illustration 8-4. The process
Illustration 8-4
The target costing process Specify features and price
Determine desired profit

Change price and/or features
if product cannot be designed
to meet target cost
Target cost =
Price – Desired profit
Design to meet the target cost
Link to PRACTICE
Insull’s Most Radical Innovation Wasn’t But Insull knew that he was building demand and that
Technology—It Was Pricing! the fixed cost per hour would drop, making huge power
stations feasible and profitable.
Samuel Insull was Thomas Edison’s right-hand business
Sir Harold Evans, the author of They Made America
partner, taking care of financing, operations, hirings, fir
(Little, Brown, 2004), refers to this action as “the single
ings, and mergers. In 1892, he left his position with Edison
most significant innovation in the single most important
and became the president of a small electricity producer.
technological advance of the 20th century.” By 1898
The problem for the company back then, as it is for many
Insull had bought out all the power generators in down
companies today, was the mismatch between capacity
town Chicago. Fifteen years later his company, then
and spikes in demand during peak usage hours. Insull
known as Commonwealth Edison, had become the
solved that problem by charging different rates to con
dominant energy company in the Midwest.
sumers to boost demand when usage tended to be slow,
primarily in the evenings when companies were shut down
for the night. It was obvious that Insull was charging Source: Nicholas G. Carr, “Suits to the Rescue,” Strategy +
consumers less than the average cost per kilowatt-hour. Business, Spring 2005, pp. 26–29.
Illustration 8-5
Quantity demanded given features 50,000 units
Target cost of KC
Home Appliances’s Price given features $200
new coffeemaker Required profit margin per unit (30% × $200) 60
Target cost $140
begins with a careful analysis of competing products and customer needs and wants.
This leads to a specification of product features and a price that the company believes
will be attractive to customers, given the product features. Suppose KC Home Appliances
determines that, given the features of its new coffeemaker, it can sell 50,000 units per year
at $200 each. The second step in the target costing process is to specify a desired level
of profit. Suppose that KC wants a profit margin of 30 percent or, alternatively, a profit
of $60. The price and the desired profit determine the target cost, which is $140 (see
Illustration 8-5). Finally, the product engineering department, working with substantial
input from the cost accounting department, develops a detailed design for a product
that can be produced for $140 or less. If the product cannot be produced for $140 per
unit, then the company will reconsider features and price. For example, the company
may decide to slightly lower its price and go with a plastic carafe as opposed to a more
expensive stainless steel carafe.
Companies using target costing often set up cross-functional product development
teams, including staff from engineering, marketing, and cost accounting. This helps
ensure good communication among the parties involved in the product development/
pricing process.
Link to Practice
Target Costing Analyst Position process and necessary analytical support. The Target
at Whirlpool Costing analyst will have a working knowledge of apply
ing the Target Costing process for new and existing
Whirlpool, a leading consumer appliance company with products and will provide support to project analysis
brands such as Amana, KitchenAid, and Maytag, views tasks to facilitate the process enabling project teams to
target costing as crucial to the company’s success. This reach performance and cost targets.
is clear from reading an ad placed online for a product Excellent communication and teaming skills will
target costing analyst: be required for the necessary interfacing with Project
Management and counterparts/management in
The Product Target Costing Analyst will be a highly Marketing, GCD, Finance, Engineering, Manufacturing
visible position, reporting to the Product Target Costing and Procurement. The desired outcome is the initiation
Manager. This role will focus on assisting project teams of a world-class Target Costing process enabling sustain
in the logical and systematic conversion of customer or able competitive advantage in product cost.
product requirements into total affordable system solu
tions through the administration of the Target Costing Source: Posted on Jobing.com, January 22, 2012.
Learning Analyzing Customer Profitability:

Objective 3
Analyze customer prof-
Revisiting the Priced Right Office
itability, and explain the Supplies Case
activity-based pricing Recall that in the chapter opener, Nancy Sanchez, vice president of Priced Right Office
approach. Supplies, wanted to know the profitability of various customers as a basis for setting
prices and targeting marketing campaigns. To accomplish her objective, she needs a
customer profitability measurement (CPM) system. With a CPM system, the indirect
A n a l y z i n g C u s t o m e r P r o f i t a b i l i t y : R e v i s i t i n g t h e P r i c e d R i g h t O f f i c e S u p p l i e s C a s e 303
Illustration 8-6
Graphical presentation of customer profitability measurement
Indirect costs of servicing customers are assigned to cost pools.
Cost pool 1 Cost pool 2 Cost pool 3
Cost drivers
used to
assign costs
Profitability of Profitability of Profitability of
Customer 1 Customer 2 Customer 3
Revenue Cost of goods sold
costs of servicing customers (including the cost of processing orders, the cost of handling
returns, the cost of shipments, etc.) are assigned to cost pools. Using cost drivers, these
costs are then allocated to specific customers. Subtracting these costs and product costs
from customer revenue yields a measure of customer profitability. A graphical presenta-
tion of CPM is presented in Illustration 8-6.
You probably notice a connection between activity-based costing (ABC) presented
in Chapter 6 and CPM. In Chapter 6, we used ABC to allocate costs to products and
services. In this section, we’re going to use ABC to allocate costs to customers so that
we can determine the full cost of serving them. To facilitate our discussion of customer
profitability measurement, we will consider the situation facing Nancy Sanchez at Priced
Right Office Supplies. Assuming her company has a reasonably sophisticated comput-
erized information system, it can easily trace sales revenue and cost of goods sold to
individual customers. The challenging task will be to trace the indirect costs of serving
customers to individual customers.3
Suppose the team that investigated CPM at Priced Right Office Supplies determined
the cost pools and cost drivers indicated in Illustration 8-7. In total, indirect costs
amount to $14,982,400 per year. The first two cost pools relate to the costs of process-
ing Internet orders versus orders placed by phone, fax, or mail. Note that the cost per
Internet order is substantially less ($1.20 per order versus $4.50 per order). The next
cost pool relates to the costs incurred in picking orders from stock in the warehouse.
More time is spent as the number of different items in the order increases since differ-
ent items are stored in different locations in the warehouse, and each line on an order
form relates to a specific item. Thus, the cost driver is the number of line items in an
order. The final three cost pools relate to shipping and packing orders and processing
returned merchandise.
3
See L. Brem and V. G. Narayanan. “Owens and Minor (A) and (B),” Harvard Business School Cases (2000)
for a description of customer profitability measurement at the company Owens and Minor. These cases also
discuss an activity-based pricing system that we will cover at the end of this chapter.
Illustration 8-7
Cost pools and drivers for indirect costs to service customers at Priced Right Office Supplies
Annual Driver Allocation

Cost Pools Annual Cost Cost Driver Quantity Rate
Cost pool related to processing Number of Internet orders 362,000 $1.20

Internet orders $ 434,400
Cost pool related to processing orders Number of fax/phone/
received via phone, fax, or mail 576,000 mail orders 128,000 $4.50
Cost pool related to picking orders Number of line items
from stock in the warehouse 7,200,000 in orders 8,000,000 $0.90
Cost pool related to shipping 720,000 Miles to customer location 2,000,000 $0.36
Cost pool related to packing orders 6,000,000 Weight of order 15,000,000 $0.40
Cost pool related to processing returns 52,000 Number of items returned 65,000 $0.80
$14,982,400
The next step in the customer profitability analysis is to apply the indirect costs to
specific customers. Consider the two customers analyzed in Illustration 8-8. Although
Customers 1 and 2 have about the same level of sales, Customer 2 imposes more than
twice as much indirect costs on Priced Right Office Supplies ($8,294 for Customer 2 ver-
sus $3,498 for Customer 1). This results because Customer 2 places more orders and uses
Illustration 8-8
Customer 1
Customer profitability analysis
for two customers
Revenue $732,600
Gross margin 66,600
Less indirect costs:
165 Internet orders × $1.20 $ 198
20 fax orders × $4.50 90
2,500 line items × $0.90 2,250
1,200 miles × $0.36 432
900 pounds × $0.40 360
210 items returned × $0.80 168 3,498
Customer profit $ 63,102
Profit as a percent of sales 8.61%
Customer 2
Revenue $727,650
Gross margin 66,150
Less indirect costs:
0 Internet orders × $1.20 $ –0–
320 fax orders × $4.50 1,440
5,100 line items × $0.90 4,590
3,300 miles × $0.36 1,188
870 pounds × $0.40 348
910 items returned × $0.80 728 8,294
Customer profit $ 57,850
Profit as a percent of sales 7.95%
A n a l y z i n g C u s t o m e r P r o f i t a b i l i t y : R e v i s i t i n g t h e P r i c e d R i g h t O f f i c e S u p p l i e s C a s e 305
Link to PRACTICE
How to Fix Unprofitable Customers 3. Educate customers to use less-costly services. Discuss
with customers how ordering in small batches,
Before giving up on unprofitable customers, a company
requesting expedited deliveries, and cancelling orders
should consider ways to “fix” them. Here are three sug-
all increase supplier costs. Such discussion may lead
gestions from Jiwoong Shin and K. Sudhir, professors at
to avoidance of these behaviors.
the Yale School of Management:
Source: Jiwoong Shin and K. Sudhir, “Should You Punish or
1. Reduce services. For example, for low profitability Reward Current Customers?” MIT Sloan Management Review
customers, the Royal Bank of Canada will conduct (Fall, 2013).
a check trace taking 3 to 5 days. The same service
for a more profitable customer is 1 day.
2. Charge fees for costly services. For example, some
banks now charge for paper statements while online
statements are free.
the more costly fax method rather than the Internet. Customer 2 also orders a greater
variety of items (indicated by its 5,100 line items), which leads to higher order-picking
costs. Finally, more miles are traveled to deliver orders for Customer 2, and Customer 2
returns more merchandise.
Priced Right Office Supplies could perform the same analysis for all of its customers
and then sort them into groups based on their relative profitability. The most profitable
customers may receive special treatment (e.g., occasional calls/visits from the president
of Priced Right Office Supplies, special discounts or promotions, etc.) to ensure their
continued business. The company may also study the characteristics of the most prof-
itable customers in an effort to gain a better understanding of how to expand business
to similar customers. With respect to the least profitable customers, the company may
increase prices, try to move them to less costly service (e.g., require that they place orders
over the Internet ordering system), or even drop them.
T e st y o u r K N O W L E D G E
A customer profitability measurement (CPM) system:
a. Allocates indirect costs to individual customers.
b. Traces revenue to individual customers.
c. Traces cost of goods sold to individual customers.
d. All of these answer choices are correct.
Link to Practice
Sprint Drops Customers for Excessive Use per month. That rate is 40 times higher than average. After
of Customer Service identifying the customers, Sprint “fired” them! In a letter to
the customers, Sprint stated, “The number of inquiries you
In some cases, customer profitability is negatively impacted
have made to us . . . has led us to determine that we are
by customers making an excessive number of calls to
unable to meet your current wireless needs.”
customer service. Sprint Nextel, the nation’s third largest
wireless service provider, identified 1,000 customers who Source: Samar Srivastava, “Sprint Drops Clients over Excessive
were making an average of 25 calls to customer service Inquires,” Wall Street Journal, July 7, 2007, p. A3.
T est y o u r K NO W L EDGE
Which type of customer is likely to be more profitable?
a. C
ustomer A makes frequent small purchases each month of many different items
via faxed orders.
b. Customer B makes major purchases of a few items each month via the Internet.
Customer Profitability and

Performance Measures
You get what you To focus the attention of managers on improving customer profitability, companies need
M e a s u r e to use performance measures. Remember, as we’ve said many times, “You get what you
measure!”
Here are some examples of performance measures that will grab the attention of
managers and drive them to improve customer profitability:
• Percent of customers who are not profitable
• Dollar loss for customers who are not profitable
• Average profit per customer
• Number of customer service requests per 100 customers
• Percent of customers who return items
• Dollar value of returned merchandise
Consider the measure percent of customers who return items. If this measure is highly
visible and recognized as important, managers will try to reduce it, which in turn, will
improve the profitability of customers. But how do you reduce returns? One approach
may be to train sales people so that they sell the right products to meet customers’ needs.
Or processes may need to be improved in the fulfillment system to ensure that orders
are filled correctly.
Activity-Based Pricing
The same type of information used to analyze customer profitability can form the basis
for an activity-based pricing system. Essentially, activity-based pricing is an approach to
pricing in which customers are presented with separate prices for services they request in
addition to the cost of goods they purchase. This causes customers to carefully consider
the services they request and may lead them to impose less cost on their suppliers. Some
companies refer to activity-based pricing as menu-based pricing since customers are
presented with a menu of prices related to the various services they request in addition
to the products they purchase.
Let’s see how an activity-based pricing system might work at Priced Right Office
Supplies. Suppose that, based on the study of indirect costs presented in Illustration 8-7,
the company set the prices for services indicated in Illustration 8-9. As you can see, the
company proposes to charge customers $1.25 for every order placed via the Internet
whereas phone, fax, or mail orders are priced at $4.75 per order. Each line item in an
order is associated with picking an item from the warehouse, and the company charges
$1 for this activity. Delivery charges are $0.40 per mile ($0.04 higher than cost), packing
A c t i v i t y - B a s e d P r i c i n g 307
Illustration 8-9
Charge for Internet orders $1.25
Activity-based pricing for
indirect cost at Priced Right Charge for phone, fax, or mail orders $4.75
Office Supplies Charge per line item in an order $1.00
Delivery charge per mile $0.40
Packing charge per pound $0.50
Per item restocking charge for
returned merchandise $1.00
is $0.50 per pound ($0.10 higher than cost), and the company charges $1 to restock a
returned item ($0.20 higher than cost).
Some customers might object to this pricing scheme, arguing that the price they
pay for the goods they purchase should cover these costs. There are a number of ways
to deal with this resistance. The company could lower its prices for goods (at least
slightly) and then encourage customers to make fewer but larger purchases to reduce
their overall costs. Customers could also be encouraged to limit the variety of goods they
purchase, since variety leads to separate line items on order forms and higher cost (e.g.,
does the customer really need 10 different pens in four different colors?). Alternatively,
the company might decide just to use the activity-based pricing approach for its less
profitable customers. Then the most profitable customers, who are still paying just for
the goods they purchase, will perceive that they are getting a “break” because they are
valued customers. And the least profitable customers will be paying for the extra costs
they impose on the company.
Decision Making
When making a pricing decision about a product you manufacture, don’t get overly
Insight focused on the current cost per unit. The quantity demanded is affected by the price,
and this quantity changes the cost per unit because fixed costs are spread out over
more or fewer units.
Ideally, you want to determine the price that maximizes profit. The profit-maximizing
approach we learned in this chapter can be difficult to implement because of difficulty
in estimating the relation between the quantity demanded and price. However, at a
minimum, it provides a useful framework for thinking about pricing decisions since it
takes into account price, demand, variable costs, and fixed costs.

Learning Objective 1 Compute the profit-
maximizing price for a product or service, and
costs to determine profit. The price that yields the highest profit
perform incremental analysis related to pricing is the profit-maximizing price.
a special order. Special orders will yield an incremental profit as long as
The first step in computing the profit-maximizing price is to the selling price exceeds the incremental cost of filling the
estimate the quantity demanded at various prices. Then subtract order. Fixed costs that are not affected by the special order
variable costs from price to determine the contribution margin are irrelevant to the decision as to whether the order should
per unit. From the total contribution margin, subtract fixed be taken.
Learning Objective 2 Explain the cost-plus Learning Objective 3 Analyze customer profitabil-
pproach to pricing and why it is inherently circular
a ity, and explain the activity-based pricing approach.
for manufacturing firms. Also, explain the target The profitability of a customer depends not just on what is pur-
costing process for a new product. chased but also on the set of services provided to the customer
In cost-plus pricing, the full cost per unit is determined and (e.g., order processing, shipping, handling returns, etc.). To
price is set by adding a prespecified markup to the cost. This analyze the profitability of a customer, the cost of such services
process is circular for manufacturing firms in that the quantity must be subtracted from the customer’s gross margin. This
demanded, which is needed to estimate full cost per unit, is requires that service costs must be grouped into cost pools and
determined prior to setting the price, which has a major impact related cost drivers must be identified so that the cost per unit
on the quantity demanded. of service can be allocated to specific customers.
Using target costing, companies analyze the marketplace In activity-based pricing, customers are presented with a
and decide on a set of features and a price point for their menu of prices and are charged for services provided to them
product. They subtract a desired profit level from the price to (in addition to being charged for the goods they purchase). The
solve for the target cost. The product is then designed to meet charge for such services usually is determined based on an anal-
the target cost when it is produced. If the target cost cannot be ysis of their costs. Since they are charged for specific services,
achieved, the company may reconsider the set of features and customers will carefully consider the services they request and
the price or decide not to go ahead with the product. may end up imposing less cost on suppliers.
Review Problem 1
Heartland Tools is a large Midwest company that designs and manufactures dies, jigs, fixtures, roll-
form tooling, and special machines. Equipment used by the company includes milling machines,
HeliArc welders, drill presses, hydraulic presses, and heat treatment ovens. Due to intense compe-
tition from foreign companies, the firm currently has substantial excess capacity, and in the prior
year, the company laid off 545 employees.
To price its product, the company estimates design and product costs and marks the total
up by 40 percent to cover administrative and marketing costs and to earn a profit. Product costs
include material, labor, depreciation of equipment, and other overhead. The costs in the “other
overhead” cost pool are primarily fixed costs.
Costs are estimated as follows:
1. Design costs Based on estimated engineering hours times a rate of
$40 per hour.
2. Material Estimate of the actual cost of materials.
3. Labor Estimate of actual direct labor costs (estimate of actual
hours multiplied by the wage rate of employees likely
to be assigned to the job).
4. Depreciation of Based on predetermined overhead rates for each type of
manufacturing equipment. For each type of equipment, the company
equipment divides estimated annual depreciation by estimated
annual hours of use.
Equipment Type Annual Depreciation Annual Hours of Use
Milling $6,000,000 4,000

Welding $2,000,000 8,000
Drill press $1,000,000 5,000
Hydraulic press $4,000,000 4,000
Heat treatment $5,000,000 4,000
5. Other manufacturing Estimated as $50 per direct labor hour.
overhead (i.e., other
than depreciation)
The company is currently pricing a job for Preston Manufacturing. A preliminary bid form indi-
cates the following:
Preliminary/Incomplete Cost Estimate and

Bid for Preston Manufacturing
Material $25,000
Direct labor 28 hours × $25 $ 700
15 hours × $18 $ 270
25 hours × $30 $ 750
Design time 18 hours
Milling time 9.0 hours
Welding time 5.0 hours
Drill press time 7.0 hours
Hydraulic press time 6.5 hours
Heat treat time 2.0 hours
Other overhead ________
Estimated total cost ________
Markup at 40% ________
Bid ________
Req u ir ed
a. Estimate total cost and the bid price with the 40 percent markup.
b. Preston has told Heartland that it will use another supplier if Heartland’s bid is over $50,000.
Heartland’s CFO strongly objects to a $50,000 price since it will not even cover full costs.
Evaluate the CFO’s position. Should the company price the job at $50,000?
A n s we r
a. Cost-Plus Price for Preston Manufacturing
Material $25,000
Direct labor 28 hours × $25 $ 700
15 hours × $18 270
25 hours × $30 750 1,720
Design time 18 hours × $40 720
Milling time 9.0 hours × $1,500 13,500
Welding time 5.0 hours × $250 1,250
Drill press time 7.0 hours × $200 1,400
Hydraulic press time 6.5 hours × $1,000 6,500
Heat treatment time 2.0 hours × $1,250 2,500 25,150
Other overhead 68 direct labor hours × $50 $ 3,400
Estimated total cost $55,990
Markup at 40% 22,396
Bid $78,386
Equipment Annual Annual Overhead

Type Depreciation House of Use Rate
Milling $6,000,000 4,000 $1,500

Welding $2,000,000 8,000 $ 250
Drill press $1,000,000 5,000 $ 200
Hydraulic press $4,000,000 4,000 $1,000
Heat treatment $5,000,000 4,000 $1,250
b. It appears that the only costs that are likely to be incremental are those related to design,
material, and labor. Assuming this is the case, the company will generate an incremental
profit of $22,560 at a price of $50,000. Given that the company is operating below capacity
(and assuming this “low” price does not negatively impact future prices to Preston or other
customers), charging $50,000 for the job is a good decision.

Incremental costs
Design costs $ 720
Material 25,000
Incremental profit $22,560
Review Problem 2
Automated Packaging Solutions is a distributor of high-speed packaging systems that include
conveyor belts, automated wrapping equipment, box loading systems, and other high-speed
equipment. The following steps are required for a “typical” order:
1. Meet with customer to determine requirements.
2. Design a preliminary system.
3. Meet with customer to discuss the preliminary system.
4. Revise design and fax to customer for final approval.
5. Pick components from stock or source from suppliers.
6. Ship to customer.
7. Supply installation service as required. Note that some customers perform the installation
with no help from Automated Packaging Solutions.
While this is a “typical” sequence, some customers simply place orders to replace broken
components or for specific components needed to upgrade their systems. In these cases, no design
work is needed.
Currently, the company prices most orders to achieve a 30 percent gross margin [(Sales -
Component costs) ÷ Sales = 30%]. Put another way, the company marks up component cost by
1.42857. However, the company vice president of marketing, Paxton Taylor, recently attended
a seminar on customer profitability measurement. She is concerned that the approach may be
severely limiting the company’s financial performance. According to the seminar presenter, the
cost-plus approach has a major flaw:
Cost-plus assumes that each customer imposes costs on your company in proportion to product costs.
That’s simply not true. Some customers are great—they buy a product, use it, and come back for more.
Others, well, you know the problem customers. They buy a product, return it, ask for a redesign, want
their order to be expedited and then they want a ton of customer service. You need to identify these
customers and then “fire them” or charge them for the value-added services they demand.
The seminar convinced Paxton that the time was right to implement an activity-based costing
approach to measure customer profitability. She got agreement from the company president and
the CFO and signed an agreement with Activity Analysis Consulting (AAC) to have Brian Hart, a
senior consultant, design a customer profitability measurement (CPM) system.
Paxton was amazed that Brian and his AAC staff were able to develop the CPM system in only
3 days. On the first day, Brian explained the idea of CPM and interviewed employees to determine
key activities and how much time they spend on them. On the second day, Brian finalized a set of
cost pools and drivers and allocated costs to the pools (see Exhibit 1). On the third day, the AAC
staff designed an Excel-based template that Automated Packaging Systems can use to calculate the
profitability of any customer. Later the next week, Brian presented an analysis of three customers
using the new tool (see Exhibit 2).
Common Cost R
Exhibit 1
Cost pools and drivers
Driver Cost per

Activities Annual Cost Driver Quantity Driver Unit
Order processing $ 637,859 No. of orders 16,258 $39.234

Pulling parts from stock 1,485,648 No. of parts picked 113,806 13.054
Shipping 1,405,793 No. of orders 16,258 86.468
Expediting 304,430 No. of expedited orders 4,177 72.882
Problem order activities 104,500 No. of problem orders 2,363 44.223
Engineering 482,351 No. of engineering hours 10,380 46.469
Installation activities 90,879 Hours of installation 1,985 45.783
Business sustaining activities 1,015,650 No. of orders 16,258 62.471
Total overhead $5,527,110
Order processing. Includes labor, depreciation of office equipment, depreciation of building, etc.
Pulling parts from stock. Includes labor, depreciation of equipment, depreciation of warehouse, etc.
Shipping. Includes labor related to packing orders and loading trucks, depreciation of forklift trucks, and payment to shipper.
Expediting. Includes premium for air and next day shipping.
Problem order activities. Estimate calculated as Total wages paid to customer service representatives × Percent of time they spend
on “problem orders”.
Engineering. Includes labor, drafting supplies, depreciation of computers, software, etc.
Installation activities. Includes labor used for installations and expenses related to small tools.
Business sustaining activities. Includes all costs other than cost of components and the seven other cost pools. Items include
executive salaries, accounting and legal expenses, depreciation of the office building and furniture and fixtures, etc.
Exhibit 2
Customer Profitability Analysis
Analysis of three customers
Customer A Customer B Customer C
Actual customer sales $25,000.00 $15,000.00 $2,000.00

Cost of goods sold 17,500.00 10,500.00 1,400.00
Gross margin 7,500.00 4,500.00 600.00
Gross margin percent 30% 30% 30%
Other Cost Drivers
Order processing 1 2 4
Pulling parts from stock 30 10 4
Shipping 1 2 4
Expediting — — 4
Problem order activities 1 — —
Engineering 102 6 —
Installation activities 20 10 —
Business sustaining activities 1 2 4
Other costs 6,279.51 1,243.53 1,096.44
ABC customer profitability $ 1,220.49 $ 3,256.47 ($ 496.44)
Profit percent of sales 4.88% 21.71% -24.82%
Note:
Customer A purchased a single, relatively complex system.
Customer B purchased two relatively simple systems.
Customer C purchased single components on four occasions to replace broken parts. The customer requested
expediting to get their system up and running as quickly as possible.
Req u i red
a. Show the details of the calculation of the “other costs” (amounting to $6,279.51) for C
ustomer A.
b. Paxton Taylor recently stated that she “now knows the true costs of serving each customer.”
Is this the case? What does the term true cost mean to Paxton? What should the term mean?
c. Paxton has now reviewed the profitability of each customer, and she finds that they generally
fit into one of three categories:
• Customers purchasing large, complex systems (like Customer A) whose profit as a percent
of sales ranges from 3 to 7 percent
• Customers purchasing relatively simple systems (like Customer B) whose profit as a per-
cent of sales ranges from 15 to 25 percent and
• Customers purchasing one or two components (like Customer C) who generate a negative
profit
Next week, Paxton will have a meeting with Bill Ruben, CFO, to discuss the analysis. She
believes that Bill will recommend dropping sales to customers who purchase only one or two
components, and she believes that this action will increase company profit.
Do you agree that profit will increase if the company drops Customer C types? Explain.
d. Suppose that at the meeting, Bill Ruben recommends not only dropping Customer C types
but also phasing out sales to Customer A types so that more attention can be paid to the
“sweet spot” (i.e., Customer B types).
Why might Bill’s recommendation hurt the profitability of Automated Packaging
1.
Solutions?
2. What type of analysis would you suggest be performed prior to adopting Bill’s recom-
mendation? Be specific as to what exactly the analysis will involve.
A n sw e r
a. Order processing $ 39.23 (1 × $39.234)
Pulling 391.62 (30 × $13.054)
Shipping 86.47 (1 × $86.468)
Expediting —
Problem order 44.22 (1 × $44.223)
Engineering 4,739.84 (102 × $46.469)
Installation 915.66 (20 × $45.783)
Business sustaining 62.47 (1 × $62.471)
Total $6,279.51
b. True cost is a very nebulous term. There is no “true cost” applicable to all decisions. There
is, however, a true incremental cost applicable to each specific decision. Paxton most likely
means she has a better full cost number where “better” is still a bit vague.
c. The cost associated with Customer C is:
Order processing $ 156.94
Pulling 52.22
Shipping 345.87
Expediting 291.53
Problem order —
Engineering —
Installation —
Business sustaining 249.88
Total $1,096.44
Some of these costs (especially business-sustaining and some order processing costs) will
not go away if the business is dropped. More importantly, if the company doesn’t supply
parts (that’s what C ordered), then they may lose type A and B sales. This suggests keeping C
customers—perhaps with increased prices for shipping and expediting.
C o m m o n C o s t BSe eh laf v- A e sast tme er nnst 313
i osrs P
d. 1. The company may enter a cost allocation death spiral. Much of the costs allocated to A
and C don’t go away and are allocated to B. In other words, the company may lose more
revenue than it gains in cost savings.
2. Not surprisingly, an incremental analysis should be performed. The company needs to
calculate:
• Lost revenue from A and C
• Cost savings from dropping A and C
• Incremental effect on B sales
• Incremental effect on B costs
Key Terms Activity-based pricing (306) Customer profitability measure- Target costing (301)
Cost-plus pricing (299) ment (CPM) system (302)

1. To determine the profit-maximizing price, a manager 6. The formula for target cost is:
must: a. Price - Desired profit.
a. Estimate the quantity demanded for various prices. b. Desired profit ÷ Price.
b. Estimate variable costs. c. Absorption cost × Profit percentage.
c. Estimate both the quantity demanded for various d. Desired profit - Absorption cost.
prices and variable costs.
7. Typically, which departments are involved in setting
d. None of these answer choices is correct. target costs?
2. Cost-plus pricing: a. Engineering.
a. Leads to profit maximization. b. Marketing.
b. Is inherently circular for manufacturing firms. c. Cost accounting.
c. Is difficult to perform. d. All of these answer choices are correct.
d. None of these answer choices is correct. 8. Which of the following is an advantage of cost-plus pricing?
3. Target costing: a. The selection of a markup percent is easily done.
a. Requires specification of desired level of profit. b. The method is simple to apply.
b. Targets specific costs for reduction. c. The cost-plus pricing method is inherently circular.
c. Is used primarily with products that are already in d. All of these are advantages to the cost-plus pricing
production. method.
d. Leads to profit maximization. 9. When is it beneficial for companies to accept an order
4. Customer profitability is measured as: that is priced at less than the product’s full cost?
a. Revenue - Cost of goods sold. a. When the company is operating at capacity.
b. Revenue - Indirect manufacturing costs. b. When incremental revenue exceeds incremental cost.
c. Revenue - Cost of goods sold - Indirect service c. It is always advantageous to have higher sales.
costs. d. It is never beneficial to accept an order that is priced
d. Revenue - Cost of goods sold - Indirect below full cost.
manufacturing costs. 10. Cost-plus pricing includes which of the following costs?
5. With activity-based pricing: a. Manufacturing costs.
a. Customers face a menu of prices for various services. b. Selling costs.
b. Customers are encouraged to consider the costs c. Administrative costs.
they impose on a supplier. d. All of these costs are included in cost-plus pricing.
c. Customers may be charged less if they request less
product variety in their orders. Answers to Self-Assessment
d. All of these answer choices are correct. 1. c 2. b 3. a 4. c 5. d 6. a 7. d 8. b 9. b 10. a
Questions 1. According to economic theory, how would a manager determine the profit-maximizing price
for a product or service?
2. Why is cost-plus pricing inherently circular for a manufacturing firm?
3. To implement target costing for a new product, companies often set up a cross-functional team
with members from engineering, marketing, and cost accounting. Why is a cross-functional
team desirable when implementing the target costing approach?
4. How is cost allocation used in customer profitability analysis?
5. Explain why less profitable customers may become more profitable if a supplier switches to
activity-based pricing.
6. Explain the target costing process. How is it calculated?
7. Explain how the profit-maximizing price is calculated. Why is the profit-maximizing price
extremely difficult to calculate for an actual product?
8. What is a “special order”? How does whether a company is operating at capacity or not matter
in deciding whether to accept the special order?
9. What are the disadvantages of the cost-plus approach to pricing?
10. What is the lowest per unit price on a special order that a company could accept and still not
show a loss from the special order?
Exercises EXERCISE 8-1. [LO 1, 2] Consider a company that manufactures and sells personal computers
(let’s call the company Bell Computers). Recently the company lowered its prices dramatically.
The company is very efficient and needs only 5 days of inventory, collects its receivables within
30 days, and has suppliers who are willing to wait 59 days for payment. A competitor commenting
on the aggressive pricing stated, “We’re in a commodity business, and a price war in a commodity
business is really dumb.”
Req u i r ed
Discuss the competitor’s comment that lowering prices is a dumb move by Bell Computers.
EXERCISE 8-2. [LO 3] The Brindle Corporation is considering an initiative to assess customer
profitability. The company’s CFO, John Bradley, stated his position as follows: “I strongly suspect
that some of our customers are losers—in other words, they’re not covering product costs and
service costs. Think about our Weston account. Weston places a ton of small orders, and they’re
always asking us to expedite them. Then our accounting department has to follow up because
Weston misplaces billing records, which really slows down their payments. We’re going to make
a $1,000,000 investment in CRM [customer relationship management] software to help us assess
customer profitability, but I’m confident that the investment will really pay off when it helps us
identify this type of loser customer.”
The position of the company’s marketing vice president, Jerry Brown, is quite different. “This
$1,000,000 investment is a waste of money. We’ll go through the exercise and find out that some
customers are more profitable than others, but we’re not going to change a thing. Even the less
profitable customers make a contribution to covering overhead, and we’re not going to drop a
single one.”
Req u i r ed
Write one or two paragraphs elaborating on the arguments of the CFO and the marketing vice
president. In your discussion, consider the fact that the bonus compensation of the marketing VP
is based on sales volume. Could this be influencing Jerry’s position?
EXERCISE 8-3. [LO 1] The Portland Brewing Company is a small craft brewer that produces
five standard varieties of beer. The beers sell for $6 per six-pack, and the company currently sells
10,000 six-packs per month.
C o m m o n C o s t B e h a v i o rEP e s 315
x ea rt ct ei sr n
The company is considering producing a seasonal beer that will be sold in October, N ovember,
and December. The company estimates that at $6 per six-pack, the company will sell 2,000 six-
packs. At $7 per six-pack, sales will be 1,000 six-packs. The company also estimates that sales of
the seasonal beer will eat into sales of its standard items. Specifically, for every 1,000 six-packs of
the seasonal beer that are sold, 300 six-packs of the standard varieties will not be sold. The variable
production costs of all beers is $1.20 per six-pack.
Req u i red
Calculate the incremental profit associated with the two selling prices under consideration for the
seasonal beer (i.e., $6 and $7 per six-pack). Should Portland Brewing produce the beer and, if so,
what price should the company charge?
EXERCISE 8-4. Profit-Maximizing Price [LO 1] The editor of Spunk magazine is consider-
ing three alternative prices for her new monthly periodical. Her estimate of price and quantity
demanded are:
Price Quantity Demanded
$7.95 25,000
$6.95 31,000
$5.95 37,000
Monthly costs of producing and delivering the magazine include $95,000 of fixed costs and vari-
able costs of $2.20 per issue.
Req u i red
Which price will yield the largest monthly profit?
EXERCISE 8-5. Profit-Maximizing Price [LO 1] Erin Hamill is the owner/operator of a tanning
salon. She is considering four prices for a weekly tanning pass. Her estimate of price and quantity
demanded are:
Price Quantity Demanded
$12.50 330
$11.50 380
$10.50 390
$ 9.50 430
Monthly costs of providing the tanning service include $1,750 of fixed costs and variable costs of
$2.50 per service.
Req u i red
Which price will yield the largest monthly profit?
EXERCISE 8-6. Analyzing a Special Order [LO 1] PowerDrive produces a hard disk drive that
sells for $175 per unit. The cost of producing 25,000 drives in the prior year was:

Direct labor 475,000
Variable overhead 225,000
Fixed overhead 1,500,000
Total cost $2,925,000
At the start of the current year, the company received an order for 3,000 drives from a computer
company in China. Management of PowerDrive has mixed feelings about the order. On one hand,
they welcome the order because they currently have excess capacity. Also, this is the company’s
first international order. On the other hand, the company in China is willing to pay only $125 per
unit.
Req u i red
What will be the effect on profit of accepting the order?
EXERCISE 8-7. Analyzing a Special Order [LO 1] Budget Tax Service prepares tax returns for
small businesses. The cost of preparing 800 tax returns in the prior year was:
Direct labor $360,000

Fixed overhead 250,000
Total cost $930,000
At the start of the current year, the company received an offer from Advantage Business, a firm that
provides bundled services to businesses. Advantage wants Budget Tax Service to prepare tax re-
turns for its 150 small-business clients. Budget Tax Service has the capacity to prepare up to 1,000
returns in a given year, so this special order would not take away revenue from any of Budget Tax
Service’s current clients. Advantage is willing to pay $900 per tax return.
R equ i r ed
What will be the effect on Budget Tax Service’s profit if it agrees to prepare returns for the 150
clients of Advantage Business?
EXERCISE 8-8. Analyzing a Special Order Service Company [LO 1] Flamingos to Go is a service
company owned by Irvin Vonnet that will “plant” plastic flamingos on a special day in people’s
yards to help celebrate and advertise birthdays, births, anniversaries, and other important mile-
stones. The average delivery is priced at $75. The costs of providing 775 deliveries in the past year
were:
Direct labor $13,950

Fixed overhead (advertising costs, phone service, insurance) 17,000
Total cost $40,250
At the start of the current year, Irv received a phone call from the local Rotary club. The club would
like to contract with Flamingos to Go to have flamingos delivered to the yards of each of its mem-
bers in the upcoming year; this contract would provide an additional 130 deliveries for Flamingos
to Go. However, the club wants a special price since it is ordering a large number of deliveries; it
has said it would like a price of $57 per delivery. Flamingos to Go can make up to 1,000 deliveries
per year without incurring additional fixed costs.
Req u ir ed
What will be the affect on profit if Irv accepts the special order?
EXERCISE 8-9. Cost-Plus Pricing [LO 2] World View is considering production of a lighted
world globe that the company would price at a markup of 25 percent above full cost. Management
estimates that the variable cost of the globe will be $80 per unit and fixed costs per year will be
$240,000.
Req u i red
a. Assuming sales of 1,200 units, what is the full cost of a globe, and what is the price with a 25
percent markup?
b. Assume that the quantity demanded at the price calculated in part a is only 600 units. What is
the full cost of the globe, and what is the price with a 25 percent markup?
c. Is the company likely to sell 600 units at the price calculated in part b?
EXERCISE 8-10. Cost-Plus Pricing [LO 2] The chief engineer at Future Tech has proposed pro-
duction of a portable electronic storage device to be sold at a 30 percent markup above its full cost.
Management estimates that the fixed costs per year will be $210,000, and the variable cost of the
storage device will be $15 per unit.
R equ ir ed
a. Assuming production and sales of 60,000 units, what is the full cost of a storage device, and what
is the price with a 30 percent markup?
b. Assume that the quantity demanded at the price calculated in part a is only 40,000 units and
only 40,000 units are produced. What is the full cost of the storage device, and what is the price
with a 30 percent markup?
c. Compare the selling prices computed in parts a and b; does the selling price increase, decrease, or
stay the same when the number of units produced and sold decreases? Why does this change occur?
EXERCISE 8-11. Target Costing [LO 2] Use the Web and search for information on how compa-
nies are implementing target costing. Find an example of how target costing has actually been used
at a company and summarize that company’s experience in a few paragraphs.
EXERCISE 8-12. Target Costing [LO 2] A cross-functional team at Mazzor Systems is developing
a new product using the target costing methodology. Product features in comparison to compet-
ing products suggest a price of $2,800 per unit. The company requires a profit of 25 percent of
selling price.
Req u ir ed
a. What is the target cost per unit?
b. Suppose the engineering and cost accounting members of the team determine that the product
cannot be produced for the cost calculated in part a. What is the next step in the target costing
process?
EXERCISE 8-13. Target Costing [LO 2] A new product is being designed by an engineering team
at Odin Security. Several managers and employees from the cost accounting department and the
marketing department are also on the team to evaluate the product and determine the cost using a
target costing methodology. An analysis of similar products on the market suggests a price of $150
per unit. The company requires a profit of 35 percent of selling price.
Req u i red
a. What is the target cost per unit?
b. The members of the team subsequently determine that the product cannot be produced for the
cost calculated in part a. What is the next step in the target costing process? Does the new product
get eliminated from consideration now?
EXERCISE 8-14. Target Costing [LO 2] The product design team at New Time Products is in the
process of designing a clock using target costing. Product features in comparison to competing
products suggest a price of $35 per unit. The company requires a profit of 30 percent of selling
price.
Req u i red
a. What is the target cost per clock?
b. Suppose it appears that the clocks cannot be manufactured for the target cost. What are some of
the options that the company should consider?
EXERCISE 8-15. Customer Profitability Analysis [LO 3] Delta Products has determined the fol-
lowing costs:
Order processing (per order) $ 6

Additional handling costs if order marked rush (per order) $11
Customer service calls (per call) $12
Relationship management costs (per customer per year) $3,500
In addition to these costs, product costs amount to 85 percent of sales. In the prior year, Delta had
the following experience with one of its customers, Johnson Brands:
Sales $55,000
Number of orders 250
Percent of orders marked rush 70%
Calls to customer service 160
R equ i r ed
Calculate the profitability of the Johnson Brands account.
EXERCISE 8-16. Activity-Based Pricing [LO 3] Refer to the information in Exercise 8-15. For the
coming year, Delta Products has told Johnson Brands that it will be switched to an activity-based
pricing system or it will be dropped as a customer. In addition to regular prices, Johnson will be
required to pay:
Order processing (per order) $ 7

Customer service calls (per call) $17
R equ i r ed
a. Calculate the profitability of the Johnson Brands account if activity is the same as in the prior
year.
b. Assume that Johnson Brands decides to accept the activity-based pricing system offered by
Delta Products. What changes will likely be made by Johnson?
EXERCISE 8-17. Customer Profitability Analysis [LO 3] The Triumph Corporation has analyzed
its customer and order handling data for the past year and has determined the following costs:
Order processing cost per order $ 9

Additional costs if order must be expedited (rushed) $ 11
Customer technical support calls (per call) $ 13
Relationship management costs (per customer per year) $1,800
In addition to these costs, product costs amount to 80 percent of sales. In the prior year, Triumph
had the following experience with one of its customers, the Julius Company:
P r o b l e m s 319
Sales $22,000
Number of orders 170
Percent of orders marked rush 80%
Calls to technical support 90
Req u i red
Calculate the profitability of the Julius Company account.
EXERCISE 8-18. Activity-Based Pricing [LO 3] Refer to the information in Exercise 8-17. For
the coming year, the Triumph Corporation has told the Julius Company that it will be switched to
an activity-based pricing system or it will be dropped as a customer. In addition to regular prices,
Julius will be required to pay:
Order processing (per order) $11

Technical support calls (per call) $21
R equ ir ed
a. Calculate the profitability of the Julius Company account if activity is the same as in the prior
year.
b. Is it realistic to expect Julius’s activity to be the same this year as the previous year if activity-based
pricing is instituted? How might the Julius Company react to the new pricing scheme? How might
its order behavior change as a result of the new fees?
Problems PROBLEM 8-1. Determining the Profit-Maximizing Price [LO 1] Spencer Electronics has just de-
veloped a low-end electronic calendar that it plans to sell via a cable channel marketing program.
The cable program’s fee for selling the item is 20 percent of revenue. For this fee, the program will
sell the calendar over six 10-minute segments in September.
Spencer’s fixed costs of producing the calendar are $160,000 per production run. The
company plans to wait for all orders to come in, then it will produce exactly the number
of units ordered. Production time will be less than 3 weeks. Variable production costs
are $28 per unit. In addition, it will cost approximately $5 per unit to ship the calendars to
customers.
Marsha Andersen, a product manager at Spencer, is charged with recommending a price for
the item. Based on her experience with similar items, focus group responses, and survey informa-
tion, she has estimated the number of units that can be sold at various prices:
Price Quantity
$85 15,000
$75 20,000
$65 30,000
$55 45,000
$45 65,000
Req u ir ed
a. Calculate expected profit for each price.
b. Which price maximizes company profit?
PROBLEM 8-2. Determining the Profit-Maximizing Price [LO 1] Elite Kitchenware has come
out with a new line of dishes that it plans to test market through a series of demonstrations at
the local mall throughout the month of August. If the demonstrations result in enough sales,
the program will be expanded to other malls in the region. The cost of the demonstrations is a
flat fee of $1,500 to the mall owner/operator and a commission of 25 percent of revenue to the
person giving the demonstrations. (The demonstrator will not receive any salary beyond this
commission.)
Elite Kitchenware’s fixed costs of producing the dishes are $7,000 per production run.
The company plans to wait for all orders to come in, then it will produce exactly the number
of units ordered. (There will be no beginning or ending inventory.) Variable production costs
are $15 per set of dishes. In addition, it will cost approximately $10 per set to ship the dishes
to customers.
Beverly Slater, a product manager at Elite Kitchenware, is charged with recommending
a price for the item. Based on her experience with similar items, focus group responses,
and survey information, she has estimated the number of units that can be sold at various
prices:
Price Quantity
$65.99 450
$55.99 725
$45.99 800
$35.99 1,000
$25.99 1,300
Req u i r ed
a. Calculate expected profit for each price.

b. Which price maximizes company profit?
PROBLEM 8-3. Ethics and Pricing Decisions [LO 1] LowCostDrugs.com is an online drugstore.
Recently the company used a computer program to analyze the purchase behavior of customers
sorted by zip code and found that customers in some zip codes are, on average, less price sensitive
than customers in other zip codes. Accordingly, the company has raised prices by 3 percent for the
customers in the less-price-sensitive zip codes. Note that zip code is automatically identified when
a customer comes to the company Web site.
Req u i r ed
Is it ethical for LowCostDrugs.com to charge some customers a higher price based on its analysis
of prior purchasing behavior?
PROBLEM 8-4. Determining the Profit-Maximizing Price [LO 1] RoverPlus, a pet product
s uperstore, is considering pricing a new RoverPlus-labeled dog food. The company will buy the
premium dog food from a company in Indiana that packs the product with a RoverPlus label.
Rover pays $9 for a 50-pound bag delivered to its store.
The company also sells Royal Dog Food (under the Royal Dog Food label), which it pur-
chases for $12 per 50-pound bag and sells for $20.99. The company currently sells 26,000 bags
of Royal Dog Food per month, but that is expected to change when the RoverPlus brand is
introduced.
The company will continue to price the Royal Dog Food brand at $20.99. The quantity of
RoverPlus and the quantity of Royal Dog Food that will be sold at various prices for Royal are
estimated as:
P r o b l e m s 321
Price Quantity Quantity

RoverPlus RoverPlus Royal
$ 9.99 36,000 12,000

$10.99 35,500 12,300
$11.99 35,000 12,500
$12.99 34,000 13,000
$13.99 31,000 14,000
$14.99 26,000 15,000
$15.99 16,000 16,000
$16.99 11,000 20,000
$17.99 6,000 22,000
For example, if RoverPlus is priced at $9.99, the company will sell 36,000 bags of RoverPlus and
12,000 bags of Royal at $20.99. If the company prices RoverPlus at $17.99, it will sell 6,000 bags of
RoverPlus and 22,000 bags of Royal at $20.99. This is 4,000 fewer bags of Royal than is currently
being sold.
Req u ir ed
a. Calculate the profit-maximizing price for the RoverPlus brand, taking into account the effect of
the sales of RoverPlus on sales of the Royal Dog Food brand.
b. At the price calculated in part a, what is the incremental profit over the profit earned before the
introduction of the RoverPlus-branded dog food?
PROBLEM 8-5. Determining the Profit-Maximizing Price [LO 1] Adagio Music Publishing is a
boutique company that publishes and prints sheet music for composers and also records and sells
CDs of their compositions. Adagio is considering purchasing a line of CDs from a well-regarded
composer, Jacques Elles, from another company, to be sold under the Adagio Music label. Adagio
pays $6 for a CD to be delivered to its store.
The company also sells CDs of the composer Julian West, which it purchases for $7 per CD
and sells for $16. The company currently sells 800 Julian West CDs per month, but that is expected
to change when the Elles CD is introduced.
The company will continue to price the Julian West CD at $16. The quantity of Elles CDs and
the quantity of West CDs that will be sold at various prices for Elles is estimated as:
Price Quantity Quantity

Elles CD Elles CD West CD
$10 950 200

$11 900 275
$12 825 350
$13 725 395
$14 550 475
$15 460 525
$16 300 575
$17 200 625
$18 125 675
For example, if the Elles CD is priced at $10, the company will sell 950 CDs by Elles and 200 CDs
by West at $16. If the company prices the Elles CD at $18, it will sell 125 CDs by Elles and 675 CDs
by West at $16. This is 125 fewer West CDs than is currently being sold.
Req u i red
a. Calculate the profit-maximizing price for the Jacques Elles CD, taking into account the effect of
the sales of the Elles CD on sales of the Julian West CD.
b. At the price calculated in part a, what is the incremental profit over the profit earned before the
introduction of the Jacques Elles CD?
PROBLEM 8-6. Cost-Plus Pricing [LO 2] The Wendel Stove Company is developing a “profes-
sional”-model stove aimed at the home market. The company estimates that variable costs will be
$2,700 per unit and fixed costs will be $12,600,000 per year.
R equ i r ed
a. Suppose the company wants to set its price equal to full cost plus 30 percent. To determine cost,
the company must estimate the number of units it will produce and sell in a year. Suppose the
company estimates that it can sell 6,000 units. What price will the company set?
b. What is odd about setting the price based on an estimate of how many units will be sold?
c. Suppose the company sets a price as in part a, but the number of units demanded at that price
turns out to be 5,000. Revise the price in light of demand for 5,000 units.
d. What will happen to the number of units that will be sold if the price is raised to the one you
calculated in part c?
e. Explain why setting price by marking up cost is inherently circular for a manufacturing firm.
PROBLEM 8-7. Cost-Plus Pricing [LO 2] The product design team of Cervantes Golf is in the
process of designing a new model of golf bag cart. The company estimates that variable costs will
be $33 per unit and fixed costs will be $850,000 per year.
Req u i red
a. Suppose the company wants to set its price equal to full cost plus 35 percent. To determine cost,
the company must estimate the number of units it will produce and sell in a year. Suppose the
company estimates that it can sell 8,500 units. What price will the company set?
b. Suppose the company sets a price as in part a, but the number of units demanded at that price
turns out to be 6,250. Revise the price in light of demand for 6,250 units.
c. Compare the two prices you just calculated; why are the prices different? What is likely to hap-
pen to the quantity demanded if the company is forced to raise its price to the price calculated in
part b?
PROBLEM 8-8. Cost-Plus Pricing [LO 2] Emerson Ventures is considering producing a new line
of hang gliders. The company estimates that variable costs will be $400 per unit and fixed costs
will be $400,000 per year.
Req u i red
a. Emerson has a pricing policy that dictates that a product’s price must be equal to full cost plus
50 percent. To calculate full cost, Emerson must estimate the number of units it will produce and
sell in a year. At the beginning of the year, Emerson estimates that it will sell 1,600 gliders and sets
its price according to that sales and production volume. What is the price?
b. Right after the beginning of the year, the economy takes a dive and Emerson finds that demand
for their gliders has fallen drastically. Emerson revises its sales and production estimate to just
1,000 gliders for the year. According to company policy, what price must now be set?
c. What is likely to happen to the number of gliders sold if Emerson follows company policy and
raises the glider price to that calculated in part b?
d. Why is setting price by marking up cost inherently circular for a manufacturing firm?
C o m m o n C o s t B e h a v i o rPPr oa b n s 323
t tleerm
PROBLEM 8-9. Target Costing [LO 2] Baker Plumbing Fixtures is developing a preplumbed
acrylic shower unit. The team developing the product includes representatives from marketing,
engineering, and cost accounting. To date, the team has developed a set of features that it plans to
incorporate in the unit, including a seat, two shower heads, four body sprays, and a steam unit.
With this set of features, the team believes that a price of $5,000 will be attractive in the market-
place. Baker seeks to earn a per unit profit of 30 percent of selling price.
R equ ir ed
a. Calculate the target cost per unit.
b. The team has estimated that the fixed production costs associated with the product will be
$2,500,000, and variable costs to produce and sell the item will be $2,500 per unit. In light of this,
how many units must be produced and sold to meet the target cost per unit?
c. Suppose the company decides that only 1,400 units can be sold at a price of $5,000 and, there-
fore, the target cost cannot be reached. The company is considering dropping the steam feature,
which adds $800 of variable cost per unit. With this feature dropped, the company believes it can
sell 2,500 units at $4,000 per unit. Will Baker be able to produce the item at the new target cost
or less?
PROBLEM 8-10. Target Costing [LO 2] Symphony Sound is designing a portable recording
studio to be sold to consumers. The team developing the product includes representatives from
marketing, engineering, and cost accounting. The recording studio will include sound-canceling
monitor headphones, audio recording and enhancement software, several instrumental and vocal
microphones, and portable folding acoustic panels. With this set of features, the team believes that
a price of $4,700 will be attractive in the marketplace. Symphony Sound seeks to earn a per unit
profit of 25 percent of selling price.
R equ ir ed
a. Calculate the target cost per unit.
b. The team has estimated that the fixed production costs associated with the product will be
$1,800,000, and variable costs to produce and sell the item will be $2,900 per unit. In light of this,
how many units must be produced and sold to meet the target cost per unit?
c. Suppose the company decides that only 2,000 units can be sold at a price of $4,700 and, there-
fore, the target cost cannot be reached. The company is considering dropping the folding acoustic
panels, which add $650 of variable cost per unit. With this feature dropped, the company believes
it can sell 2,600 units at $4,000 per unit. Will Symphony Sound be able to produce the item at the
new target cost or less?
PROBLEM 8-11. Analyzing Customer Profitability [LO 3] Lauden Conference Solutions special-
izes in the design and installation of meeting and conference centers for large corporations. When
bidding on jobs, the company estimates product cost and direct labor for installers and marks up
the total cost by 35 percent. On a recent job for Orvieto Industries, the company set its price as
follows:
Product costs including podiums, seating, lighting, etc. $175,000

Installer salaries 25,000
Total 200,000
Markup at 35 percent 70,000
Bid price $270,000
The job turned out to be a big hassle. Orvieto requested 25 change orders, although the dollar
value of the products it requested changed very little. The company also returned 33 items that
had extremely minor flaws (scratches that were barely visible and would be expected in normal
shipping). Orvieto also requested seven meetings with designers taking 40 hours before its plan
was finalized. Normally, only two or three meetings are necessary.
Alison Jackson, controller for Lauden, decided to conduct a customer profitability analysis
to determine the profitability of Orvieto. She grouped support costs into three categories with the
following drivers:
Driver Annual Value of Driver Annual Cost
Change orders 850 change orders $212,500

Number of returns 1,000 product returns 70,000
Design meeting hours 1,300 meeting hours 78,000
Req u i r ed
a. Calculate the indirect service costs related to the job performed for Orvieto Industries.
b. Assuming that Orvieto Industries causes a disproportionate amount of indirect service costs,
how should Lauden deal with this situation?
PROBLEM 8-12. Activity-Based Pricing [LO 3] Consider the information in Problem 8-11.
Lauden Conference Solutions has decided to adopt an activity-based pricing scheme. On future
jobs, the company will charge a 35 percent markup on the sum of product costs plus installer
salaries. In addition, the company will charge $300 per change order, $90 per product return for
products that are in excellent condition, and $85 per meeting hour with a Lauden conference
room designer.
Req u i r ed
a. What would the profit be on the order from Orvieto in Problem 8-11?
b. Identify pros and cons of adopting the activity-based pricing scheme.
CASE
8-1 Preston Concrete [LO 1, 2]
Preston Concrete is a major supplier of concrete to res site, the truck must be kept running (so the concrete mix will
idential and commercial builders in the Pacific North not solidify) and the driver must be paid. At the start of 2017,
west. The company’s policy is to price deliveries at 25 percent the company estimated that it would deliver 500,000 cubic
over full cost per cubic yard (including an allowance for admin- yards.
istrative costs). At the start of 2017, the company estimated costs
as follows: R eq uired
Material costs = $75 per cubic yard a. On October 28, Fairview Construction asked Preston to
Delivery costs = $500,000 per year + $10 (mile) + $50 deliver 6,000 cubic yards of concrete. The job will require driv-
(truck hour) ing 8,400 miles and 300 truck hours. What will the price be if
Preston follows its normal pricing policy?
Yard operation costs = $300,000 per year + $17 per
cubic yard b. A sharp increase in interest rates has reduced housing starts
and the demand for concrete. Fairview has indicated that it will
Administrative costs = $2,000,000 per year
sign a firm order agreement only if the price is $115 per cubic
Delivery costs include a rate per mile, recognizing that more yard. Should Preston accept the order? Briefly indicate factors
miles result in more gas and maintenance costs, and a rate per that, while hard to quantify, should be taken into account in
truck hour since, even if a delivery truck is kept waiting at a job this decision.
C a s e 325
CASE
8-2 Galloway University Medical Center Pharmacy [LO 1]
Galloway University Medical Center (GUMC) has a top- per year. To deal with the increased volume, the pharmacy will
rated medical facility that draws patients from a three- need to hire two pharmacists at $90,000 each per year and an
state area. On the day of discharge from the GUMC hospital, additional staff person (to handle shipping) at $50,000 per year.
most patients fill their prescriptions from the GUMC pharmacy. Alternatively, the pharmacy can generate 125,000 renewal
However, when it comes time to renew them, they turn to a local orders per year by offering 20 percent off the prices of renewal
pharmacy because that is more convenient than driving back orders. With this option, two pharmacists must be hired, but no
to the GUMC pharmacy. To encourage prescription renewals, additional staff person will be needed.
GUMC is considering offering either free overnight delivery or
reduced prices on renewal orders.
Currently, the GUMC pharmacy has revenue of $54,990,000 R eq uired
per year on 846,000 orders. The gross margin (price minus cost Estimate the impact on annual pharmacy profit of free overnight
of drugs) is approximately 25 percent. Free overnight delivery is delivery and 20 percent off on renewals. Which option should be
expected to cost $9 per order and result in 125,000 renewal o
rders selected?
9
Capital Budgeting and Other
Long-Run Decisions
For several years, Steve Wilson, president of Wilson Air, has
operated a successful business flying passengers between
Seattle and resorts in Idaho and around Washington State.
Now Steve thinks it’s time to consider adding to his fleet of three seven-passenger
aircraft. “Look,” he explains to his chief accountant, Ellen Ortega, “with another plane,
we can service 3,500 additional round-trip passengers a year. At an average fare of
$200, that’s $700,000!” “But don’t forget,” Ellen points out, “a new plane will cost
around $1,000,000, operating cost will be nearly $400,000 per year, and, after 5
years, that $1,000,000 plane will only be worth $500,000. It’s not clear that buying
another plane is a good business decision.”
This chapter extends the discussion of decision making in Chapter 7 to include
problems like the one facing Steve Wilson. Steve is considering investing cash today
in order to receive cash in the future. Obviously, Steve will require a total cash inflow
that is larger than his initial outflow, since he wants to earn a return on his investment
in the plane. Here we discuss how to determine whether future cash inflows are
sufficient to earn a satisfactory return.
We begin our discussion by focusing on capital budgeting decisions. Essentially,
these are decisions related to investments in property, plant, and equipment. As you
will see, the approach to the proper analysis of these decisions requires that we take
into account the fact that a dollar today is worth more than a dollar tomorrow. In
other words, we must consider the time value of money. After we learn about capital
budgeting decisions and time value of money approaches to decision making, we will
use the same techniques to evaluate other long-run decisions. Since these decisions
also affect cash flows across multiple years, we will need to take the time value of
money into account in analyzing them.
Medioimages/Photodisc/Getty Images
Learning Objectives
1 Define capital expenditure decisions and capital budgets and evaluate investment opportunities
using the net present value approach and the internal rate of return approach.
2 Calculate the depreciation tax shield and evaluate long-run decisions, other than investment
decisions, using time value of money techniques.
3 Use the payback period and the accounting rate of return methods to evaluate investment
opportunities, and explain why managers may concentrate erroneously on the short-run
profitability of investments rather than their net present values.
327
328 chapte r 9 C a p i t a l B u d g e t i n g a n d O t h e r L o n g - R u n D e c i s i o n s
Learning CAPITAL BUDGETING DECISIONS

Objective 1
Individuals make investments in their homes, automobiles, major appliances, furniture,
Define capital expen- and other long-lived assets. Companies also make investments in long-lived assets.
diture decisions and Examples of investment decisions are presented in Illustration 9-1. In each example, a firm
capital budgets and is considering investing in one or more assets that will affect its operations for several years.
evaluate investment Investment decisions are extremely important because they have a major, long-
opportunities using term effect on a firm’s operations. When BMW decided to expand its South Carolina
the net present value plant, it made an investment in additional productive capacity that will affect its labor
approach and the and transportation costs for many years to come. Labor to build the cars is supplied by
internal rate of return American rather than German workers, so labor costs are largely determined by busi-
approach. ness conditions in the United States rather than in Germany. Transportation costs are
greatly reduced for cars sold in the United States because cars can be shipped from South
Carolina rather than continental Europe.
The investment decisions of small companies are also extremely important. Consider a
small print shop that decides to make an investment in a computerized printing machine.
The cost of the machine may represent 50 percent or more of the company’s total assets. But
the cost savings from the investment in new technology may make the difference between
being a solid competitor in its market or being on the verge of financial failure.
Investment decisions involving the acquisition of long-lived assets are often referred
to as capital expenditure decisions because they require that capital (company funds)
be expended to acquire additional resources. Investment decisions are also called capital
budgeting decisions. Most firms carefully analyze the potential projects in which they
may invest. The process of evaluating the investment opportunities is referred to as capital
budgeting, and the final list of approved projects is referred to as the capital budget.
EVALUATING INVESTMENT OPPORTUNITIES:

TIME VALUE OF MONEY APPROACHES
Crucial to an understanding of capital budgeting decisions is an understanding of the time
value of money. In evaluating an investment opportunity, a company must know not only
how much cash it receives from or pays for an investment but also when the cash is received
or paid. The time value of money concept recognizes that it is better to receive a dollar today
than it is to receive a dollar next year or any other time in the future. This is because the dollar
received today can be invested so that at the end of the year, it amounts to more than a dollar.
In an investment decision, a company invests money today in the hopes of receiving
more money in the future. Obviously, the company would not invest money in a project
unless it expected the total amount of funds received in the future to exceed the amount
of the original investment. But by how much must the future cash flows exceed the orig-
inal investment? Because money in the future is not equivalent to money today, we need
to develop a way of converting future dollars into their equivalent current, or present,
value. The techniques developed to equate future dollars to current dollars are referred
to as present value techniques or time value of money methods.
Illustration 9-1
1. Duke Energy invests in 400 roof-top solar panel installations.
Examples of investment
decisions 2. Pfizer invests in a $294 million biotechnology factory in Ireland.
3. Lotte Hotel Chain invests in a new hotel in Moscow.
4. Nordstrom invests in a new store in New Jersey.
5. Starbucks invests in a new product: instant coffee.
E v a l u a t i n g I n v e s t m e n t O p p o r t u n i t i e s : T i m e V a l u e o f M o n e y A p p r o a c h e s 329
Link to Practice
Royal Caribbean International Invests It may seem odd to have launched a luxury cruise
$1.4 Billion in Cruise Ship ship in 2010 since this was just after the great recession.
But keep in mind that the decision to
Royal Caribbean International invested
build the ship started in 2006, when
$1.4 billion in the construction of the
the order was placed with a shipyard
world’s largest ship, the Allure of the
in Finland. And to gain economies of
Seas. The ship, launched in December
scale, Royal Caribbean ordered two
2010, is 1,187 feet long and 16 decks
nearly identical ships, the Allure and its
high, and it holds more than 6,000 pas-
sister ship, the Oasis (which is 2 inches
sengers and 2,000 crew members.
shorter!).
In making this investment, Royal Stock Connection/SuperStock
Caribbean decided that the net future
cash inflows generated by the ship would earn a Source: Toni Schlesinger, “A City on the Sea,” New York
satisfactory return on the cost of building it. Times, February 13, 2011.
Some readers of this book will have been introduced to present value techniques
in their study of financial accounting and the valuation of long-term debt. We review
the basics in the next section, “Basic Time Value of Money Calculations.” After that, we
discuss two approaches for evaluating investments that take into account the time value
of money: the net present value method and the internal rate of return method.
Basic Time Value of Money Calculations

Suppose you invest $100 at an interest rate of 10 percent. At the end of one year, you
will have $110.
$100 × (1 + .10 ) = $110
Now let’s turn this problem around. Suppose you require a return of 10 percent on your
investments. How much is a payment of $110, one year from now, worth today? A little
algebra (dividing both sides by 1 + .10) indicates that it is worth $100. In other words, if
your required return is 10 percent, the present value of $110 received 1 year from now is
$100. Put another way, $100 is the amount you would have to invest today, at an interest
rate of 10 percent, to have $110 at the end of 1 year:
$110
$100 =
(1 + .10 )
Now suppose you invest $100 at 10 percent for 2 years. At the end of the first year, you
will have $100 times (1 + .10). At the end of the second year, you will have this new
amount times (1 + .10), which equals $121:
$100 × (1 + .10 ) × (1 + .10 ) = $100(1 + .10 ) = $121

2
Turning this problem around, if you require a return of 10 percent on your investments,
then how much is a payment of $121, 2 years from now, worth today? The answer is
$100:
$121
$100 =
(1 + .10 )2
You may note that a pattern is emerging. In general, if your required rate of return is r,
the present value (P) of any amount (F) received n years in the future is:
F
P=
(1 + r )n
That is, to calculate the present value (P) of an amount (F) received n years in the future,
we divide F by 1 plus the required rate of return (r) raised to the nth power.
Let’s try out the formula. What is the present value of $1,000 received 5 years from
now if your required rate of return is 12 percent? To answer the question, we divide
$1,000 (the amount received in the future) by 1 plus the required return raised to the
fifth power, since the cash is received at the end of year 5. The answer is $567.43:
F
p=
(1 + r )n
$1,000
=

(1 + .12 )5
$1,000
=
1.7623417
= $567.43
To simplify calculations, managers can use present value tables to look up present
value factors (also called discount factors).1 Present value factors are simply calculations
1
of (1 + r )n . Thus, to calculate the present value of a future amount, you can multiply the
future amount by the present value factor.
For example, let’s consider again the present value of $1,000 received 5 years from
now if the required rate of return is 12 percent. The present value factor, or discount
1
factor, is (1 + r )n . Substituting values into this equation and rounding the result to four
places, we find that the factor is:
1
Present value factor =
(1 + r )n
1
=
1.7623417
= .5674
Rather than working through the calculation of present value factors, we can turn to
the present value of $1 table, Table B9-1 in Appendix B of this chapter. Going across the
top of the table to a discount rate of 12 percent and down five rows (since the amount
is to be received 5 years in the future), we come to a present value factor of .5674, the
same as the value we calculated. Now we can find the present value itself by multiplying
the factor times $1,000 (the amount to be received at the end of 5 years):
Present value = $1,000 × Present value factor

= $1,000 × .5674
= $567.40
1
Managers can also use financial calculators and spreadsheet programs rather than tables of present value
factors. In fact, this is what most managers do. We discuss use of Excel® to perform present value calculations
in Appendix A of this chapter.
T est y ou r K N O W L E D GE
Using the previous formula, what is the present value of $500 received 2 years in the future
if you desire a return of 10 percent?
a. $413.20. b. $468.58. c. $471.60. d. $480.30.
Correct answer is a ($500 × [1 ÷ (1 + .10)2]).
The Net Present Value Method

The time value of money forms the basis of the net present value method for evaluating
capital investments.
Decision Making/ Steps in the NPV Method. The first step in using the net present value method is to
Incremental identify the amount and time period of each cash flow associated with a potential invest-
Analysis ment. Investment projects have both cash inflows (which are positive) and cash outflows
(which are negative). Consistent with our discussion in Chapter 8, the only relevant cash
flows are those that are incremental—the cash flows that will be incurred if the project is
undertaken. Cash flows that have already been incurred are sunk and have no bearing
on a current investment decision.
The second step is to equate or discount the cash flows to their present values using
a required rate of return. The required rate of return is discussed later. For now, simply
assume that the required rate of return (also called the hurdle rate) is the minimum
return that top management wants to earn on investments.
The third and final step is to evaluate the net present value. The sum of the present
values of all cash flows (inflows and outflows) is the net present value (NPV) of the
investment. If the NPV is zero, the investment is generating a rate of return exactly
equal to the required rate of return. Thus, the investment should be undertaken. If the
NPV is positive, it should also be undertaken because it is generating a rate of return
that is even greater than the required rate of return. Investment opportunities that have
a negative NPV are not accepted because their rate of return is less than the required
rate of return. A graphical presentation of the NPV approach to evaluating investments
An Example of the NPV Approach. An example will show how the NPV approach is
used. Suppose an auto repair shop is considering purchasing automated paint-spraying
equipment. The company estimates that the equipment will last 5 years. Each year it
will save the company $2,000 in paint wasted in the current manual spraying operation.
It will also reduce labor costs by $20,000. It is estimated that the machine will require
Illustration 9-2
NPV approach to
evaluating investments Equal to or greater than zero Accept the investment
Net present
value
Less than zero Reject the investment

Illustration 9-3
Evaluation of automated paint-spraying equipment
Time Period Present Year Year Year Year Year

0 1 2 3 4 5
Cash flow
Purchase price ($70,000)
Labor saving $20,000 $20,000 $20,000 $20,000 $20,000
Paint saving $ 2,000 $ 2,000 $ 2,000 $ 2,000 $ 2,000
Maintenance ($ 1,000) ($ 1,000) ($ 1,000) ($ 1,000) ($ 1,000)
Residual value $ 5,000
Total cash flow ($70,000) 21,000 $21,000 $21,000 $21,000 $26,000
PV factor (Table in Appendix B) ×1.000 ×.8929 ×.7972 ×.7118 ×.6355 ×.5674
Total ($70,000) $18,751 $16,741 $14,948 $13,346 $14,752 = $8,538 (NPV)
maintenance costs of $1,000 per year. The machine costs $70,000, and it is expected
to have a residual value (also called salvage value) of $5,000 at the end of 5 years. Top
management has determined that the required rate of return is 12 percent. Should the
company invest in the new equipment?
The cash flows related to the investment opportunity are presented on the timeline
at the top of Illustration 9-3. In analyzing the cash flows, we make the assumption that
all cash inflows and outflows (other than the cash outflow of $70,000 for purchasing the
equipment) occur at the end of a year. To simplify analysis, managers commonly make
this assumption, and it is unlikely to introduce significant error, even though cash flows
actually take place throughout the year (not just at year-end).
Illustration 9-3 also includes present value (PV) factors for each year’s cash-flow
total. Consider first the $70,000 cash outflow created by the purchase of the spraying
equipment. Note that the present value factor associated with the $70,000 purchase price
is 1.0000. Because this amount is going to be spent immediately, it is already expressed
in terms of its present value. Now consider the cash flows in year 1. In this year, the net
cash inflow is $21,000. The present value factor for an amount received at the end of year
1 using a 12 percent rate of return is .8929 (see Table B9-1 in Appendix B). Multiplying
the present value factor by the cash inflow of $21,000 indicates that the present value
of the net cash inflow in year 1 is $18,751. The net present value of the investment in
spraying equipment is found by summing the present values of the cash flows in each
year. This amounts to $8,538. Because the net present value is positive, the company
should go ahead with plans to purchase the equipment.
In the preceding problem, the $20,000 labor savings, the $2,000 paint savings, and
the $1,000 maintenance expense are identical in each of the 5 years. Thus, the net annual
amount of $21,000 can be treated as a five-year annuity (series of equal payments) in
calculating the present value. This treatment is presented in Illustration 9-4. Present value
factors that apply to annuities are in Table B9-2 in Appendix B. The present value factor,
using a 12 percent rate of return, for an annuity lasting 5 years is 3.6048 (see Table B9-2
in Appendix B). Multiplying this factor by the $21,000 annuity indicates a present value
of $75,701. In other words, a five-year annuity of $21,000 is worth $75,701 if you require
a 12 percent rate of return. The present value of the $5,000 residual value in year 5 is
calculated using a factor from the Present Value of $1 table B9-1 (Appendix B). Note that
the total net present value, $8,538, is equal to the amount calculated in Illustration 9-3.
Illustration 9-4
Evaluation of automated Item Cash Flow Present Value Factor Present Value
paint-spraying equipment
Purchase price ($70,000) 1.0000 ($70,000)
using present value of an
annuity approach Labor, paint, and $21,000 per year
maintenance for 5 years 3.6048 75,701
Residual value $5,000 at end
of year 5 .5674 2,837
Net present value $ 8,538
Present value of
an annuity of $1 Present value of $1
table. Table B9-2 table. Table B9-1 in
in Appendix B. Appendix B.
LINK TO PRACTICE
NPV of Livengood Gold Mine Depends and closure costs were estimated at $353 million. At this
on Estimates point, NPV would only be positive if gold prices were
$1,600 per ounce or higher. In June, 2015, International
In 2011, International Tower Hill, the owner of the Livengood
Tower Hill was still working to determine if “optimization”
gold mine near Fairbanks, Alaska, released a preliminary
of the project would yield a positive NPV. In June, 2015
economic analysis of the mine showing a net present value
gold prices were “only” $1,200 per ounce.
of $1.2 billion. This analysis used a 5 percent required rate
This demonstrates the inherent uncertainty in esti-
of return, a 23-year life, a gold price of $1,100 per ounce
mates of cash inflows and outflows related to major
and estimated capital expenditures of $1.6 billion.
projects.
A new feasibility study was conducted in 2013, and
estimated capital expenditures related to construction Sources: Press Release, International Tower, Alaska, August 23,
grew to $2.7 billion. In addition, ongoing capital expen- 2011; Anthony Vaccaro, “ITH’s Livengood Struggles at Today’s
ditures were estimated at $667 million and reclamation Gold Price, The Northern Miner, August 8, 2013.
Comparing Alternatives with NPV. It is relatively easy to evaluate decision alter-

natives with the NPV approach. Essentially, we calculate the NPV of each alternative
and select the one with the highest NPV. The difference between the NPVs of any two
alternatives is the incremental value of the highest NPV investment.
Consider an alternative to the investment we have just considered. Let’s call the
previous investment A and the alternative B. The alternative piece of equipment will also
last 5 years. Each year it will save the company $3,000 in paint wasted in the current
manual spraying operation, and it will reduce labor costs by $27,000 per year. It will
require $4,000 of annual maintenance. Thus, the net savings each year is $26,000:
Paint savings $ 3,000
Labor savings 27,000
Maintenance (4,000)
Net annual savings $26,000
The cost of the machine is $80,000, and it will have a residual value of $7,000. The alter-
native investments are evaluated in Illustration 9-5. As indicated, alternative B has the
highest NPV, $17,697, and, thus, it is the preferred alternative. Its incremental value over
alternative A is the difference in their NPVs, which is $9,159.
Another way to evaluate alternatives is to compute the present values of their
incremental cash flows. This is presented in the bottom panel of Illustration 9-5. As indi-
cated, alternative B has an incremental outflow related to the purchase price of $10,000.
However, it has positive incremental cash flows related to labor, paint, and maintenance
Illustration 9-5
Evaluation of alternatives using NPV
Comparison of Each Alternative’s NPV

Alternative A Cash Flow 12% Factor Present Value
Purchase price ($70,000) 1.0000 ($70,000)
Labor, paint, and $21,000 per year
Residual value $5,000 at end of
year 5 0.5674 2,837
NPV $ 8,538
$9,159
Alternative B Cash Flow 12% Factor Present Value Incremental Value
of Alternative B
Purchase price ($80,000) 1.0000 ($80,000)
year 5 0.5674 3,972
NPV $17,697
Analysis of Incremental Cash Flows of Alternative B versus Alternative A
Incremental Cash
Flows of B versus A Cash Flow 12% Factor Present Value
Purchase price ($10,000) 1.0000 ($10,000)
year 5 0.5674 1,135
NPV $ 9,159
Note: Present value factors are in Tables B9-1 and B9-2 of Appendix B.
each year of $5,000 ($26,000 of savings for B versus $21,000 for A). Also, it has an incre-
mental salvage value of $2,000. Applying present value factors to these incremental cash
flows again shows us that the incremental value of alternative B is $9,159 greater com-
pared to alternative A. While the approach you take will yield the same answer, students
seem to make fewer errors when they calculate each alternative’s NPV and compare these
values to determine which alternative is best.
The Internal Rate of Return Method

The internal rate of return method is an alternative to net present value for evaluating
investment possibilities. Like net present value, it takes into account the time value of
money. Specifically, the internal rate of return (IRR) is the rate of return that equates
the present value of future cash flows to the investment outlay. In other words, it is the
return that makes the NPV equal to zero. If the IRR of a potential investment is equal
to or greater than the required rate of return, the investment should be undertaken. In
Illustration 9-6, the IRR approach to evaluating investments is outlined.
Consider a simple case where $100 is invested to yield $60 at the end of year 1 and
$60 at the end of year 2. What rate of return equates the two-year, $60 annuity to $100?
Illustration 9-6
IRR approach to
evaluating investments Equal to or greater than
Accept the investment
required rate of return
IRR
Less than required

Reject the investment
rate of return
Recall that when we performed present value analysis for previous annuities, we multi-
plied a present value factor by the annuity to solve for a present value. That is:
Present value = Present value factor × Annuity
In the current case, we set the present value equal to the initial outlay for the investment.
Then, we can solve for the present value factor and use it to look up the rate of return
implicit in the investment:
Initial outlay
Present value factor =
Annuity amount
With a $100 cost of the investment and a $60 annuity, the present value factor is 1.667:
$100
1.6667 =
$60
Because the $60 is to be received in each of 2 years, we use the annuity table (Table B9-2
in Appendix B) to look up the internal rate of return. In the row in Table B9-2 for two
periods, we find a present value factor of 1.6681 (very close to 1.6667) in the column for
a 13 percent rate of return. Thus, the IRR on this investment is approximately 13 percent.
If the required rate of return is 13 percent or less, the investment should be undertaken.
Insight into the IRR can be gained by using it to calculate the net present value of the
project. If we evaluated the previous project using a 13 percent required rate of return,
what would be the net present value? The answer is zero, because the internal rate of
return equates the present value of future cash flows to the investment outlay:
Present Value
Item Cash Flow Factor Present Value
Cash flow $ 60 1.6681 $100.09
Table B9-2, Appendix B
Initial investment ($100) 1.0000 (100.00)
Difference (due to rounding) $ .09
A potential investment should be undertaken if:
a. The NPV is zero or positive.
b. The IRR is equal to or greater than the required rate of return.
c. Both a and b are true.
The Internal Rate of Return with Unequal Cash Flows

For cases where cash flows are not equal each year, the approach previously presented
cannot be used to calculate the IRR, because we cannot divide the initial investment by
a single cash flow annuity to yield a present value factor. Instead, we must estimate the
internal rate of return and use the estimate to calculate the net present value of the project.
If the net present value is greater than zero (implying an internal rate of return greater
than the estimate), the estimate of the internal rate of return should be increased. If the net
present value is less than zero (implying an internal rate of return less than the estimate),
the estimate should be decreased. By estimating the internal rate of return in this trial-
and-error fashion, it is possible to eventually arrive at the actual internal rate of return.
Link to Practice
College Education Yields 15% Return this is more than double the average return to investments
in stocks since 1950 and more than five times the return
In this chapter, we focus on business investments and
to corporate bonds. While the study didn’t specifically
how to calculate their internal rates of return. The same
address the return on investments in an undergraduate
procedures can be applied to calculate the IRR on an
business degree or an MBA, it wouldn’t be surprising if
investment in a college education. Indeed, the calculation
they were quite a bit higher than 15 percent!
was performed by the Brookings Institution, a nonprofit
public policy organization based in Washington, DC. Source: Michael Greenstone and Adam Looney, “Where is
According to a paper it published in 2011, a four-year the Best Place to Invest $102,000—In Stocks, Bonds, or a
college degree had a return of 15.2 percent. Interestingly, College Degree?” Brookings, June 25, 2011.
Let’s consider an example to illustrate the method. Suppose a company is considering

changes in its production process that will involve purchasing several pieces of equipment
costing a total of $120,000. The changes are expected to yield cost savings of $49,500 in
year 1; $45,000 in year 2; $35,000 in year 3; $22,000 in year 4; and $19,600 in year 5:
Time Period 0 1 2 3 4 5
Cash Flow ($120,000) $49,500 $45,000 $35,000 $22,000 $19,600
The company wants to evaluate the potential project in terms of its internal rate of
return. The first step is to estimate what the internal rate of return is likely to be. Since
the cash flow is fairly large in relation to the initial investment, a reasonable guess as
to the internal rate of return might be 14 percent. However, when we calculate the net
present value of the investment as in Illustration 9-7 using 14 percent, we see that the
present value is a positive $4,880. Thus, the true internal rate of return is greater than
14 percent. As a next approximation, we can try 20 percent. However, with this rate of
return, the present value is a negative $8,761. This indicates that our second estimate of
the internal rate of return was too high.
At this point, we know that the internal rate of return is somewhere between 14
percent and 20 percent. Thus, as a further attempt, we might try 16 percent. The present
value using a rate of 16 percent is $26. This is sufficiently close to zero to allow us to
conclude that the internal rate of return is approximately 16 percent. If management of
the company believes that a return of 16 percent is sufficient, then the company should
go ahead with the project.
It may appear that the need to estimate the internal rate of return using a trial-
and-error approach presents a significant obstacle to its use. Actually, this is not
the case. A spreadsheet program such as Excel® and even some pocket calculators
C o n s i d e r i n g “ S o f t ” B e n e f i t s i n I n v e s t m e n t D e c i s i o n s 337
Illustration 9-7
Calculating the IRR when there are unequal cash flows
14% 20% 16%
Time Cash Factor Present Factor Present Factor Present

Period Flows for 14% Value for 20% Value for 16% Value
0 ($120,000) 1 ($120,000) 1 ($120,000) 1 ($120,000)
1 $ 49,500 0.8772 $ 43,421 0.8333 $ 41,248 0.8621 $ 42,674
2 $ 45,000 0.7695 $ 34,628 0.6944 $ 31,248 0.7432 $ 33,444
3 $ 35,000 0.6750 $ 23,625 0.5787 $ 20,255 0.6407 $ 22,425
4 $ 22,000 0.5921 $ 13,026 0.4823 $ 10,611 0.5523 $ 12,151
5 $ 19,600 0.5194 $ 10,180 0.4019 $ 7,877 0.4761 $ 9,332
Total $ 4,880 ($ 8,761) $ 26
contain functions that easily estimate the internal rate of return of a project. The user
simply inputs the cash flow information, and the IRR is computed automatically.
Summary of Net Present Value and Internal Rate

of Return Methods
Although both the net present value method and the internal rate of return method
take into account the time value of money, they differ in their approach to evaluating
investment alternatives. With net present value, any investment with a zero or positive
net present value should be undertaken. With the internal rate of return method, any
investment with an internal rate of return equal to or greater than the required rate of
return should be undertaken.2
CONSIDERING “SOFT” BENEFITS

IN INVESTMENT DECISIONS
When managers make investment decisions, it is important that they consider so-called
soft benefits in addition to a project’s NPV or IRR. Soft benefits are benefits that are difficult
to quantify.3 Consider a situation faced by Dynamic Medical Equipment. The company is
considering production of a high-tech wheelchair. The wheelchair would take advantage of
advances in lightweight graphite construction techniques pioneered in the manufacturing
of tennis racquets and design improvements suggested by athletes competing in wheelchair
events. Suppose that in evaluating the project, the finance department fails to consider the
fact that production of the high-tech wheelchair will improve the firm’s reputation as an
industry leader committed to innovation. Such a reputation is clearly valuable, since it has
a positive effect on sales of the firm’s entire product line. However, the value is also very
difficult to quantify. Or consider the fact that producing the wheelchair will introduce
new construction techniques that will help the firm produce future products made from
graphite. This may be a major benefit to the firm, but it is very difficult to quantify.
2
Under some circumstances, the net present value and the internal rate of return methods may be
inconsistent with one another in evaluating the desirability of an investment opportunity. This potential
problem is discussed in introductory corporate finance texts.
3
Firms may also have difficulty quantifying certain costs. For example, an investment in a new
manufacturing process may result in additional pollution, the cost of which is hard to quantify. If “soft costs”
are ignored in investment analysis, companies will tend to overinvest.
Link to Practice
Use of NPV and IRR by CFOs companies. After NPV and IRR, the payback method
(discussed later in this chapter) is the most frequently
John Graham and Campbell Harvey of Duke University
used capital budgeting technique with 56.7 percent of
conducted a survey of chief financial officers (CFOs)
the CFOs stating that they always or almost always use it.
to assess their use of capital budgeting techniques.
According to their results, 74.9 percent of CFOs always
Source: J. Graham and C. Harvey, “How Do CFOs Make
or almost always use NPV and 75.7 percent always Capital Budgeting and Capital Structure Decisions,” Journal of
or almost always use IRR. Moreover, large companies Applied Corporate Finance, Spring 2002, pp. 8–22. Reprinted
are significantly more likely to use NPV than small by permission of Blackwell Publishing Ltd.
Ignoring soft benefits may lead firms to pass up investments that are of strategic
importance, especially investments in advanced manufacturing technology. For exam-
ple, investment in robotics may be needed to reduce product defects. And defect-free
production may be a source of competitive advantage. However, the NPV analysis of the
investment may focus on the cash savings resulting from a reduction in labor, which is
relatively easy to quantify, and ignore the cash savings resulting from increased product
demand, which is relatively hard to quantify.
As a further example, consider an investment in a flexible manufacturing system. Such
systems are generally highly automated and often involve computer-controlled equipment.
They are configured so that machines can be easily adjusted to produce a number of dif-
ferent products or variations of standard products. With a flexible manufacturing system,
companies can easily respond to custom orders that meet the exact specifications of their
individual customers. Flexible manufacturing systems also improve delivery times on
orders and allow companies to introduce new products quickly. But while being able to
improve delivery times and introduce new products quickly may greatly improve a com-
pany’s competitive position, these benefits are quite difficult to quantify in dollar terms.
Calculating the Value of Soft Benefits Required

to Make an Investment Acceptable
Managers should make a reasonable effort to calculate the cash value of soft benefits
when analyzing investment opportunities. However, in some cases, they may decide that
quantifying the benefits is too costly. In these cases, if the NPV of a potential investment is
negative, managers should calculate the amount of additional cash inflows needed to have
a positive NPV. Then, if managers believe that the value of soft benefits, while uncertain,
will clearly exceed the additional cash inflows, they can decide to fund the investment.
For example, suppose the high-tech wheelchair project at Dynamic Medical
Equipment has a NPV of negative $80,000. In calculating the NPV, the finance department
used a required rate of return of 15 percent and assumed that the project would have a
10-year life. After 10 years, the chair will be out of date and replaced in the product line. As
we know, the finance department did not consider soft benefits in calculating the NPV. But
what must be the value of the soft benefits each year before the wheelchair is an acceptable
investment? The calculation needed to answer this question is presented in Illustration 9-8.
The present value of the soft benefits must be at least $80,000 before the project is
acceptable. Using the present value of an annuity table, we find that the discount factor
for 10 periods at 15 percent is 5.019. This implies that as long as the soft benefits are
worth at least $15,939 per year, the project should be funded. Managers at Dynamic
Medical Equipment will likely find this analysis very useful. For example, while they
may be unable to specify the exact value of the soft benefits, there may be general agree-
ment that the value will certainly exceed $16,000 each year. If this is the case, then the
E s t i m a t i n g t h e R e q u i r e d R a t e o f R e t u r n 339
Illustration 9-8
Calculation of soft benefits Needed present value = Discount factor × Value of benefits
needed to make the
investment acceptable Needed present value
Value of benefits =
Discount factor
$80,000
Value of benefits =
5.019
Value of benefits = $15,939
Link to Practice
Soft Benefits Related to Investing enneth Murphy and Steven Simon, these benefits
K
in ERP System may include reduced number of customer complaints,
improved customer satisfaction, improved customer
As discussed in Chapter 1, enterprise resource plan-
retention, early identification of
market trends, and
ning (ERP) systems are complex and comprehen-
support of organizational change.
sive systems used to computerize inventory control,
The authors also did a case study
manage company supply chains, and

of an ERP decision and found that after
automate customer support and other
quantifying one soft benefit, customer
key business functions. Such systems
satisfaction, the IRR increased from
can cost more than $1 million and
39.2 percent to 124 percent!
receive careful consideration before
purchase decisions are made. In running Source: Kenneth E. Murphy and Steven
the numbers, managers find it difficult John Simon, “Intangible Benefits Valuation
to take into account a number of soft in ERP Projects,” Information Systems
benefits. According to an article by Neustockimages/iStockphoto
Journal, 2002, pp. 301–320.
wheelchair appears to be a good investment. However, there may be general agreement

that while there certainly will be some soft benefit, the value is unlikely to exceed even
$10,000 per year. If this is the case, then the wheelchair is not a good investment.
ESTIMATING THE REQUIRED RATE OF RETURN

In the problems presented earlier, we simply stated a required rate of return that could
be used to calculate an investment’s net present value or that could be compared with
an investment’s internal rate of return. In practice, the required rate of return must be
estimated by management. Under certain conditions, the required rate of return should
be equal to the cost of capital for the firm. The cost of capital is the weighted average of
the costs of debt and equity financing used to generate capital for investments. The cost
of debt arises because interest must be paid to individuals, banks, and other companies
that lend money to the firm. Essentially, the cost of equity is the return demanded by
shareholders for the risk they bear in supplying capital to the firm. Estimating the cost
of capital, especially the cost due to equity capital, is a challenge even to sophisticated
financial managers.4 Because of this difficulty, many managers use their judgment to
determine the required rate of return, following the general principle that the more risky
the investment, the higher the required rate of return.
4
Complications arise, for example, because some debt issues allow for conversion to common stock. Also,
some companies have multiple classes of stock with different voting rules and other features that make
calculation of the cost of equity capital difficult.
Link to Practice
Cost of Capital for Various Some examples as of January 2015 are:
Business Sectors Aerospace/defense 7.93%
The Stern School of New York University has a website Apparel 7.09%
Auto parts 8.44%
that lists the cost of capital by b
usiness sector. The val-
Brug. (Biotechnology) 8.25%
ues provide you with a good feel for differences in the
Entertainment 7.09%
cost of capital across c ompanies. Food processing 6.78%
http://people.stern.nyu.edu/~adamodar/New_ Semiconductor 8.58%
Home_Page/datafile/wacc.htm Telecoms Equipment 8.69%
ADDITIONAL CASH FLOW CONSIDERATIONS

To be useful in investment analysis, both the net present value and the internal rate of
return methods require a proper specification of cash flows. It is particularly important to
remember that only cash inflows and outflows, not revenues and expenses, are discounted
back to present value. Thus, if a sale is expected to occur in period 1 but the collection of
the sale is not anticipated until period 2, the cash flow that is discounted back to present
value is a period 2 cash flow, even though the related revenue will be recorded in period 1.
Similarly, if a cash payment is anticipated at the start of period 1 to purchase an asset, and
related depreciation is to be recorded in periods 1 through 5, only the start of period 1
cash outflow is used in the net present value analysis. Depreciation is a legitimate busi-
ness cost, but it does not require a cash outflow in the period in which it is recorded.
Present value analysis is concerned only with cash flows.
In this section, we consider two special topics related to cash flows. The first deals
with depreciation. Although depreciation does not have a direct effect on cash flows, it
does have an indirect effect because of taxes. The second topic deals with the effect of
inflation on cash flows.
Learning Cash Flows, Taxes, and the Depreciation Tax Shield

Objective 2
In all of the previous examples, we ignored the effect of income taxes on cash flows.
Calculate the However, tax considerations play a major role in capital budgeting decisions, and we
depreciation tax shield discuss them here. If an investment project generates taxable revenue, cash inflows from
and evaluate long-run the project will be reduced by the taxes that must be paid on the revenue. Similarly, if
decisions, other than an investment project generates tax-deductible expenses, cash inflows from the project
investment decisions, will be increased by the tax savings resulting from the decrease in income taxes payable.
using time value of Earlier we stated that depreciation is not relevant in a present value analysis of an
money techniques. investment opportunity because it is not a cash flow. But although depreciation does not
directly affect cash flow, it indirectly affects cash flow because it reduces the amount of tax
a company must pay. That is, it acts to shield income from taxes. The term depreciation
tax shield is used to refer to the tax savings resulting from depreciation.
As an example, suppose the Mando Party Supply Company is considering a new
product, custom-imprinted T-shirts. Imprinting will require an investment in equip-
ment costing $100,000. Each year, the company expects sales to amount to $70,000 and
expenses (other than depreciation on the equipment) to amount to $40,000. Depreciation
calculated on a straight-line basis for the expected 10-year life of the equipment is $10,000
per year. The company has a 40 percent tax rate.5 Assume that revenue is c ollected in
5
Our discussion and examples assume a 40 percent tax rate. This assumption ignores complexities in tax
rates and rules in practice that may change from year to year. However, the assumption allows us to more
clearly convey the essential role of taxes in investment decisions.
A d d i t i o n a l C a s h F l o w C o n s i d e r a t i o n s 341
the period earned and expenses other than depreciation are paid in the period incurred.
Thus, net income and cash flows related to the investment are as follows:
Net Income
Revenue $70,000
Less:
Operating expense other than depreciation $40,000
Depreciation 10,000 50,000
Income before taxes 20,000
Income taxes (40% tax rate) 8,000
Net income $12,000
Cash Flows
Revenue $70,000
Less taxes on revenue (28,000)
Less expenses other than depreciation (40,000)
Plus tax savings related to expenses other than depreciation 16,000
Plus tax savings related to depreciation ($10,000 × .40) 4,000
Cash flow $22,000
Note that revenue increases cash inflows by $70,000 but taxes on the revenue decrease
cash flows by $28,000. Expenses other than depreciation reduce cash flows by $40,000
but, since they reduce taxable income by $40,000, they also save taxes of $16,000. Now
note that depreciation expense does not reduce cash flows—that’s because depreciation
is a noncash expense. However, it does reduce taxable income and thus results in a cash
inflow equal to the amount of depreciation times the tax rate ($10,000 × .40 = $4,000).
Thus, there is a depreciation tax shield of $4,000.
In the example, we calculated cash flows in a rather circuitous way because we
wanted to show the depreciation tax shield. A much more direct way would be to simply
add depreciation back to net income as follows:
Net income $12,000

Plus depreciation 10,000
Cash flow $22,000
We add depreciation back because it is the only item in the calculation of Mando Party
Supply’s net income that is not a cash flow.
Because the project is fairly risky, top management of Mando Party Supply has set a
required rate of return of 16 percent. The net present value calculation for the investment
under consideration is presented in Illustration 9-9. Note that because the amounts of
revenue, expense, and tax are the same each year, we can work with the net amount and
treat it as a 10-year annuity with a required rate of return of 16 percent. Because the net
present value is a positive $6,330, the investment in the equipment should be undertaken.
The fact that depreciation reduced taxes had a significant effect on the value of the
investment project. With depreciation of $10,000 and a 40 percent tax rate, we saw that
there is a $4,000 tax savings each year due to depreciation. The present value of this “tax
shield” over 10 years at 16 percent is $19,333 ($4,000 × present value factor of 4.8332).
Thus, it is apparent that without the tax shield afforded by depreciation, the investment
would not have a positive net present value and would not be worth undertaking.
Illustration 9-9
Present Present
NPV analysis taking taxes
Item Cash Flow Value Factor Value
into account
Initial investment ($100,000) 1,000 ($100,000)
Revenue $70,000
Expense (other than
depreciation) (40,000)
Taxes (8,000) 22,000 4.8332 106,330
Table B9-2, Appendix B

Link to Practice
Depreciation Tax Shield at Delta Air Lines taxes. The reason—it had more than $15 billion in tax
loss carry forwards related to previous years when the
Federal tax laws (with certain restrictions that we won’t
company had significant losses.
go into) allow companies to carry losses backward
How would this affect the value of the depreciation
to reduce previous taxes paid and receive a refund. If
tax shield for an investment in equipment in January
the losses cannot be carried back, they can be carried
2014 that results in depreciation expense in 2014 and
forward to offset future income in the determination of
2015? Since the company isn’t going to pay taxes in
federal income taxes.
2014 or 2015, it is clear that the incremental depreciation
The use of tax loss carry forwards appears to
related to the investment will not save taxes in these
be particularly useful to Delta Air Lines. In 2013, the
years, and there is no depreciation tax shield in 2014
company had income of $2.7 billion excluding special
or 2015.
items. However, it was not required to pay federal income
Adjusting Cash Flows for Inflation

An additional topic that must be addressed in estimating the cash flows of investments is
how to handle inflation. During the 1970s and early 1980s, the United States experienced
double-digit inflation. Because high rates of inflation are still common in many foreign
countries, it may be quite important to consider inflation when estimating the cash flows
associated with investment opportunities.
Inflation can be taken into account by multiplying the current level of cash flow by
the expected rate of inflation. For example, if an investment is expected to yield a cash
flow in period 1 of $100 and the rate of inflation is expected to be 5 percent per year in
the foreseeable future, then a reasonable estimate of the cash flow would be $105 ($100 ×
1.05) in period 2, $110.25 ($105 × 1.05) in period 3, $115.76 in period 4, and so forth.
Estimates of inflation can be obtained from financial journals or can be purchased for a
fee from firms that specialize in economic forecasts.
If inflation is ignored in net present value analysis, many worthwhile investment
opportunities may be rejected. Why? Because current rates of return for debt and equity
financing already include estimates of future inflation. For example, banks charge higher
rates of interest on loans to companies when they estimate that inflation will be high.
Suppose a company uses its current costs of debt and equity financing (which are high
because a high rate of inflation is expected) to determine its required rate of return. Now,
if the company does not take inflation into account in estimating future cash inflows, the
cash inflows will be relatively low, whereas the required rate of return will be relatively
high. The result may be that suitable projects will appear to have a negative net present
value.
O t h e r L o n g - R u n D e c i s i o n s 343
Illustration 9-10
1. Decision to outsource grounds maintenance
Other long-run decisions
2. Decision to drop a product line
3. Decision to buy rather than make a subcomponent of a product
4. Decision to conduct a multiyear advertising campaign
5. Decision involving customers paying for goods with alternative payment plans (e.g.,
large upfront payment and smaller annual payments versus small upfront payment and
larger annual payments)
OTHER LONG-RUN DECISIONS

So far we have discussed capital budgeting decisions that involve investments in long-lived
assets, and we have shown how to analyze them using time value of money techniques: spe-
cifically, the net present value method and the internal rate of return method. In addition
to being used to analyze capital budgeting decisions, time value of money techniques are
also applicable to the analysis of other long-run decisions. Long-run decisions are those
that affect the cash flows of a number of future periods. Since cash flows occur in the future
and a dollar today is worth more than a dollar tomorrow, the NPV and IRR methods are
applicable to these types of decisions. Examples of long-run decisions that are not invest-
ment decisions but should be analyzed using NPV or IRR are listed in Illustration 9-10.
Let’s consider an example that shows how time value of money techniques can
be used to analyze a decision other than a capital budgeting decision. Suppose that
Accelerator Consulting is considering signing a contract to sponsor a golf tournament
in Phoenix. The contract specifies that Accelerator will pay $600,000 at the start of each
of 5 years. In return, the tournament will be called the Accelerator Open when it is
broadcast on television and there will be highly visible signage around the clubhouse and
course. Additionally, Accelerator will receive free catering and seats on the 18th hole so
the company can entertain customers and other VIPs.
Accelerator estimates that over the 5 years, exposure from the tournament will
increase revenue by $2,000,000, $3,000,000, $4,000,000, $5,000,000, and $6,000,000. The
company’s normal pretax profit margin (pretax profit divided by revenue) is 20 percent,
and the company’s tax rate is 40 percent. The company would like to earn a 10 percent
return related to the event. Should the company agree to sponsor the tournament?
Analysis of the decision using NPV and IRR is presented in Illustration 9-11. Note that
the NPV is a positive $141,048. Thus, Accelerator should sponsor the tournament. The
illustration also shows that the IRR on the project is 14.59 percent. This was calculated
using the IRR function in Excel® as demonstrated in Appendix A.
Q: In Chapter 7, we analyzed decisions much like those described in Illustra-
tion 9-10 and in the example related to Accelerator Consulting, but we focused
on incremental revenues and incremental costs rather than cash inflows and
outflows, and we didn’t use NPV. Why could we ignore the time value of money in
Chapter 7 but we have to use it in this chapter?
A : In Chapter 7, we analyzed incremental revenues and incremental costs. An underlying

assumption, which was not spelled out because it would have been confusing then, is that
the incremental revenues were also incremental cash inflows, and the incremental costs were
also incremental cash outflows. Also, we assumed that the time value of money wasn’t im-
portant to analyzing the decision. This could be because the decision affected only one or two
periods, so ignoring the time value of money wouldn’t result in a significant error. Or, it may
have been that the decision alternatives did not require significant investments and one alter-
native clearly dominated the others because its incremental profit was the highest in all years.
Illustration 9-11
Evaluation of decision to sponsor a golf tournament
Cash Flows Present Year 1 Year 2 Year 3 Year 4 Year 5

Payments ($600,000) ($600,000) ($600,000) ($600,000) ($600,000) —
Tax savings from
payments — 240.000a 240,000 240,000 240,000 240,000
Additional pretax
profit exluding
payments — 400,000b 600,000 800,000 1,000,000 1,200,000
Additional taxes
related to additional
pretax profit — (160,000)c (240,000) (320,000) (400,000) (480,000)
Cash flows ($600,000) ($120,000) $ — $120,000 $240,000 $ 960,000
PV factor (Table B9-1,
Appendix B) ×1.0000 ×0.9091 ×0.8264 ×0.7513 ×0.6830 ×0.6209
Total ($600,000) ($109,092) $ –0– $ 90,156 $163,920 $ 596,064 = $141,048 (NPV)
14.59% (IRR)d
a
Equals $(600,000) × .4.
b
Equals $2,000,000 × .2.
c
Equals $400,000 × .4.
d
Calculated using Excel®, as described in Appendix A.
Learning SIMPLIFIED APPROACHES TO CAPITAL

Objective 3
BUDGETING
Use the payback period
and the accounting The net present value and the internal rate of return methods are widely used in industry
rate of return methods to evaluate capital projects. However, many companies continue to use other, simpler,
to evaluate investment approaches to evaluating capital projects. Two of these approaches, the payback period
opportunities, and method and the accounting rate of return method, are discussed in this section. As you
explain why managers will see, both of these methods have significant limitations in comparison to net present
may concentrate erro- value and internal rate of return.
neously on the short-run
profitability of invest- Payback Period Method
ments rather than their
The payback period is the length of time it takes to recover the initial cost of an invest-
net present values.
ment. Thus, if an investment opportunity costs $1,000 and yields cash flows of $500
per year, it has a payback period of 2 years. If an investment costs $1,000 and yields
cash flows of $300 per year, it has a payback period of 3⅓ years. All else being equal, a
company would like to have projects with short payback periods.
One approach to using the payback method is to accept investment projects that
have a payback period less than some specified requirement. However, this can lead to
extremely poor decisions. For example, suppose a company has two investment oppor-
tunities, both costing $1,000. The first investment yields cash flows of $500 per year for
3 years and has a payback period of 2 years. The second investment yields no cash
flows in the first 2 years but has cash flows of $1,000 in the third year and $4,000 in
the fourth year. Thus, it has a payback period of 3 years. Obviously, the second
investment is preferable. However, if the company has a 2-year payback requirement,
it will select the first investment and reject the second. The problem is that the payback
S i m p l i f i e d A p p r o a c h e s t o C a p i t a l B u d g e t i n g 345
Link to Practice
Payback on Home Solar Power Thus, he estimated that his payback period would be
around 11.7 years ($29,205 ÷ $2,500). After he made the
What’s the payback on an investment in a home
investment, Tofel sold his gas powered car and bought an
solar panel project? That depends on the number of
electric vehicle. He saved on gas and had no incremental
panels, local cost of electricity, and other factors. But,
electricity costs as his system had plenty of capacity. This
here’s an example from a homeowner in southeastern
made his actual payback period even lower.
Pennsylvania. Kevin Tofel added solar panels to his four-
bedroom house at a cost of $51,865. After a federal tax Source: Kevin C. Tofel, “Adding an electric car cut the pay-
credit and a state rebate, the net cost was only $29,205. back point of our solar panel investment in half,” GIGAOM,
His typical electric bill had been around $2,500 per year. May 12, 2013.
method does not take into account the total stream of cash flows related to an investment.
It only considers the stream of cash flows up to the time the investment is paid back.
Thus, in this example, the payback period method ignores the $4,000 cash inflow in the
fourth year of the second investment.
A further limitation of the payback method is that it does not consider the time value
of money. Consider two investments, each with a cost of $1,000. The first yields cash flows
of $700 in the first year, $300 in the second year, and $300 in the third year. Thus, it has
a payback of 2 years. The second investment yields cash flows of $300 in the first year,
$700 in the second year, and $300 in the third year. Thus, it also has a payback period
of 2 years. But although both investments have the same payback period (implying
they are equally valuable), the first investment is actually more favorable, because the
$700 cash inflow is received in the first year rather than the second year. In fact, the first
investment has an internal rate of return of 17 percent, whereas the second investment
has an internal rate of return of only 14 percent.
Although the payback method has significant limitations, some companies may
find it useful, particularly if they have cash flow problems. Companies with cash flow
problems may need to focus on investments that quickly return cash in order to avoid
bankruptcy.
Accounting Rate of Return

The accounting rate of return is equal to the average after-tax income from a project
divided by the average investment in the project:
Average net income
Accounting rate of return ( ARR ) =
Average investment
Here the average investment is simply the initial investment divided by 2.6 The account-
ing rate of return can be used to evaluate investment opportunities by comparing their
accounting rates of return with a required accounting rate of return. The primary
limitation of this approach is that, like the payback period method, it ignores the time
value of money.
Consider two investment alternatives facing a firm with a cost of capital of 15 percent
and a 40 percent tax rate. Both require investments in equipment costing $100,000, and
6
Note that if an investment in a project has scrap value, the average investment is equal to (initial investment
plus scrap value) ÷ 2. Also, some textbooks define the denominator to be the initial investment rather than
the average investment. For our purposes, however, we will use the average investment in the denominator.
Illustration 9-12
Project 1 Project 2
Net income and cash flow
data for alternative projects Year 1
Revenue $90,000 $ 70,000
Less: Operating expenses
other than depreciation 20,000 20,000
Income before taxes 20,000 0
Taxes 8,000 0
Net income 12,000 0
Plus: depreciation 50,000 50,000
Cash flow $62,000 $ 50,000
Year 2
Revenue $90,000 $110,000
Less: Operating expenses
other than depreciation 20,000 20,000
Income before taxes 20,000 40,000
Taxes 8,000 16,000
Net income 12,000 24,000
Plus: depreciation 50,000 50,000
Cash flow $62,000 $ 74,000
both generate cash flows for 2 years. The investments are identical except that, while
both have total revenue over 2 years of $180,000, project 1 has $90,000 of revenue in the
first year, while project 2 has $70,000. In the second year, project 1 again has $90,000
of revenue, while project 2 has $110,000. Illustration 9-12 presents the net incomes and
cash flows of the two alternatives for the 2 years. We assume that all revenue items are
collected in the period earned and all expense items (other than depreciation) are paid
in the period incurred. Thus, the difference between net income and cash flow is simply
the amount of depreciation.
Based on the information, it is easy to calculate the accounting rate of return for each
project, as indicated in Illustration 9-13. Both have identical accounting rates of return
of 24 percent, indicating that the two projects are equally desirable. When we take into
account the time value of money, however, it is clear that project 1 is more desirable than
project 2. As indicated in Illustration 9-14, using a cost of capital of 15 percent, the net
present value of project 1 is $793.40, whereas project 2 has a negative net present value
of $568.60. Thus, taking into account the time value of money, project 1 is an acceptable
investment while project 2 is not acceptable.
Illustration 9-13
Average net income
Comparison of ARRs for Accounting rate of return (ARR) =
alternative projects Average investment
($12,000 + $12,000) ÷ 2
ARR for project 1 = = .24
($100,000 ÷ 2)
($0 + $24,000) ÷ 2
ARR for project 2 = = .24
($100,000 ÷ 2)
C o n f l i c t B e t w e e n P e r f o r m a n c e E v a l u a t i o n a n d C a p i t a l B u d g e t i n g 347
Illustration 9-14
NPV comparison of Project 1
alternative projects Present Value
Time Period Cash Flow Factor Present Value
–0– ($100,000) 1.0000 ($100,000.00)

1 $ 62,000 .8696 53,915.20
2 $ 62,000 .7561 46,878.20
Net present value $ 793.40
Project 2
Present Value
Time Period Cash Flow Factor Present Value
–0– ($100,000) 1.0000 ($100,000.00)

1 $ 50,000 .8696 43,480.00
2 $ 74,000 .7561 55,951.40
Net present value ($ 568.60)
Compared to NPV, both the accounting rate of return and the payback method suffer from
a failure to consider:
a. Soft benefits. b. Unexpected consequences. c. The time value of money.
The Accounting Rate of Return Is Not a Reliable Estimate of the Internal Rate
of Return. Some people think that while the accounting rate of return ignores the time
value of money, it still provides a reasonably accurate estimate of a project’s internal rate
of return. This is not the case. Using Excel™ (see Apprendix A), we can easily calculate
the IRR of project 1 in Illustration 9-14 to be 15.62 percent. Recall that this is the rate
that makes the NPV of the project equal to zero. The accounting rate of return provided
a return of 24 percent, which is more than 50 percent greater than the internal rate of
return. This clearly demonstrates that the accounting rate of return need not be a rea-
sonable estimate of a project’s real economic return, which is measured by IRR.
CONFLICT BETWEEN PERFORMANCE

EVALUATION AND CAPITAL BUDGETING
You get what you An NPV greater than zero or an IRR greater than the required rate of return informs
M e a s u r e managers that an investment opportunity will increase their firm’s value. Thus, managers
who wish to maximize shareholder wealth should use these present value techniques to
evaluate investments. However, in some companies, managers may be discouraged from
using present value techniques for evaluating investments because of the way in which
their own performance is evaluated.
For example, an investment may result in high amounts of depreciation in the early
years of its life. At the same time, in these early start-up years, revenues may be quite
low, resulting in low profits or even losses. However, revenues in later years may be large
enough to ensure that the project has a positive net present value. If a manager knows
that job performance is evaluated in terms of reported accounting income, he or she may
fear being fired because of the low initial profits of this investment. If this is the case,
the manager will likely ignore the fact that a project has a positive net present value and
concentrate instead on reported income.
To illustrate this, suppose a manager is considering producing a new product that
requires an investment of $1,000,000 in equipment. Depreciation on the equipment will
be recorded using the straight-line method. Based on a 10-year life, depreciation will be
$100,000 per year. The product is not expected to sell well in the early years. Expected
first-year revenue is only $40,000. However, by the end of the seventh year, expected
revenue is up to $400,000 per year. In addition to depreciation, there are $40,000 of other
expenses each year. The company has a 10 percent required rate of return.
Illustration 9-15 is a net present value analysis of the investment. The net present
value is $26,998, indicating that the project should be undertaken. However, will the
Illustration 9-15
Net present value analysis of new producta
Year 1 Year 2 Year 3 Year 4 Year 5
Revenue $ 40,000 $ 60,000 $100,000 $150,000 $200,000

Less: Operating expenses other
than depreciation 40,000 40,000 40,000 40,000 40,000
Depreciation 100,000 100,000 100,000 100,000 100,000
Net income (100,000) (80,000) (40,000) 10,000 60,000
Plus: depreciation 100,000 100,000 100,000 100,000 100,000
Cash flow $ 0 $ 20,000 $ 60,000 $110,000 $160,000
Year 6 Year 7 Year 8 Year 9 Year 10
Revenue $300,000 $400,000 $400,000 $400,000 $400,000

Less: Operating expenses other
than depreciation 40,000 40,000 40,000 40,000 40,000
Depreciation 100,000 100,000 100,000 100,000 100,000
Net income 160,000 260,000 260,000 260,000 260,000
Plus: depreciation 100,000 100,000 100,000 100,000 100,000
Cash flow $260,000 $360,000 $360,000 $360,000 $360,000
Time Period Cash Flows Factor for 10% Present Value
0 ($1,000,000) 1.0000 ($1,000,000)

1 0 0.9091 0
2 20,000 0.8264 16,528
3 60,000 0.7513 45,078
4 110,000 0.6830 75,130
5 160,000 0.6209 99,344
6 260,000 0.5645 146,770
7 360,000 0.5132 184,752
8 360,000 0.4665 167,940
9 360,000 0.4241 152,676
10 360,000 0.3855 138,780
a
Note that the example is simplified and ignores taxes. Therefore, there is no depreciation tax shield. Also, the example assumes that
revenue is collected in the period earned and other expenses are paid in the period incurred.
W i l s o n A i r E x a m p l e R e v i s i t e d 349
manager be motivated to undertake this project, which is in the best interest of the
company? Note that the project shows a substantial loss in each of the first 3 years. The
manager may fear that this will reflect badly on his or her performance, perhaps leading
to dismissal from the firm. If this is the case, the manager may opt to pass up this valuable
investment opportunity.
At least a partial solution to this problem is to make sure managers realize that, if
they approve projects with positive net present values that lower reported income in
the short run, evaluations of their performance and their compensation will take the
expected future benefits into account. Managers must be confident that their perfor-
mance will be evaluated with respect to the long-run profitability of the firm, or they
will not take a long-run perspective in evaluating capital projects.
At some firms, top managers are required to hold stock in the company they work
for. The idea behind the requirement is that it aligns the interests of managers with the
interests of shareholders. These managers will tend to take actions that maximize the
value of the firm, because increasing firm value increases their own wealth. It is hoped
that these managers will tend to focus on present value techniques in evaluating invest-
ments because these techniques identify investments that increase the firm’s value.
WILSON AIR EXAMPLE REVISITED

At the beginning of the chapter, Steve Wilson, president of Wilson Air, was trying to
decide whether he should purchase another plane. At this point, we have developed the
tools needed to analyze problems like the one facing Steve.
Recall that a new plane costs $1,000,000. The residual value of the plane after
5 years will be $500,000, and annual depreciation using the straight-line method is
$100,000. Revenue will increase by $700,000 per year, and operating costs (ignoring
depreciation and taxes) will be $400,000. Revenue will be collected in the period earned,
and operating costs other than depreciation will be paid in the period incurred. Assume
the income tax rate is 40 percent. What is the net present value of the investment in the
plane if the required rate of return is 10 percent? The answer is $144,426, as shown in
Illustration 9-16. Because the NPV is positive, the investment should be undertaken.
Illustration 9-16
Present value of investment in plane
Present Value Present

Item Cash Flow Factor Value
Purchase price ($1,000,000) 1,0000 ($1,000,000)

Revenue $700,000
Less:
Operating expenses other
than depreciation 400,000 Appendix B, Table Appendix B, Table
Depreciation 100,000 B9-2, 10%, 5 years B9-1, 10%, 5 years
Income before income taxes 200,000
Income taxes 80,000
Net income 120,000
Plus: depreciation 100,000
Annual cash flow 220,000 3.7908 833,976
Residual value 500,000 .6209 310,450
350 c h a p t e r 9 C a p i t a l B u d g e t i n g a n d O t h e r L o n g - R u n D e c i s i o n s
Decision Making
Capital budgeting decisions involve estimation of incremental cash inflows and out-
Insight flows. Since the cash flows don’t occur in the same periods and because a dollar
today is worth more than a dollar tomorrow, we need to take into account the time
value of money by using the net present value (NPV) approach or the internal rate
of return (IRR) approach.
However, managers may not make investments in projects with substantial
NPVs (or projects with IRRs greater than the required rate of return) because they
are evaluated in terms of short-run accounting profit, which may decrease when the
projects are undertaken.

Learning Objective 1 Define capital expenditure relevant to the analysis. The tax savings owing to depreciation
decisions and capital budgets and evaluate are referred to as the depreciation tax shield.
investment opportunities using the net present value NPV and IRR are also used to evaluate long-run decisions
approach and the internal rate of return approach. that are not capital budgeting decisions. Examples include
outsourcing decisions and decisions related to multiyear adver-
Capital expenditure decisions are investment decisions involv- tising campaigns.
ing the acquisition of long-lived assets. A capital budget is the
final list of approved acquisitions. Learning Objective 3 Use the payback period
Two of the primary methods for evaluating investment and the accounting rate of return methods to
opportunities, which take into account the time value of evaluate investment opportunities, and explain why
money, are the net present value method (NPV) and the
managers may concentrate erroneously on the
internal rate of return method (IRR). The net present value
method equates all cash flows to their present values. If the
short-run profitability of investments rather than
sum of the present values of cash inflows and outflows (i.e., their net present values.
the NPV) is zero or positive, the return on the investment The payback method evaluates capital projects in terms of
equals or exceeds the required return and the investment how quickly the initial investment is recovered by future cash
should be made. inflows. The accounting rate of return method evaluates capital
The internal rate of return method calculates the rate of projects in terms of the ratio of average after-tax accounting
return that equates the present value of the future cash flows to income to the average investment. Both of these methods have
the initial investment. If this rate of return is equal to or greater the major limitation that they ignore the time value of money.
than the required rate of return, the investment is warranted. Managers who want to maximize shareholder wealth should
evaluate investment opportunities using the net present value
Learning Objective 2 Calculate the depreciation method or the internal rate of return method. In some cases,
however, projects with a positive net present value or with an
tax shield and evaluate long-run decisions, other
internal rate of return greater than required may have a nega-
than investment decisions, using time value of
tive effect on short-run income. Although these projects may
money techniques. be quite valuable to the long-run success of the firm, managers
In analyzing cash flows for a net present value analysis or an may not approve them because they fear that their own job
internal rate of return analysis, remember that depreciation is performance will receive negative evaluations if short-run
not a cash flow but the tax savings generated by depreciation are income is reduced.
Appendix A
USING EXCEL® TO CALCULATE NPV AND IRR

In this appendix, you will see how to use functions in Excel® to calculate the net present value
(NPV) and internal rate of return (IRR) of investment opportunities. Let’s focus on the data related
to the paint-spraying equipment example presented in Illustration 9-3.
A p p e n d i x A 351
Illustration A9-1
Input data into Excel®
The first step in performing present value calculations in Excel® is to input the relevant
cash flows into a spreadsheet: cells B2–G2 in Illustration A9-1. As indicated, purchase of the
paint-spraying equipment requires a $70,000 payment at time 0. The company buying the equip-
ment will save $21,000 each year for 5 years and sell the equipment for $5,000 at the end of the
fifth year. Thus, the cash inflow at the end of year 5 is $26,000 ($21,000 + $5,000). The required
rate of return on the investment is 0.12, which we input in cell B5.
To calculate net present value, we need to input the NPV function into a cell; click on cell
B8. Now click on Formulas, then click on Financial, and then click on NPV, which is one of the
programs in the Financial section. The first item we input into the NPV function is the required
rate of return, which is in cell B5. The NPV function calculates the present value of cash flows
assuming the first cash flow occurs at the end of year 1. So, be careful: Don’t include the cash flow
at time 0 at this point. Simply input the cash flows from C2 through G2. At this point, your screen
should be similar to the one in Illustration A9-2.
Illustration A9-2
Using the NPV function
Illustration A9-3
Using the IRR function
Now click OK, go back to cell B8, and add the cash flow occurring at time 0, which is in cell
B2. As you can see, this gives us the project’s NPV of $8,537.43.
Let’s turn our attention now to the IRR function and put it in cell B9. Go to the Function
button, click the Financial Category, and click the IRR function name. Now input B2:G2, which
highlights the project’s cash flows. Then, if you want, input an estimated internal rate of return.
This estimate just helps the program have an efficient starting point for calculating the IRR. You
can generally ignore this step, and we will do that here (see Illustration A9-3).
Once you click OK, Excel® will calculate the internal rate of return, which is 16.68 percent in
this example (see Illustration A9-4).
Since the NPV is positive and the IRR is greater than the required rate of 12 percent, the
project should be undertaken.
Illustration A9-4
NPV and IRR results
A p p e n d i x B 353
Appendix B
Table B9-1
Present value of $1 due in n periods
6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 20% 30%
1 0.9434 0.9346 0.9259 0.9174 0.9091 0.9009 0.8929 0.8850 0.8772 0.8696 0.8621 0.8333 0.7692
2 0.8900 0.8734 0.8573 0.8417 0.8264 0.8116 0.7972 0.7831 0.7695 0.7561 0.7432 0.6944 0.5917
3 0.8396 0.8163 0.7938 0.7722 0.7513 0.7312 0.7118 0.6931 0.6750 0.6575 0.6407 0.5787 0.4552
4 0.7921 0.7629 0.7350 0.7084 0.6830 0.6587 0.6355 0.6133 0.5921 0.5718 0.5523 0.4823 0.3501
5 0.7473 0.7130 0.6806 0.6499 0.6209 0.5935 0.5674 0.5428 0.5194 0.4972 0.4761 0.4019 0.2693
6 0.7050 0.6663 0.6302 0.5963 0.5645 0.5346 0.5066 0.4803 0.4556 0.4323 0.4104 0.3349 0.2072
7 0.6651 0.6227 0.5835 0.5470 0.5132 0.4817 0.4523 0.4251 0.3996 0.3759 0.3538 0.2791 0.1594
8 0.6274 0.5820 0.5403 0.5019 0.4665 0.4339 0.4039 0.3762 0.3506 0.3269 0.3050 0.2326 0.1226
9 0.5919 0.5439 0.5002 0.4604 0.4241 0.3909 0.3606 0.3329 0.3075 0.2843 0.2630 0.1938 0.0943
10 0.5584 0.5083 0.4632 0.4224 0.3855 0.3522 0.3220 0.2946 0.2697 0.2472 0.2267 0.1615 0.0725
11 0.5268 0.4751 0.4289 0.3875 0.3505 0.3173 0.2875 0.2607 0.2366 0.2149 0.1954 0.1346 0.0558
12 0.4970 0.4440 0.3971 0.3555 0.3186 0.2858 0.2567 0.2307 0.2076 0.1869 0.1685 0.1122 0.0429
13 0.4688 0.4150 0.3677 0.3262 0.2897 0.2575 0.2292 0.2042 0.1821 0.1625 0.1452 0.0935 0.0330
14 0.4423 0.3878 0.3405 0.2992 0.2633 0.2320 0.2046 0.1807 0.1597 0.1413 0.1252 0.0779 0.0254
15 0.4173 0.3624 0.3152 0.2745 0.2394 0.2090 0.1827 0.1599 0.1401 0.1229 0.1079 0.0649 0.0195
16 0.3936 0.3387 0.2919 0.2519 0.2176 0.1883 0.1631 0.1415 0.1229 0.1069 0.0930 0.0541 0.0150
17 0.3714 0.3166 0.2703 0.2311 0.1978 0.1696 0.1456 0.1252 0.1078 0.0929 0.0802 0.0451 0.0116
18 0.3503 0.2959 0.2502 0.2120 0.1799 0.1528 0.1300 0.1108 0.0946 0.0808 0.0691 0.0376 0.0089
19 0.3305 0.2765 0.2317 0.1945 0.1635 0.1377 0.1161 0.0981 0.0829 0.0703 0.0596 0.0313 0.0068
20 0.3118 0.2584 0.2145 0.1784 0.1486 0.1240 0.1037 0.0868 0.0728 0.0611 0.0514 0.0261 0.0053
Table B9-2
Present value of an annuity of $1 per period
6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 20% 30%
1 0.9434 0.9346 0.9259 0.9174 0.9091 0.9009 0.8929 0.8850 0.8772 0.8696 0.8621 0.8333 0.7692
2 1.8334 1.8080 1.7833 1.7591 1.7355 1.7125 1.6901 1.6681 1.6467 1.6257 1.6052 1.5278 1.3609
3 2.6730 2.6243 2.5771 2.5313 2.4869 2.4437 2.4018 2.3612 2.3216 2.2832 2.2459 2.1065 1.8161
4 3.4651 3.3872 3.3121 3.2397 3.1699 3.1024 3.0373 2.9745 2.9137 2.8550 2.7982 2.5887 2.1662
5 4.2124 4.1002 3.9927 3.8897 3.7908 3.6959 3.6048 3.5172 3.4331 3.3522 3.2743 2.9906 2.4356
6 4.9173 4.7665 4.6229 4.4859 4.3553 4.2305 4.1114 3.9975 3.8887 3.7845 3.6847 3.3255 2.6427
7 5.5824 5.3893 5.2064 5.0330 4.8684 4.7122 4.5638 4.4226 4.2883 4.1604 4.0386 3.6046 2.8021
8 6.2098 5.9713 5.7466 5.5348 5.3349 5.1461 4.9676 4.7988 4.6389 4.4873 4.3436 3.8372 2.9247
9 6.8017 6.5152 6.2469 5.9952 5.7590 5.5370 5.3282 5.1317 4.9464 4.7716 4.6065 4.0310 3.0190
10 7.3601 7.0236 6.7101 6.4177 6.1446 5.8892 5.6502 5.4262 5.2161 5.0188 4.8332 4.1925 3.0915
11 7.8869 7.4987 7.1390 6.8052 6.4951 6.2065 5.9377 5.6869 5.4527 5.2337 5.0286 4.3271 3.1473
12 8.3838 7.9427 7.5361 7.1607 6.8137 6.4924 6.1944 5.9176 5.6603 5.4206 5.1971 4.4392 3.1903
13 8.8527 8.3577 7.9038 7.4869 7.1034 6.7499 6.4235 6.1218 5.8424 5.5831 5.3423 4.5327 3.2233
14 9.2950 8.7455 8.2442 7.7862 7.3667 6.9819 6.6282 6.3025 6.0021 5.7245 5.4675 4.6106 3.2487
15 9.7122 9.1079 8.5595 8.0607 7.6061 7.1909 6.8109 6.4624 6.1422 5.8474 5.5755 4.6755 3.2682
16 10.1059 9.4466 8.8514 8.3126 7.8237 7.3792 6.9740 6.6039 6.2651 5.9542 5.6685 4.7296 3.2832
17 10.4773 9.7632 9.1216 8.5436 8.0216 7.5488 7.1196 6.7291 6.3729 6.0472 5.7487 4.7746 3.2948
18 10.8276 10.0591 9.3719 8.7556 8.2014 7.7016 7.2497 6.8399 6.4674 6.1280 5.8178 4.8122 3.3037
19 11.1581 10.3356 9.6036 8.9501 8.3649 7.8393 7.3658 6.9380 6.5504 6.1982 5.8775 4.8435 3.3105
20 11.4699 10.5940 9.8181 9.1285 8.5136 7.9633 7.4694 7.0248 6.6231 6.2593 5.9288 4.8696 3.3158
Review Problem 1
Summit Maintenance Technology sells a software package that companies can use to manage their
facility and equipment maintenance functions. Features include work order tracking, maintenance
history reporting, repair history reporting, and parts inventory management. The software is used
mainly by large organizations such as airports, manufacturing plants, office complexes, hospitals, and
commercial bakeries. A unique aspect of Summit’s product is that it has a very intuitive interface and
can be accessed via the Web with Summit providing application servers, database servers, and security.
Thus, firms that implement the system do not need to add information technology staff or equipment.
Currently Summit is negotiating with Ogden National Airport, which has considerable mainte-
nance challenges. For example, the airport has six employees whose sole job is relamping (i.e., replacing
light bulbs). In total, the maintenance department at Ogden has 45 employees who maintain esca-
lators, elevators, trams, lighting, and perform painting and other miscellaneous maintenance duties.
Craig Bradley, a senior manager at Ogden National Airport, has held a series of meetings
with Summit and has identified the following cost savings:
1. The company can avoid purchasing a server costing $10,000 next year.
2. Due to better tracking, parts inventory can be reduced. The effect on purchases is $30,000,
$20,000, and $10,000 over the next 3 years.
3. The company will need one less maintenance employee with an annual salary and benefits of
$60,000.
4. The company is currently paying $5,000 per year to upgrade its maintenance software.
Craig anticipates that the charges to Ogden for software and consulting services will be as follows:
Initial costs—$90,000 “program fee” plus $55,000 consultant charges for systems integration
and customization of reports
Ongoing costs—$14,000 annual program fee after the initial year plus $6,000 per year con-
sulting charges for ongoing customization beyond the initial year
Req u i red
Calculate the net present value (NPV), assuming a required rate of return of 15 percent. Also
calculate the internal rate of return (IRR). In performing your calculations, use a three-year time
horizon and ignore taxes.
Should Ogden invest in the new software?
An s w er
Time 0 1 2 3
Initial program fee (90,000.00)

Initial consulting charges (55,000.00)
Ongoing charges (20,000.00) (20,000.00) (20,000.00)
IT equipment 10,000.00
Parts inventory 30,000.00 20,000.00 10,000.00
Maintenance employee 60,000.00 60,000.00 60,000.00
Old software upgrade 5,000.00 5,000.00 5,000.00
Total (145,000.00) 85,000.00 65,000.00 55,000.00
Present value factors at 15% 1.0000 0.8696 0.7561 0.6575
(145,000.00) 73,916.00 49,146.50 36,162.50
NPV 14,225.00
IRR, in % 21.33
Note: IRR calculated using Excel®, as explained in Appendix A.
Since the NPV is greater than zero and the IRR is greater than the required rate of return, Ogden
should invest in the software.
C o m m o n C o s t BSe eh laf v- A e sast tme er nnst 355
i osrs P
Review Problem 2
United Insurance of Hawaii is building a new facility to house its staff of 500 in downtown
Honolulu. The company prides itself on a commitment to sustainability, and, in this regard, it is
considering two alternatives that will reduce its demand for electricity generated using fossil fuel.
The first alternative is to install solar panels on the roof of the building. The company esti-
mates that this alternative will cost $1,000,000 and save the company $280,000 per year in elec-
tricity costs. The panels are expected to have a five-year life.
The second alternative is to utilize nanotechnology to produce a photovoltaic material that
can be installed over windows. This alternative is more expensive, $1,500,000, but is expected to
save $400,000 per year over its five-year life.
Req u i red
Use the NPV approach to determine the better alternative. Assume the company desires a return
of 12 percent.
An s w er
Cash 12% Present
Solar Panels Flow Factor Value
Purchase price ($1,000,000) 1.0000 ($1,000,000)

Energy savings $280,000 per year
for 5 years 3.6048 1,009,344
NPV $ 9,344
Cash 12% Present $67,424

Nanotechnology Flow Factor Value
Purchase price ($1,500,000) 1.0000 ($1,500,000)

Energy savings $400,000 per year
for 5 years 3.6048 1,441,920
NPV ($ 58,080)
As indicated, the investment in solar panels is the better alternative. It has an incremental NPV of
$67,424 over the investment in nanotechnology.
Key Terms Accounting rate of return (345)

Capital budget (328)
Cost of capital (339)
Depreciation tax shield
present value (NPV) (331)
Payback period (344)
Capital budgeting decisions (328) (340) Required rate of return
Capital expenditure decisions Internal rate of return (IRR) (331)
(328) (334) Trial-and-error (336)

1. Which of the following is not a capital expenditure 2. Which of the following methods equates future dollars
decision? to current dollars?
a. Building a new factory. a. Net present value method.
b. Purchasing a new piece of equipment. b. Accounting rate of return.
c. Purchasing a computer system. c. Payback period method.
d. All of the above are capital expenditure decisions. d. All of these answer choices are correct.
3. If you require a return of 8 percent, the present value of 8. A project with a useful life of 5 years requires an
$100 received 2 years from now would be calculated investment of $100,000 and yields after-tax income of
as: $40,000 per year for 5 years. Assuming the investment
$100 (1 + .08)2 has no value at the end of 5 years, the accounting rate of
a. 2 . b. . return is:
( .08 ) $100
100 a. 40 percent.
c. $ .
(1 + .08 )2 b. 20 percent.
d. None of these answer choices is correct. c. 10 percent.
d. None of these answer choices are correct.
4. If the net present value of a project is zero, the project is
earning a return equal to: 9. A project requires a $2,000,000 investment and has an
a. Zero. internal rate of return of 20 percent. The cost of capital
is only 15 percent. A manager with a short-run orienta-
b. The rate of inflation.
tion may still reject this investment if:
c. The accounting rate of return.
a. The net present value is positive.
d. The required rate of return.
b. The rate of inflation is high.
5. An investment should be made if: c. The accounting rate of return is high.
a. The IRR is equal to or greater than the required rate d. Accelerated depreciation leads to reported losses in
of return. the early years of the investment’s useful life.
b. The IRR is equal to or greater than zero.
10. A project has unequal cash flows, and a manager guesses
c. The IRR is greater than the accounting rate of that the internal rate of return will be 10 percent. If the
return. net present value is positive at 10 percent, then:
d. The IRR is greater than the present value factor. a. The internal rate of return is greater than
6. The cost of capital is: 10 percent.
a. The cost of debt financing. b. The internal rate of return is less than 10 percent.
b. The cost of equity financing. c. The internal rate of return is exactly 10 percent.
c. The weighted average of the costs of debt and equity d. None of these answer choices is correct.
financing.
d. The internal rate of return. Answers to Self-Assessment
7. A piece of equipment costs $100,000 and has a five-year 1. d 2. a 3. c 4. d 5. a 6. c 7. d 8. d 9. d 10. a
life. Assuming straight-line depreciation and a 40 percent
tax rate, this investment:
a. Will generate a positive cash inflow at time 0.
b. Will have a negative depreciation tax shield.
c. Will generate a $40,000 expense each year but will
not affect cash flows beyond year 0.
d. Will generate a depreciation tax shield equivalent to
an annual cash inflow of $8,000 for 5 years.
QUESTIONS 1. What is a capital expenditure decision?

2. Why is it important to take into account the time value of money when making capital bud-
geting decisions?
3. What are the two approaches for evaluating investments that take into account the time value
of money?
4. How do the net present value and the internal rate of return methods differ in their approach
to evaluating investment alternatives?
5. What is the cost of equity financing?

6. How are cash flows affected as a result of the tax consequences of depreciation?
7. What are the advantages of evaluating projects using the net present value and internal rate of
return methods instead of the payback and accounting rate of return methods?
8. Why may managers concentrate on the short-run profitability of investments rather than their
net present values?
9. How is the internal rate of return (IRR) determined if there are uneven cash flows?
10. Why does the failure to consider soft benefits discourage investment?
Exercises EXERCISE 9-1. [LO 1] Explain why interest expense is not treated as a cash outflow in capital
budgeting decisions made using net present value (NPV) analysis.
EXERCISE 9-2. [LO 1, 3] Sally Omar is the manager of the office products division of Wallace
nterprises. In this position, her annual bonus is based on an appraisal of return on investment
E
(ROI) measured as Division income ÷ End-of-year division assets (net of accumulated depreciation).
Currently, Sally is considering investing $40,000,000 in modernization of the division plant
in Tennessee. She estimates that the project will generate cash savings of $6,550,000 per year
for 8 years. The plant improvements will be depreciated over 8 years ($40,000,000 ÷ 8 years =
$5,000,000). Thus, the annual effect on income will be $1,550,000 ($6,550,000 - $5,000,000).
Req u ir ed
Using a discount rate of 10 percent, calculate the NPV of the modernization project. Then calculate
the ROI of the project each year over its eight-year life. (Calculate ROI as effect on income divided
by end-of-year book value. Note that the value of ROI is not defined at the end of year 8 when
book value is zero.) Finally, write a paragraph explaining why Sally may not make the investment
even though it has a positive NPV.
EXERCISE 9-3. [LO 1] Generally speaking, the cost of capital for a food-processing company is
lower than the cost of capital for a company that runs casinos. Briefly expain why this is the case.
EXERCISE 9-4. Using Present Value Tables [LO 1] What is the present value of $850 per year for
6 years if the required return is 11 percent (answer using Table B9-2 in Appendix B).
EXERCISE 9-5. Using Present Value Tables [LO 1] Examine Table B9-1 in Appendix B. Explain
why the numbers decrease as you move from left to right in a given row. Explain why the numbers
decrease as you move from top to bottom in a given column.
EXERCISE 9-6. Calculate Present Value [LO 1] Suppose you face the prospect of receiving
$1,200 per year for the next 7 years plus an extra $950 payment at the end of 7 years. Determine
how much this prospect is worth today if the required rate of return is 15 percent.
EXERCISE 9-7. Calculate Present Value [LO 1] Mary Martinez is ready to retire and has a choice
of three pension plans. Plan A provides for an immediate cash payment of $350,000. Plan B pro-
vides for the payment of $40,000 per year for 8 years and the payment of $200,000 at the end of
year 8. Plan C will pay $35,000 per year for 8 years. Mary Martinez desires a return of 8 percent.
Determine the present value of each plan and select the best one.
EXERCISE 9-8. Calculate Net Present Value [LO 1] An investment that costs $85,000 will return
$35,000 per year for 5 years. Determine the net present value of the investment if the required
rate of return is 12 percent. (Ignore taxes.) Should the investment be undertaken?
EXERCISE 9-9. Calculate the Internal Rate of Return [LO 1] An investment that costs $200,000
will reduce operating costs by $35,000 per year for 12 years. Determine the internal rate of return
of the investment (ignore taxes). Should the investment be undertaken if the required rate of
return is 18 percent?
EXERCISE 9-10. Calculate the Internal Rate of Return [LO 1] Tanya Sinclair, owner of Sinclair
Fine Wine, is considering investing $195,000 in a temperature-controlled wine storage room. She
plans to rent space to customers and expects to generate $55,000 annually (rental charges less
miscellaneous expenses other than depreciation).
Req u i red
a. Assuming Tanya wishes to evaluate the project with a five-year time horizon, what is the internal
rate of return of the investment? (Ignore taxes.)
b. Should Tanya make the investment if her required rate of return is 10 percent?
EXERCISE 9-11. Depreciation Tax Shield [LO 2] Strauss Corporation is making a $90,000 invest-
ment in equipment with a five-year life. The company uses the straight-line method of deprecia-
tion and has a tax rate of 40 percent. The company’s required rate of return is 15 percent.
Req u i red
What is the present value of the tax savings related to depreciation of the equipment?
EXERCISE 9-12. Cash Flow Implications of Tax Losses [LO 2] WesternGear.com is expected to
have operating losses of $350,000 in its first year of business and $270,000 in its second year. How-
ever, the company expects to have income before taxes of $400,000 in its third year and $650,000
in its fourth year. The company’s required rate of return is 14 percent.
Req u i red
Assume a tax rate of 35 percent and that current losses can be used to offset taxable income in
future years. What is the present value of tax savings related to the operating losses in years 1 and 2?
EXERCISE 9-13. Net Present Value with Taxes [LO 1, 2] Great Northern Fishing Company
is contemplating the purchase of a new smoker. The smoker will cost $60,000 but will generate
additional revenue of $34,000 per year for 6 years. Additional costs, other than depreciation, will
equal $12,000 per year. The smoker has an expected life of 6 years, at which time it will have
no residual value. Great Northern uses the straight-line method of depreciation for tax purposes.
Determine the net present value of the investment if the required rate of return is 14 percent and
the tax rate is 40 percent. Should Great Northern make the investment in the smoker?
EXERCISE 9-14. Calculate the Payback Period [LO 3] The Sunny Valley Wheat Cooperative is
considering the construction of a new silo. It will cost $126,000 to construct the silo. Determine
the payback period if the expected cash inflows are $21,000 per year.
EXERCISE 9-15. Calculate the Accounting Rate of Return [LO 3] The Herbolt Company is
considering a new line of business. Starting the business will require an initial investment in
equipment of $355,000. It is expected that the new business will increase net income by $32,000
per year for 5 years. The equipment will be depreciated over a 5-year period using straight-
line depreciation with no residual value. Determine the accounting rate of return of the new
business.
EXERCISE 9-16. IRR and Unequal Cash Flows [LO 1] Newport Department Store is considering
development of an e-commerce business. The company estimates that development will require an
P r o b l e m s 359
initial outlay of $1,300,000. Other cash flows will be as follows:
Year 1 ($750,000)
Year 2 $221,000
Year 3 $850,000
Year 4 $950,000
Year 5 $940,000
Req u i red
Assuming the company limits its analysis to 5 years, estimate the internal rate of return of the
e-commerce business. Should the company develop the e-commerce business if the required rate
of return is 14 percent?
EXERCISE 9-17. IRR and Unequal Cash Flows [LO 1] A company is making an investment of
$2,500,000 that will yield the following cash flows:
Year 1 $ 250,000
Year 2 $ 440,000
Year 3 $ 650,000
Year 4 $ 850,000
Year 5 $1,102,765
R equ ir ed
What is the internal rate of return of the investment?
EXERCISE 9-18. Soft Benefits [LO 1] Reece Jewelry has 45 stores in major malls around the
country. The company is considering starting an online business, ReeceJewelry.com, which will
require a substantial investment in technology.
R equ ir ed
Identify a potential benefit of the online business that would be difficult to quantify in a net present
value analysis.
Problems PROBLEM 9-1. Present Value Analysis [LO 1, 2] James Hardy recently rejected a $20,000,000,
five-year contract with the Vancouver Seals hockey team. The contract offer called for an imme-
diate signing bonus of $7,500,000 and annual payments of $2,500,000. To sweeten the deal, the
president of player personnel for the Seals has now offered a $22,000,000, five-year contract. This
contract calls for annual increases and a balloon payment at the end of 5 years.
Year 1 $ 2,500,000
Year 2 2,600,000
Year 3 2,700,000
Year 4 2,800,000
Year 5 2,900,000
Year 5 balloon payment 8,500,000
Total $22,000,000
Req u i red
Suppose you are Hardy’s agent and you wish to evaluate the two contracts using a required rate of
return of 15 percent. In present value terms, how much better is the second contract?
PROBLEM 9-2. Calculate Net Present Value [LO 1] Memory Florist is considering replacing
an old refrigeration unit with a larger unit to store flowers. Because the new refrigeration unit
has a larger capacity, Memory estimates that it can sell an additional $9,000 of flowers a year.
(The cost of the flowers is $5,000). In addition, the new unit is energy efficient and should
save $2,500 in electricity each year. It will cost an extra $4,000 per year for maintenance. The
new refrigeration unit costs $25,000 and has an expected life of 10 years. The old unit is fully
depreciated and can be sold for an amount equal to disposal cost. At the end of 10 years, the
new unit has an expected residual value of $6,000. Determine the net present value of the
investment if the required rate of return is 14 percent. (Ignore taxes.) Should the investment
be undertaken?
PROBLEM 9-3. Choosing among Alternative Investments [LO 1] Albert Shoe Company is con-
sidering investing in one of two machines that attach heels to shoes. Machine A costs $70,000 and
is expected to save the company $20,000 per year for 6 years. Machine B costs $95,000 and is
expected to save the company $25,000 per year for 6 years. Determine the net present value for
each machine and decide which machine should be purchased if the required rate of return is
13 percent. Ignore taxes.
PROBLEM 9-4. Present Value and “What If” Analysis [LO 1] National Cruise Line is consid-
ering the acquisition of a new ship that will cost $200,000,000. In this regard, the president of
the company asked the CFO to analyze cash flows associated with operating the ship under two
alternative itineraries: Itinerary 1, Caribbean Winter/Alaska Summer and Itinerary 2, Caribbean
Winter/Eastern Canada Summer. The CFO estimated the following cash flows, which are expected
to apply to each of the next 15 years:
Caribbean/Alaska Caribbean/Eastern Canada
Net revenue $120,000,000 $105,000,000

Less:
Direct program expenses (25,000,000) (24,000,000)
Indirect program expenses (20,000,000) (20,000,000)
Nonoperating expenses (21,000,000) (21,000,000)
Add back depreciation 115,000,000 115,000,000
Cash flow per year $169,000,000 $155,000,000
Req u i r ed
a. For each of the itineraries, calculate the present values of the cash flows using required rates of
return of both 12 and 16 percent. Assume a 15-year time horizon. Should the company purchase
the ship with either or both required rates of return?
b. The president is uncertain whether a 12 percent or a 16 percent required return is appropriate.
Explain why, in the present circumstance, spending a great deal of time determining the correct
required return may not be necessary.
c. Focusing on a 12 percent required rate of return, what would be the opportunity cost to the
company of using the ship in a Caribbean/Eastern Canada itinerary rather than a Caribbean/
Alaska itinerary?
PROBLEM 9-5. Net Present Value and Taxes [LO 1, 2] Penguin Productions is evaluating a
film project. The president of Penguin estimates that the film will cost $20,000,000 to produce.
In its first year, the film is expected to generate $16,500,000 in net revenue, after which the film
will be released to video. Video is expected to generate $10,000,000 in net revenue in its first year,
$2,500,000 in its second year, and $1,000,000 in its third year. For tax purposes, amortization of
the cost of the film will be $12,000,000 in year 1 and $8,000,000 in year 2. The company’s tax rate
is 35 percent, and the company requires a 12 percent rate of return on its films.
Req u i r ed
What is the net present value of the film project? To simplify, assume that all outlays to produce
the film occur at time 0. Should the company produce the film?
P r o b l e m s 361
PROBLEM 9-6. Internal Rate of Return and Taxes [LO 1] The Boston Culinary Institute is
e valuating a classroom remodeling project. The cost of the remodel will be $350,000 and will be
depreciated over 6 years using the straight-line method. The remodeled room will accommodate
five extra students per year. Each student pays annual tuition of $22,000. The before-tax incremental
cost of a student (e.g., the cost of food prepared and consumed by a student) is $2,000 per year.
The company’s tax rate is 40 percent, and the company requires a 12 percent rate of return on the
remodeling project.
Req u ired
Assuming a six-year time horizon, what is the internal rate of return of the remodeling project?
Should the company invest in the remodel?
PROBLEM 9-7. Net Present Value, Internal Rate of Return, Payback, Accounting Rate of
Return, and Taxes [LO 1, 2, 3] Adrian Sonnetson, the owner of Adrian Motors, is considering
the addition of a paint and body shop to his automobile dealership. Construction of a building
and the purchase of necessary equipment is estimated to cost $800,000, and both the building
and equipment will be depreciated over 10 years using the straight-line method. The building and
equipment have zero estimated residual value at the end of 10 years. Sonnetson’s required rate of
return for this project is 12 percent. Net income related to each year of the investment is as follows:
Revenue $650,000
Less:
Material cost 70,000
Labor 150,000
Depreciation 80,000
Other 10,000
Taxes at 40% 136,000
Net income $204,000
Req u i r ed
a. Determine the net present value of the investment in the paint and body shop. Should Sonnet-
son invest in the paint and body shop?
b. Calculate the internal rate of return of the investment (approximate).
c. Calculate the payback period of the investment.
d. Calculate the accounting rate of return.
PROBLEM 9-8. Choosing among Alternative Investments [LO 1] Pronto Cleaners, a chain of
dry cleaning stores, has the opportunity to invest in one of two dry cleaning machines. Machine
A has a four-year expected life and a cost of $30,000. It will cost an additional $6,500 to have the
machine delivered and installed, and the expected residual value at the end of 4 years is $4,000.
Machine B has a 4-year expected life and a cost of $55,000. It will cost an additional $7,000 to
have the machine delivered and installed, and the expected residual value at the end of four years
is $6,000. Pronto has a required rate of return of 14 percent. Additional cash flows related to the
machines are as follows:
Machine A
Item Year 1 Year 2 Year 3 Year 4

Labor saving $25,000 $25,000 $25,000 $25,000
Power saving 1,500 1,500 1,500 1,500
Chemical saving 3,000 3,000 3,000 3,000
Additional maintenance (1,200) (1,200) (1,200) (1,200)
Additional miscellaneous (2,500) (2,500) (2,500) (2,500)
Machine B
Item Year 1 Year 2 Year 3 Year 4

Labor saving $32,000 $32,000 $32,000 $32,000
Power saving 2,000 2,000 2,000 2,000
Chemical saving 3,500 3,500 3,500 3,500
Additional maintenance (1,500) (1,500) (1,500) (1,500)
Additional miscellaneous (2,700) (2,700) (2,700) (2,700)
Req u i r ed
a. Ignoring taxes, determine the net present value of investing in Machine A.
b. Ignoring taxes, determine the net present value of investing in Machine B.
c. Which, if any, machine should be purchased?
PROBLEM 9-9. Net Present Value and Taxes [LO 1, 2] Drake Limousine Service is considering
acquisition of an additional vehicle. The model under consideration will cost $160,000 and have
a five-year life and a $45,000 residual value. The company anticipates that the effect on annual net
income will be as follows:
Revenue $120,000
Less expenses:
Driver 40,000
Fuel 9,000
Maintenance 2,000
Insurance 1,800
Depreciation 23,000
Miscellaneous 2,000
Total expense 77,800
Taxes at 40% 16,880
Net income $ 25,320
Req u i r ed
Calculate the net present value of the investment assuming the company has a required rate of
return of 14 percent. Should the company invest in the new limousine?
PROBLEM 9-10. Net Present Value and Taxes [LO 1, 2] Island Ferry plans to expand operations
by acquiring another boat. It has a bid of $950,000 from a boat manufacturer to provide a boat
that can carry 40 passengers. The boat has an expected life of 7 years with an expected residual
value for financial reporting and tax purposes of $50,000. Island Ferry has a tax rate of 40 percent
and uses straight-line depreciation for tax purposes. Its required rate of return is 10 percent. The
following annual cash flows relate to the investment in the new boat:
Item Cash Flow
Passenger revenues $325,000

Labor cost (90,000)
Fuel cost (16,000)
Maintenance cost (15,000)
Miscellaneous cost (4,000)
Taxes ?
Req u i r ed
Calculate the net present value of the investment in the boat. Should the company make the
investment?
P r o b l e m s 363
PROBLEM 9-11. Quantifying Soft Benefits [LO 1] Pritchard Manufactured Products is consider-
ing investing in a flexible manufacturing system that will enable the company to respond rapidly to
customer requests. Ben Jarvis, the controller of Pritchard, has estimated that the system will have a
nine-year life and a net present value of negative $600,000. However, he admits that he did not take
into account the potential sales increases that will result from improvement in on-time delivery.
According to Ben, “This is just too hard to estimate.”
R equ ir ed
Using a nine-year life and a required return of 10 percent, what must be the annual value of the soft
benefits associated with the project to yield a zero net present value? Assume that there is general
agreement that the annual “soft” benefits will yield at least $120,000 in additional net cash flows.
In this case, should the investment be undertaken?
PROBLEM 9-12. Comprehensive Capital Budgeting Problem [LO 1, 3] Van Doren Corporation
is considering producing a new temperature regulator called Digidial. Marketing data indicate
that the company will be able to sell 45,000 units per year at $30. The product will be produced in
a section of an existing factory that is currently not in use.
To produce Digidial, Van Doren must buy a machine that costs $500,000. The machine has
an expected life of 6 years and will have an ending residual value of $15,000. Van Doren will
depreciate the machine over 6 years using the straight-line method for both tax and financial
reporting purposes.
In addition to the cost of the machine, the company will incur incremental manufacturing
costs of $370,000 for component parts, $425,000 for direct labor, and $200,000 of miscellaneous
costs. Also, the company plans to spend $150,000 annually to advertise Digidial. Van Doren has a
tax rate of 40 percent, and the company’s required rate of return is 15 percent.
Req u i r ed
a. Compute the net present value.
b. Compute the payback period.
c. Compute the accounting rate of return.
d. Should Van Doren make the investment required to produce Digidial?
PROBLEM 9-13. Comprehensive Capital Budgeting Problem [LO 1] True Fresh Grocery
perates a chain of 40 grocery stores. Currently the company is considering starting a new divi-
o
sion, TrueFresh.com, to provide home delivery services. Customers will be able to order groceries
by phone or using the Internet, and TrueFresh.com will deliver them within 24 hours at a price
guaranteed to be identical to the prices charged in the company’s stores.
The company has projected revenue and cost related to this business for the next 7 years,
as follows:
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7
Revenue $1,700,000 $1,870,000 $2,057,000 $2,262,700 $2,488,970 $2,737,867 $3,011,654

Less expenses:
Cost of merchandise 1,120,000 1,175,000 1,200,000 1,200,000 1,260,000 1,300,000 1,375,000
Salaries 350,000 365,000 380,750 397,000 414,652 432,884 462,030
Depreciation 60,000 60,000 60,000 60,000 60,000 60,000 60,000
Miscellaneous 23,333 21,667 20,917 28,000 27,015 28,783 27,970
Total expense 1,553,333 1,621,667 1,661,667 1,685,000 1,761,667 1,821,667 1,925,000
Income before taxes 146,667 248,333 395,333 577,700 727,303 916,200 1,086,654
Taxes at 40% 58,667 99,333 158,133 231,080 290,921 366,480 434,662
Net income $ 88,000 $ 149,000 $ 237,200 $ 346,620 $ 436,382 $ 549,720 $ 651,992
The business will require an initial investment in delivery trucks and other equipment of $500,000.
The trucks and equipment will be depreciated over a seven-year life using straight-line depreciation
with a residual value of $80,000.
Req u i red
Assume that True Fresh has decided to limit its analysis to 7 years. Calculate the net present
value of the new business using a 14 percent required rate of return. Should True Fresh make the
investment in the new business?
PROBLEM 9-14. Net Present Value and Inflation [LO 1, 2] Edward Laren, an accountant
with Tenergy Industries, prepared the following analysis of an investment in manufacturing
equipment:
Cost savings:
Labor savings $ 525,000
Reduction in rework materials 125,000
Other 60,000
Total 710,000
Additional taxes related to cost savings (239,750)
Tax savings related to depreciation of new equipment 161,000
Annual cash flow $ 631,250
Present value at 10 percent for 5 years $ 2,392,934
Cost of equipment (2,300,000)
Edward’s boss, Megan Mangione, reviewed the calculation and made the following observation:
“Ed, you’ve assumed that there won’t be inflation, but inflation is built into our 10 percent cost of
capital. I think it’s reasonable to assume that labor and costs other than depreciation will increase
by 4 percent per year. Why don’t you redo the analysis with that assumption?”
R equ i red
a. What does Megan Mangione mean by “inflation is built into our 10 percent cost of capital”?
b. Redo Edward Laren’s analysis assuming an inflation rate of 4 percent. Should the company make
the investment in the equipment?
PROBLEM 9-15. Internal Rate of Return with Uneven Cash Flows [LO 1] Based on the informa-
tion in Problem 9-14, what is the internal rate of return of the investment, assuming an inflation
rate of 4 percent applicable to labor and costs other than depreciation? Should the company make
the investment if its cost of capital is 10 percent?
PROBLEM 9-16. Risk and Cost of Capital [LO 1] Talich Industries is considering investing in
an automated welding system. The system employs a 300-watt laser with fiber optic beam delivery
to weld dissimilar metals. The specifications of the system indicate that it can make hundreds
of welds per minute—significantly faster than the company’s current welding equipment—and
improve the quality of welds.
P r o b l e m s 365
In the recent past, Talich has evaluated investments using a 12 percent cost of capital.
However, the automated welding system is not in general use. While the company expects that
it will result in significant labor savings and improve quality leading to increased sales, the cash
flows are not at all certain.
Req u i red
Assume that the cash inflows associated with the automated welding system are more risky than
those associated with the company’s typical investment. Should the company evaluate the invest-
ment using the cost of capital of 12 percent, or should a higher or lower rate be used? Briefly
explain the basis for your answer.
PROBLEM 9-17. Conflict between Performance Evaluation and Use of NPV [LO 3] Division
managers at Creighton Aerospace are evaluated and rewarded based on ROI (return on invest-
ment) targets. In the current year, Delmar Richards, the president of the commercial products
division, has an ROI target of 12 percent. If the division has an ROI of 12 percent or greater,
Delmar will receive 250,000 options on Creighton stock in addition to a base salary of $400,000.
The commercial products division is considering a major investment in product development,
which has a net present value of $25,000,000. However, the investment will have a negative effect
on reported profit over the next 2 years, after which the investment will begin to have a significant
positive effect on firm profitability for the next 8 years.
R equ ir ed
a. Discuss the potential conflict between the company’s evaluation/compensation system and Del-
mar’s focus on the NPV of the investment in product development.
b. Suppose Delmar currently holds stock in Creighton Aerospace with a market value of $1,250,000
and has options on 500,000 shares (awarded in previous years). Is this likely to acerbate or mitigate
the conflict you discussed in part a?
PROBLEM 9-18. Internal Rate of Return with Uneven Cash Flows [LO 1] Palermo Pizzeria is
considering expanding operations by establishing a delivery business. This will require the pur-
chase of an oven that will cost $50,000, including installation. The oven is expected to last 5 years,
have a $5,000 residual value, and will be depreciated using the straight-line method. Cash flows
associated with the delivery business are as follows:
Item Year 1 Year 2 Year 3 Year 4 Year 5
Revenue $65,000 $66,300 $78,230 $88,000 $95,238

Ingredients (25,100) (27,600) (30,392) (33,441) (36,695)
Salary (24,900) (26,900) (28,900) (30,900) (32,800)
Additional misc. (2,100) (2,300) (2,500) (2,700) (2,800)
Residual value 5,000
In addition to the above, there are tax consequences related to the new business, and the company’s
tax rate is 40 percent.
Req u i red
Calculate the internal rate of return for the delivery business. (Hint: Try a range of rates between
8 percent and 15 percent.) Should Palermo Pizzeria invest in the delivery business if the required
rate of return is 10 percent?
366 c h a p t e r 9 C a p i t a l B u d g e t i n g a n d O t h e r L o n g - R u n D e c i s i o n s
CASE
9-1 ETHICS CASE: JUNIPER PACKAGING SOLUTIONS. [LO 1]
Juniper Packaging Solutions provides custom packag- Spencer and the controller of the Maryland plant both believe
ing products to companies all over the United States. that the new equipment is absolutely necessary for the company
With five production facilities, the company produces cardboard to maintain customer satisfaction and market share. Together
boxes, plastic and steel drums, aluminum bottles, and absorbent they’ve devised a plan to circumvent the capital expenditure
pouches and bags. Companies using their products ship every- freeze. Each piece of equipment is actually a “system” with multi-
thing from chemicals in 55-gallon containers to biological speci- ple components (e.g., conveyor belt, box molding unit, box taping
mens in tamper-evident pouches. unit, etc.). Spencer will ask the equipment manufacturers to break
Spencer Williams is the vice president in charge of the Mary- each system into components and submit multiple bills (e.g., a
land production facility, and in the last year he’s become concerned separate bill for the conveyor, a separate bill for the box molding
about plant performance. The plant needs a long lead time for unit, etc.) each less than $500,000. The plant controller will then
orders, and defect rates have increased—both of which hurt cus- approve the expenditures as being consistent with the guidelines
tomer satisfaction. In Spencer’s opinion, the problems are the re- that only prohibit expenditures on equipment costing more than
sult of outmoded production equipment. Recently Spencer’s team $500,000.
of production managers identified three pieces of state-of-the-art
equipment that they believe will turn the plant around and make
R eq uired
it the most efficient of the company’s five plants. Unfortunately,
the price tag of the equipment is $2,000,000 and the company has Is the plan devised by Spencer and the CFO ethical? In answer-
a freeze on capital expenditures greater than $500,000. The freeze ing this question, assume that Spencer and the controller are both
was mandated by the company chief executive officer (CEO) after firmly convinced that the new equipment will increase share-
third-quarter earnings dropped by 10 percent due to a weakening holder value.
of the Asian economy and reduced shipments to Japan and Korea
by several of Juniper’s major customers.
CASE
9-2 SERGO GAMES [LO 1, 2]
Sergo Games produces a variety of action games in- Leslie Eastman, an accounting manager, has been given the re-
cluding a flight simulation game, Airport 10, which sold sponsibility to analyze outsourcing the production of CDs. Her
more than 800,000 copies in the past year. The programs report is provided below.
are run on computers, and the company operates an in-house
production facility that manufactures and packages CDs for ship-
R eq uired
ment to customers.
In 2017, the production plant prepared 2,600,000 CDs and in- Should production of CDs be outsourced? Unlike Leslie, support
curred the following costs: your answer with appropriate calculations.
Units processed 2,600,000
Labor $ 900,000
Material 4,800,000
Supervisory salaries 350,000
Heat, light, phone, etc. 200,000
Total $ 6,670,000
C a s e 367
Sergo Games
April 19, 2018
TO: Shane Santiago, CFO

FROM: Leslie Eastman
SUBJECT: Outsourcing CD production
In 2017, total production and packaging costs were $6,670,000, or $2.57 per
CD. The low-cost outside bidder for this business was XLS. They are a highly
respected firm, and their offer is $2.52 per CD. Although the savings related
to outsourcing is only $0.05 per CD, with annual production of 2,600,000
units, this amounts to $130,000 per year. The present value with a five-year
horizon and a 11 percent cost of capital is $480,467. Thus, I recommend that
we outsource CD production.
You asked me to determine the selling price of the production equipment.
I had a representative of XLS walk through the facility. In his opinion, the
equipment is dated, and he believes that the market value is essentially zero.
At any rate, his company is not interested in purchasing the equipment even if
we select them as a supplier. If we outsource, I do not believe that we can use
the production facility for another purpose. As you know, the building is run
down, and it’s not a suitable space even for programmers!
Finally, I want to mention another aspect of the problem that enhances
the appeal of outsourcing. We currently have equipment with a book value
of $2,000,000 and an average remaining life of 5 years. This generates
approximately $400,000 per year of depreciation. If we outsource, we’ll have
a $2,000,000 tax loss, which will save us approximately $700,000 (assuming
a 35 percent tax rate). Thus, the total value of outsourcing is $1,180,467 (i.e.,
$480,467 + $700,000).
Please call me if you have any questions regarding my analysis.
10
Budgetary Planning
and Control
Preston Joystick produces a joystick that is the top
choice for many serious gamers.
At a meeting of key managers, Alan Renton, president of Preston Joystick, reviewed

the past successes and failures of his firm. “As you know,” he concluded, “we’ve
begun a new marketing campaign, and I am confident that next year sales will
increase by at least 20 percent.” Jack North, the production manager, seemed
caught off guard by this good news. “Look, Alan,” he said, “if you really think sales
are going to take off, we’ve got to plan for the increase. I’ll have to hire additional
workers, and the people in purchasing will need to buy more parts so we don’t run
out.” Pam Smith, vice president of finance, chimed in. “Also, more sales means more
inventory, and more inventory means we’ll have to borrow additional funds to finance
the expansion. I’ll need some lead time to arrange the loan.”
The meeting ended with everyone agreeing that more attention should be
devoted to planning company activities. Alan went back to his office convinced that
without a plan to guide and coordinate company activities, the coming year would be
a series of near disasters. “The marketing, production, and finance people need to
know what is anticipated so we can operate effectively and efficiently,” he concluded.
In business, budgets are the formal documents that quantify a company’s
plans for achieving its goals. The entire planning and control process of many com-
panies is built around budgets. This chapter illustrates the preparation of several
budgets that are in common use. The chapter also describes the role of budgets in
the performance evaluation process and discusses a number of issues associated
with budgets.
Squaredpixels/Istock/Getty Images Plus
Learning Objectives
1 Discuss the use of budgets in planning and control.
2 Prepare the budget schedules that make up a master budget.
3 Explain why flexible budgets are needed for performance evaluation, and discuss the conflict
between the planning and control uses of budgets.
369
370 c h apter 1 0 B u d g e t a r y P l a n n i n g a n d C o n t r o l
LEARNING USE OF BUDGETS IN PLANNING AND CONTROL

O BJECTIVE 1
At companies from Microsoft to Marriott, from Walmart to Wendy’s, budgets are a high
Discuss the use of priority. As mentioned, the entire planning and control process of many companies is built
budgets in planning around budgets. This section describes how budgets are used in planning and control.
and control.
Planning
Budgets are useful in the planning process because they enhance communication and
coordination. The process of developing a formal plan—that is, a budget—forces managers
to consider carefully their goals and objectives and to specify means of achieving them.
Budgets become the vehicle for communicating information about where the company
is heading, and they aid coordination of managers’ activities. For example, the marketing
department may prepare a budget that includes estimates of sales for each month of a
future year. The production department may use the information contained in this budget
to schedule workers and material deliveries. Thus, the necessary coordination of product
sales and product production is achieved.
Control
Budgets are useful in the control process because they provide a basis for evaluating
performance. To control a company—to make sure it is heading in the proper direction
and operating efficiently—it is essential to assess the performance of managers and the
operations for which they are responsible. Often performance evaluation is carried out
by comparing actual performance with planned or budgeted performance.
Significant deviations from planned performance are associated with three potential
causes:
1. It is possible that the plan or budget was poorly conceived. If a budget is not
carefully developed, it should not be surprising that actual results are different
from planned results.
2. It is possible that although the budget was carefully developed, conditions have
changed. For example, if the economy were to take a sudden downturn, actual
sales might be less than budgeted sales.
3. It is possible that managers have done a particularly good or poor job managing
operations. If this is the case, the managers will be rewarded for good performance
(e.g., given a bonus or a promotion) or punished for poor performance (e.g., given
reduced responsibility or even fired).
You get what you A graphic presentation of the role of budgets in the planning and control process appears
M e a s u r e in Illustration 10-1. As you study this illustration, remember that you get what you
measure! This idea is central to an understanding of the control process. If managers
know that their performance will be evaluated with respect to the budget, they are likely
to work especially hard to achieve budgeted goals. Thus, it is critical that the budgeted
goals be well thought out and clearly communicated to managers
DEVELOPING THE BUDGET

Budgets are prepared for departments, for divisions of a company, and for the company as
a whole. Often the group within a company that is responsible for approval of the various
budgets is the budget committee. This committee consists of senior managers, including
the president, the chief financial officer, the vice president for operations, and the
controller. Typically, the budget committee works with departments to develop realistic
D e v e l o p i n g t h e B u d g e t 371
Illustration 10-1 Development of Budget

Role of budgets in the planning (financial plan)
and control process Budget
Revenue Spendin
g
Budget
Production Marketing Administration

Amount Amount Amount
Operations changed
or plan revised
Action taken to implement plan
ment
StateStatement
Statement
s Term
B onu inati
on
Results
Stat
get eme
Manager performance Bud ding
nt
Spen
nue
rewarded/punished Reve
Comparison
of budgeted and actual results
Evaluation
Was the plan well conceived? Did conditions change?

Was managers' performance
particularly good or poor?
plans that are consistent with overall company goals. In some cases, however, the budget
committee may impose a budget without soliciting input from department managers.
The extent to which departments are consulted relates to the distinction between
top-down and bottom-up approaches to the development of a budget. In a top-down
approach, budgets are developed at higher organizational levels without substantial input
from lower-level managers. In a bottom-up approach, lower-level managers are the primary
source of information used in setting the budget. Most managers believe a successful
budgeting process requires a bottom-up approach. After all, lower-level managers often
Link to Practice
Problems with Five-Year Budgets may become obsolete within 6 months when unfore-
seen circumstances occur? One reason is that lenders
The farther out you go in a budget, the more guess-
demand them. John Daniels, senior vice president in
work is involved. That’s why many managers are
the commercial banking group at Bank of America,
opposed to 5-year plans. Jim Bell, director of corporate
notes: “We’re obviously asking so we u nderstand
finance at Huntsman, a U.S.-based petrochemical
the risk of a deal.” And some CFOs
company with operations throughout
prepare them simply because their
Asia, says, “Truthfully, once you get
bosses want one!
out past 2 years, it’s so fuzzy that it’s
fairly meaningless.” Bell also notes the
tendency to inflate later years in the

budget. “For some reason, the best Source: Based on Kris Frieswick, “The
Five-Year Itch: For CFOs, the Biggest
year is always the fifth year.” Question about Doing Five-Year Plans Is,
So why do companies spend Why?” CFO Asia, March 2003. Reprinted
months to craft a 5-year plan when it Digital Vision/Getty Images by permission.
have the best information regarding business conditions affecting their departments. If
this is the case, their input is critical in developing realistic financial plans.
Budget Time Period

Before a budget can be prepared, managers must decide on an appropriate budget period.
A company may prepare budgets for a variety of time periods, depending on its needs. In
some cases, long-run budgets are prepared for a 3-year or even a 5-year period. Short-run
budgets may cover a month, a quarter, or a year. Generally, the longer the time period,
the less detailed the budget.
Zero-Based Budgeting
A common starting point in developing a budget is a consideration of the costs and
revenues of the previous period. These amounts are adjusted up or down based on
current information and assumptions or estimates of what will happen in the future.
However, this approach may not lead to a fresh consideration of activities.
Link to Practice
People Problems in Budgeting · Not taking ownership or being accountable.
In spring 2007, Centage and the Institute of Management · Lack of cooperation and/or participation.
and Administration c onducted a survey · Lack of understanding of the process
of chief financial officers (CFOs) from or what’s required.
more than 20 industries regarding their · Not meeting deadlines.
budgeting p ractices. According to the · Padding their budgets/providing unre-
respondents, the number one b udgeting alistic numbers.
pain point was dealing with managers.
In particular, the CFOs faulted managers Source: Centage/IOMA, Budgeting Survey:
for: OJO Images/SUPERSTOCK Benchmarks & Issues, 2008.
T h e M a s t e r B u d g e t 373
So-called zero-based budgeting is a method of budget preparation that requires

budgeted amounts to be justified by each department at the start of each budget period,
even if the amounts were supported in prior budget periods. That is, managers must start
from zero in developing their budgets. This results in a fresh consideration of the validity
of budget amounts, but the technique is time-consuming and expensive. Although zero-
based budgeting has gained some support in governmental budgeting, it is not widely
practiced by business enterprises.
LEARNING THE MASTER BUDGET

OBJECTIVE 2
The master budget is a comprehensive planning document that incorporates a number
Prepare the budget of individual budgets. Typically, it includes budgets for sales, production, direct
schedules that make up materials, direct labor, manufacturing overhead, selling and administrative expenses,
a master budget. capital acquisitions, and cash receipts and disbursements, as well as a budgeted income
statement and a budgeted balance sheet.
In this section, we present examples of each of these components of a master budget.
For purposes of the example, budgetary information is prepared by quarter for Preston
Joystick. As you will see, the various budgets are interrelated. In particular, the sales
budget influences the production budget. The production budget, in turn, influences
the material purchases budget, the direct labor budget, and the manufacturing overhead
budget. The relationships among the various budgets are presented in Illustration 10-2.
Sales Budget
The first step in the budget process involves preparation of sales forecasts and develop-
ment of a sales budget. This budget comes first because other budgets cannot be prepared
without an estimate of sales. For example, managers preparing the production budget
must have an estimate of future sales before they can determine what level of production
will be necessary to meet demand.
Illustration 10-2
Relationships among Sales Budget
various budgets that
comprise the master
budget
Production Budget
Material Manufacturing
Labor Budget
Purchases Budget Overhead Budget
Selling and Administrative

Capital Acquisitions Budget
Expense Budget
Budgeted Income
Cash Budget Budgeted Balance Sheet
Statement
Link to Practice
Budget Process in Great Britain · The budget process is being completed much more
quickly than 4 years ago.
In 2002, Financial Director (a business magazine) and
Hyperion (a software company) conducted a survey of · Large organizations believe that there is too little
financial managers in Great Britain. Here are some of accountability when plans are not achieved.
the major findings: · Half of the large companies surveyed believe there is
some “game playing” in negotiating budgets.
· Budget holders involved in preparing their budgets
· Large companies believe their budgets are too detailed.
are more likely to take ownership of the results.
· Bottom-up budgeting is more common than Source: “Budgeting; More of the Same,” Financial Director,
“imposed” top-down budgets. November 2002, p. 41. Reprinted by permission of VNU.
Companies use numerous methods to estimate sales. Very large companies may hire
economists to prepare sales forecasts using sophisticated mathematical models that take
into consideration the rate of inflation, national capital expenditures, and other economic
data. Smaller companies may develop forecasts based on an analysis of the trend in their
own sales data. Trade journals or magazines exist for almost every industry, and they
may provide useful information for developing sales forecasts. Typically, these journals
contain information on past industry sales. They may also make predictions about the
growth of the industry. Sales personnel may be another good source of information for
forecasting sales. Some companies periodically ask all of their salespersons to estimate
sales in their territories for the coming year. These estimates may be highly accurate if
the salespersons make their estimates based on thorough knowledge of their customers’
needs. In general, forecasts of sales are part science and part art. The forecasts of even
the most sophisticated mathematical models are often adjusted based on the professional
judgment of experienced managers.
Based on the trend of sales and taking into account a planned marketing campaign,
Alan Renton, president of Preston Joystick, has predicted that unit sales will increase by
20 percent in the coming year. Sales personnel generally agree that this level of increase
is realistic provided the company maintains a price per unit of $45. Accordingly, the
company budgeted sales for each quarter simply by increasing prior year sales in units
by 20 percent. The result is the sales budget presented in Illustration 10-3.
Illustration 10-3
Sales budget
Preston Joystick
Sales Budget
First Second Third Fourth

Quarter Quarter Quarter Quarter Year
Prior year sales in units 17,500 20,833 19,167 18,333 75,833
Projected sales at 120% of prior year 21,000 25,000 23,000 22,000 91,000
Sales price per unit $ ×45 $ ×45 $ ×45 $ ×45 $ ×45
Budgeted sales revenue $945,000 $1,125,000 $1,035,000 $990,000 $4,095,000
Production Budget
Once the sales budget has been prepared, the production budget can be developed.
In deciding how much to produce, managers must take into account how much they
expect to sell, how much is in beginning inventory, and how much they want in
ending inventory.1
The quantity that must be produced can be calculated from the following formula:
Finished Expected Desired Beginning

units to be = sales in + ending inventory - inventory of
produced units of finished units finished units
Preston Joystick would like the ending inventory of finished goods to be equal to
10 percent of next quarter’s sales. In the first quarter, Preston estimates that 21,000 units
will be sold; 2,500 units are needed in ending inventory (i.e., 10 percent of 25,000 units
expected to be sold in the second quarter). Thus, a total of 23,500 units are required.
However, the company has 2,100 units in beginning inventory, so only 21,400 units must
be produced. The production budget for Preston Joystick is presented in Illustration 10-4.
T est y our K N O W L E D G E
Mason Manufacturing expects to sell 10,000 units in the first quarter and 14,000 in the
second quarter. The company desires ending inventory equal to 20 percent of the next quar-
ter’s sales, and finished goods on hand at the start of the first quarter equals 2,000 units.
How many units should be produced in the first quarter?
a. 14,000. b. 16,000. c. 10,800. d. 12,000.
Correct answer is c (10,000 + 2,800 - 2,000) = $10,800.
Illustration 10-4
Production budget
Preston Joystick
Production Budget

Unit salesa 21,000 25,000 23,000 22,000 91,000
Plus desired ending inventory of finished unitsb 2,500 2,300 2,200 2,400c 2,400
Total needed 23,500 27,300 25,200 24,400 93,400
Less beginning inventory of finished units 2,100 2,500 2,300 2,200 2,100
Units to be produced 21,400 24,800 22,900 22,200 91,300
a
Information from sales budget in Illustration 10-3.
b
Equals 10 percent of next quarter’s sales.
c
Based on estimate of sales in the first quarter of the following year.
1
Preston Joystick does not have a significant amount of Work in Process inventory. Thus, we do not need to
take work in process into account in our calculations of anticipated production.
Direct Material Purchases Budget

The amount of direct materials that must be purchased depends on the amount needed
for production and the amount needed for ending inventory. Obviously, a company
needs some direct materials on hand at the end of the period for use in production at
the start of the subsequent period (although, as explained in Chapter 2, the amount
would be small in a just-in-time environment). The amount that must be purchased can
be calculated using the following formula:
Required Amount Desired ending Beginning

purchases of = required for + inventory of - inventory of
direct materials production direct materials direct materials
Preston Joystick has established a policy of maintaining direct materials inventory

equal to 10 percent of the amount required for production in the subsequent quarter.
In the first quarter, the company plans on producing 21,400 units. Each unit requires
parts costing $6. In addition, $14,880 of parts must be on hand at the end of the
quarter (i.e., 10 percent of the amount required for next quarter’s production), but
$12,840 of parts are on hand at the start of the quarter. Thus, $130,440 of parts must be
purchased in the first quarter. This information is presented in the purchases budget,
Illustration 10-5.
Direct Labor Budget

The direct labor budget for Preston Joystick presents direct labor cost by quarter. Direct
labor cost is calculated by multiplying the number of units produced each quarter by
the labor hours per unit and the rate per hour. In the first quarter, the company expects
to produce 21,400 units, and 1 labor hour per unit is required. At a rate of $15 per labor
hour, this amounts to $321,000. Preston estimates that, on average, each employee works
480 hours per quarter. This information can be used to estimate the approximate number
of employees needed each quarter. In the first quarter, 21,400 labor hours are required.
Since an average employee works 480 hours per quarter, approximately 45 employees
Illustration 10-5
Direct material purchases budget
Preston Joystick
Direct Material Purchases Budget


Units to be produceda 21,400 24,800 22,900 22,200 91,300
Cost of parts per unit $ ×6 $ ×6 $ ×6 $ ×6 $ ×6
Cost of parts needed for production $128,400 $148,800 $137,400 $133,200 $547,800
Plus desired ending inventory of partsb 14,880 13,740 13,320 14,700c 14,700
Total needed 143,280 162,540 150,720 147,900 562,500
Less beginning inventory of parts 12,840 14,880 13,740 13,320 12,840
Cost of purchases $130,440 $147,660 $136,980 $134,580 $549,660
a
Information from production budget in Illustration 10-4.
b
Equals 10 percent of parts required for next quarter’s production.
c
Based on estimate of parts required for production in the first quarter of next year.
Illustration 10-6
Direct labor budget
Preston Joystick
Direct Labor Budget


Direct labor hours per unit 1.0 1.0 1.0 1.0 1.0
Labor rate per hour $ ×15 $ ×15 $ ×15 $ ×15 $ ×15
Direct labor cost per unit 15 15 15 15 15
Units to be produceda ×21,400 ×24,800 ×22,900 ×22,200 ×91,300
Direct labor cost $321,000 $372,000 $343,500 $333,000 $1,369,500
Total hours 21,400 24,800 22,900 22,200
Average hours per quarter per employee ÷480 ÷480 ÷480 ÷480
Approximate number of employees needed 45 52 48 46
Information from production budget in Illustration 10-4.
a
will be needed for production. The direct labor budget for Preston Joystick is presented
Note that the direct labor budget indicates that 52 employees are needed in the second
quarter, whereas only 45 are needed in the first quarter. With this information, the company
may decide to adjust its production plans to keep employment stable. If new employees are
hired in the second quarter, operations may not be efficient. And if several of these employees
are fired in the third quarter, when only 48 employees are needed, morale may suffer. A
better idea may be to hire part-time workers or have full-time employees work overtime.
Manufacturing Overhead Budget

Preston Joystick separates variable and fixed costs in the budget for manufacturing
overhead. The cost per unit of production of each variable cost item is multiplied by the
quantity produced each quarter. The fixed costs are identical each quarter except for the
amount of depreciation. This cost increases in the third and fourth quarters because of
planned acquisitions of equipment that increase the level of depreciation.
The manufacturing overhead budget is presented in Illustration 10-7. Note that in
the budget, we subtract depreciation from total overhead to determine the amount of
cash paid out for overhead each quarter. This information will be used when we prepare
the budget for cash receipts and disbursements.
Selling and Administrative Expense Budget

To this point, we have presented only the sales budget and production-related budgets.
However, budget information is also needed for selling and administrative expenses.
Preston Joystick estimates that these expenses are all fixed. The 2017 selling and admin-
istrative expense budget is presented in Illustration 10-8.
Budgeted Income Statement

Much of the information contained in the budgets already described is utilized in the prepa-
ration of a budgeted income statement. This budget is presented in Illustration 10-9. As you
Illustration 10-7
Manufacturing overhead budget
Preston Joystick
Manufacturing Overhead Budget


Units to be produceda 21,400 24,800 22,900 22,200 91,300
Variable costs:
Indirect material ($2 per unit) $ 42,800 $ 49,600 $ 45,800 $ 44,400 $182,600
Indirect labor ($1.50 per unit) 32,100 37,200 34,350 33,300 136,950
Other variable costs ($1.00 per unit) 21,400 24,800 22,900 22,200 91,300
Total variable overhead 96,300 111,600 103,050 99,900 410,850
Fixed costs:
Supervisory salaries 90,000 90,000 90,000 90,000 360,000
Depreciation of plant and equipmentb 20,000 20,000 26,000 28,000 94,000
Other 5,000 5,000 5,000 5,000 20,000
Total fixed overhead 115,000 115,000 121,000 123,000 474,000
Total overhead 211,300 226,600 224,050 222,900 884,850
Less depreciation 20,000 20,000 26,000 28,000 94,000
Cash payments for overhead $191,300 $206,600 $198,050 $194,900 $790,850
Estimated overhead rate = annual overhead ÷ annual production = $884,850 ÷ 91,300 = $9.69 per unit
a
Information from production budget, Illustration 10-4.
b
Increase in third and fourth quarter due to acquisition of additional equipment. See capital acquisitions budget in Illustration 10-10.
can see, the sales figures come directly from the sales budget (Illustration 10-3). Cost
of goods sold requires a calculation of the unit cost of production. The direct material
budget indicates that material cost is $6 per unit (Illustration 10-5). The direct labor
budget indicates that direct labor is $15 per unit. And the manufacturing overhead
Illustration 10-8
Selling and administrative expense budget
Preston Joystick
Selling and Administrative Expense Budget


Salaries $160,000 $160,000 $160,000 $160,000 $ 640,000
Advertising 70,000 70,000 70,000 70,000 280,000
Depreciation of office equipment 5,000 5,000 5,000 5,000 20,000
Other 15,000 15,000 15,000 15,000 60,000
Total 250,000 250,000 250,000 250,000 1,000,000
Less depreciation 5,000 5,000 5,000 5,000 20,000
Cash disbursements for selling and
administrative expense $245,000 $245,000 $245,000 $245,000 $ 980,000
Illustration 10-9
Budgeted income statement
Preston Joystick


Salesa $945,000 $1,125,000 $1,035,000 $990,000 $4,095,000
Less cost of goods soldb 644,490 767,250 705,870 675,180 2,792,790
Gross margin 300,510 357,750 329,130 314,820 1,302,210
Less selling and administrative expensesc 250,000 250,000 250,000 250,000 1,000,000
Net income $ 50,510 $ 107,750 $ 79,130 $ 64,820 $ 302,210
a
Information per sales budget, Illustration 10-3.
b
First quarter calculation is: 21,000 units × $30.69 = $644,490.
c
Information per selling and administrative expense budget in Illustration 10-8.
budget indicates that manufacturing overhead is $9.69 per unit. Thus, the unit cost of
production is $30.69:
Direct materials $ 6.00 (Illustration 10-5)

Direct labor 15.00 (Illustration 10-6)
Manufacturing overhead 9.69 (Illustration 10-7)
Total $30.69 per unit
Management should carefully consider the budgeted income statement to make

sure that anticipated profit is consistent with company goals. If budgeted profit is less
than the amount management considers satisfactory, steps may be taken to increase sales
and reduce costs. Perhaps the advertising campaign can be expanded to further increase
sales. Or perhaps material costs can be reduced through negotiations with suppliers. If
management decides to take steps to increase profit, then the previous budgets will need
to be adjusted to reflect the anticipated changes.

Decision Making/ Recall that in Chapter 9 we discussed how to make decisions with respect to long-lived
Incremental assets such as plant and equipment. The recommended approach was to identify incre-
Analysis mental cash flows and evaluate them in terms of their net present value (NPV) and/or
the internal rate of return (IRR). Decisions involving long-lived assets often are called
capital expenditure decisions, and the final list of approved projects is documented in
the capital acquisitions budget.
Acquisitions of capital assets must be carefully planned, in part because they may
substantially reduce cash reserves. Preston Joystick anticipates purchases of office
equipment and machinery during the coming year, and this is reflected in the capital
acquisitions budget presented in Illustration 10-10.
Cash Budget
In the cash budget, managers plan the amount and timing of cash flows. The information
in this budget is a necessary supplement to the information presented in the budgeted
Illustration 10-10
Capital acquisitions budget
Preston Joystick


Office equipment (5-year life) $10,000 — — — $ 10,000
Machinery (5-year life) — — $120,000a $40,000b 160,000
Total $10,000 — $120,000 $40,000 $170,000
a
Increases depreciation by $6,000 in third quarter [i.e., ($120,000 ÷ 5-year life) × 1/4 for third quarter]. See manufacturing overhead budget in
Illustration 10-7.
b
Increases depreciation by $2,000 in fourth quarter [i.e., ($40,000 ÷ 5-year life) × 1/4 for fourth quarter]. See manufacturing overhead budget in
Illustration 10-7.
income statement. It is quite possible for a company to project a substantial amount of

net income and still face financial distress because its entire set of plans imply more
cash outflows than cash inflows. For example, a considerable amount of income may
be recognized when a major sale is made. However, the cash received in payment for
the sale may not arrive for many months. Or consider a company that makes a major
equipment purchase. Although cash reserves may be reduced immediately by the total
cost of the equipment, current period income will be reduced by only a fraction of
the cost of the equipment (i.e., by the amount of depreciation). By carefully planning
cash receipts and disbursements, companies can anticipate cash shortages and arrange
to borrow funds to enhance their cash positions. Or if cash surpluses are anticipated,
companies can seek additional investment opportunities or consider paying higher
dividends to shareholders.
To prepare an estimate of cash collections, management must determine the percent
of credit sales revenue that is collected in the period of sale and the percent collected in
the subsequent period. The percentages usually can be estimated based on past collection
experience. Preston Joystick has only credit sales. Fifty percent of the sales revenue is
collected in the quarter of sale, and 50 percent is collected in the next quarter.
To prepare an estimate of cash disbursements, management must determine the
percent of material purchases that is paid in the period of purchase and the percent that
is paid in the subsequent period. Preston Joystick determines that 70 percent is paid in
the quarter of purchase and 30 percent is paid in the subsequent quarter. The company
has determined that, for practical purposes, all other disbursements are made in the
quarter in which the related cost is incurred.
In preparing a cash budget, it is important to remember that some expenses do not
require cash outlays. For example, depreciation is part of manufacturing overhead, but it
does not require a current outlay of cash. Cash is disbursed when an asset is purchased,
not when depreciation is recorded. Another example of a noncash expense is the amor-
tization of prepaid insurance. Cash is disbursed when the insurance is purchased, not
when the expense is recognized through the amortization of prepaid insurance.
In the cash budget for Preston Joystick, Illustration 10-11, note that cash disbursed
for manufacturing overhead in the first quarter is only $191,300. This is $20,000 less
than the $211,300 of overhead cost planned for the first quarter in the manufacturing
overhead budget, Illustration 10-7. The $20,000 is the amount of depreciation in the
first quarter.
Illustration 10-11
Cash budget
Preston Joystick
Cash Budget

Cash receipts
Collection of credit salesa
4th quarter prior year $430,435 $ 430,435
1st quarter ($945,000) 472,500 $ 472,500 945,000
2nd quarter ($1,125,000) 562,500 $ 562,500 1,125,000
3rd quarter ($1,035,000) 517,500 $ 517,500 1,035,000
4th quarter ($990,000) 495,000 495,000
Total cash receipts 902,935 1,035,000 1,080,000 1,012,500 4,030,435
Cash disbursements
Purchases of materialsb
4th quarter prior year 36,180 36,180
1st quarter ($130,440) 91,308 39,132 130,440
2nd quarter ($147,660) 103,362 44,298 147,660
3rd quarter ($136,980) 95,886 41,094 136,980
4th quarter ($134,580) 94,206 94,206
Total disbursement for purchases 127,488 142,494 140,184 135,300 545,466
Payment for direct laborc 321,000 372,000 343,500 333,000 1,369,500
Payment for manufacturing overheadd 191,300 206,600 198,050 194,900 790,850
Payment for sell. & adm. expensee 245,000 245,000 245,000 245,000 980,000
Capital acquisitions f 10,000 120,000 40,000 170,000
Total cash disbursements 894,788 966,094 1,046,734 948,200 3,855,816
Excess of receipts over disbursements 8,147 68,906 33,266 64,300 174,619
Plus beginning cash balance 20,000 28,147 97,053 130,319 20,000
Ending cash balance $ 28,147 $ 97,053 $ 130,319 $ 194,619 $ 194,619
a
See Illustration 10-3 for sales information; 50% collected in quarter of sale and 50% collected in subsequent quarter.
b
See Illustration 10-5 for purchase information; 70% paid in quarter of purchase and 30% paid in subsequent quarter.
c
See Illustration 10-6 for labor cost information.
d
Does not include depreciation indicated in manufacturing overhead budget (Illustration 10-7), since depreciation does not require a cash outlay.
e
Does not include depreciation indicated in selling and administrative expense budget (Illustration 10-8), since depreciation does not require a
cash outlay.
f
See capital acquisitions budget (Illustration 10-10).
T est y our K N O W L E D G E
Mason Manufacturing expects sales of $100,000 in the first quarter and $140,000 in
the second quarter. The company collects 70 percent of sales in the quarter sold and
30 percent in the subsequent quarter.
What are expected cash collections in the second quarter?
a. $128,000. b. $30,000. c. $98,000. d. $142,000.
Correct answer is a [(.3 × $100,000) + (.7 × $140,000) = $128,000].
As indicated in the illustration, the anticipated cash flows fluctuate significantly

from quarter to quarter. The result is that at the end of the first quarter, the cash bal-
ance is expected to be only $28,147, whereas the cash balance at the end of the fourth
quarter is expected to be $194,619. Obviously, a low cash balance is dangerous because
the company may not have enough funds to pay employees and suppliers. Thus, Preston
Joystick may wish to consider borrowing money to improve its cash position in the
first quarter. The cash budget alerts management to such potential problems well in
advance. This gives management sufficient time to arrange a loan on favorable terms.
As the budget indicates, the loan can be repaid easily in the fourth quarter, when cash
reserves are high.
Excessively large cash balances generally should be avoided because they earn
little if any interest. If a company is building up financial reserves for expansion
(purchasing a major piece of equipment or even another company), excess cash
generally will be invested in low-risk, highly marketable securities. If the company is
not building up reserves to expand, the excess cash may be distributed to shareholders
as dividends.
Budgeted Balance Sheet

The last component of the master budget that we consider is the budgeted balance sheet.
This budget is simply a planned balance sheet (sometimes called a pro forma balance
sheet). Managers can use this budget to assess the effect of their planned decisions on
the future financial position of the firm. The budgeted balance sheet for Preston Joystick
Illustration 10-12
Preston Joystick
Budgeted balance sheet
December 31, 2017
Current Assets
Casha $ 194,619
Accounts receivableb 495,000
Raw material inventoryc 14,700
Finished goods inventoryd 73,656
Property, plant, and equipment (net) 620,000
Total assets $1,397,975
Current Liabilities
Accounts payablee $ 40,374
Stockholders’ Equity
Common stock 906,456
Retained earnings 451,145
Total liabilities and stockholders’ equity $1,397,975
a
Ending balance per cash receipts and disbursements budget (Illustration 10-11).
b
50% of 4th quarter sales not yet collected per cash receipts and disbursements budget (Illustration 10-11).
c
See direct material purchases budget in Illustration 10-5.
d
Per the production budget (Illustration 10-4), 2,400 units of finished goods are required. The cost per
unit is $30.69 ($6 of direct material per Illustration 10-5; $15 of direct labor per Illustration 10-6; and
$9.69 of manufacturing overhead per Illustration 10-7).
e
30% of 4th quarter purchases of materials not yet paid per cash receipts and disbursements budget
(Illustration 10-11).
U s e o f C o m p u t e r s i n t h e B u d g e t P l a n n i n g P r o c e s s 383
Link to Practice
Address Cash Flow Uncertainty with a A problem is that companies are often uncertain as
Revolving Loan to the exact amount they will need to borrow and when
the loan will be needed. In such cases, companies often
Many companies know they are going to need to
set up a revolving loan (also known as a revolver) with
borrow money when they must stock up on inventory
a bank. With a revolving loan, the bank sets up a credit
in anticipation of peak demand. This follows because
limit and a company can borrow up to that limit at a
the cash collected from related sales may be weeks or
specified rate of interest. If the credit limit isn’t reached, a
months after the necessary payment for purchases of
company can borrow additional funds without reapplying
inventory.
for a new loan.
USE OF COMPUTERS IN THE BUDGET

PLANNING PROCESS
The budget committee may review a budget and decide that it is inconsistent with
company goals. This conclusion may lead managers to explore a variety of actions that
affect future costs and revenues. If the managers decide to make changes, then they
must also revise the budget. Since budgets are highly interdependent, a change in one
can affect several others.
Computers are very useful in this situation. Most companies that use budgets define
the budget relationships in a computer model using a spreadsheet program such as
Excel® or a custom program specifically designed for them. With computerized budget
information, an item in a budget can be changed, and the computer can recalculate
that budget and any other budget affected by the change. Obviously, this results in a
substantial savings in time and managerial effort.
“What if ” analysis, discussed in Chapter 4, is also facilitated when budgets are
prepared using a spreadsheet program. Suppose the management of Preston Joystick
wants to know what the cash balance will be in the fourth quarter if sales in the
first quarter are 22,000 instead of the 21,000 units budgeted. If all of the budgetary
relationships have been properly specified in a spreadsheet, the answer can be found
simply by changing the sales figure in the first-quarter sales budget from 21,000 to 22,000
and letting the computer recalculate the cash balance in the fourth quarter cash receipts
and disbursements budget.
Link to Practice
Spreadsheets for Budgeting The problem with spreadsheets is that they don’t
have the controls of the more sophisticated software
Most large companies use sophisticated software pack-
packages. Still, companies can protect their spreadsheet
ages for budgeting, such as those by SAP or Oracle.
budgets by password protection, hosting spreadsheets
Most small companies, however, turn to relatively simple
on protected servers, and locking cells in spreadsheets.
spreadsheets when preparing budgets. According to a
survey by CFO Magazine, the percentage of companies Source: Based on Tim Reason, “Budgeting in the Real
relying solely on spreadsheets for budgeting is only World,” CFO, July 2005.
30 percent when annual revenue is more than $1 billion.
When annual revenue is less than $100 million, the
percent jumps to 78 percent.
Learning BUDGETARY CONTROL

Objective 3
Our discussion of the master budget and its components gave you some indication
Explain why flexible of how budgets are used in the planning process to communicate company goals and
budgets are needed for coordinate diverse activities. Budgets, as noted earlier, also facilitate control of operations.
performance evaluation, Next, we discuss that function in more detail.
and discuss the conflict
between the planning
and control uses of Budgets as a Standard for Evaluation
budgets. Budgets facilitate control by providing a standard for evaluation. The standard is the
budgeted amount, against which actual results are compared. Differences between
budgeted and actual amounts are referred to as budget variances, and reports that
indicate budget variances are referred to as performance reports. If budgeted and actual
costs are approximately equal, no action needs to be taken because results are consistent
with management’s expectations. However, if actual costs differ from budgeted costs by
a material amount, management should launch an investigation to determine the cause
of the difference.
How would performance be evaluated if budgets were not prepared? Most likely,
actual performance in the current period would be compared with actual performance in
the prior period. This is obviously an inferior approach because conditions may change
significantly from one period to the next, making a comparison of the two periods
meaningless. For example, suppose Preston Joystick evaluates the performance of the
marketing department by comparing sales in the current year with sales in the past year.
Further, suppose sales in the prior year are 75,833 units and actual sales in the current
year are 85,000 units. An evaluation of performance based on a comparison with the
prior year would lead to a favorable evaluation of the marketing department, because
sales are up by approximately 12 percent. However, senior managers at Preston antici-
pated that, given an expanded advertising campaign, the company should have sales of
91,000 units, a 20 percent increase that is reflected in the budget. A comparison of actual
sales to budgeted sales indicates that rather than receiving a favorable evaluation, the
marketing department should be asked to explain why actual sales are only 85,000 units
instead of the 91,000 units forecasted.
Static and Flexible Budgets

In evaluating performance by using budgets, care must be taken to make sure that the
level of activity used in the budget is equal to the actual level of activity. Let’s consider an
example to see why this is the case. Suppose the manager responsible for manufacturing
overhead at Preston Joystick is evaluated at the end of the first quarter by comparing the
actual level of overhead cost to the overhead costs budgeted at the start of the year. This
comparison is presented in Illustration 10-13.
The analysis implies that the manager responsible for overhead costs has not done a
good job of cost control. After all, total variable overhead costs are $15,300 higher than
planned, and total fixed overhead costs are $500 higher than planned. However, note
that actual production was 25,000 units, whereas planned production was only 21,400
units. The extra production may be due to an unexpected increase in sales necessitating
increased production. With the increase in production, an increase in variable costs is
expected. Fixed costs, however, would be expected to remain the same. Since changes
in cost are expected when actual production is different from planned production, the
analysis presented is not very useful for evaluating performance.
The budget presented in Illustration 10-13 is referred to as a static budget because
it is not adjusted for the actual level of production. A more appropriate analysis of
performance would make use of a flexible budget, which is a set of budget relationships
B u d g e t a r y C o n t r o l 385
Illustration 10-13
Performance evaluation Preston Joystick
with a static budget
Performance Report, Manufacturing Overhead
Static Budget Comparison
First Quarter, 2017
Static Budget Actual Variance

Units produced 21,400 25,000 3,600
Variable costs:
Indirect materials (budgeted at $2 per unit) $ 42,800 $ 49,000 ($ 6,200)
Indirect labor (budgeted at $1.50 per unit) 32,100 38,000 (5,900)
Power and light (budgeted at $1 per unit) 21,400 24,600 (3,200)
Total variable costs 96,300 111,600 (15,300)
Fixed costs:
Supervisory salaries 90,000 90,200 (200)
Depreciation on plant and equipment 20,000 20,300 (300)
Other 5,000 5,000 –0–
Total fixed cost 115,000 115,500 (500)
Total overhead $211,300 $227,100 ($15,800)
( ) denotes unfavorable variance.
that can be adjusted to various activity levels. Thus, flexible budgets take into account
the fact that when production increases or decreases, variable costs change. Fixed costs,
however, stay the same. Consider a company that anticipates variable production costs
of $10 per unit and fixed production costs of $500,000. With this cost structure, flexible
budgets for production levels of 20,000 units, 30,000 units, and 40,000 units can be
prepared as in Illustration 10-14.
In Illustration 10-15, a flexible budget is used to evaluate the performance of the
manager responsible for manufacturing overhead at Preston Joystick. Note that the
variable costs are adjusted to the actual level of units produced. The fixed costs are at
the same level as in the static budget, because they are not expected to change when
production increases or decreases. Comparison of actual overhead costs with the
overhead costs in a flexible budget is potentially more revealing about the manager’s
ability to control costs. Actual variable costs are $900 less than the flexible budget
amount. This contrasts sharply with the $15,300 amount by which actual costs were
greater than the static budget amount for variable costs. The variance with respect to
fixed costs is still $500 more than budgeted—the same as in the static budget comparison.
Illustration 10-14
Flexible budgets for various Preston Joystick
production levels
Flexible Budgets for Production
Levels of 20,000, 30,000, and 40,000 Units
Units produced 20,000 30,000 40,000
Variable costs ($10 per unit) $200,000 $300,000 $400,000
Fixed costs 500,000 500,000 500,000
Total $700,000 $800,000 $900,000
Illustration 10-15
Performance evaluation with Preston Joystick
a flexible budget
Performance Report, Manufacturing Overhead
Flexible Budget Comparison
First Quarter, 2017
Flexible
Budget Actual Variance
Units produced 25,000 25,000 –0–
Variable costs:
Indirect materials (budgeted at $2 per unit) $ 50,000 $ 49,000 $1,000
Indirect labor (budgeted at $1.50 per unit) 37,500 38,000 (500)
Power and light (budgeted at $1 per unit) 25,000 24,600 400
Total variable costs 112,500 111,600 900
Fixed costs:
Supervisory salaries 90,000 90,200 (200)
Depreciation on plant and equipment 20,000 20,300 (300)
Other 5,000 5,000 –0–
Total fixed cost 115,000 115,500 (500)
Total overhead $227,500 $227,100 $ 400
( ) denotes unfavorable variances.
INVESTIGATING BUDGET VARIANCES

As noted at the beginning of the chapter, significant deviations from the budget (i.e.,
significant variances) may have three causes:
1. The budget may not have been well conceived.
2. Conditions may have changed.
3. Managers may have performed their jobs particularly well or poorly.
If the budget is not carefully developed with reasonable estimates of cost, it should not
be surprising if actual costs are not equal to the budgeted amounts. In this case, budget
variances should not be blamed on the manager responsible for meeting the budget.
Even if the budget is carefully developed, the company may nonetheless experience
unforeseen and unavoidable price increases. As a result, the actual costs will be different
from budgeted costs.
Finally, budget variances are sometimes due to inefficiencies resulting from poor
management techniques or decisions. In this case, top management may adjust the
compensation of the manager responsible for meeting the budget (e.g., reduce or
eliminate his or her bonus compensation) and suggest ways the manager can improve
the performance of his or her operation. In some cases, it may be necessary to fire a
manager who is incapable of improving.
The cause of a variance cannot be determined without an investigation. However,
because of the cost of investigation, it is not practical to investigate all budget variances.
A management by exception approach is more economical. Under this approach, only
exceptional variances are investigated. Generally, variances that are large in absolute
dollars or relative to budgeted amounts are considered exceptional. It is important to point
out that both exceptional “unfavorable” and exceptional “favorable” variances should
be investigated. For example, in the performance report in Illustration 10-15, there is a
$1,000 “favorable” variance for indirect materials, indicating that actual costs are less
C o n f l i c t i n P l a n n i n g a n d C o n t r o l U s e s o f B u d g e t s 387
Link to Practice
Using Rolling Budgets to Deal with account information on changes in economic conditions
Changes in Economic Conditions that come to light in the first quarter which may affect
spending for capital acquisitions as well as product mix
Many companies find that shortly after they prepare
and prices. The process is then repeated each quarter.
their annual budget, it’s out of date. The problem is
Rolling budgets also can be updated monthly if desired.
unanticipated changes in economic conditions. To
To implement rolling budgets, companies must have
deal with this situation, companies such as Electrolux
a good handle on fixed and variable expenses so they
and General Electric have turned to so-called rolling
can predict how unanticipated changes in sales will
budgets. At the start of their fiscal year, the companies
affect costs in the revised budget.
prepare an annual budget covering four quarters, based
on best estimates of what they expect to occur. At the
For more information, see Marc P. Lynn and Roland L.
end of the first quarter, a new annual budget is prepared Madison, “A Closer Look at Rolling Budgets,” Management
that covers the remaining three quarters and the first Accounting Quarterly, Fall 2004, and Randy Myers, “Budgets
quarter of the following year. This new budget takes into on a Roll,” Journal of Accountancy, December 2001.
than budgeted costs. This seems to indicate a favorable state of affairs. However, it is
possible that cheap, low-quality materials are being used. This could result in substandard
products that damage the reputation of the company.
Any Q ues tions ?

Q: The chapter provides an example of a “favorable” variance from the budget
that is actually unfavorable from the standpoint of increasing shareholder value.
Can there also be “unfavorable” variances that are associated with increasing
shareholder value?
A : It is quite possible that an “unfavorable” budget variance could be due to an action that
increased shareholder value. For example, suppose a manager decides to spend much more
on customer service than budgeted. But the outcome of the additional expenditures is that
the company makes great strides in customer satisfaction and sales increase dramatically. In
this case, there’s an unfavorable variance, but the action that generated the variance increased
shareholder value.
CONFLICT IN PLANNING AND CONTROL

USES OF BUDGETS
As previously discussed, budgets are used for both planning and control. With respect to
planning, they communicate company goals and help coordinate various activities. With
respect to control, they focus the attention of managers on meeting or beating budget
targets. This is because a manager’s total compensation, including his or her bonus, may
depend on meeting or beating budget targets.
Unfortunately, there is an inherent conflict when budgets are used for both planning
and control. The result of the conflict is that managers may: (1) pad their budgets and
(2) shift income between periods to increase their compensation.2 Both problems are
discussed in the next section.
2
The well-known economist Michael Jensen has an excellent discussion of the two problems (and their
s olution) in his article “Corporate Budgeting Is Broken—Let’s Fix It,” Harvard Business Review, November
2001. Illustration 10-16 is taken from this article.
Why Budget-Based Compensation Can Lead

to Budget Padding and Income Shifting
Illustration 10-16 helps understanding of the two related problems. The illustration
shows a common budget-based compensation scheme in which a manager receives a
“hurdle” bonus once he or she hits a target, which is commonly 80 percent of budgeted
performance. (Here the budget could be in sales dollars, units of output, profit, or some
other performance measure. For our purposes, we will assume the performance measure
is profit.) Performance better than 80 percent of budgeted profit results in additional
“variable” bonus compensation until a cap is reached. This is commonly 120 percent of
the budget. At this point, no additional compensation is earned for the budget period
under consideration.
Now let’s examine the two potential problems. Recall that managers who are
evaluated with respect to a budget are likely to provide information used in setting
it. This follows because they are likely to have better information about costs and
revenues than their superiors. This leads to the first problem, which is that managers
have an incentive to pad a budget and create budget slack—that is, a budget with
targets that are easy to achieve. That’s because the lower the budget target, the more
likely it is that the managers will receive the hurdle bonus and the maximum variable
bonus. Managers can create slack by lowering their forecasts of sales and increasing
their forecasts of costs.
The second problem relates to the fact that managers who are evaluated with respect
to the budget may have an incentive to shift income from one period to another. Consider
a manager who estimates that it is unlikely he or she will meet the hurdle target. This
manager has an incentive to shift income from a future period into the current period
so that the hurdle target (80 percent of the budget) is reached and the hurdle bonus is
received. This might be done by cutting back research and development expenditures
in the current year and delaying them until a future year. Or a manager could recognize
revenue in the current year on goods that are not going to be shipped until the start of
the next year. This latter option violates generally accepted accounting principles (GAAP)
Illustration 10-16
Common budget-based
compensation scheme
Salary and Bonus
Variable Bonus
Hurdle Bonus
Salary
80% of Budget 120% of

Budget Budget
Performance Relative to Budget
E v a l u a t i o n , M e a s u r e m e n t , a n d M a n a g e m e n t B e h a v i o r 389
and is, most likely, illegal. But the action has been used over the years by a number of
ethically challenged managers.
Now consider a manager who estimates that the performance of his or her business
unit is likely to exceed 120 percent of the budget target. This manager has an incentive
to shift income from the current period to a future period. The excess performance
(performance in excess of 120 percent of the budget) won’t help the manager’s compen-
sation since the bonus is capped once 120 percent of the budget is reached. The manager
might delay shipments scheduled at year-end so that revenue won’t be recognized in the
current period but will be recognized at the start of the next year, when goods are finally
shipped. The extra revenue in the next year will make achievement of the budget target
in that year relatively easy.
A factor that deters both budget padding and income shifting is the chance
of getting caught. There is always a chance that senior managers will detect that a
lower-level manager has padded a budget and punish this behavior by, for example,
firing him or her. That certainly reduces the incentive to build in excessive budget
slack. With respect to income shifting, there is also a chance that it will be detected
and punished by higher-level managers. And if the income shifting is illegal, penalties
may be stiff indeed.
Perhaps the best that can be done to mitigate the conflict between the planning and
control uses of budgets is to assure managers that their performance in comparison to
the budget will be fairly evaluated and compensated. Managers should be confident that
they will be allowed to comment on the real causes of budget variances and tell their
side of the story.
EVALUATION, MEASUREMENT, AND

MANAGEMENT BEHAVIOR
You get what you Managers pay close attention to those aspects of their jobs that are measured and
M e a s u r e evaluated. Thus, it is important to quantify in budgets key “success factors” for the c ompany.
Historically, budgets primarily have included dollar amounts. However, including some
nonmonetary measures of performance in the budget is likely to be advantageous. For
example, if a key aspect of a company’s success is high-quality, defect-free products, it
may be useful to budget the number of defects and the number of customer complaints
at levels consistent with high quality. The actual number of defects and complaints can
be compared with the budgeted quantities to evaluate performance. Or if a company is
Link to Practice
Ratcheting and the Ability to Achieve to the target is, indeed, associated with increases in
Budget Targets the target. However, it appears that this isn’t a major
obstacle in that well-performing managers are able

Some managers worry that beating their budgeted earn-
to repeatedly meet these higher targets. Thus, while
ings targets may lead superiors to make their budgets
ratcheting exists, it doesn’t appear to create negative
harder to achieve in the next budget period. That prac-
incentives for the best managers.
tice, know as ratcheting, is thought to create an incentive
problem in that it motivates managers to avoid striving to Source: Matthias Mahlendorf, Michal Matejka, and Utz
beat budgeted earnings by a significant margin. Schäffer, “Target Ratcheting, Incentives, and Achievability of
Recent research by Mahlendorf, Matejaka, and Earnings Targets.” Working Paper (August 2014).
Schäffer documents that favorable performance relative
experiencing problems with employee absenteeism, it may be useful to budget an accept-

able number of days missed and compare actual days missed with the target. Remember,
you get what you measure!
THE PRESTON JOYSTICK CASE REVISITED

At the start of the chapter, Alan Renton, president of Preston Joystick, noted: “The
marketing, production, and financing people need to know what is anticipated so we
can operate effectively and efficiently.” How can Alan plan and coordinate the activities
of his company?
As you know from reading the preceding material, the answer lies in developing
budgets. Once a sales budget is produced, the production group can develop budgets
for labor, material, and overhead that are consistent with the production level needed to
meet expected sales. Once these budgets are produced, the finance group can prepare
budgets that take into account the cash inflows and outflows anticipated in the sales
and production budgets as well as the cash flows related to selling and administrative
activities and capital acquisitions.
Decision Making
Budget-based compensation schemes can encourage budget padding (e.g.,
Insight overestimation of expense and underestimation of revenue). But can this hurt decision
making? Absolutely. Suppose a manager underestimates next year’s sales so that his
or her budgeted income target will be relatively easy to beat. Since the sales figures
in the budget are used to prepare the production budget, production managers may
fail to make optimal hiring and material acquisition decisions. The result could be
needless overtime and more costly rush orders for materials when sales turn out to
be higher than anticipated by the people in production.

LEARNING OBJECTIVE 1 Discuss the use of LEARNING OBJECTIVE 3 Explain why flexible
budgets in planning and control. budgets are needed for performance evaluation,
Budgets are useful in the planning process because they and discuss the conflict between the planning and
enhance communication and coordination. Budgets are also control uses of budgets.
useful in the control process because they provide a standard In evaluating performance, flexible budgets should be used
for evaluating performance. because they present amounts adjusted to the actual level of
production. Comparing actual performance with a static budget
is not very useful because variable costs are expected to differ
LEARNING OBJECTIVE 2 Prepare the budget from the budget if actual production is different from the
schedules that make up a master budget. production level indicated in the static budget.
The master budget is a comprehensive planning document and The fact that budgets are used for both planning and
usually includes budgets for sales, production, direct materials, performance evaluation presents a difficulty in that managers
direct labor, manufacturing overhead, selling and administra- who participate in the development of their own budgets may
tive expenses, capital acquisitions, cash receipts and disburse- tend to understate budgeted revenues and overstate budgeted
ments, a budgeted income statement, and a budgeted balance expenses. The result is a budget that is easy to achieve and
sheet. These budgets are highly interrelated in that the amounts contains budget slack. Managers may also shift income from
presented in one budget may be dependent on the amounts in one budget period to the next to improve their chances of
one or more other budgets. receiving the hurdle bonus and the maximum variable bonus.
Review Problem 1
Boston Accounting Services provides accounting services to small businesses. The following data
relate to the preparation of a master budget for January 2017.
1. At the end of 2016, the company’s general ledger indicated the following balances:
Cash $ 62,000 Accounts payable $ 40,000

Accounts receivable 48,000 Note payable 10,000
Equipment (net) 80,000 Common stock 50,000
Total $190,000 $190,000
2. Revenue in December 2016 was $80,000, and revenue budgeted for January 2017 is
$70,000.
3. Forty percent of revenue is collected in the month earned, and 60 percent is collected in
the subsequent month. The receivable balance at the end of 2016 reflects revenue earned in
December 2016.
4. Monthly expenses (excluding interest expense) are budgeted as follows: salaries,
$50,000; rent, $3,000; depreciation of equipment, $3,000; utilities, $1,000; other,
$2,000.
5. Expenses are paid in the month incurred. Purchases of equipment are paid in the month
after purchase. The $40,000 payable at the end of 2016 represents money owed for the
purchase of equipment in December 2016. No purchases of equipment are anticipated
for January.
6. The note is at 10 percent per annum and requires monthly interest payments of $83. The
entire principal must be paid in October 2017.
7. The tax rate is 35 percent. Taxes are paid as incurred.
Req u i red
Complete the following budgets:
a. Cash Budget
For January 2017
Cash Receipts
Collection of December 2016 revenue $
Collection of January 2017 revenue
Total cash receipts
Cash Disbursements
Payment of salaries
Payment of rent
Payment of utilities
Payment of other expenses
Payment for purchases of computer equipment
Payment of interest on note
Payment of taxes
Total cash disbursements
Plus beginning cash balance
Ending cash balance $
b. Budgeted Income Statement

For January 2017
Revenue $
Less:
Salaries $
Rent
Utilities
Other expenses
Depreciation
Interest expense
Total expense
Income before taxes
Taxes on income at 35%
Net income $
c. Budgeted Balance Sheet

As of January 31, 2017
Assets
Cash $
Accounts receivable
Equipment (net)
Total assets $
Liabilities
Accounts payable $
Note payable
Total liabilities
Common stock
Retained earnings
Total stockholders’ equity
Total liabilities and stockholders’ equity $
Answer
a. Cash Budget
For January 2017
Cash Receipts
Collection of December 2016 revenue (.6 × $80,000) $48,000
Collection of January 2017 revenue (.4 × $70,000) 28,000
Total cash receipts 76,000
Cash Disbursements
Payment of salaries 50,000
Payment of rent 3,000
Payment of utilities 1,000
Payment of other expenses 2,000
Payment for purchases of computer equipment 40,000
Payment of interest on note 83
Payment of taxes 3,821
Total cash disbursements (99,904)
Plus beginning cash balance 62,000
Ending cash balance $38,096
b. Budgeted Income Statement

For January 2017
Revenue $70,000
Less:
Salaries $50,000
Rent 3,000
Utilities 1,000
Other expenses 2,000
Depreciation 3,000
Interest expense 83
Total expense 59,083
Taxes on income at 35% 3,821
Net income $ 7,096
c. Budgeted Balance Sheet

Assets
Cash $ 38,096
Accounts receivable (.6 × $70,000) 42,000
Equipment (net) ($80,000 - $3,000) 77,000
Total assets $157,096
Liabilities
Accounts payable $ —
Note payable 10,000
Total liabilities 10,000
Common stock $ 50,000
Retained earnings ($90,000 + 7,096) 97,096
Total stockholders’ equity 147,096
Total liabilities and stockholders’ equity $157,096
Review Problem 2
The results of operations for the Jackson Manufacturing Company for the fourth quarter of 2016
were as follows:
Sales $600,000
Less variable cost of sales 240,000
Less fixed production costs $ 65,000
Less fixed selling and administrative expenses 105,000 170,000
Less taxes on income 76,000
Net income $114,000
Note: Jackson Manufacturing uses the variable costing method. Thus, only variable production
costs are included in inventory and cost of goods sold. Fixed production costs are charged to
expense in the period incurred.
The company’s balance sheet as of the end of the fourth quarter of 2016 was as follows:
Cash $200,000
Accounts receivable 120,000
Inventory 400,000
Total current assets 720,000
Property, plant, and equipment 200,000
Less accumulated depreciation 100,000
Accounts payable $ 12,000
Total liabilities and stockholders’ equity $820,000
Additional information:
1. Sales and variable costs of sales are expected to increase by 10 percent in the next quarter.
2. All sales are on credit with 80 percent collected in the quarter of sale and 20 percent
collected in the following quarter.
3. Variable cost of sales consists of 50 percent materials, 30 percent direct labor, and
20 percent variable overhead. Materials are purchased on credit: 90 percent are paid for
in the quarter of purchase, and the remaining amount is paid for in the quarter after
purchase. The inventory balance is not expected to change. Also, direct labor and variable
overhead are paid in the quarter the expenses are incurred.
4. Fixed production costs (other than $10,000 of depreciation) are expected to increase
by 5 percent. Fixed production costs requiring payment are paid in the quarter they are
incurred.
5. Fixed selling and administrative costs (other than $5,000 of depreciation expense) are
expected to increase by 5 percent. Fixed selling and administrative costs requiring payment
are paid in the quarter they are incurred.
6. The tax rate is expected to be 40 percent. All taxes are paid in the quarter they are incurred.
7. No purchases of property, plant, or equipment are expected in the first quarter of 2017.
Req u i r ed
a. Prepare a budgeted income statement for the first quarter of 2017.
b. Prepare a budgeted statement of cash receipts and disbursements for the first quarter of 2017.
c. Prepare a budgeted balance sheet as of the end of the first quarter of 2017.
A n sw e r
a. Jackson Manufacturing Company
For the Quarter Ended March 31, 2017
Sales $660,000 10% increase over prior quarter

Less variable cost of sales 264,000 10% increase over prior quarter
Contribution margin $396,000
Less fixed production costs $ 67,750 $10,000 + 1.05 ($65,000 - $10,000)
Less fixed selling and adm. 110,000 177,750 $5,000 + 1.05 ($105,000 - $5,000)
Income before taxes $218,250
Less taxes on income 87,300 40% of income before taxes
Net income $130,950
b. Jackson Manufacturing Company

Cash Budget For the Quarter Ended March 31, 2017
Cash collected from sales:

$120,000 + .8 ($660,000)a $648,000
Cash payments:
Payment of material ($12,000 + 0.9 × $132,000)b 130,800
Payment for laborc 79,200
Payment for variable overheadd 52,800
Payment for fixed production costs
($67,750 - $10,000 depreciation) 57,750
Payment for fixed selling and administrative expenses
($110,000 - $5,000 depreciation) 105,000
Payment of income taxes 87,300
Total cash payments 512,850
Excess of receipts over disbursements 135,150
Plus beginning cash balance 200,000
Ending cash balance $335,150
a
20% of prior quarter sales collected in next quarter (0.2 × $600,000) = $120,000
b
Material used in prior quarter (0.5 × $240,000) = $120,000
10% paid in next quarter $12,000
Material used in current quarter (0.5 × $264,000) = $132,000
c
Direct labor used (0.3 × $264,000) = $79,200
d
Variable overhead incurred (0.2 × $264,000) = $52,800
c. Jackson Manufacturing Company

Budgeted Balance Sheet As of March 31, 2017
Assets:
Cash $335,150
Accounts receivable 132,000 (0.2 × $660,000)
Inventory 400,000
Less accumulated depreciation (115,000) ($100,000 + $10,000 + $5,000)
Liabilities and stockholders’ equity:
Accounts payable $ 13,200 (0.1 × $132,000)
Retained earnings 338,950 ($208,000 + $130,950)
Total liabilities and stockholders’ $952,150
equity
Key Terms Budgets (368) Flexible budget (384) Slack (388)

Budget committee (370) Management by exception (386) Static budget (384)
Budget variances (384) Master budget (373) Zero-based budgeting (373)

1. Which of the following statements about budgets is false? They enhance communication and coordination.
b.
a. They are formal documents that quantify a They are useful in planning but not in control.
c.
company’s plans. They provide a basis for evaluating performance.
d.
2. Budgets are useful in the planning process because they 7. A ________________ budget is not adjusted for the
enhance ________________ and ________________. actual level of production whereas a _____________
3. Which of the following statements regarding a sales budget is adjusted for the actual level of production.
budget is false? 8. Which of the following is true about management by
Input from the sales force may be useful in predict-
a. exception?
ing sales. a. Only large favorable variances are investigated.
Very large companies may hire economists to help
b. b. Management by exception is an economical ap-
forecast sales. proach to cost control.
The sales budget is prepared before the cash receipts
c. c. Management by exception can be used only with
and disbursements budget. computers.
The sales budget is developed after the production
d. d. Large favorable variances should not be investigated.
budget. 9. True or false? There is never a conflict between the
4. Which of the following is the correct formula to deter- planning and control use of budgets.
mine required purchases of direct materials? 10. Which of the following is false?
a. Quantity required for production + Desired ending a. Including some nonmonetary measures of perfor-
quantity - Beginning quantity mance in a budget is not likely to be advantageous.
b. Quantity required for production - Desired ending b. If a key aspect of a company’s success is high-quality,
quantity + Beginning quantity defect-free products, it may be useful to budget
c. Quantity required for production + Desired ending the number of defects and the number of customer
quantity + Beginning quantity complaints at levels consistent with high quality.
d. Beginning quantity + Purchases - Desired ending c. The actual number of defects and complaints can be
quantity compared with the budgeted quantities to evaluate
5. Which of the following items do not require cash performance.
outflow? d. If a company is experiencing problems with em-
a. Salaries ployee absenteeism, it may be useful to budget an
b. Purchase of raw materials acceptable number of days missed and compare
actual days missed with the target.
c. Advertising
d. Depreciation Answers to Self-Assessment
6. Differences between budgeted and actual amounts are 1. c 2. communication, coordination 3. d 4. a 5. d
referred to as ________________. 6. budget variances 7. static, flexible 8. b 9. false 10. a
QUESTIONS 1. Why are budgets useful in the planning process?

2. Why are budgets useful in the control process?
3. What is the difference between the top-down and the bottom-up approach to developing a
budget?
4. What is meant by a zero-based budget?
5. How does use of a spreadsheet program facilitate “what if ” analysis in budgeting?
6. What are the main purposes of preparing a cash budget?
7. Explain the difference between a static and a flexible budget.
8. The number of defects in a manufacturing process is an example of a nonmonetary measure
of employee performance. Describe a financial measure that captures the effect of defects.
9. How would performance be evaluated if there were no budgets?
10. Why is there an inherent conflict between planning and control uses of budgets?
Exercises EXERCISE 10-1. [LO 3] Explain why a budget-based compensation scheme may encourage a man-
ager to shift income from the current period to a future period if expected performance is quite
high (e.g., greater than 120 percent of budgeted performance). How could the income shifting be
accomplished?
EXERCISE 10-2. [LO 3] Write a paragraph that explains why a budget-based compensation scheme
may lead managers to create budget slack.
EXERCISE 10-3. Order of Budgets [LO 1] Determine the order in which the following budgets
are generally prepared.
a. Material purchases budget
b. Sales budget
c. Budgeted income statement
d. Production budget
EXERCISE 10-4. Sales Budget [LO 2] Locksafe Company manufactures burglar-resistant com-
mercial door locks. Recently the company began selling locks on the Web, and the company ex-
pects sales to increase dramatically compared with the prior year. For the past year, 2017, unit
sales were:
First quarter 23,000 units

Second quarter 28,000 units
Third quarter 27,000 units
Fourth quarter 32,000 units
Req u ir ed
Assume that total unit sales for each quarter in 2018 will be 20 percent higher than in 2017 and
that the selling price per lock is $25. Prepare a sales budget by quarter for 2018.
EXERCISE 10-5. Sales Budget for Service Company [LO 2] Oregon Adventures provides tours
of scenic locations in Oregon. The company expects tours taken to increase dramatically com-
pared with the prior year.
For the past year, 2017, the number of tours given were as follows:
First quarter 6,000

Second quarter 7,000
Third quarter 10,000
Fourth quarter 9,000
Req u i red
Assume that sales for each quarter in 2018 will be 35 percent higher than in 2017 and that the
price per tour is $75. Prepare a sales budget by quarter for 2018.
EXERCISE 10-6. Production Budget [LO 2] VitaPup produces a vitamin-enhanced dog food
that is sold in Kansas. The company expects sales to be 13,000 bags in January, 14,900 bags in
February, 19,400 bags in March, and 22,000 bags in April. There are 1,300 bags on hand at the
start of January. VitaPup desires to maintain monthly ending inventory equal to 15 percent of next
month’s expected sales.
Req u i r ed
Prepare the production budget for VitaPup for the months of January, February, and March.
EXERCISE 10-7. Direct Materials Purchases Budget [LO 2] Roehler Industrial has estimated
that production for the next five quarters will be:
Production Information
1st quarter, 2017 45,000 units

2nd quarter, 2017 41,000 units
3rd quarter, 2017 49,000 units
4th quarter, 2017 38,000 units
1st quarter, 2018 47,000 units
Finished units of production require 6 pounds of raw material per unit. The raw material cost is $7 per
pound. There is $283,500 of raw material on hand at the beginning of the first quarter, 2017. Roehler
desires to have 15 percent of next quarter’s material requirements on hand at the end of each quarter.
Req u i r ed
Prepare quarterly direct materials purchases budgets for Roehler Industrial for 2017.
EXERCISE 10-8. Direct Labor Budget [LO 1] Prepare quarterly direct labor budgets for Roehler
Industrial for 2017, using the production information in Exercise 10-7. It takes 3.0 hours of direct
labor to produce each finished unit of product. Direct labor costs are $20 per hour. Each employee
can work 470 hours per quarter.
EXERCISE 10-9. Manufacturing Overhead Budget [LO 2] Prepare quarterly manufacturing

overhead budgets for Roehler Industrial for 2017, using the production information from
Exercise 10-7. Roehler has overhead costs as follows:
Variable Costs Fixed Costs per Quarter
Indirect material $3.25 per unit Supervisory salaries $70,000

Indirect labor 2.20 per unit Factory depreciation 37,000
Utilities 0.50 per unit Other 6,000
EXERCISE 10-10. Budgeted Sales and Cash Receipts [LO 2] The Warrenburg Antique Mall
budgeted credit sales in the first quarter of 2018 to be as follows:
January $160,000
February 170,000
March 182,000
Credit sales in December 2017 are expected to be $200,000. The company expects to collect
70 percent of a month’s sales in the month of sale and 30 percent in the following month.
Req u i r ed
Estimate cash receipts for each month of the first quarter of 2018.
EXERCISE 10-11. Cash Disbursements for Purchases [LO 2] The Warrenburg Antique Mall
expects to make purchases in the first quarter of 2018 as follows:
January $95,000
February 120,000
March 85,000
Purchases in December 2017 are expected to be $92,000. The company expects that 50 percent
of a month’s purchases will be paid in the month of purchase and 50 percent will be paid in the
following month.
Req u i r ed
Estimate cash disbursements related to purchases for each month of the first quarter of 2018.
EXERCISE 10-12. Budgeted Sales and Cash Receipts [LO 2] Mississippi Retailers expects
credit sales in the next quarter as follows:
April $ 80,000
May 90,000
June 113,000
Prior experience has shown that 70 percent of a month’s sales are collected in the month of sale,
20 percent are collected in the month following sale, and the remaining 10 percent are collected in
the second month following sale. February and March sales were $90,000 and $100,000, respectively.
Req u ir ed
Estimate budgeted cash receipts for April, May, and June.
EXERCISE 10-13. Cash Disbursements for Purchases [LO 2] Mississippi Retailers expects to
make inventory purchases in the next quarter as follows:
April $60,000
May 70,000
June 95,000
Prior experience has shown that 70 percent of a month’s purchases are paid in the month of pur-
chase and 30 percent are paid in the month following purchase. March purchases were $55,000.
Req u ir ed
Estimate cash disbursements related to purchases for April, May, and June.
EXERCISE 10-14. Flexible Budget [LO 3] Expected manufacturing costs for Imperial Data
Devices are as follows:
Variable Costs Fixed Costs per Month
Direct material $8.00/unit Supervisory salaries $17,000

Direct labor 3.50/unit Factory depreciation 10,500
Variable overhead 1.80/unit Other factory costs 3,100
Req u i red
Estimate manufacturing costs for production levels of 12,000 units, 15,000 units, and 17,000 units
per month.
EXERCISE 10-15. Performance Report [LO 3] Prepare a performance report for Imperial Data
Devices using the budget information from Exercise 10-14 and the next performance information.
During the period, Imperial produced 13,000 units and incurred the following costs:
Variable Costs Fixed Costs per Month
Direct material $102,500 Supervisory salaries $17,750

Direct labor 50,000 Factory depreciation 9,500
Variable overhead 23,000 Other factory costs 3,400
EXERCISE 10-16. Performance Report [LO 2, 3] At the start of 2018, the New Orleans Fine Food
Company budgeted before-tax income as follows:
Sales $550,000
Less:
Material cost $100,000
Labor cost 220,000
Rent 55,000
Depreciation 45,000
Utilities 22,000 507,000
Actual before tax income for 2018 was:

Sales $660,000
Less:
Material cost $130,000
Labor cost 285,000
Rent 55,000
Depreciation 45,200
Utilities 21,000 601,950
Req u i r ed
Florence Roden, the owner of the company, is pleased that sales were much higher than planned,
but she also is concerned that expenses were $94,950 higher than the amounts she budgeted.
Should she be concerned with the level of actual expenses? Prepare a performance report that will
help her focus on areas needing attention.
EXERCISE 10-17. Conflict in Planning and Control [LO 3] Riemers Jewelry operates 45 stores
in major shopping malls around the country, and Walter Chan is the manager of a store in Dallas.
The company is in the third quarter of 2017 and is beginning preparation of its fiscal 2018 budget.
Typically, the company begins its profit-planning process by asking store managers to forecast
sales and expenses. Individual profit plans are developed for each store and aggregated to develop
a profit plan for the company as a whole.
In the control process, company executives compare actual profit performance to the plan
on a store-by-store basis. Managers of stores that beat their budgeted profit levels are rewarded
with significant bonuses.
Req u i r ed
Will Walter Chan be motivated to provide unbiased forecasts of revenue and expense for the Dallas
store? If not, what will be the direction of the bias for revenue and for expense?
Problems PROBLEM 10-1. Master Budget [LO 2] (Note: This problem is similar to Review Problem 2, only
the numbers have been changed. Students who get stuck should consult the solution to Review
Problem 2.)
The results of operations for the Preston Manufacturing Company for the fourth quarter of
2017 were as follows:
Sales $550,000
Less variable cost of sales 330,000
Less fixed production costs $120,000
Net income $ 27,000
Note: Preston Manufacturing uses the variable costing method. Thus, only variable production
costs are included in inventory and cost of goods sold. Fixed production costs are charged to
expense in the period incurred.
P r o b l e m s 401
The company’s balance sheet as of the end of the fourth quarter of 2017 was as follows:
Assets:
Cash $ 160,000
Inventory 385,000
Less accumulated depreciation 110,000
Total assets $1,095,000
Liabilities and owners’ equity:
Total liabilities and owners’ equity $1,095,000
2. All sales are on credit with 60 percent collected in the quarter of sale and 40 percent col-
lected in the following quarter.
3. Variable cost of sales consists of 40 percent materials, 40 percent direct labor, and 20 percent
variable overhead. Materials are purchased on credit. Fifty percent are paid for in the quarter
of purchase, and the remaining amount is paid for in the quarter after purchase. The inven-
tory balance is not expected to change. Also, direct labor and variable overhead costs are
paid in the quarter the expenses are incurred.
4. Fixed production costs (other than $9,000 of depreciation expense) are expected to increase
by 3 percent. Fixed production costs requiring payment are paid in the quarter they are
incurred.
7. No purchases of property, plant, or equipment are expected in the first quarter of 2018.
Req u i red
b. Prepare a cash budget for the first quarter of 2018.
PROBLEM 10-2. Master Budget [LO 2] The results of operations for the Garret Bug Spray
Manufacturing Company for the fourth quarter of 2017 were as follows (in thousands):
Sales of bug spray $500,000

Less variable cost of goods sold 280,000
Less fixed production costs $90,000
Net income $ 48,000
Note: Garret uses the variable costing method. Thus, only variable costs are included in the cost
of goods sold. Fixed costs are charged to expense in the period incurred.
The company’s balance sheet as of the end of the fourth quarter of 2017 was as follows (in
thousands):
Assets:
Cash $ 30,000
Fixtures and equipment $130,000
Less accumulated depreciation 80,000 50,000
Liabilities and owners’ equity:
Total liabilities and owners’ equity $330,000
2. All sales are on credit with 50 percent collected in the quarter of sale and 50 percent
collected in the following quarter.
3. Variable cost of sales consists of 40 percent materials, 40 percent direct labor, and 20 percent
variable overhead. Materials are purchased on credit. Sixty percent are paid for in the quarter
of purchase, and the remaining amount is paid for in the quarter after purchase. There is no
inventory. Also, direct labor and variable overhead costs are paid in the quarter the expenses
are incurred.
4. Fixed production costs (other than $5,000 of depreciation expense) are expected to increase
by 1.5 percent. Fixed production costs requiring payment are paid in the quarter they are
incurred.
7. No purchases of fixtures or equipment are expected in the first quarter of 2018.
Req u i r ed
b. Prepare a budgeted statement of cash budget for the first quarter of 2018.
PROBLEM 10-3. Master Budget [LO 2] Techlabs operates a computer training center. The following
data relate to the preparation of a master budget for January 2018.
1. At the end of 2017, the company’s general ledger indicated the following balances:
Debits Credits
Cash $ 60,000 Accounts Payable $ 40,000

Accounts receivable 40,000 Note payable 60,000
Equipment (net) 120,000 Common stock 30,000
Total $220,000 $220,000
2. Tuition revenue in December 2017 was $80,000, and tuition revenue budgeted for January
2018 is $110,000.
P r o b l e m s 403
3. Fifty percent of tuition revenue is collected in the month earned, and 50 percent is collected
in the subsequent month. The receivable balance at the end of 2017 reflects tuition earned in
December 2017.
4. Monthly expenses (excluding interest expense) are budgeted as follows: salaries, $60,000;
rent, $4,000; depreciation on equipment, $8,000; utilities, $2,000; other, $800.
5. Expenses are paid in the month incurred. Purchases of equipment are paid in the month
after purchase. The $40,000 payable at the end of 2017 represents money owed for the
purchase of computer equipment in December 2017.
6. The company intends to purchase $50,000 of computer equipment in January 2018. The
anticipated $8,000 per month of depreciation (see number 4) reflects the addition of $2,000
of monthly depreciation related to this purchase.
7. The note is at 15 percent per annum and requires monthly interest payments of $750. The
payments are made on the 20th of each month. The principal must be paid in February 2019.
8. The tax rate is 35 percent.
Req u i red
Complete the following budgets:
a. Techlabs
Cash Budget
For January 2018
Cash receipts
Collection of December 2017 tuition $
Collection of January 2018 tuition
Total cash receipts
Cash disbursements
Payment of salaries
Payment of rent
Payment of utilities
Payment of other expenses
Payment for purchases of computer equipment
Payment of interest on note
Payment of taxes
Total disbursements
Excess disbursements over receipts
Plus beginning cash balance
Ending cash balance $
b. Techlabs
Budget Income Statement
For January 2018
Tuition revenue $
Less:
Salaries
Rent
Utilities
Depreciation
Other
Interest expense
Total expense
Income before taxes
Taxes on income
Net income $
c. Techlabs
Assets
Cash $
Accounts receivable
Equipment (net)
Total assets $
Liabilities
Accounts payable $
Note payable
Total liabilities $
Stockholders’ equity
Common stock
Retained earnings
Total stockholders’ equity
Total liabilities and stockholders’ equity $
PROBLEM 10-4. Master Budget [LO 2] The Schrödinger Science Store operates a retail store in a
local shopping mall. The results of operations for the fourth quarter of 2017 are as follows:
Sales $350,000
Less cost of sales 205,000
Less selling, general, and administrative expenses 50,000
Less income taxes 38,000
Net income $ 57,000
1. Sales and cost of sales are expected to increase by 10 percent, are expected to increase by
12 percent, in each of the next two quarters.
2. 75 percent of sales are collected in the quarter of sale, and 25 percent are collected in the
quarter following sale.
3. The balance in accounts receivable at the end of 2017 relates to sales in the fourth quarter of 2017.
4. Inventory purchases in the fourth quarter of 2017 are $200,000.
5. The balance in accounts payable at the end of 2017 relates to purchases in the fourth quarter
of 2017.
6. Inventory at the end of 2017 is $150,000. For 2018, the company plans to hold ending
inventory equal to 65 percent of subsequent quarter cost of sales.
7. Selling and administrative expenses are expected to increase by $8,000 due to increases in
advertising and salaries. All other expenses in this category are expected to remain constant.
8. Fifty percent of inventory purchases are paid in the quarter of purchase, and 50 percent are paid
in the following quarter. All other expenses, including taxes, are paid in the quarter incurred.
9. Selling, general, and administrative expense includes $2,500 of depreciation related to furniture
and fixtures with a book value (net of accumulated depreciation) of $50,000 at the end of 2017.
10. The tax rate is expected to remain at 40 percent.
11. The cash balance at the end of 2017 is $40,000.
12. Common stock at the end of 2017 is $80,000 and retained earnings is $147,500.
13. Asset accounts are cash, accounts receivable, inventory, and furniture and fixtures. The
only liability account is accounts payable. Owner’s equity accounts are common stock and
retained earnings.
P r o b l e m s 405
Req u i red
d. The company is discussing the possibility of opening a new store late in the first quarter of
2018. A store opening would require cash payments of $50,000. Assuming the company wants a
minimum cash balance of $30,000 at the end of the first quarter, can a new store be opened with-
out obtaining additional funds?
PROBLEM 10-5. Master Budget [LO 2] The World Restaurant is situated in a local shopping
center and serves food of many different cultures. It also caters private functions for companies. The
results of operations for the fourth quarter of 2017 are as follows:
Sales $500,000
Less selling, general, and
administrative expenses 60,000
Less income taxes 38,000
Net income $ 57,000
1. Sales and cost of sales are expected to increase by 13 percent in each of the next two quarters.
2. Eighty percent of sales are collected in the quarter of sale and 20 percent are collected in the
quarter following sale.
3. The balance in accounts receivable at the end of 2017 relates to sales in the fourth quarter of 2017.
4. Food purchases in the fourth quarter of 2017 are $346,975.
5. The balance in accounts payable at the end of 2017 relates to purchases in the fourth quarter
of 2017.
6. Food inventory at the end of 2017 is $17,000. For 2018, the company plans to hold ending
inventory equal to 30 percent of the subsequent quarter’s cost of sales.
7. Selling, general, and administrative expenses are expected to increase by $12,000 due to increases
in advertising and salaries. All other expenses in this category are expected to remain constant.
8. Seventy-five percent of inventory purchases are paid in the quarter of purchase and 25 percent are
paid in the following quarter. All other expenses, including taxes, are paid in the quarter incurred.
9. Selling and administrative expense includes $5,000 of depreciation related to fixtures and
equipment with a book value (net of accumulated depreciation) of $60,000 at the end of 2017.
10. The tax rate is expected to remain at 40 percent.
11. The cash balance at the end of 2017 is $40,000.
12. Common stock at the end of 2017 is $25,000 and retained earnings is $105,256.
13. Asset accounts are cash, accounts receivable, inventory, and furniture and fixtures. The only liability
account is accounts payable. Owner’s equity accounts are common stock and retained earnings.
Req u i red
d. The company is discussing the possibility of expanding its restaurant to include a Thai section
late in the first quarter of 2018. The section’s construction would require cash payments of $50,000.
Assuming the company wants a minimum cash balance of $15,000 at the end of the first quarter,
can a new section be added without obtaining additional funds?
PROBLEM 10-6. Budgeted Income Statement [LO 2] Modern Healthcare, a group practice
clinic with 10 physicians, had the following income in 2017:
Revenue $3,250,000
Salaries
Physicians $1,300,000
Nurses 152,000
Nursing aide 68,500
Receptionist 50,000
Accounting services 45,000
Training 120,000
Supplies 250,000
Phone and fax 3,750
Insurance 275,000
Depreciation 242,000
Utilities 19,800
Miscellaneous 66,000
Total operating expenses 2,592,050
The following changes are expected in 2018:
1. The clinic is expecting a 2 percent decline in revenues because of increasing pressure from
insurance companies.
2. Physicians are planning to hire a physician assistant at a salary of $50,000 per year.
3. Training costs are expected to increase by $15,000.
4. Supplies are expected to increase to be 10 percent of revenue.
5. Phone, fax, and insurance amounts will stay the same.
6. Depreciation expense will increase by $20,000 per year, since the clinic is planning to pur-
chase equipment for $125,000.
7. Utilities and miscellaneous expenses are expected to increase by 5 percent next year.
8. Taxes on income will be 35 percent.
R equ i r ed
Prepare a budgeted income statement for Modern Healthcare for the year 2018.
PROBLEM 10-7. Budgeted Income Statement [LO 2] Pinnacle Engineering, an acclaimed chemical
engineering team of engineers, chemists, and other scientists, had the following income in 2017:
Revenue $3,550,000
Salaries $2,400,000
Accounting services 63,000
Training 182,000
Supplies 175,000
Phone and fax 3,850
Insurance 303,000
Utilities 35,000
Miscellaneous 7,100
Total operating expenses 3,388,950
Net income $ 96,630
P r o b l e m s 407
The following changes are expected in 2018:
1. The company is expecting a 12 percent increase in revenues because of increasing demand in

the marketplace for its services.
2. Training costs are expected to increase by $50,000.
3. Supplies are expected to increase to 8 percent of revenue.
4. Phone, fax, accounting services, and insurance amounts will stay the same.
5. Depreciation expense will increase by $9,000 per year, since the company is planning to
purchase equipment for $75,000.
6. Pinnacle is planning to hire a laboratory technician at a salary of $36,000 per year.
7. Utilities and miscellaneous expenses are expected to increase next year by 10 percent.
8. Taxes on income will be 40 percent.
Req u i red
Prepare a budgeted income statement for Pinnacle Engineering for fiscal year 2018.
PROBLEM 10-8. Combined Production and Purchases Budgets [LO 2] Super Clean produces
and sells stain remover. Information about the budget for the year 2018 is as follows:
1. The company expects to sell 57,000 bottles of stain remover in the first quarter, 65,000 in the
second quarter, 105,000 in the third quarter, and 42,000 in the fourth quarter.
2. A bottle of stain remover requires 6 ounces of Chemical A and 11 ounces of Chemical B.
3. For 2018, the desired ending inventory of finished goods is equal to 12 percent of next
quarter’s sales, whereas the desired ending inventory for material is 15 percent of next
quarter’s production requirements.
4. There are 7,000 bottles of stain remover, 25,000 ounces of Chemical A, and 60,000 ounces of
Chemical B on hand at the beginning of the first quarter.
5. At the end of the fourth quarter, the company must have 10,000 bottles of stain remover,
35,000 ounces of Chemical A, and 85,000 ounces of Chemical B to meet its needs in the first
quarter of 2018.
6. The cost of Chemical A is $0.13 per ounce, the cost of Chemical B is $0.08 per ounce, and
the selling price of the stain remover is $10.50 per bottle.
7. The cost of direct labor is $0.80 per bottle, and the cost of variable overhead is $1.20 per
bottle. Fixed manufacturing overhead is $65,000 per quarter.
8. Variable selling and administrative expense is 5 percent of sales, and fixed selling and
administrative expenses is $42,000 per quarter.
Req u ir ed
a. Prepare a production budget for each quarter of 2018.
b. Prepare a material purchases budget for each quarter of 2018.
c. Prepare a budgeted income statement for each quarter of 2018 (ignore taxes).
PROBLEM 10-9. Combined Production and Purchases Budgets [LO 2] Fenzel Slide Oil
roduces a lubricant, SlickTone, which is used on trombone slides. Information about the budget
p
for the year 2018 is as follows:
1. The company expects to sell 7,000 bottles of SlickTone in the first quarter, 6,000 in the
second quarter, 10,000 in the third quarter, and 8,000 in the fourth quarter.
2. A bottle of SlickTone requires 6 ounces of Chemical A and 3.5 ounces of Chemical B.
3. For the first, second, and third quarters of 2018, the desired ending inventory of finished
goods is equal to 8 percent of next quarter’s sales, whereas the desired ending inventory for
material is 12 percent of next quarter’s production requirements.
4. There are 1,600 bottles of SlickTone, 4,800 ounces of Chemical A, and 2,400 ounces of
Chemical B on hand at the beginning of the first quarter.
5. At the end of the fourth quarter, the company must have 1,000 bottles of SlickTone, 8,000 ounces
of Chemical A, and 4,000 ounces of Chemical B to meet its needs in the first quarter of 2019.
6. The cost of Chemical A is $1.05 per ounce, the cost of Chemical B is $0.15 per ounce, and
the selling price of SlickTone is $12.00 per bottle.
7. The cost of direct labor is $0.55 per bottle, and the cost of variable overhead is $0.75 per
bottle. Fixed manufacturing overhead is $3,000 per quarter.
8. Variable selling and administrative expense is 4 percent of sales and fixed selling and
administrative expense is $3,000 per quarter.
Req u i red
a. Prepare a production budget for each quarter of 2018.
b. Prepare a material purchases budget for each quarter of 2018.
c. Prepare a budgeted income statement for each quarter of 2018 (ignore taxes).
PROBLEM 10-10. Cash Budget [LO 2] In the fourth quarter of 2017, Casey Wholesalers had the
following net income:
Sales $650,000
Selling and administration 250,000
Income taxes 35,000
Net income $ 65,000
Purchases in the fourth quarter amounted to $375,000.
Estimated data for Casey Wholesalers, Inc. for 2018 are as follows:
Quarter 1 Quarter 2 Quarter 3 Quarter 4
Sales $725,000 $805,000 $875,000 $968,000

Cost of sales 350,000 420,000 500,000 580,000
Purchases 410,000 450,000 525,000 600,000
Selling and administration 250,000 250,000 250,000 250,000
Taxes are 35 percent of pretax income and are paid in the quarter incurred. Sixty percent of sales
are collected in the quarter of sale and 40 percent are collected in the next quarter. Eighty percent
of purchases are paid in the quarter of purchase and 20 percent are paid in the next quarter. Selling
and administrative expenses are paid in the quarter incurred except for $10,000 of depreciation
included in selling and administrative expense. A capital expenditure for $75,000 is planned for
the fourth quarter of 2018.
Req u i r ed
Prepare a cash budget for each quarter of 2018.
PROBLEM 10-11. Cash Budget [LO 2] In the fourth quarter of 2017, Eurofit Cycling, a bike shop,
had the following net income:
Sales $550,000
Selling and administration 70,000
Income taxes 80,500
Net income $149,500
Purchases in the fourth quarter amounted to $195,000.
P r o b l e m s 409
Estimated data for Eurofit Cycling for 2018 are as follows:
Sales $400,000 $475,000 $550,000 $600,000

Cost of sales 170,000 185,000 220,000 230,000
Purchases 160,000 200,000 225,000 267,000
Selling and administration 67,000 69,000 71,000 73,000
Taxes are 35 percent of pretax income and are paid in the quarter incurred. Fifty percent of sales
are collected in the quarter of sale and 50 percent are collected in the next quarter. Seventy percent
of purchases are paid in the quarter of purchase and 30 percent are paid in the next quarter. Selling
and administrative expenses are paid in the quarter incurred except for $7,000 of depreciation
included in selling and administrative expense. A capital expenditure for $20,000 is planned for
the fourth quarter of 2018.
Req u i red
Prepare a cash budget for each quarter of 2018.
PROBLEM 10-12. Budget Relationships [LO 2] The accountant at Supreme Audio resigned while
he was in the midst of preparing the budget for 2018. His work papers indicated the following:
Budgeted Sales and Inventory Purchases for 2018
Quarter 1 Quarter 2 Quarter 3 Quarter 4 Total
Sales in 2017 $256,000 $300,000 $290,000 $368,000 $1,214,000

Expected sales in 2018 $320,000 $ $ $ $
Cost of sales $192,000 $ $ $ $
Beginning inventory $ 69,500 $ $ $ $
Ending inventory $ $ $ $ $
Purchases $ $ $ $ $
Assumptions:
Sales will increase by 25 percent over 2017.
Cost of sales equals 75 percent of sales.
For 2018, ending inventory should equal 35 percent of the cost of sales for the next quarter.
Sales in the first quarter of 2019 will be $300,000.
Req u i r ed
Fill in the missing information to determine the sales and purchases budgets for 2018.
PROBLEM 10-13. “What If” Analysis Using a Spreadsheet [LO 2] Javier Andreas is in the
rocess of developing a spreadsheet to budget annual sales and purchases of inventory for his
p
company, The Backyard Place, a retail store that sells lighting, furniture, and other amenities for
the backyard. In 2017, sales were as follows:
$254,000 $275,000 $320,000 $205,000

Inventory at the end of 2017 is $27,800.
Req u i red
Help Javier build a spreadsheet that will allow him to examine the impact on purchases of inventory
of the following three items:
1. Sales growth from 2017 to 2018. Javier believes that quarterly sales will grow by 8 percent in
2018 compared to the corresponding quarter in 2017, and sales in the first quarter of 2019
will be 8 percent higher than in the corresponding quarter in 2018. However, he would also
like to explore the effect on purchases of alternative growth rates. Thus, your spreadsheet
must allow you to change this value and observe the effect on all other values.
2. Inventory on hand at the end of each quarter for 2018. Javier is tentatively planning to have
ending inventory equal to 15 percent of the cost of sales needed for the next quarter. He
would also like to explore the effect on purchases of alternative rates. Thus, your s preadsheet
must allow you to change this value and observe the effect on purchases.
3. Cost of goods sold. Javier estimates that cost of goods sold as a percent of sales will be 35 percent.
He would also like to explore the effect on purchases of different rates. Thus, your spreadsheet
must allow you to change this value. After you have developed your spreadsheet, calculate pur-
chases in the first quarter through the fourth quarter of 2018 for the following combinations:
Combination 1—Sales growth of 10 percent, ending inventory of 22 percent of
next quarter’s cost of goods sold, cost of goods sold of 33 percent of current
quarter’s projected sales
PROBLEM 10-14. Budgeting Process [LO 3] Debra Green is the division manager of the Con-
sumer Banking Division of Pennywise Bank. Each year Debra submits an annual budget to Barney
Stringer, the bank’s chief financial officer. Debra’s bonus, salary increases, and promotion oppor-
tunities are based on how her performance compares with budgeted divisional income. Debra has
to negotiate the budget with the CFO each year.
In the past, Barney has insisted that Debra underestimated revenue and overestimated
expenses, whereas Debra tells Barney that he is expecting too much from her division.
During 2017, the Consumer Banking Division had a record year, and Debra received a huge
bonus. For 2018, Barney insisted that Debra’s budget be at least equal to the prior year’s per-
formance level. Debra stated that the prior year was exceptional and performance could not be
repeated. After getting into a rather heated argument, they scheduled a meeting with the president
and CEO of the bank to resolve their conflict.
Req u i red
a. Explain why Barney and Debra have conflicting opinions.
b. If you were the president of Pennywise Bank, how would you resolve the argument between
Barney and Debra?
PROBLEM 10-15. Performance Report [LO 1, 2, 3] The Customer Support Department at

Silvan.com budgeted for the following costs in June, assuming 35 customer consultants respond-
ing to 11,200 customer calls:
Salaries of customer consultants $160,000

Salaries of supervisors 30,000
Office space charge 5,000
Depreciation on equipment 7,000
Total $202,000
The department is located in a wing of the company’s new office building and has space to
accommodate extra customer consultants. Each customer consultant works at a computer/
telecommunications center. Depreciation on equipment relates to the equipment used by each
customer consultant.
During the month of June, the department handled 14,000 customer calls and incurred the
following costs:
P r o b l e m s 411
Salaries of customer consultants $182,000

Salaries of supervisors 30,250
Office space charge 5,000
Depreciation on equipment 8,000
Total $225,250
Req u ired
a. Making assumptions about fixed and variable costs, prepare a performance report comparing
actual costs with flexible budget costs applicable to handling 14,000 customer calls.
b. List possible causes for significant variances in the performance report.
c. In addition to the variances calculated above, what nonfinancial measures could be used to
evaluate the Customer Support Department?
PROBLEM 10-16. Performance Report [LO 3] The Watch and Timepiece Division of Geraldo
Jewelers had significant problems in 2018. Sales and production were down by almost 35 p ercent
as compared with the budget. Manufacturing was plagued by quality problems and had frequent
customer complaints. Timothy Atlee, the division’s manager, recently received a report comparing
his division’s actual costs with the costs in the master budget prepared at the start of 2018.
Surprisingly, actual costs were less than budgeted, indicating favorable variances.
Timothy was upbeat when told that the president had scheduled a meeting with him to
discuss the Watch and Timepiece Division’s performance. Although sales were down, at least he
could point to a large number of favorable cost variances.
Req u ired
Briefly explain why the variances are positive, and discuss what John should know about flexible
budgets. Assuming that the president understands flexible budgets, will the president be impressed
by the favorable cost variances?
PROBLEM 10-17. Conflict in Planning and Control [LO 3] Franz Manteca is the president of Max
Storage Devices, a wholly owned subsidiary of Vanguard Industries. His annual salary is $600,000.
In addition, he receives a $200,000 bonus if Max Storage’s profit exceeds 75 percent of budget. He
also receives 1 percent of any profit over 75 percent of budget. His total bonus is capped when Max
Storage’s profit exceeds 120 percent of budget.
Req u i r ed
a. Each year, Franz spends hours negotiating the profit budget for Max Storage Devices with the
senior management team of Vanguard Industries. Invariably he claims that their sales estimates
are too high and their cost estimates are too low. They in turn claim that Franz is padding his
budget. In this context, what is meant by budget padding? Explain why Franz may indeed have
an incentive to pad his budget. Provide an example of how budget padding may hurt company
performance.
b. For the current year, the profit budget was set at $45,000,000. Late in the fourth quarter of the
current year, Franz received a report from Max Storage’s CFO indicating that actual profit would
be close to $62,000,000. Franz then ordered that planned shipments for the last 2 weeks of the
quarter be delayed until the start of the next year. Why did Franz take this step? What is the effect
of this action on shareholder value?
PROBLEM 10-18. Budgeting and Nonmonetary Measures [LO 1] The Xtreme Board
ompany manufactures skateboards. The president of the company, Greg Conklin, believes:
C
“You get what you measure!” Accordingly, he would like to include a number of nonmonetary
measures related to factors that affect the success of the company in the annual budget. In
Greg’s opinion, this will get his management team focused on important success factors, and
the budgeted amounts can be compared to actual values at year-end to determine whether
goals have been achieved.
Req u i red
Suggest four nonmonetary measures that Greg Conklin can include in the annual budget for
Xtreme Board Company.
CASE
10-1 ETHICS CASE: COLUMBUS PARK—WASTE TREATMENT FACILITY [LO 3]
As manager of the waste treatment facility for the city expenses than anticipated? A new labor contract, for instance,
of Columbus Park, Illinois, Ann Paxton is in the process could increase costs by more than $300,000. Or waste could be
of preparing an annual expense budget. While eating 500,000 gallons higher than estimated. The last thing I want
lunch at her desk, she thought about the coming year. “Next is to incur more costs than budgeted. I’ve got to stay within
year, my department will probably be asked to process some budget to have any chance for a promotion out of this stinking
9,000,000 gallons of waste. Our variable costs are about $.20 per department!”
gallon, and our fixed costs are about $2,400,000. So, the total
cost should be somewhere around $4,200,000. I better submit a
R eq uired
budget of around $4,900,000. The city’s tax revenues are down
and the city controller will probably reduce whatever budget I Discuss whether it is ethical for Ann to submit a budget for an
submit by 10 percent. And what if I end up incurring higher amount higher than the cost expected to be incurred.
CASE
10-2 ABRUZZI OLIVE OIL COMPANY [LO 1]
The Abruzzi Olive Oil Company is a small producer of At a planning meeting in November 2017, Jay Peters, the
premium olive oil. Cheryl Sounders, the owner of Abruzzi, is marketing manager for Abruzzi, told Cheryl that he expected
currently developing a budget spreadsheet to explore the impact monthly sales to increase by 5 to 15 percent in the coming year.
of various sales goals on production. But in late December 2017, Jay rushed into Cheryl’s office with
In 2017, the company had monthly sales as follows: some good news. “Cheryl, I just had a meeting with Consoli-
dated Restaurants, and they’re considering an order for 1,250
Month Sales (gallons) gallons each month for all of 2018.”
“Gosh,” Cheryl replied, “that’s an exciting bit of news,
January 9,200 but I’m concerned about whether we have the capacity to ac-
February 9,000 cept such a large order. I’ll prepare budgets assuming we don’t
March 9,400 get the Consolidated business but we increase monthly sales
April 8,600 by 5, 10, or 15 percent. Then I’ll assume the Consolidated
May 8,000 order comes through, and on top of that we have monthly
June 8,500 sales increases of 5, 10, and 15 percent. This should give us
July 8,200 a good idea of whether we’ll bump up against capacity.” Jay
August 7,500 thought that this sounded fine, but he wondered whether
September 8,900 Cheryl had the time to do this much work. Cheryl indicated
October 9,300 that the analysis was relatively easy since she was preparing
November 9,200 the budget on a spreadsheet and each analysis would require
December 9,600 only a simple change.
C a s e 413
R e q uir ed sales in January 2019 will be the same as December 2018

sales.
a. Using a spreadsheet, prepare the six monthly budget
schedules that Cheryl suggested (i.e., monthly budgets with b. Suppose that capacity is 12,000 gallons. Is the company likely
and without the Consolidated business assuming other sales to encounter a capacity problem?
increases of 5, 10, and 15 percent). As a general rule, Cheryl c. Abruzzi sells its oil for $25 per gallon. The variable cost
likes to have ending inventory equal to 12 percent of next per gallon is $10. What will be the annual impact on profit of
month’s sales. Assume that the company ended 2017 with an obtaining the Consolidated business (assuming that there is no
inventory of 1,500 gallons of olive oil. In order to calculate capacity problem)?
ending inventory at the end of December 2018, assume that
11
Standard Costs and
Variance Analysis
At the start of the year, Darrington Ice Cream
budgeted material costs at $2 per gallon.
During the year, the company produced 1,000,000 and, ultimately, help the company develop a stan
gallons, and the material cost was approximately dard costing system. In such systems, manufac
$2,200,000. Linda Evert, director of operations, tured goods are not recorded at their actual product
immediately called a meeting of the plant manager cost but rather at the cost that should have been
and the production supervisor. Linda’s opening state incurred to produce the items. This cost is referred
ment grabbed their attention. “What’s going on? Our to as the standard cost.
actual costs are 10 percent higher than budgeted.”
A primary benefit of a standard costing system
Both managers assured her that the increased costs
is that it allows managers to compare differences
were not due to waste in the use of materials. The
between standard and actual costs. Such differ
plant manager was confident that the increased
ences are referred to as standard cost variances.
costs resulted from a sudden jump in sugar and milk
For material costs, the standard cost variances
prices. And, he observed, “Price changes are beyond
distinguish between the variance due to a difference
our control. Talk to the guys in purchasing—they’ll
between the actual price and the standard price and
back me up on the price increase.”
the variance due to a difference between the actual
Linda went back to her office and continued to quantity of raw material and the standard quantity.
think about the situation. “What would really be use Standard costing systems also generate variances
ful,” she concluded, “would be a report that broke for direct labor and manufacturing overhead. Large
the material cost increase out into two parts: the or unusual variances are investigated by manage
part due to using more material than planned and ment to determine whether production is inefficient.
the part due to paying a higher price than planned. If problems exist, corrective action can be taken.
I wonder if Jane in the accounting department can Thus, standard costs play an important role in con-
help out with the calculations.” trolling operations as well as in determining product
costs. This chapter illustrates both of these uses of
Fortunately, Linda was on the right track. An ac
standard costs.
countant could help her with the needed calculations
©ASA studio/Shutterstock
Learning Objectives
1 Explain how standard costs are developed, and calculate and interpret variances for direct
material and direct labor.
2 Calculate and interpret variances for manufacturing overhead, and calculate the financial
impact of operating at more or less than planned capacity.
3 Discuss how the management-by-exception approach is applied to the investigation of stan

dard cost variances. Also, explain why a favorable variance may be unfavorable, how process
improvements may lead to unfavorable variances, and why evaluation in terms of variances
may lead to overproduction.
415
416 c h apte r 1 1 S t a n d a r d C o s t s a n d V a r i a n c e A n a l y s i s
Learning STANDARD COSTS

Objective 1
The term standard cost refers to the cost that management believes should be incurred
Explain how standard to produce a good or service under anticipated conditions. A tool manufacturing com-
costs are developed, pany may set a standard cost for the production of a hammer, whereas a bank may set
and calculate and a standard cost for processing a check. In the following examples, we concentrate on
interpret variances for standard costing in a manufacturing setting. But much of the discussion also applies to
direct material and service companies, such as banks, that also use standard costs.
direct labor.
Standard Costs and Budgets
Some accountants use the terms budgeted cost and standard cost interchangeably.
However, the term standard cost often refers to the cost of a single unit, whereas the term
budgeted cost often refers to the cost, at standard, of the total number of budgeted units.
The cost information contained in budgets must be consistent with standard costs. For
example, suppose the standard cost of a unit of production is:
Standard Cost per Unit
Direct material (2 lb. at $5 per lb.) $10.00

Direct labor (3 hours at $10 per hour) 30.00
Manufacturing overhead ($5 per labor hour) 15.00
Standard cost per unit $55.00
If the budget for direct material purchases calls for purchasing 5,000 pounds of raw mate-
rial, the budget would show an expected cost of $25,000 (i.e., 5,000 pounds at the standard
price of $5 per pound). Similarly, if the direct labor budget is prepared for an expected
production level of 1,000 units, it would indicate 3,000 hours of labor costing $30,000.
Link to Practice
Starbucks Uses Standard Costs Starbucks uses standard costing to control
the cost of beans in its roasting operation.
When we think of companies that use stan
Beans lose weight in the roasting process
dard costing, manufacturing companies, such
because water is evaporated from them. The
as Boeing and General Motors, and chemical
company sets a standard weight loss and
producers, such as Dow Chemical, come to
compares that to the actual loss in weight for
mind. But even companies in the food services
a batch of roasted beans.
industry use standard costing. For example,
© andrearoad/iStockphoto
Development of Standard Costs

Standard costs for material, labor, and overhead are developed in a variety of ways.
The standard quantity of material may be specified in engineering plans that provide
detailed lists of raw materials needed in production. For some companies, the standard
quantity of raw material actually is specified in recipes or formulas. This is the case in
large commercial bakeries and other companies that manufacture food products. The
standard price of the materials often is determined from price lists provided by suppliers.
S t a n d a r d C o s t s 417
The standard quantity of direct labor can be determined by time-and-motion studies

conducted by industrial engineers. In time-and-motion studies, standard labor hours
are determined based on observation of workers under simulated or actual working
conditions. Standard labor hours can also be estimated from an analysis of past data.
For example, suppose a company developed the following information on production
and labor hours:
Production in Units Labor Hours
1st quarter, 2018 2,025 6,500

2nd quarter, 2018 2,500 7,400
3rd quarter, 2018 2,100 6,800
4th quarter, 2018 2,600 7,900
Total 9,225 28,600
Based on these data, the average time to produce one unit is approximately 3.10 hours
(28,600 hours ÷ 9,225 units). If the company does not anticipate any major changes in
the production process, this average could be used as the standard quantity of labor.
However, if the company has operated inefficiently in the past, basing current standards
on past performance will result in standards that do not reflect efficient production
practices. The standard labor wage rates usually are set at the rates management expects
to pay the various categories of workers. In many cases, the wage rates are set equal to
the rates specified in labor contracts.
Developing standard costs for overhead involves procedures similar to the ones used
to develop the predetermined overhead rates discussed earlier in the book. Dividing the
amount of anticipated overhead by the standard quantity of the allocation base results in
a standard cost of overhead. For example, suppose a company anticipates that $60,000 of
overhead will be incurred if the company works 5,000 standard labor hours. In this case,
the standard overhead rate would be $12 per standard labor hour. At companies that
use activity-based costing, standard costs are developed for a number of overhead cost
drivers, such as the number of setups, the number of purchase orders, and the number
of shipments received.
Link to Practice
How Often Do Companies Update an annual basis. But changes in commodity raw mate
Standards? rial prices, foreign exchange movements, and partial or
full factory closures may require updates throughout
According to a survey of 12 companies conducted by
the year.
KPMG in the United Kingdom, increased economic
volatility is leading companies to update their standard Source: Based on KPMG, “Standard Costing: Insights from
costs more frequently. Most update standard costs on Leading Companies,” Financial Management, February 2010.
Ideal versus Attainable Standards

In developing standard costs, some managers emphasize ideal standards, whereas other
managers emphasize attainable standards. Ideal standards are developed under the
assumption that no obstacles to the production process will be encountered. Thus, they
do not allow for a breakdown of equipment that would increase the quantity of labor
hours or defects in raw material that would increase the quantity of material required for
production. Ideal standards are sometimes referred to as perfection standards because they
Link to Practice
Standard Costing—In the used to make shoes should be recorded at a
Beginning “proper cost,” his term for standard cost. He
also noted that the variance between proper
An early presentation of standard cost
cost and actual cost could be due to differ
ing came in 1908 when John Whitmore,
ences between the standard price and actual
an American accountant, published a
price of leather or to differences between the
paper in the Journal of Accountancy on
standard quantity of leather and the actual
a standard costing system for a shoe
quantity of leather used in production.
factory. He suggested that the leather
Comstock/Getty Images
emphasize production in a “perfect” environment. However, if a company expects occa-

sional equipment failure, occasional substitution of inexperienced for experienced workers,
and some raw material defects, then standards should be set at a level that allows for the
cost of these events. Currently attainable standards are standard costs that take into account
the possibility that a variety of circumstances may lead to costs that are greater than ideal.
Managers who support ideal standards believe they motivate employees to strive
for the best possible control over production costs. Such managers argue that if the cost
of defects and breakdowns is built into the standards, the result will be an acceptance of
defects and breakdowns rather than an effort to eliminate them. However, because they do
not allow for expected deviations from ideal conditions, ideal standards may not be useful
for planning. If equipment breakdowns and defects are a fact of life, then it makes sense
to plan for their associated costs. Most managers support the use of attainable standards.
A GENERAL APPROACH TO VARIANCE ANALYSIS

Companies that have standard costing systems can analyze the difference between a stan-
dard and an actual cost, referred to as a standard cost variance, to determine whether
operations are being performed efficiently. The analysis—referred to as variance analysis—
generally involves decomposing (breaking down) the difference between standard and
actual cost into two components. For direct material, the two components are the material
price and the material quantity variances. For direct labor, the two components are the
labor rate variance and the labor efficiency variance. And for manufacturing overhead, the
two components are the overhead volume variance and the controllable overhead variance.
Variance analysis helps companies control operations by highlighting potential
problems in operations. In the following sections, we examine the variance calculations
for the Vulcan Polymer Company, a producer of a synthetic rubber compound used
in molding operations. The standard cost for a 50-gallon drum of the compound (the
standard production unit) is as follows:
Material
400 pounds @ $10 per pound $4,000
Labor
4 hours @ $15 per hour 60
Overhead
$50 per unit 50
Total per 50-gallon drum $4,110
M a t e r i a l V a r i a n c e s 419
MATERIAL VARIANCES
The difference between standard and actual material cost can be divided into two
material variances: a material price variance and a material quantity variance. The
formulas used to calculate the variances are presented in Illustration 11-1 and are
discussed next.
Illustration 11-1
Actual Actual Quantity Standard
Direct material variance
Material Cost at Standard Price Material Cost
formulas
AQP × AP AQP × SP SQ × SP
200,000 lb. × $9.90 200,000 lb. × $10 180,000 lb. × $10
$1,980,000 $2,000,000 $1,800,000
(AP - SP) AQP

($20,000) favorable
Material Price Variance
AQU × SP
181,000 × $10
$1,810,000
(AQU - SQ) SP
$10,000 unfavorable
Material Quantity Variance
AQP = Actual quantity of material purchased
AP = Actual price paid for materials
AQU = Actual quantity used in production
SP = Standard price for materials
SQ = Standard quantity of material for the actual level of production
Note: In computing the material price variance, use the actual quantity of material purchased (AQP). In
c omputing the material quantity variance, use the actual quantity of material used (AQU).
Material Price Variance

The material price variance is equal to the difference between the actual price per unit of
material (AP) and the standard price per unit of material (SP) times the actual quantity
of material purchased (AQP):
Material price variance = (AP - SP)AQ P
Let’s see how to calculate this variance for the Vulcan Polymer Company. Suppose the
company purchased 200,000 pounds of material and actually paid $9.90 per pound
rather than the standard price of $10. In this case, there would be a favorable $20,000
material price variance:
Material price variance = (AP - SP)AQ P

= ($9.90 - $10.00)200,000

= ($20,000)favorable

In thinking about this variance, note that material costs $0.10 less per pound than
planned, and this saving is realized on 200,000 pounds purchased. That is why the
material price variance is labeled favorable. The actual price per pound is less than the
standard price.
In the variance formulas presented in this chapter, negative variances will be favor-
able and positive variances will be unfavorable. Rather than concentrating on the sign
of the variance, however, you can simply remember that:
· Actual prices or quantities greater than standard are labeled unfavorable.
· Actual prices or quantities less than standard are labeled favorable.
Material Quantity Variance

The material quantity variance is equal to the difference between the actual quantity of
material used (AQU) and the standard quantity of material allowed for the number of
units produced (SQ) times the standard price of material (SP):
Material quantity variance = (AQ U - SQ)SP
Suppose Vulcan Polymer produces 450 of the 50-gallon drums of molding compound.
The standard quantity of material is 400 pounds per drum. Thus, the standard quantity
of material allowed for the 450 units produced is 180,000 pounds (i.e., 450 drums ×
400 lb. per drum). Recall that the standard price of material is $10 per pound. Thus, if
181,000 pounds of material are actually used, the material quantity variance is $10,000
and unfavorable:
Material quantity variance = (AQ U - SQ)SP

= (181,000 - 180,000)$10

= $10,000 unfavorable
In other words, 1,000 extra pounds are used at a standard cost of $10 per pound. Note
that the material quantity variance is labeled unfavorable. This is because more material is
actually used than called for by the standards. This is considered an unfavorable outcome
because it has a negative effect on company profit.
Link to Practice
You Get What You Measure! Buy
mate high-qu
low ri ali
You get what you A purchasing man Buy with
a l ity al
an u al but sh ty
nfav ow
u
q ateri mate orable
M e a s u r e ager at a large Mid no m ariance pric r
e va ial
v
p rice rian
western manufacturing ce
firm recounted how he had identified a new material that

would result in higher quality and cost savings for the
company. However, the material would cost a bit more
than the standard price of the current inferior material.
Buying the new material would make the purchasing
department look bad because it would be charged with
a material price variance. Any savings in manufacturing
would be credited to the manufacturing department.
Guess what happened. The company stuck with
the inferior material. This example illustrates that
placing too much emphasis on price variances when
evaluating performance ultimately can hurt company developing strong relationships with suppliers that lead
profitability. to on-time deliveries and minimal quality problems and
Rather than concentrating only on purchase price performance measures that encourage that focus should
variances, purchasing managers should also focus on be considered.
D i r e c t L a b o r V a r i a n c e s 421
DIRECT LABOR VARIANCES

As we just saw, there are two material variances: a material price variance and a material
quantity variance. Similarly, there are two direct labor variances: a labor rate variance and
a labor efficiency variance. The formulas used to calculate these variances are presented
in Illustration 11-2 and are discussed next.
Illustration 11-2
Actual Actual Quantity Standard
Direct labor variance formulas
Labor Cost at Standard Rate Labor Cost
AH × AR AH × SR SH × SR
1,700 hours × $15.50 1,700 hours × $15 1,800 hours × $15
$26,350 $25,500 $27,000
$850 unfavorable ($1,500) favorable

(AR - SR) AH (AH - SH) SR
Labor Rate Variance Labor Efficiency Variance
AH = Actual hours worked
AR = Actual wage per hour
SR = Standard wage rate per hour
SH = Standard hours for the actual level of production
Labor Rate Variance

The labor rate variance is equal to the difference between the actual wage rate (AR) and
the standard wage rate (SR) times the actual number of labor hours worked (AH). This
variance is very similar to the material price variance:
Labor rate variance = (AR - SR)AH
The standards for Vulcan Polymer call for a standard wage rate of $15 per hour. Suppose
that the actual wage rate is $15.50, and 1,700 hours are worked. In this case, the labor
rate variance is an unfavorable $850:
Labor rate variance = (AR - SR)AH

= ($15.50 - $15.00)1,700

= $850 unfavorable

In other words, the company paid $0.50 more per hour than planned for each of the
1,700 hours worked.
Labor Efficiency Variance

The labor efficiency variance is equal to the difference between the actual number
of hours worked (AH) and the standard labor hours allowed for the number of units
produced (SH) times the standard labor wage rate (SR). This variance is similar to the
material quantity variance.
Labor efficiency variance = (AH - SH)SR
The Vulcan Polymer Company used 1,700 hours to produce 450 units. Standards call for
4 hours per unit at a standard wage rate of $15 per hour. Thus, the standard number of
hours for 450 units is 1,800 (450 units × 4 hours per unit). In this case, the labor efficiency
variance is $1,500 favorable:
Labor efficiency variance = (AH - SH)SR

= (1,700 - 1,800)$15

= ($1,500)favorable

In other words, the company worked 100 hours less than planned, saving $15 per hour
at the planned rate.
Learning OVERHEAD VARIANCES

Objective 2
The total variance for manufacturing overhead is the difference between the overhead
Calculate and interpret applied to inventory at standard and actual overhead costs. The total overhead variance can
variances for manufac be separated into an overhead volume variance and a controllable overhead variance.1 The
turing overhead, and formulas for the overhead variances are presented in Illustration 11-3 and are discussed next.
calculate the financial
impact of operating Illustration 11-3
at more or less than Manufacturing overhead variance formulas
planned capacity.
Actual Flexible Budget Overhead Applied
verhead Cost
O Overhead Using the Standard Rate
$15,000 + ($20 × 450) $50 × 450
$23,000 $24,000 $22,500
($1,000) favorable $1,500 unfavorable

Controllable Overhead Variance Overhead Volume Variance
Controllable Overhead Variance

The controllable overhead variance is the difference between the actual amount of
overhead and the amount of overhead that would be included in a flexible budget for the
actual level of production. The variance is referred to as controllable because managers
are expected to be able to control costs so that they are not substantially different from
the amount that would be included in the flexible budget:
Controllable Flexible budget level of overhead
= Actual overhead -
overhead variance for actual level of production
Suppose the Vulcan Polymer Company expects $15,000 of fixed overhead and $20 of vari-
able overhead per unit. In this case, the flexible budget for the actual level of production
(450 units) is $24,000 [$15,000 + ($20 × 450)]. During the period, Vulcan Polymer incurs
$23,000 of overhead. Thus, there is a $1,000 favorable controllable overhead variance:
= Actual overhead -
= $23,000 - [$15,000 + ($20 × 450)]

= ($1,000)favorable

Again, the variance is labeled favorable because the actual amount of cost is less than the
amount indicated in the flexible budget.
Detailed Analysis of the Controllable Overhead Variance

To gain insight into the causes of a controllable overhead variance, we can compare details
of actual overhead cost to details of overhead costs in a flexible budget. Assume that the
details of the $23,000 of actual overhead are as follows:
1
It is possible to decompose the difference between variable overhead applied at standard and actual variable
overhead into a variable overhead spending and a variable overhead efficiency variance. And the difference
between applied and actual fixed overhead can be decomposed into a fixed overhead budget variance and a fixed
overhead volume variance. This “four-way analysis” of overhead variances is covered in cost accounting textbooks.
O v e r h e a d V a r i a n c e s 423
Actual Overhead
Costs
Fixed Overhead Costs

Rent $ 3,125
Depreciation 3,725
Other fixed 750
Total $14,735
Variable Overhead Costs
Power $ 4,725
Indirect materials 2,940
Machine maintenance 600
Total $ 8,265
Total actual overhead $23,000
Recall the flexible budget = $15,000 of fixed overhead cost + $20 of variable overhead
cost per unit.
Now suppose budgeted fixed overhead costs are as follows:
Rent $ 3,000
Depreciation 4,000
Other fixed 1,000
Total budget fixed costs $15,000
And suppose budgeted variable overhead costs per unit are:

Power $10
Indirect materials 6
Machine maintenance 4
Total budget fixed costs $20
Now let’s prepare a flexible budget for overhead at the actual level of production (450 units):
Flexible Budget
Overhead Costs

Rent $ 3,000
Depreciation 4,000
Other fixed 1,000
Total $15,000
Power ($10 × 450) $ 4,500
Indirect materials ($6 × 450) 2,700
Machine maintenance ($4 × 450) 1,800
Total $ 9,000
Total flexible budget overhead $24,000
Now let’s compare actual costs to the flexible budget. This analysis is in Illustration 11-4.
Again, we see that the controllable overhead variance is $1,000 favorable. However,
we also have gained considerable insight into the cause of the variance. Note that the larg-
est single variance is the favorable $1,200 variance for machine maintenance. Although
this variance is favorable, it would be important to investigate why it occurred. It may
Illustration 11-4
Details of actual overhead versus overhead in the flexible budget
Actual Overhead Flexible Budget

Costs Overhead Costs Variance
Rent $ 3,125 $ 3,000 $ 125 unfavorable
Supervisor salary 7,135 7,000 135 unfavorable
Depreciation 3,725 4,000 (275) favorable
Other fixed 750 1,000 (250) favorable
Total $14,735 $15,000 ($ 265) favorable
Power $ 4,725 $ 4,500 $ 225 unfavorable
Indirect materials 2,940 2,700 240 unfavorable
Machine maintenance 600 1,800 (1,200) favorable
Total $ 8,265 $ 9,000 (735) favorable
Totals $23,000 $24,000 ($1,000) favorable
be that the company is cutting back on needed maintenance to show good performance.
Actually, this may be damaging in the long run.
Overhead Volume Variance

The overhead volume variance is equal to the difference between the amount of over-
head included in the flexible budget and the amount of overhead applied to production
using the standard overhead rate:
Flexible budget level Overhead applied to
Overhead volume
= of overhead for actual - production using
variance
level of production standard overhead rate
Before calculating the volume variance, let’s review the calculation of the standard
overhead rate. Suppose that at the start of its accounting period, Vulcan Polymer anticipates
producing 500 of the 50-gallon drums of compound. Further, the company anticipates
having $15,000 of fixed manufacturing overhead and variable overhead equal to $20 per
unit. In this case, total expected overhead is $25,000 [$15,000 + ($20 × 500 units)], and the
overhead rate is $50 per unit (i.e., $25,000 ÷ 500 units):
$15,000 + ($20 × 500 units) $25,000

÷ Expected production 500 units
= Standard overhead rate $ 50 per unit
Note that the standard overhead rate in this example is expressed on a per unit basis. This
is because Vulcan Polymer only produces a single product. When multiple products are
produced, the overhead rate should be based on labor hours, machine hours, or some
other measure of activity that is common to the various products. Or an activity-based
costing system can be used with standard rates for each driver of overhead cost.
Computing the Overhead Volume Variance. If Vulcan Polymer actually produces
450 units, $22,500 of standard overhead would be applied to production (450 × $50).
However, the flexible budget amount for 450 units of production is $24,000. Thus, the
overhead volume variance is $1,500 unfavorable:
O v e r h e a d V a r i a n c e s 425

Overhead volume
= of overhead for actual - production using
variance
level of production standard overhead rate
= 15,000 + ($20 × 450) - ($50 × 450 units)

$1,500 unfavorable = $24,000 - $22,500
Why is this variance labeled unfavorable? We turn to that question next.
Interpreting the Overhead Volume Variance. Volume variances do not signal that
overhead costs are in or out of control. That signal is provided by the controllable over-
head variance, discussed earlier. An overhead volume variance simply signals that the
quantity of production was greater or less than anticipated when the standard overhead
rate was developed. When more units are produced than anticipated, the amount of
overhead applied to inventory exceeds the flexible budget because the amount of fixed
cost per unit is being applied to more units than anticipated.
Consider the standard overhead rate of the Vulcan Polymer Company. The rate of
$50 per unit is composed of $20 per unit of variable cost and $30 of fixed cost. The $30
of fixed cost per unit results from dividing the expected amount of fixed cost ($15,000)
by the anticipated production of 500 units:
Standard Overhead Rate
Variable cost per unit $20

Fixed cost per unit ($15,000 ÷ 500 expected units) 30
Total $50
When this rate is applied to 450 units, a fixed cost of $13,500 is applied to inventory
rather than the expected amount of fixed cost, which is $15,000. Thus, the amount of
fixed cost applied to inventory is $1,500 less than the amount of fixed cost in the flexible
budget (which is not affected by the level of activity):
Standard Cost Flexible Budget

Applied to 450 Units for 450 Units Difference
Variable cost $ 9,000 ($20 × 450) $ 9,000 ($20 × 450) –0–

Fixed cost 13,500 ($30 × 450) 15,000 $1,500
Total $22,500 $24,000 $1,500
If the company had anticipated that 450 units would be produced, the fixed cost per unit
would have been $33.3333, and the standard overhead rate would have been set at $53.3333:
Standard Overhead Rate
Variable cost per unit $20.0000

Fixed cost per unit ($15,000 ÷ 450 expected units) 33.3333
Total $53.3333
With a rate of $53.3333 per unit, $24,000 of overhead would have been applied to the
450 units produced, and the volume variance would be zero.
The usefulness of the volume variance is limited. It signals only that more or fewer
units have been produced than planned when the standard overhead rate was set. If more
units are produced than were originally planned, the variance is labeled favorable because
additional production often (but not always) reflects unexpectedly high customer demand
(a favorable outcome). If fewer units are produced, the variance is referred to as unfavorable.
Calculating the Financial Impact of Operating

at More or Less than Planned Capacity
Decision Making/ As just explained, the volume variance really doesn’t measure the financial impact of
Incremental operating at more or less than planned capacity. So you are probably wondering how one
Analysis would go about calculating the financial impact of producing more or fewer units than
planned. To perform the calculation, we return to a familiar concept: incremental analysis.
Recall that at the start of the accounting period, Vulcan Polymer anticipated pro-
ducing 500 units. As it turned out, the company operated at less than planned capacity
and produced only 450 units. Let’s assume that a unit (a 50-gallon drum of compound)
sells for $5,000. How much profit does the company lose when a unit is not produced
and sold? The company obviously loses the selling price per unit, but it saves the vari-
able cost per unit of production. Fixed costs are not saved since they are not affected by
production volume. In other words, the company loses the contribution margin per unit.
The contribution margin of a 50-gallon drum is $920:
Selling price per unit $5,000

Material $4,000
Labor 60
Variable overhead 20 4,080
Contribution margin $ 920
Since 50 units were not produced and sold, Vulcan Polymer lost $46,000 of profit:
Number of units not produced and sold 50

Contribution margin per unit × $ 920
Financial effect of not producing and selling
50 units $46,000
Similarly, if 50 units more than planned were produced and sold, the company would
have gained $46,000 of incremental profit.
TEST YOUR KNOWLEDGE:

COMPREHENSIVE EXAMPLE
Let’s apply the information just discussed to the Darrington Ice Cream Company. Recall
from the scenario at the start of the chapter that Linda Evert, director of operations
for Darrington, was concerned about a 10 percent increase in material cost. The plant
manager assured her that the increase was not due to waste in the use of raw materials.
The material variances we calculate next will provide insight into the validity of the plant
manager’s statement.
At the start of the year, Darrington Ice Cream planned on producing 900,000 gallons
of ice cream. Production of ice cream requires various raw materials (e.g., milk, cream,
sugar, and flavorings). Most likely Darrington develops separate standards for each. To
simplify the setting, however, we assume that Darrington uses only one raw material.
Each gallon of ice cream requires .8 gallons of raw material costing $2.50 per gallon—
T e s t Y o u r K n o w l e d g e : C o m p r e h e n s i v e E x a m p l e 427
a gallon of ice cream does not require a gallon of raw material, because air is incorporated
in the production process. Each gallon of ice cream also requires .125 hours of direct
labor costing $12 per hour.
The company estimates that fixed overhead costs will equal $450,000 per year and
variable overhead costs will equal $0.25 per gallon. Thus, the standard overhead rate is
set at $0.75 per gallon [$0.50 of fixed overhead per gallon ($450,000 ÷ 900,000 gallons) +
$0.25 of variable overhead per gallon].
In summary, the standard cost per unit is:
Standard Cost per Unit
Direct material (.8 gallons × $2.50) $2.00

Direct labor (.125 hours × $12) 1.50
Manufacturing overhead .75
Total $4.25
Actual demand during the year is somewhat greater than anticipated, necessitating
production of 1,000,000 gallons. Darrington purchases 810,000 gallons and uses 809,000
gallons of material, at a cost of $2.72 per gallon, to produce the 1,000,000 gallons of ice
cream. Actual direct labor costs of $1,573,000 are incurred for 130,000 actual hours.
Thus, the actual wage rate is $12.10 per hour ($1,573,000 ÷ 130,000). Finally, actual
overhead costs of $680,000 are incurred.
At this point, you should attempt to calculate the standard cost variances for the
Darrington Ice Cream data. For your convenience in working through the example and
in solving problems at the end of the chapter, a summary of the variance formulas is
presented in Illustration 11-5. Some key figures needed in the calculation of the variances
for Darrington Ice Cream are summarized in Illustration 11-6.
Illustration 11-5
Material Price Variance = (AP - SP) AQP
Standard cost variance
formulas AP = actual price per unit of material
SP = standard price per unit of material
AQP = actual quantity of material purchased
Material Quantity Variance = (AQU - SQ) SP
AQU = actual quantity of material used
SQ = standard quantity of material for the actual level of production
SP = standard price per unit of material
Labor Rate Variance = (AR - SR) AH
AR = actual labor rate per hour
SR = standard labor rate per hour
AH = actual hours worked
Labor Efficiency Variance = (AH - SH) SR
AH = actual hours worked
SH = standard hours of labor for the actual level of production
SR = standard labor rate per hour
Flexible budget level
Controllable overhead
= Actual overhead - of overhead for actual
Variance
level of production

overhead
= of overhead for - production using
Volume Variance
actual level of production standard overhead rate

Illustration 11-6
Summary of data for production of 1,000,000 gallons of ice cream
Standard Cost Information Actual Cost Information
Direct material 800,000 gallons at $2.50 per gallon 810,000 gallons purchased at $2.72 per gallon
809,000 gallons used in production
i lla
Va n
Direct labor 125,000 hours at $12 per hour 130,000 hours at $12.10 per hour
Overhead $0.75 × 1,000,000

applied at standard gallons = $750,000
$450,000 + ($0.25 × 1,000,000 Actual $680,000

Flexible budget
gallons) = $700,000 overhead
overhead
Material Variances
The actual price of material is $2.72 per gallon, whereas the standard price is $2.50 per
gallon. The actual quantity of material purchased is 810,000 gallons. Thus, the material
price variance is:
Material price variance = ($2.72 - $2.50)810,000
= $178,200unfavorable

Note that the material price variance is based on the quantity of material purchased, not
the quantity used.
The actual quantity of material used is 809,000 gallons. Since 1,000,000 gallons of
ice cream were produced, and the standard quantity of material per gallon is .8 gallons,
the standard quantity of material for the total units produced is 800,000 gallons. The
standard price is $2.50 per gallon. Thus, the material quantity variance is:
Material quantity variance = (809,000 - 800,000)$2.50

Note that these results support the plant manager’s contention that the large material
variance was not due to wasting materials. Of the total $200,700 unfavorable variance,
only $22,500 is due to using more material than planned. Most of the variance is due to
paying more per gallon for raw material than planned.
Labor Variances
The actual wage rate is $12.10 per hour, whereas the standard wage rate is $12 per hour.
Because 130,000 actual hours are worked, the labor rate variance is:
Labor rate variance = ($12.10 - $12)130,000

I n v e s t i g a t i o n o f S t a n d a r d C o s t V a r i a n c e s 429
The actual quantity of labor is 130,000 hours, whereas the standard quantity of labor
for the 1,000,000 gallons produced is 125,000 hours (1,000,000 gallons × .125 hours per
gallon). The standard wage rate is $12 per hour. Thus, the labor efficiency variance is:
Labor efficiency variance = (130,000 - 125,000)$12

Overhead Variances
The actual amount of overhead is $680,000, whereas the flexible budget amount of over-
head for 1,000,000 gallons produced is $700,000 [$450,000 + ($0.25 × 1,000,000 gallons)].
Thus, the controllable overhead variance is:
Controllable overhead variance = $680,000 - $700,000

The amount of overhead applied to production is equal to the standard overhead rate
of $0.75 per gallon times the 1,000,000 gallons produced. This amounts to $750,000.
The flexible budget amount of overhead is $700,000. The difference between the flexible
budget amount of overhead and the amount of overhead applied is the overhead volume
variance, which is $50,000:
Overhead volume variance = $700,000 - $750,000

Learning INVESTIGATION OF STANDARD COST VARIANCES

Objective 3
Once standard cost variances have been computed, how should they be used? It is important
Discuss how the to note that standard cost variances do not provide definitive evidence that costs are out of
management-by- control and that managers are not performing effectively. Rather, they should be viewed as
exception approach indicators of potential problem areas. The only way to determine whether costs are being
is applied to the effectively controlled or not is to investigate the facts behind the variances.
investigation of stan To illustrate, consider again the standard cost variances just computed for
dard cost variances. Darrington Ice Cream. The variances are summarized in Illustration 11-7. As indicated
Also, explain why a in the illustration, there is a $178,200 unfavorable material price variance. Does this
favorable variance may imply that the purchasing department is not doing a good job of searching for the
be unfavorable, how lowest-cost material consistent with desired quality levels? Not necessarily. Investigation
process improvements may reveal that price increases were unavoidable. Obviously, the purchasing department
may lead to unfavorable can do very little if all of the company’s suppliers increase their prices.
variances, and why
evaluation in terms of Illustration 11-7
variances may lead to
Variance summary
overproduction.
Darrington Ice Cream
Variance Summary
For the Period Ending December 31, 2016
Material price variance $178,200 unfavorable
Material quantity variance 22,500 unfavorable
Labor rate variance 13,000 unfavorable
Labor efficiency variance 60,000 unfavorable
Controllable overhead variance (20,000) favorable
Overhead volume variance (50,000) favorable
Total $203,700 unfavorable
As another example, consider the $60,000 unfavorable labor efficiency variance

indicated in Illustration 11-7. What factors might account for this unfavorable variance?
The first explanation that comes to mind may be that the manager responsible for super-
vising the production workforce has not done a competent job. However, this is just one
possibility. Perhaps workers went on strike, and inexperienced substitutes were hired.
These substitutes would have a difficult time meeting standard allowable production
times even if they were properly supervised. Another possibility is that a new piece of
equipment was placed into production during the period. Workers may simply require
additional time to become familiar with the new equipment. Which of these, among
other possible explanations, is correct can be determined only by an investigation to
discover the real cause of the variance.
Any Q u e s t i ons ?
Q: In Chapter 10, we learned that there are three reasons why actual results
may be different from the budget. Does the same logic apply to standard cost
variances?
A: Yes. Actual costs may differ from standard because:
1. The standards were not properly developed;

2. The standards were properly developed but conditions changed; or
3. Management performance was particularly good (or bad).
An investigation is usually needed to determine which of these factors caused a par

ticular variance.
Management by Exception
Because investigation of standard cost variances is itself a costly activity, management
must decide which variances to investigate. Most managers take a management-
by-exception approach and investigate only those variances that they deem to be excep-
tional. Of course, this implies that some criterion for determining what is meant by
“exceptional” must be established. The absolute dollar value of the variance or the variance
as a percent of actual or standard cost is often used as the criterion.
Suppose, for example, that Darrington Ice Cream decides to investigate any variance
in excess of $40,000. This implies that the material price variance, the labor efficiency
variance, and the overhead volume variance should be investigated. However, the cause
of the overhead volume variance is quite obvious: More units were produced than antic-
ipated when the standard overhead rate was developed. Thus, management need only
investigate the material price variance and the labor efficiency variance.
Favorable Variances May Be Unfavorable

The fact that a variance is favorable does not mean that it should not be investigated.
Indeed, a favorable variance may be indicative of poor management decisions. For
example, suppose the price of raw materials increases. In order to avoid an unfavorable
material price variance, a manager could order the purchase of cheap, inferior materials.
This could generate a favorable material price variance if the price of the inferior goods
is less than the standard price of materials. However, the inferior materials may result in
undetected product defects and cause the company to lose its reputation as a high-quality
producer. If the defects are detected, items would be scrapped or reworked. This would
lead to an unfavorable material quantity variance, because additional materials would be
used to replace or rework defective items.
I n v e s t i g a t i o n o f S t a n d a r d C o s t V a r i a n c e s 431
Can Process Improvements Lead to Unfavorable Variances?

A surprising reason why a firm may have an unfavorable variance is because it engaged
in process improvements! Recall that at the Vulcan Polymer Company the standard labor
hours for a unit of production is four hours and the company anticipated producing 500
units. Thus, the company anticipates needing 2,000 labor hours and staffs its production
department to this level. Now suppose production workers at Vulcan Polymer suggest
a change in a manufacturing process such that they can produce a unit with only three
hours of labor instead of four, and standards are changed accordingly. If the company
produces 500 units, standard labor will be 1,500 hours. But what will actual labor be?
Unless the company fires workers, actual labor will still be 2,000 hours and there will be
an unfavorable variance. And it will be very difficult to fire workers who just improved
the production process!
Company anticipates production of 500 units

at 4 labor hours per unit 2,000 labor hours
Less process improvement results in standard labor
for 500 units of only 3 hours per unit 1,500 labor hours
Unfavorable labor hour variance 500 labor hours
What the company really needs to do is stimulate demand for its product so it can pro-
duce and sell more than 500 units and take advantage of the extra free capacity generated
by the process improvement.
Beware: Evaluation in Terms of Variances

Can Lead to Excess Production
You get what you If you read the appendix on the Theory of Constraints in Chapter 7, you know that a
M e a s u r e production department in front of a bottleneck department should not produce more
units than the bottleneck can handle. If it does, the company will be making an invest-
ment in excess work-in-process inventory with a negative impact on shareholder value.
However, evaluation in terms of standard cost variances might just encourage such
counterproductive behavior.
Let’s see why this is the case. Suppose a company has two production departments:
assembly and finishing. The company anticipates that both departments will process
1,000 units per month, and standard labor is 1.92 hours per unit in the assembly depart-
ment. Since assembly anticipates the need for 1,920 labor hours per month, it hires
12 full-time workers (1,920 hours per month ÷ 160 hours per employee per month).
Now suppose the finishing department becomes a bottleneck due to sporadic failure of a
paint curing device. In this case, the assembly department should cut back its production
until the finishing department has solved the problem of the paint curing device. Let’s
assume that the assembly department cuts back production to 900 units. With 900 units,
standard labor hours are only 1,728. But unless the assembly department fires workers, it
will have an unfavorable labor hour variance of 192 hours if only 900 units are produced:
Staffing for 1,000 units (1,000 × 1.92 hours per unit) 1,920 hours
Less standard for 900 units needed (900 × 1.92 hours per unit) 1,728 hours
Unfavorable variance unless the assembly department fires workers 192 hours
Since the assembly department does not want to fire workers for a short-term problem, it
may go ahead and produce 1,000 units (100 more than needed) to avoid an unfavorable
labor efficiency variance. Remember: “You get what you measure!” And if you measure
efficiency in terms of the labor efficiency variance, you just might get overproduction in
a nonbottleneck department.
RESPONSIBILITY ACCOUNTING AND VARIANCES

As noted previously, the central idea of responsibility accounting is that managers should
be held responsible only for costs they can control. The implication for variances is that
managers and workers should be held responsible only for variances they can control.
Thus, a supervisor who can control material usage but has no control over the price paid
for materials should be held responsible for the material quantity variance but not for
the material price variance. The purchasing agent responsible for buying material at the
lowest price consistent with quality considerations should be held responsible for the
price variance.
Decision Making
Managers need to assure their subordinates that they recognize that an unfavorable
Insight variance does not necessarily imply poor performance. Otherwise, subordinates may
make decisions that hurt shareholder value. Let’s see why this is the case. Suppose
a manager unfairly criticizes a subordinate for having an unfavorable material price
variance when, beyond the control of the subordinate, suppliers increase prices. What
will happen the next time prices increase? The subordinate may turn to a lower-quality
(and lower-price) supplier in an effort to avoid an unfavorable material price variance.
That decision, however, could have a major negative impact on shareholder value.

LEARNING OBJECTIVE 1 Explain how standard LEARNING OBJECTIVE 3 Discuss how the
costs are developed, and calculate and interpret anagement-by-exception approach is applied
m
variances for direct material and direct labor. to the investigation of standard cost variances.
Standard costs are developed in a variety of ways. Standard Also, explain why a favorable variance may be
material quantities may be determined by engineering studies. unfavorable, how process improvements may lead
Supplier price lists may be used to determine standard prices to unfavorable variances, and why evaluation in
of materials. Time-and-motion studies are sometimes used to terms of variances may lead to overproduction.
determine standard labor hours. Because the investigation of variances is costly, managers only
The total material variance can be divided into a material investigate exceptional variances. Variances that are large in
price variance and a material quantity variance. absolute dollar value or as a percent of actual or standard cost
The total labor variance can be divided into labor rate and are generally considered exceptional.
labor efficiency variances. A favorable material price variance may result from buying
inferior materials at a price lower than standard.
LEARNING OBJECTIVE 2 Calculate and interpret A process improvement might result in the need for less
labor and lower standard labor hours per unit. Then, unless
variances for manufacturing overhead, and calculate
a firm fires workers or increases output, an unfavorable labor
the financial impact of operating at more or less efficiency variance will result.
than planned capacity. A production department generally should not produce
The total overhead variance can be divided into an overhead more units than required by downstream production depart-
volume variance and a controllable overhead variance. ments. However, if a downstream department is a bottleneck
When a company produces and sells more (fewer) units and requires fewer units than planned, the nonbottleneck
than planned, the company gains (loses) an amount equal department will have an unfavorable labor efficiency variance
to the contribution margin per unit times the number of if it decreases production to the level required by the bottleneck
units. (unless it fires or lays off workers).
A p p e n d i x 433
Appendix
Learning Recording Standard Costs in Accounts

Objective A1
Standard costing systems are used to control the operations of manufacturing companies and to
Record standard costs determine product costs. In this chapter, we have illustrated the calculation of standard cost vari-
in the accounts of a ances and discussed how they can be used to evaluate operations. Now we’ll see how product costs
manufacturing firm. are recorded at the standard rate in the accounts of a manufacturing company. In a standard costing
system, the costs added to the Raw Material Inventory, Work in Process Inventory, Finished Goods
Inventory, and Cost of Goods Sold accounts are all recorded at standard rather than actual cost. In
the process of recording inventory at standard cost, variances are also calculated and recorded for
management’s use in performance evaluation. As a concrete example, we will present the entries
for recording material, labor, and manufacturing overhead using the information presented for
Darrington Ice Cream (see Illustration 11-6).
Recording Material Costs

Darrington Ice Cream purchased 810,000 gallons of raw materials. The company actually paid
$2.72 per gallon, or $2,203,200. This amount is recorded as a credit to accounts payable. The Raw
Material Inventory account, however, is debited for the standard cost of the material purchased.
Because the standard price is $2.50 per gallon, this amounts to $2,025,000 in total. The difference
between actual and the standard cost is the material price variance of $178,200:
(date) Raw Material Inventory 2,025,000
Material Price Variance 178,200
Accounts Payable 2,203,200
To record material purchases.
Darrington Ice Cream used 809,000 gallons of material in production. The standard cost of
this material (809,000 × $2.50 = $2,022,500) is removed from Raw Material Inventory by crediting
that account. The standard quantity of material to produce 1,000,000 gallons of ice cream is 800,000
gallons. At the standard price of $2.50 per gallon, the standard material cost is $2,000,000. The
standard amount is recorded as a debit in Work in Process Inventory. The difference between the
debit and the credit is due to the material quantity variance ($22,500).
Variance accounts are temporary accounts and are always closed before financial statements
are prepared. We demonstrate the closing process later. Note that in this example, both the mate-
rial price variance and the material quantity variance are unfavorable and recorded as debits.
Unfavorable variances are associated with increases in the expenses of a company and have a debit
balance like expense accounts. Favorable variances are associated with reductions in the expenses
of a company and have a credit balance:
(date) Work in Process Inventory 2,000,000
Material Quantity Variance 22,500
Raw Material Inventory 2,022,500
To record material used in production.
Recording Labor Cost

During the year, 130,000 actual labor hours are worked at a rate of $12.10 per hour for a total cost
of $1,573,000. The standard number of hours is 125,000, and the standard wage rate is $12 per hour.
Thus, the total standard cost of labor to be added to Work in Process Inventory is $1,500,000. The
difference between the total actual labor cost payable and the total standard labor cost assigned to
Work in Process Inventory is the sum of the labor rate and labor efficiency variances:
(date) Work in Process Inventory 1,500,000
Labor Rate Variance 13,000
Labor Efficiency Variance 60,000
Wages and Salaries Payable 1,573,000
To record labor cost.
Recording Manufacturing Overhead

Recording manufacturing overhead in a standard costing system is a three-step process:
1. Actual overhead is recorded in the Manufacturing Overhead account.
2. Overhead is applied to Work in Process Inventory at the standard cost.
3. The difference between actual overhead and overhead applied at standard is closed and
overhead variances are identified.
These three steps are illustrated next.
Actual overhead incurred during the year is $680,000. Various accounts (e.g., indirect wages
payable, utilities payable, and accumulated depreciation) are credited to record this amount, and
the actual cost of overhead is debited in the Manufacturing Overhead account:
(date) Manufacturing Overhead 680,000

Various Accounts 680,000
To record actual overhead cost.
Work in Process Inventory is assigned the standard cost of overhead, which is equal to the
standard overhead rate times the number of units produced. In the example, this amounts to
$750,000 (i.e., 1,000,000 gallons × $0.75 per gallon). When this amount is applied to Work in
Process Inventory, Manufacturing Overhead is reduced by the same amount:
(date) Work in Process Inventory 750,000

Manufacturing Overhead 750,000
To apply overhead cost to inventory at
standard.
At this point, Manufacturing Overhead has been debited for the actual amount of overhead
and credited for the amount of overhead applied to Work in Process Inventory at the standard
overhead rate. The difference between the actual overhead cost and the standard overhead applied
to inventory ($70,000) is equal to the sum of the overhead volume variance and the controllable
overhead variance. These two variances are identified when the journal entry to close out
Manufacturing Overhead is recorded:
(date) Manufacturing Overhead 70,000

Overhead Volume Variance 50,000
Controllable Overhead Variance 20,000
To close out Manufacturing Overhead and
record Overhead Variances.
Recording Finished Goods

At this point, Work in Process Inventory contains the following costs:
Raw material $2,000,000

Overhead 750,000
Total $4,250,000
The total of $4,250,000 is equal to the 1,000,000 gallons produced at a standard cost per gallon of
$4.25. When the units are completed, the cost is transferred from Work in Process Inventory to
Finished Goods Inventory:
(date) Finished Goods Inventory 4,250,000

Work in Process Inventory 4,250,000
To record completed units in Finished
Goods Inventory.
A p p e n d i x 435
Recording Cost of Goods Sold

When units are sold, the cost of Finished Goods Inventory is reduced and Cost of Goods Sold is
increased by the standard cost of the units sold. Assume that all 1,000,000 gallons of ice cream
produced are sold. The standard cost is $4.25 per gallon. Therefore, the entry to record the Cost
of Goods Sold is:
(date) Cost of Goods Sold 4,250,000

Finished Goods Inventory 4,250,000
To record Cost of Goods Sold.
Closing Variance Accounts

At the end of the accounting period, the temporary variance accounts must be closed. As a prac-
tical matter, this is usually accomplished by debiting or crediting the variances to Cost of Goods
Sold. Before closing the variance accounts, Cost of Goods Sold is recorded at standard cost. Thus,
closing the variances results in the account being adjusted to approximate actual cost. It would
be more accurate to adjust Work in Process Inventory and Finished Goods Inventory (as well
as Cost of Goods Sold) to actual cost by allocating part of the total variance to these accounts.
However, unless the variances are significant and the balances in Work in Process Inventory and
Finished Goods Inventory are large relative to Cost of Goods Sold, closing the total variance to
Cost of Goods Sold is convenient and not misleading. In the case of Darrington Ice Cream, there
is no Work in Process or Finished Goods Inventory at the end of the year. (All of the ice cream
produced was sold.) Therefore, the variances are closed to Cost of Goods Sold.
The journal entry to close the variance accounts is as follows. Note that a favorable variance
reduces the amount of Cost of Goods Sold, whereas an unfavorable variance increases the account:
(date) Cost of Goods Sold 203,700

Overhead Volume Variance 50,000
Controllable Overhead Variance 20,000
Material Price Variance 178,200
Material Quantity Variance 22,500
Labor Rate Variance 13,000
Labor Efficiency Variance 60,000
To close variance accounts to
Cost of Goods Sold.
Review Problem 1
Sterling Steel Company produces steel billets that are sold to specialty steel fabricators. Fixed
overhead costs are budgeted at $20,000,000 per year, and variable overhead costs are budgeted at
$350 per ton. At the start of the year, the company planned to produce 70,000 tons.
During the year, the company actually produced 60,000 tons and incurred $42,000,000 of
overhead costs.
R equ ir ed
Calculate the controllable overhead variance and the overhead volume variance.
A n sw er
= Actual overhead -
= $42,000,000 - ($20,000,000 + ($350 × 60,000 tons))
= $42,000,000 - $41,000,000
= $1,000,000unfavorable
Overhead volume Flexible budget level of overhead Overhead applied to production

= -
variance for actual level of production using standard overhead rate
= $41,000,000 - ($635.7143 × 60,000 tons)

= $41,000,000 - $38,142,858
= $2,857,142 unfavorable
Note: The standard overhead rate
= [$20,000,000 + ($350 × 70,000 tons)] ÷ 70,000 tons = $635.7143.

Review Problem 2
RampUp Storage Containers produces a 1,000-cubic-foot metal storage unit that is used by storage
companies and other businesses needing low-cost, mobile storage units. The units sell for $3,000
per unit.
The company uses a standard costing system. At the start of 2016, standard costs were set
as follows:
Standard cost per unit:
Material cost (6 prefabricated metal sheets × $200) $1,200

Direct labor (10 hours × $20) 200
Overhead ($500 per unit) 500
Total $1,900
The overhead rate was calculated as follows: At the start of 2016, the company estimated that it
would produce and sell 5,000 units and incur $500,000 of variable overhead costs and $2,000,000
of fixed overhead costs:
Variable overhead $ 500,000

Total 2,500,000
Divided by estimated production 5,000
Overhead cost per unit $ 500
Based on estimated sales, standard costs, and other information, the following budget was pre-
pared:
2016 Budget (Expected Production and Sales of 5,000 Units)
Sales $15,000,000
Cost of sales 9,500,000
Gross profit 5,500,000
Selling, general, and administrative expense 3,900,000
Income from operations $ 1,600,000
During 2016, the company received an unexpected large order (1,000 units) from a national storage
company. The result was a substantial increase in the number of units produced and sold (6,000
units in total). Of the 6,000 units, 5,000 were sold at the standard price of $3,000 per unit. The
1,000 units sold to the national storage company were sold at $2,800 per unit.
A p p e n d i x 437
To produce the 6,000 units, the company incurred the following production costs:
Material purchased and used
(36,200 metal sheets × $200) $ 7,240,000
Direct labor
(62,000 hours × $21) 1,302,000
Total actual production costs $11,616,000
Req u i red
a. Calculate the production cost variances and indicate whether they are favorable or u
nfavorable.
b. Provide a brief interpretation of the overhead volume variance. In other words, answer the
question: What is the meaning of an overhead volume variance?
c. Calculate the financial impact of the 1,000 unit special order from the national storage c ompany.
A n sw er
a. Material price variance
(AP - SP) AQ
($200 - $200) 36,200 = –0–
Material quantity variance
(AQ - SQ) SP
(36,200 - 36,000) $200 = $40,000 unfavorable
Labor rate variance
(AR - SR) AH
($21 - $20) 62,000 = $62,000 unfavorable
Labor efficiency variance
(AH - SH) SR
(62,000 - 60,000) $20 = $40,000 unfavorable
Controllable overhead variance
Actual overhead - Flexible budget for actual production
$3,074,000 - [$2,000,000 + $100 (6,000)] = $474,000 unfavorable
Overhead volume variance
Flexible budget for actual production - Overhead applied
[$2,000,000 + $100 (6,000)] - ($500 × 6,000) = ($400,000) favorable
b. The overhead volume variance results from applying a predetermined fixed overhead rate to
more or fewer units than originally planned when the rate was determined. If more units are
produced than planned, more fixed overhead than anticipated will be applied at the standard
rate. If fewer units are produced than planned, less fixed overhead than anticipated will be
applied at the standard rate.
c. The selling price per unit for the 1,000 unit order is $2,800
Variable costs at standard are:
Material $1,200
Labor 200
Variable overhead 100 1,500
Contribution margin $ 1,300
1,000 extra units results in $1,300,000 of incremental profit.

Contribution margin per unit $ 1,300
Number of units × 1,000
Incremental profit $1,300,000
Key Terms Attainable standards (417) Labor efficiency variance (421) Overhead volume
Budgeted cost (416) Labor rate variance (421) variance (424)
Controllable overhead Material price variance (419) Standard cost (416)
variance (422) Material quantity Standard cost variance (418)
Ideal standards (417) variance (420) Variance analysis (418)

1. What is the primary benefit of a standard costing s ystem? c. More labor was used than called for by standards.
a. It records costs at what should have been incurred. d. Less labor was used than called for by standards.
b. It allows a comparison of differences between actual 7. What does an unfavorable overhead volume variance
and standard costs. mean?
It is easy to implement.
c. a. Overhead costs are out of control.
It is inexpensive and easy to use.
d. b. Overhead costs are in control.
2. Which of the following is not a way to develop a stan- c. Production was greater than anticipated.
dard cost? d. Production was less than anticipated.
a. By using a fixed rate that is higher every period. 8. True or false? Standard cost variances provide definitive
b. By performing time and motion studies. evidence that costs are out of control and managers are
c. By analyzing past data. not performing effectively.
d. By using what is specified in engineering plans. 9. True or false? A favorable variance may be due to a poor
3. The total material variance can be divided into a ma- management decision.
terial ________________ variance and a material 10. (Appendix) At the end of the accounting period,
________________ variance. a journal entry is made to close variance accounts
4. Which of the following statements correctly describes to ________________ or ________________,
an unfavorable material price variance? ________________, and ________________.
a. Too much material was purchased.
b. A higher price was paid for material purchased Answers to Self-Assessment
compared with the standard price. 1. b 2. a 3. price, quantity 4. b
c. More material was used than called for by the 5. false 6. d 7. d 8. false 9. true
standard. 10. Cost of Goods Sold, Work in Process, Finished Goods,
d. Less material was used than called for by the Cost of Goods Sold
standard.
5. True or false? The labor rate variance is equal to the differ-
ence between the actual wage rate and the standard wage
rate times the standard number of labor hours worked.
6. What does a favorable labor efficiency variance indicate?
a. Labor rates were higher than called for by standards.
b. Inexperienced labor was used, causing the rate to be
lower than standard.
QUESTIONS 1. What role do standard costs play in controlling the operations of a business?
2. How are standard costs developed for direct materials, direct labor, and manufacturing
overhead?
3. What is the difference between an ideal standard and an attainable standard?
4. “You get what you measure!” If so, what problem might be created by managers attempting to
achieve favorable material price variances?
5. How might a favorable material price variance or a favorable labor rate variance be related to
an unfavorable material quantity variance?
6. Should managers investigate only unfavorable variances?
7. Overhead volume variances do not signal that overhead costs are in or out of control. Do you
agree? Explain.
8. What factors should be considered when investigating variances?
9. What is management by exception?
10. What does responsibility accounting imply with respect to holding managers responsible for
standard cost variances?
EXERCISES EXERCISE 11-1.2 [LO 3] Five Star Tools is a small family-owned firm that manufactures
diamond-coated cutting tools (chisels and saws) used by jewelers. Production involves three
major processes. First, steel “blanks” (tools without the diamond coating) are cut to size. Second,
the blanks are sent to a chemical bath that prepares the tools for the coating process. In coating,
the third major process, the blanks are coated with diamond chips in a proprietary process that
simultaneously coats and sharpens the blade of each tool. Following the coating process, each tool
is inspected and defects are repaired or scrapped:
Coating and
Cutting Chemical bath Inspection
sharpening
Currently, the chemical bath department is a bottleneck due to intermittent failures related to an
antiquated dipping tank. The result is that the department can process only 600 items per hour
from the cutting department rather than the 700 items per hour that are normally processed.
Req u i red
Explain why the cutting department should cut back production from 700 items per hour to 600.
Further, explain why if the cutting department does cut back, as it should, it is likely to have an
unfavorable labor efficiency variance.
EXERCISE 11-2. [LO 3] Write a paragraph explaining how, if workers improve a production pro-
cess, they actually may generate an unfavorable labor efficiency variance.
EXERCISE 11-3. Calculating Material Variances [LO 1] At Frigicor, the standard price for the
M640 electrical relay (a component used in the production of a commercial refrigeration unit) is
$57. Standards call for 2.5 relays per unit of finished product. In July, the company purchased
150 relays for $8,900. The company used 104 relays in the production of 50 refrigeration units
(4 relays were damaged in the installation process).
Req u ired
Calculate the material price variance and the material quantity variance related to the M640 elec-
trical relay. Indicate whether the variances are favorable or unfavorable.
EXERCISE 11-4. Calculating Labor Variances [LO 1] At Frigicor, the standard quantity of labor
is 22 hours per refrigeration unit. The standard wage rate is $35. In July, the company produced
75 refrigeration units and incurred 2,100 labor hours at a cost of $69,000.
2
This exercise is related to a case in Chapter 7 that dealt with decision making and constraints.
Req u i red
Calculate the labor rate variance and the labor efficiency variance. Indicate whether the variances
are favorable or unfavorable.
EXERCISE 11-5. Calculating Overhead Variances [LO 2, 3] The Stanton Supply Company
roduces cleaning equipment for professional cleaners. At the start of the year, Stanton estimated
p
variable overhead costs to be $13 per unit and total fixed overhead costs at $301,000, based on a
volume of 66,000 units. The detail for the overhead estimates follows:
Variable Overhead
Indirect material ($8) $ 528,000
Utilities ($2) 132,000
Maintenance ($3) 198,000
Total variable overhead $ 858,000
Fixed Overhead
Supervisor salaries $ 126,000
Other fixed overhead 25,000
Total fixed overhead $ 301,000
Total overhead costs $1,159,000
Actual costs for the year are as follows:
Actual Production 56,000 units
Variable Overhead
Indirect material $ 468,500
Utilities 95,000
Maintenance 170,000
Total variable overhead $ 733,500
Fixed Overhead
Supervisor salaries $ 127,000
Other fixed overhead 26,700
Total fixed overhead $ 298,700
Total overhead costs $1,032,200
Req u i r ed
Calculate the controllable overhead variances for variable and fixed overhead. As a manager with
limited time, which variances would you focus on?
EXERCISE 11-6. Calculating Material Variances [LO 1] Crown Jewelry produced 1,500 rings
during March. The standard cost of each ounce of gold used in a ring is $1,000 per ounce. The stan-
dard quantity of material for each ring is a half ounce of gold per ring. The cost of gold purchased
and used in March was $788,480 at $1,024 per ounce. Determine the material price variance and the
material quantity variance for March. Indicate whether each variance is favorable or unfavorable.
EXERCISE 11-7. Calculating Material Variances [LO 1] WRX uses a standard costing system.
For production of a fuel cell, standards call for 4 model RN-3 valves per cell costing $2,300 each.
During 2018, the company purchased 250 valves for $587,500. The company used 248 valves in the
production of 60 fuel cells (8 valves were ruined through installation error).
R equ i r ed
Calculate material price and quantity variances for the model RN-3 valves.
EXERCISE 11-8. Calculating Labor Variances [LO 1] The standard labor cost in the production
of a pair of Tukor Brand athletic shoes is .40 hours at $13.00 per hour. During the month of June,
25,000 pairs were produced. Actual labor costs were $111,700 for 8,200 hours. Compute the labor
rate and labor efficiency variances for the month of June.
EXERCISE 11-9. Calculating Material and Labor Variances [LO 1] Star Band Uniforms uses a
standard costing system. The standard material and labor costs for producing a marching band
hat are as follows:
Materials (.90 yards × $12.00) $10.80
Direct labor (1.2 hours × $14.00) $16.80
During May, the company produced 3,550 band hats; 4,000 yards of material were purchased for
$42,000, and 3,100 yards of material were used in production. Also during May, 4,450 direct labor
hours were worked at a cost of $62,000. Calculate material price and quantity variances and labor
rate and efficiency variances. Indicate whether the variances are favorable or unfavorable.
EXERCISE 11-10. Calculating Overhead Variances—Service Example [LO 2] Barret Hospital is

interested in analyzing overhead related to laundry services. The hospital administrator estimated
that monthly fixed costs would be $90,000, and variable costs would be $3.00 per patient day.
During the month of September, the hospital had 19,000 patient days. Total laundry costs were
$176,000.
Req u ir ed
Analyze laundry costs for the month of September, using the procedures for calculating a control-
lable overhead variance. Is the variance favorable or unfavorable?
EXERCISE 11-11. Calculating Labor and Overhead Variances [LO 1, 2] At the start of 2018,
Textile Express Company determined its standard labor cost to be 2.25 hours per unit at $12.00
per hour. The budget for variable overhead was $9 per unit, and budgeted fixed overhead was
$15,000 for the year. Expected annual production was 6,000 units. During 2018, the actual cost
of labor was $14.25 per hour. Textile Express produced 4,600 units requiring 11,700 direct labor
hours. Actual overhead for the year was $50,000.
Req u i red
Calculate labor rate and efficiency variances and the controllable overhead variance and the over-
head volume variance.
EXERCISE 11-12. Investigating Variances [LO 1, 2, 3] At the start of the year, Frigicor estimated
that the company would produce 960 refrigeration units during the year (80 per month). Annual
fixed overhead costs were estimated to be $1,200,000 ($100,000 per month), and estimated variable
overhead costs were estimated to be $1,000 per unit. Standard cost per unit was set at $5,200:
Standard material cost $ 700
Standard labor cost 1,000
Standard overhead rate per unit 3,500
Total $5,200
During the year, the company experienced stiff competition and ended up producing and selling only
800 units. Actual annual production costs were $4,511,900, and standard cost variances were as follows:
Summary of Production Variances
Material price variance $ 8,900 unfavorable

Labor rate variance (4,600) favorable
Controllable overhead variance 4,000 unfavorable
Overhead volume variance 300,000 unfavorable
Total $351,900 unfavorable
Req u i red
Suppose you are the CFO of Frigicor, and you want to determine the cause of significant variances.
Given the demands on your time, you don’t want to investigate variances that have an obvious
explanation or that are less than 1/2 percent of actual production cost. Which variance(s) would
you investigate? Explain the basis for your answer.
EXERCISE 11-13. (Appendix) Calculating Material Variances and Recording Material Costs
[LO 1] The Quality Cabinet Company uses a standard costing system and produced 2,000
c abinets during May. The standard cost of wood is $22 per linear foot, and the standard quantity
for each cabinet is 27 linear feet. During May, the company purchased 57,000 linear feet of wood
for $1,140,000, and 55,000 feet were used in production. Determine the material price variance
and the material quantity variance, and record the related journal entries for May.
EXERCISE 11-14. (Appendix) Recording Labor Variances [LO 1] The Vanderwaal Company
uses a standard costing system. In August, 5,450 actual labor hours were worked at a rate of $12.25
per hour. The standard number of hours is 5,270 and the standard wage rate is $13 per hour.
Prepare a journal entry to record labor cost and related variances during the month.
EXERCISE 11-15. (Appendix) Recording Manufacturing Overhead Variances [LO 2] The

inneas Company uses a standard costing system. During 2018, the company incurred actual
L
overhead of $575,000. The standard rate for applying overhead is $4.25 per unit, and 130,000
units were produced in 2018. One-third of the total overhead variance is attributed to the
volume variance, and the remainder is attributed to the controllable overhead variance. Prepare
the journal entries to record overhead incurred (you should credit “various accounts”) and the
overhead variances.
EXERCISE 11-16. (Appendix) Closing Variance Accounts [LO 1, 2] The variance summary for
Bell Computers is as follows:
Bell Computers
Variance Summary
Material price variance ($ 3,600) favorable

Labor rate variance (1,650) favorable
Controllable overhead variance 2,550 unfavorable
Overhead volume variance 4,270 unfavorable
Total $ 11,120 unfavorable
Req u i r ed
Prepare a journal entry to close the variance accounts at Bell Computers. Assume that the total
variance is not material and is closed to cost of goods sold.
EXERCISE 11-17. (Appendix) Closing Variance Accounts [LO 1, 2] Refer to the summary of
variances in Exercise 11-16. At Bell Computers, the ending balance in Finished Goods Inventory
is $117,000; the ending balance in Work in Process Inventory is $54,000, and the balance in Cost
of Goods Sold is $437,500.
Req u i r ed
Prepare a journal entry to close the variance accounts at Bell Computers. Assume that the total
variance is material and is apportioned among Finished Goods Inventory, Work in Process
Inventory, and Cost of Goods Sold.
P r o b l e m s 443
Problems PROBLEM 11-1. Material Variances [LO 1, 3] Hank’s is a chain of 55 coffee shops. The standard
amount of ground coffee per cup is .75 ounces. During the month of September, the company sold
325,000 cups of coffee (reported via electronic cash registers), and the 55 shops reported using
16,800 pounds of coffee. Also during September, the company purchased 19,000 pounds of coffee
at a cost of $290,700. The standard price per pound is $15.
Req u ir ed
a. Compute material price and quantity variances.
b. Do either or both of the variances warrant investigation?
PROBLEM 11-2. Material Variances [LO 1] T&C Tees is a manufacturer of T-shirts. The standard
amount of 100% cotton jersey fabric used to make each T-shirt is 2.3 yards. The standard price
per yard of the fabric is $2.75. During last month, T&C purchased 6,200 yards of the jersey fabric
for $13,000. The production department used 5,000 yards to produce 1,800 T-shirts during the
month.
Req u i red
a. Compute the material price and quantity variances.
b. Is the material price variance favorable or unfavorable? What might have caused this variance?
Is the material quantity variance favorable or unfavorable? How might it be related to the material
price variance?
PROBLEM 11-3. Labor Variances: Service Firm [LO 1] Sarah Aiken is the owner of Pretty Paws,
a dog-grooming service. At standard, it takes 1 hour to groom each dog. During the month of
October, it took Pretty Paws employees 350 hours to groom 300 dogs, at a total labor cost of $4,890.
In November, employees spent 355 hours grooming 310 dogs, at a total labor cost of $6,500; in
December, 360 hours were used to groom 330 dogs, at a total labor cost of $6,980. The wage rate
standard for groomers is $15 per hour.
Req u ir ed
a. Calculate the labor rate and efficiency variances for each of the past 3 months.
b. What trends can you spot regarding the variances over the past 3 months? What might be a
cause for the labor rate variance? What might be a cause for the labor efficiency variance?
PROBLEM 11-4. Labor Variances: Service Firm [LO 1] K&J Web Designs creates websites for
businesses. K&J has a basic website creation package that it offers for a flat fee of $750. This pack-
age includes everything that a business would need to have a simple but functional website built.
K&J estimates that each of these websites should take, on average, 7.5 hours of Web designer time.
K&J pays its Web design employees an average of $42 per hour.
Last month, K&J sold and built 150 websites for $750 each. Web design employees worked a
total of 850 hours at a total payroll cost of $42,000.
Req u ired
a. Calculate the labor rate and efficiency variances for the past month.
b. Calculate the standard amount of contribution margin (sales price less variable labor cost) that
K&J would expect to make on an average website.
c. Calculate the actual amount of contribution margin (sales price less variable labor cost) that
K&J made, on average, on each website in the past month.
PROBLEM 11-5. Comprehensive Variance Problem [LO 1, 2] The Hayes Chemical Company
produces a chemical used in dry cleaning. Its accounting system uses standard costs. The standards
per .5-gallon can of chemical call for 1.20 gallons of material and 1.50 hours of labor. (1.20 gallons
of material are needed to produce a .5-gallon can of product due to evaporation.) The standard
cost per gallon of material is $6.00. The standard cost per hour for labor is $9.00. Overhead is ap-
plied at the rate of $7.75 per can. Expected production is 20,000 cans with fixed overhead per year
of $55,000 and variable overhead of $5.00 per unit (a .5-gallon can).
During 2018, 23,000 cans were produced; 35,000 gallons of material were purchased at a cost
of $250,000; 30,000 gallons of material were used in production. The cost of direct labor incurred
in 2018 was $290,000 based on an average actual wage rate of $8.25 per hour. Actual overhead for
2018 was $220,000.
Req u i red
a. Determine the standard cost per unit.
b. Calculate material, labor, and overhead variances.
c. List a possible cause for each variance.
PROBLEM 11-6. Comprehensive Variance Problem [LO 1, 2] XO-20 is an oil-based product

used to remove rust on bolts and nuts that are stuck. Its accounting system uses standard costs.
The standards per .5-liter can of solution call for 0.75 liters of material and 4 hours of labor.
(0.75 liters of material are needed due to evaporation in the production process.) The standard cost
per liter of material is $2.50. The standard cost per hour for labor is $13.00. Overhead is applied
at the rate of $15.375 per can. Expected production is 8,000 cans with fixed overhead per year of
$35,000 and variable overhead of $11 per unit (a .5-liter can).
During 2018, 7,800 cans were produced; 13,000 liters of material were purchased at a cost
of $60,000; 10,100 liters of material were used in production. The cost of direct labor incurred
in 2018 was $376,250, based on an average actual wage rate of $11 per hour. Actual overhead for
2018 was $125,000.
Req u ir ed
a. Determine the standard cost per unit. Round to the nearest cent.
b. Calculate material, labor, and overhead variances.
c. List a possible cause for each variance.
PROBLEM 11-7. Comprehensive Variance Problem [LO 1, 2] Dante’s Protein Powder produces
a dietary supplement. The standard cost of producing one unit is:
Material (1.25 pounds × $2.50) $ 3.13

Labor (1.2 hours × $10) 12.00
Overhead 11.60
Total $26.73
Standard variable overhead is $8.00 per unit, and fixed annual overhead is $90,000. At the
start of 2018, expected production was 25,000 units. During 2018, 30,000 units were produced.
The following information, related to actual costs incurred in 2018, is available:
1. Purchased 40,000 pounds of material for $85,000.

2. Used 38,750 pounds of material.
3. Worked 35,300 labor hours costing $375,000.
4. Actual overhead incurred was $327,000.
Req u i r ed
a. Show the calculation of the standard overhead rate per unit.
b. Calculate all material, labor, and overhead variances.
c. Prepare a variance summary, and briefly comment on variances that should be investigated.
P r o b l e m s 445
PROBLEM 11-8. Comprehensive Variance Problem: Service Firm [LO 1] Selzer & Hollinger, a
low-cost legal firm, has set time standards for each of the two basic legal services it offers, which
include the following:
Attorney Time Paralegal Time
Business incorporation 2.5 hours @ $125 per hour 4 hours @ $38 per hour
Will preparation 1.5 hour @ $175 per hour 3 hours @ $25 per hour
Over the past month, Selzer & Hollinger has handled 40 business incorporations and 30 wills.
Actual hours and costs follow:
Costs of Attorneys Costs of Paralegals
Business incorporation 92 hours @ $140 average 135 hours @ $40 average

attorney cost per hour paralegal cost per hour
Will preparation 38 hours @ $180 average 95 hours @ $30 average
attorney cost per hour paralegal cost per hour
Req u i red
a. Calculate the labor rate and labor efficiency variances for attorneys doing business incorporations.
b. Calculate the labor rate and labor efficiency variances for attorneys preparing wills.
c. Calculate the labor rate and labor efficiency variances for paralegals assisting with business
incorporations.
d. Calculate the labor rate and labor efficiency variances for paralegals assisting with wills.
PROBLEM 11-9. Comprehensive Variance Problem [LO 1, 2] Bowser Products operates a small
plant in New Mexico that produces dog food in batches of 1,500 pounds. The product sells for $6
per pound. Standard costs for 2018 are:
Standard direct labor cost = $15 per hour
Standard direct labor hours per batch = 10 hours
Standard price of material A = $0.35 per pound
Standard pounds of material A per batch = 800 pounds
Standard price of material B = $0.55 per pound
Standard pounds of material B per batch = 250 pounds
Fixed overhead cost per batch = $500
At the start of 2018, the company estimated monthly production and sales of 50 batches. The
company estimated that all overhead costs were fixed and amounted to $25,000 per month. During
the month of June 2018 (typically a somewhat slow month), 42 batches were produced (not an
unusual level of production for June). The following costs were incurred:
Direct labor costs were $7,800 for 460 hours.
37,500 pounds of material A costing $8,500 were purchased and used.
12,000 pounds of material B costing $5,600 were purchased and used.
Fixed overhead of $23,000 was incurred.
Req u ir ed
a. Calculate variances for material, labor, and overhead.
b. Prepare a summary of the variances. Does the unfavorable overhead volume variance suggest
that overhead costs are out of control?
PROBLEM 11-10. Comprehensive Variance Problem [LO 2, 3, 4, 6] The Antikron Company

produces rubber seals used in the aerospace industry. Standards call for 3 pounds of material at
$2.50 per pound for each seal. The standard cost for labor is 1.5 hours at $15 per hour. Standard
overhead is $10 per unit. For the year 2018, expected production is 130,000 seals with fixed over-
head of $130,000 and variable overhead of $9 per seal. During 2018, a total of 125,000 seals were
produced. The company purchased 455,000 pounds of material for $1,150,000. Production re-
quired 425,000 pounds of material. The cost of direct labor incurred was $2,900,000 with an actual
average wage rate of $15.25 per hour. Actual overhead for the year was $900,000.
Req u i red
a. Determine the standard cost per seal.
b. Calculate the material, labor, and overhead variances.
c. Prepare a summary of the variances, and indicate which variances should be investigated.
PROBLEM 11-11. Labor Variances [LO 1] Northwest Medical Testing draws blood samples from
approximately 1,500 clients each month. The standard time for a technician to draw and prepare
a blood sample for testing is 20 minutes. The standard wage rate for technicians is $40 per hour.
During August, Northwest hired a temporary employee at $60 per hour to fill in for a technician
who quit unexpectedly. During the month, technicians processed 1,250 samples and were paid
$22,100 for 425 hours of work related to drawing and preparing blood samples.
Req u ir ed
Calculate labor rate and efficiency variances for August, and comment on whether labor costs for
technicians appear to be in control or out of control.
PROBLEM 11-12. Setting Standards and Assigning Responsibility for Variances [LO 1] Recycled
Plastics manufactures a plastic dimensional lumber product from recycled plastic milk jugs. The com-
pany purchases consumer-recycled milk jugs in 700-pound bales and then shreds them into small
pieces in its grinding department. Once ground, the plastic pieces are mixed in a hopper and extruded
into shaped boards in the extrusion department. When the boards are cooled, they are used much as
wood lumber would be used to build picnic tables and park benches in the fabrication department.
Recycled Plastics has grown from a small five-person operation to a company employing
more than 100 people. The company also contains a sales department, an accounting department,
an administration department, and a purchasing department. The president and owner of the
company, Alan Roberts, would like to institute a standard cost system; at this point, he has been
setting prices based on his rough pen-and-paper estimates of costs.
R equ i r ed
a. What standards could be set within each of the three production departments of the company?
How should standards be set? Who should be involved in setting the standards?
b. What benefits might Recycled Plastics receive from adopting a standard costing system? What
disadvantages or problems might arise from adopting a standard costing system?
PROBLEM 11-13. Variance Analysis [LO 3] Will Norton, the general manager of Cummings
Manufactured Siding, is reviewing a monthly variance summary. The summary reveals a large
favorable material price variance and large unfavorable material quantity and labor efficiency vari-
ances. All other variances are small. Will’s initial instinct is to reward the purchasing manager with
a substantial bonus and withhold the plant manager’s monthly bonus until material quantity and
labor efficiency variances improve.
R equ i r ed
a. Should Will act according to his initial instinct?
b. What scenario(s) other than good performance in purchasing and poor performance in manu-
facturing could lead to the same variances as those noted?
c. What should Will do to determine whether the purchasing manager’s performance is especially
good and the plant manager’s performance is poor?
PROBLEM 11-14. Labor and Overhead Variance Analysis [LO 1, 2] The Dudley Travel Agency
has found that, on average, its travel agents take 2 hours to serve each client and that those travel
agents are paid a standard rate of $30 per hour.
P r o b l e m s 447
The following table contains the labor data for the Dudley Travel Agency for 2018:
Estimated (expected) Actual
Number of clients served 5,200 5,000

Travel agent hours 10,400 10,200
Travel agent wages $312,000 $298,000
Fixed overhead $75,000 $80,000
Variable overhead $22 per travel agent hour $23 per travel agent hour
Req u i red
a. Calculate the labor rate and efficiency variances.
b. Calculate the controllable overhead variance and the overhead volume variance.
c. What might have caused each variance?
PROBLEM 11-15. Variance Analysis—Nonmonetary Measures [LO 3] XcomSoftware operates

a 24-hour help line to answer customer questions. To control the cost of operations, the company
compares the actual time required to answer customer questions with a standard time of 6 minutes
per customer call. Monthly bonuses are awarded if the standard is achieved.
In the past 5 months, the number of calls has decreased from approximately 6,000 to approx-
imately 5,000. The average time per call has decreased from 6.5 minutes to 4.80 minutes. However,
a software magazine recently gave the company a poor evaluation in an article that reviewed the
support that software companies provide customers.
Req u i r ed
a. Does the favorable variance for response time indicate good performance?
b. What might account for the “improvement” in performance related to time per call and the
poor rating of customer support?
PROBLEM 11-16. Relationships among Variances [LO 3] In her review of annual production
variances, Amy Abel, CFO of Chanceworth Manufacturing, noted that there was a $80,000 favor-
able material price variance, a $70,000 unfavorable material quantity variance, an $90,000 favor-
able labor rate variance, and a $180,000 unfavorable labor efficiency variance. From her previous
discussions with factory supervisors and other managers, she knows that the purchasing depart-
ment was able to buy materials at a bargain price. However, the material often failed stress tests,
and a large number of items needed to be reworked. Also, the company had a brief strike. During
the strike, the company hired a number of inexperienced, temporary replacement workers at wage
rates significantly below those paid to the striking workers.
Req u i red
a. Explain how the favorable material price variance and the favorable labor rate variance may be
related to the unfavorable material quantity variance and the unfavorable labor efficiency variance.
b. Would you characterize the favorable material price variance as indicative of a good decision by
the purchasing department?
PROBLEM 11-17. Interpreting the Overhead Volume Variance; Calculating the Financial
Impact of Operating below Capacity [LO 2] The National Battery Company produces a wide
variety of batteries for home, automobile, and marine use. One example of its many products is the
Road Guardian automobile battery. The standard cost for this battery is as follows:
Standard Cost, Road Guardian
Material $ 5.00
Labor 4.00
Overhead 11.00
Total $20.00
At the start of the current year, 2018, the company estimated that it would incur $48,000,000
of overhead costs and $6,000,000 of direct labor costs. Thus, $8 of overhead is applied at standard
for each dollar of direct labor. Overhead is essentially completely fixed, which reflects the high
level of investment in automated manufacturing.
During 2018, the company experienced a labor strike that severely limited production, and
standard labor cost was only $5,200,000. At a recent meeting in early January 2019, C. W. Rogers,
the president of National, asked the company controller, Walter Cox, to estimate the effect of the
strike on company profit. The following morning, Walter sent the president a memo:
Date: January 7, 2019

To: C.W.
From: Walter
Subject: Effect of strike on company profit
As you know, profit in 2018 was greatly affected by a strike, which reduced productive
capacity. The way to measure the impact of the reduced capacity is to examine the over-
head volume variance. At the start of the year, we budgeted overhead to be $48,000,000.
Actual overhead was $46,000,000 so we had a favorable overhead budget variance of
$2,000,000. However, we applied only $41,600,000 of overhead to inventory ($8 overhead
rate × $5,200,000 standard labor). Thus, we had an unfavorable overhead volume variance
of $6,400,000.
Actual Overhead Budgeted Overhead* Applied Overhead
$41,600,000
$46,000,000 $48,000,000 ($8 × $5,200,000)
$2,000,000 Favorable $6,400,000 Unfavorable

*
Note that budgeted overhead does not need to be adjusted for actual production since overhead costs
are, for practical purposes, fixed. Thus, overhead in a static budget and in a flexible budget are equal.
In my opinion, the $6,400,000 unfavorable volume variance tells the story of our
poor profit performance. If we had not had the strike, production would have been at a
higher level (a level requiring $6,000,000 of standard labor cost), and this variance would
have been avoided.
C.W., I realize that you are not an accountant, so please call me if you have any questions
about my analysis.
Req u i r ed
Suppose the strike limited production of the Road Guardian battery—a battery for which there
is excess demand. Without the strike, 700,000 more of these batteries could have been produced
and sold ($800,000 of direct labor not available × $4 of labor per battery). The selling price of the
battery is $44. Taking this into account, calculate the effect of the strike on company profit, and
comment on the controller’s analysis.
PROBLEM 11-18. (Appendix) Recording Standard Costs [LO 1, 2] Bechtel Technical Clothing
produces parkas used by arctic explorers, mountain climbers, and people living in Minnesota. The
company uses a standard costing system, and standards call for 2.5 yards of material at $55 per
yard for each parka. The standard cost for labor is 3.5 hours at $35 per hour. Standard overhead
is $14 per unit. For the year 2018, expected production is 8,000 parkas with fixed overhead of
$60,000 and variable overhead of $6.50 per parka.
During 2018, 8,500 parkas were manufactured. The company purchased 24,000 yards of
material at a cost of $1,375,000. Production required 22,300 yards of material. The cost of direct
labor was $1,000,000 for 27,500 hours. Actual overhead for the year was $90,000.
C a s e 449
Req u i red
a. Prepare a journal entry to record the purchase of material.
b. Prepare a journal entry to record material used in production.
c. Prepare a journal entry to record direct labor.
d. Prepare a journal entry to record actual overhead and overhead applied.
e. Prepare a journal entry to close the variances in requirements a through d to Cost of Goods
Sold.
CASE
11-1 JACKSON SOUND [LO 3]
Jackson Sound produces amplifiers and mixing boards Megan Welles. “I was walking through the plant yesterday and I
in a modern production facility. The company is well known saw a tremendous amount of in-process inventory. I thought we
for its quality products. Each item is thoroughly tested before it had implemented a JIT system and we were working to balance
leaves the plant. Workers are highly skilled. The company con- our production processes. That investment in work in process is
siders direct labor to be a fixed cost because it does not reduce just going to drag down company performance.”
the workforce when there is a small downturn in business, and it Megan replied that the source of the problem might be related
can accommodate production increases of up to 10 percent due to the process improvements and the fact that bonuses for pro-
to excess capacity. duction workers are tied to standard cost performance. Christo-
In the production process, workers in the circuit d
epartment pher, however, didn’t see how a process improvement could actu-
prepare circuit boards that are sent to the case department for ally make things worse.
installation in custom cases. In the past 6 months, the workers
in the circuit department have pursued a number of process R eq uired
improvement initiatives that have resulted in much shorter
production times. For example, the Model LE7 amplifier used Assume that the company is reluctant to fire workers in the circuit
to require 12.5 standard labor hours in the circuit department, department even if they are not really needed. (After all, they have
but the standard was revised last month to only 10.4 standard just worked hard to improve productivity.) Given the production
hours. improvements and the institution of new standards, explain why
Although the circuit department has made production im- the circuit department has an incentive to overproduce (i.e., pro-
provements, the chief financial officer of the company, Christo- duce more output than can be handled by the case department).
pher Carlson, is concerned about a major buildup of in-process (Hint: If the circuit department does not overproduce, what will
inventory that is occurring between the circuit department and be the effect of the process improvements on the labor efficiency
the case department. “What’s going on?” he asked his assistant, variance?)
CASE
11-2 CHAMPION INDUSTRIES [LO 1, 2, 3]
Stan Holbert, the purchasing manager for Champion In R eq uired

dustries, recently attended a meeting with a potential sup
a. Assume that annual production is 150,000 units. Calculate
plier, Wallace Materials. At the meeting, a Wallace manager
the cost savings associated with using the new material.
demonstrated a material that was easier to handle and shape than
the material currently used by Champion Industries. b. Stan knows that because of an overworked accounting
Current standards call for 10 pounds of material per unit, department, standard costs will not be updated in a timely
costing $23 per pound. Direct labor per unit is 2.5 hours at manner. Suppose that the company switches to the new mate-
$30 per hour. The new material will cost $25 per pound. How- rial. What are the expected material and labor variances if stan-
ever, only 8 pounds of material will be needed per unit due to dards are not updated?
reduced waste. Also, direct labor per unit will be reduced to c. Suppose purchase price variances play a prominent role in
0.75 hour because the new material is less toxic and easier to the evaluation of Stan’s job performance. Will he be inclined to
handle. suggest use of the new material?
12
Decentralization and
erformance Evaluation
P
Action Industries is a diversified corporation whose
divisions manufacture office products, home products,
janitorial supplies, storage containers, and a variety
of plastic products.
At a recent meeting of the board of directors of At this point, Alister Hurd, the founder and chair-
Action Industries, Bill Stern, president and CEO, man of the board of Action Industries, spoke up. “Bill,
rose to address board members. “As I’m sure you I’m not so sure that Home Products is a top per-
know,” he began, “Marie Greco is doing a really former. After all, we expect profit to increase with the
superb job as manager of our Home Products size of a division. Is the profit of Home Products that
great if we take our investment into account? I think
division. Five years ago, we gave her a mandate
it’s time we moved away from our focus on division
to turn this sleepy division around, and we granted
profit and growth in profit. When I talk to my friends at
her the authority to make the key decisions that other companies, I find they focus on ROI, and some
would improve the division’s performance. The of them are starting to use EVA and the balanced
result is that her division has increased profit by 10 scorecard approach to evaluating performance. I
to 15 percent each year, and her division has gone wonder if our approach is out of step with current
from being our fifth to our second largest! Marie’s thinking. We need to be sure that our performance
operation is really making a contribution to our measures are giving us a clear picture of performance
bottom line. Maybe it’s time to think of moving her and driving the right manager behaviors.” The meet-
into corporate. The position of VP of Operations is ing ended with Bill committed to a thorough review
opening up, and I want a results-oriented person of alternative performance measures, which he would
in the job.” present at the next board meeting.
Sebastian Duda/Shutterstock
Learning Objectives
1 Explain the advantages and disadvantages of decentralization, explain why companies
evaluate the performance of subunits and subunit managers, and identify cost centers, profit
centers, and investment centers.
2 Calculate and interpret return on investment (ROI), residual income (RI), and economic value
added (EVA).
3 Explain the potential benefits of using a balanced scorecard to assess performance, and
discuss how a strategy map can be used to communicate the linkages among the measures
in a balanced scorecard.
451
452 chapter 1 2 D e c e n t r a l i z a t i o n a n d P e r f o r m a n c e E v a l u a t i o n
As firms increase in size and complexity, business segments or subunits (such as the
Home Products division at Action Industries) are organized and the managers of the
segments are granted decision-making authority so that the firm will function efficiently
and effectively. Firms that grant substantial decision-making authority to the managers
of subunits are referred to as decentralized organizations. Likewise, firms that do not
grant substantial decision-making authority to the managers of subunits are referred to
as centralized organizations.
Most firms are neither totally centralized nor totally decentralized. Decentralization
is a matter of degree. To the extent that more decision-making authority is delegated
to subunit managers, a firm is more decentralized. Action Industries is a decentralized
organization in that substantial decision-making authority has been given to Marie
Greco, the manager of the Home Products division.
In this chapter, we examine various types of subunits, and we illustrate how perfor-
mance evaluation can be used to control the behavior of subunit managers. The goal is to
ensure that subunit managers make decisions that are in the best interest of the entire firm.
LEARNING Why Firms Decentralize

O BJECTIVE 1
Firms decentralize for a number of reasons. Here we look first at what firms hope to gain
Explain the advantages by decentralizing. Then we examine some disadvantages of decentralization.
and disadvantages of
decentralization, explain Advantages of Decentralization
why companies evalu-
ate the performance of A primary reason for decentralization is that subunit managers have better information than
subunits and subunit top management and they can respond more quickly to changing circumstances. Consider
managers, and iden- an electronics firm that has two primary divisions: a copier division and a camera division.
tify cost centers, profit Division managers report to top management responsible for both divisions. As shown in
centers, and investment Illustration 12-1, each division operates in a unique environment. Competition, customer
centers. needs, and the supply of workers and raw materials are different for each of these product lines.
Suppose a new personal copier is to be introduced in the coming year, and a pric-
ing decision must be made. Who has superior information as to an appropriate price
to charge—the manager of the copier division or top management? Because of his or
her daily involvement with the market for copiers, the manager of the division probably
has a better understanding of how the market will react to a particular price. If this is
Illustration 12-1
Firm and subunit
environments
Top Management
Total
Manager Business Manager
of Copier Environment of Camera
Division Division
Business Business
Environment for Copiers Environment for Cameras
W h y F i r m s D e c e n t r a l i z e 453
the case, then the pricing decision should be delegated to the division manager, further
enhancing the decentralization of the firm.
Suppose the manager of the camera division learns that a supplier of camera lenses is
facing excess capacity and is willing to supply the division with lenses at a bargain price.
In a decentralized organization, the manager can react quickly to this opportunity and
increase the profitability of the division and the firm. However, if the firm is more cen-
tralized, the manager of the division may have to present the facts to top management,
which will make the decision as to whether the lenses should be purchased. This can
be a time-consuming process, and by the time a decision is made, the supplier may no
longer have excess capacity. Worse, other camera companies may take advantage of the
situation and gain a competitive edge.
Some firms decentralize because they believe that managers who are given signifi-
cant decision-making authority are more motivated and work harder than managers in
centralized organizations. If managers are given broad decision-making responsibility,
they may identify so strongly with their subunits that they work as hard as they would
if they actually owned the business.
Finally, decentralized organizations provide excellent training for future top-level
executives. Subunit managers in decentralized organizations are used to making import-
ant decisions and taking responsibility for their actions. Thus, when high-level positions
in the firm need to be filled, the firm has a ready supply of managers with the required
decision-making experience.
Disadvantages of Decentralization
Although decentralization has several beneficial features, it may create problems. One
potential problem is that decentralization may result in a costly duplication of activities. For
example, two subunit managers may decide to develop their own purchasing departments
when one purchasing department would be more economical. Or each major subunit may
have its own sales force, when a single coordinated sales force would be more effective.
A second problem with a decentralized organization is that managers of subunits
may pursue personal goals that are incompatible with the goals of the company as a
whole. This problem is referred to as a lack of goal congruence. An example of a goal
congruence problem is empire building. Some managers derive substantial satisfaction
from running large subunits (their empires). Perhaps this satisfaction comes from
impressing friends and business associates with the number of employees and the size
of the facilities under their control. However, maximizing the size of the subunit, which
satisfies the manager’s personal goal, may be incompatible with the overall company goal
of profit maximization. Bigger operations are not necessarily more profitable operations.
To control goal congruence problems in decentralized organizations, companies evalu-
ate the performance of subunit managers. As we will see later in this chapter, the evaluation
process should encourage managers of subunits to take actions that are in the interest of the
company as a whole. That is, performance evaluation should encourage managers to behave
as if their own personal goals are congruent with the goals of the company as a whole.
A summary of these advantages and disadvantages of decentralization is presented
Illustration 12-2
Advantages of Decentralization
Some advantages
and disadvantages of
1. Better information, leading to superior decisions
decentralization 2. Faster response to changing circumstances
3. Increased motivation of managers
4. Excellent training for future top-level executives
Disadvantages of Decentralization
1. Costly duplication of activities
2. Lack of goal congruence
Why Companies Evaluate the

Performance of Subunits
and Subunit Managers
Decentralization leads naturally to the need to evaluate subunits and their managers.
These evaluations serve different purposes, as explained next.
Decision Making/ Evaluating Subunits

Incremental
Evaluation of subunits is undertaken to identify successful operations and areas need-
Analysis
ing improvement. If an operation is deemed successful, top management may perform
incremental analysis to determine whether the operation should be expanded. If an
operation is viewed as underperforming, top management may perform incremental
analysis to determine whether the operation should be eliminated or whether funds
should be invested to improve it.
You get what you Evaluating Subunit Managers

M e a s u r e
The reason we evaluate subunit managers is that the evaluation influences their behavior.
As first discussed in Chapter 1, “You get what you measure!” In other words, perfor-
mance measures can be used to drive the behavior of managers.
For example, suppose Marie Greco, the manager of the Home Products division of
Action Industries, has historically been evaluated in terms of total sales. In the current
year, she is also being evaluated in terms of sales to new customers. Do you think her
behavior will change? Quite likely, she will spend more time focusing the attention of her
sales team on developing new customers because she will want to perform at a high level
with respect to the new performance measure. If developing new customers is critical to
the company’s success, then it is a good idea to encourage this behavior by focusing on
the new performance measure—sales to new customers.
Keep in mind that it is possible to have a good manager and a bad subunit. A man-
ager may do all that is reasonably possible to improve a subunit, but the subunit may
not be a line of business that the company believes has good long-run profit potential.
In this case, the company may reward the performance of the manager but still exit the
subunit’s line of business.
Responsibility Accounting and Performance Evaluation

The discussion of cost allocation in Chapter 6 introduced the topic of responsibility
accounting, a technique that holds managers responsible only for costs and revenues that
they can control. This idea should play a prominent role in the design of accounting sys-
tems used to evaluate the performance of managers in a decentralized organization. To
implement responsibility accounting in a decentralized organization, costs and revenues
are traced to the organizational level where they can be controlled.
For example, consider the information presented for the Jones Tool Company in
Illustration 12-3. Jones Tool produces a variety of small tools in two plants: the Eastern
Plant and the Western Plant. Each plant has a plant manager who is responsible for
operations. Currently, two production shifts are run each day, with work supervised by
individuals with the title production supervisor. A vice president of manufacturing is
responsible for production in both the Eastern Plant and the Western Plant.
The illustration indicates, in a simplified setting, how implementation of responsibility
accounting would suggest that costs be accumulated for assessing performance. Only labor
costs and material costs are traced to the individual shift supervisors. This follows because
at the Jones Tool Company, the production supervisors make numerous decisions that affect
C o s t C e n t e r s , P r o f i t C e n t e r s , a n d I n v e s t m e n t C e n t e r s 455
Illustration 12-3
Labor cost $1,200,000
Tracing costs to the Material cost 1,000,000
organizational level where Overhead 1,400,000
they can be controlled
Total $3,600,000
Controllable by
manufacturing vice president
Labor cost $500,000 Labor cost $700,000

Material cost 400,000 Material cost 600,000
Overhead 600,000 Overhead 800,000
Total $1,500,000 Total $2,100,000
Controllable by Controllable by
Eastern Plant Western Plant
manager manager
Labor cost $300,000 Labor cost $200,000 Labor cost $400,000 Labor cost $300,000
Material 250,000 Material 150,000 Material 350,000 Material 250,000
cost cost cost cost
Total $550,000 Total $350,000 Total $750,000 Total $550,000
Controllable by Controllable by Controllable by Controllable by

supervisor on shift 1 supervisor on shift 2 supervisor on shift 1 supervisor on shift 2
at Eastern Plant at Eastern Plant at Western Plant at Western Plant
the amount of labor and material costs incurred. However, plant overhead costs are not
traced to the supervisors, because these supervisors are not involved in decisions that affect
the amount of overhead incurred. Instead, overhead costs are traced to the individual plant
managers, who can control overhead costs. The manager of the Eastern Plant, for example,
is responsible for $500,000 of labor costs ($300,000 from the first shift and $200,000 from
the second shift), $400,000 of material costs ($250,000 from the first shift and $150,000 from
the second shift), and $600,000 of overhead costs incurred in the Eastern Plant.
The vice president of manufacturing is responsible for all of the costs incurred at both
the Eastern Plant and the Western Plant. Therefore, all production costs are traced to the
vice president. For example, the overhead costs traced to the vice president are $1,400,000,
which includes $600,000 from the Eastern Plant and $800,000 from the Western Plant.
Cost Centers, Profit Centers,

and Investment Centers
Subunits are organizational units with identifiable collections of related resources and
activities. A subunit may be a department, a subsidiary, or a division. Subunits are some-
times referred to as responsibility centers, defined as organizational units responsible for
the generation of revenue and/or the incurrence of costs. Responsibility centers typically
are classified as being cost centers, profit centers, or investment centers. Let’s look at the
types of performance measures that are appropriate for each of these subunits.
Cost Centers
A cost center is a subunit that has responsibility for controlling costs but does not have
responsibility for generating revenue. Most service departments (e.g., photocopying,
janitorial services, the machine maintenance department, and the computer services
department) are classified as cost centers. The managers of these departments are respon-
sible for making sure that their services are provided at a reasonable cost to the com-
pany, but they typically do not have responsibility for generating revenue for the firm.
Production departments also are classified as cost centers. As an example, consider a
department that assembles electronic components into desktop computers. The manager
of the assembly department certainly is responsible for making sure that the computers
are assembled at the lowest cost consistent with acceptable quality standards. However,
the manager probably has little input into how the computers will be marketed and what
price will be charged. Because the manager has little direct control over the quantity
sold or the price charged, the assembly department would be considered a cost center.
A common approach to controlling cost centers is to compare their actual costs with
standard or budgeted costs. If variances from standard are significant, an investigation
into the activities of the cost center should be undertaken to determine whether costs
are out of control or, alternatively, whether cost standards need to be revised. Other
performance measures, such as defect rates, on-time delivery statistics, and measures
of customer satisfaction, also can be used to control cost centers. Such measures are
discussed later in the chapter in the section on the balanced scorecard.
Profit Centers
A profit center is a subunit that has responsibility for generating revenue as well as for
controlling costs. Consider our earlier example of an electronics firm that consists of
a copier division and a camera division. Each of these divisions can be classified as a
profit center because each has responsibility for generating revenue through sales and
controlling costs associated with producing and marketing its products.
Because both revenues and costs (the two elements that determine profit) are under
the control of the profit center manager, the performance of the profit center can be eval-
uated in terms of profitability. Evaluation in terms of profitability is useful because it moti-
vates managers to focus their attention on ways of maximizing profit-center profitability.
Companies use a variety of methods to evaluate the profitability of profit centers.
Income earned in the current year may be compared with an income target or budget.
Or income earned may be compared with income earned in the prior year. Some firms
evaluate profit centers using relative performance evaluation. Relative performance
evaluation of profit centers involves evaluating the profitability of each profit center
relative to the profitability of other, similar profit centers.
For example, the Chicken King Company operates 10 fast-food restaurants in a
major midwestern city. Each outlet (restaurant) is treated as a profit center because it is
responsible for generating revenue (sales of chicken sandwiches, sodas, ice cream, etc.)
and controlling costs (food costs, labor, heat and light, etc.). If each outlet is reasonably
similar in terms of size, appearance, and menu, comparing the income earned by each
outlet with the income earned by other outlets may be a useful means of assessing the
effectiveness of outlet managers.
Investment Centers
An investment center is a subunit that is responsible for generating revenue, controlling
costs, and investing in assets. Because it is responsible for revenue, costs, and invest-
ment, an investment center is charged with earning income consistent with the amount
of assets invested in the segment. Most divisions of a company can be treated as either
profit centers or investment centers. If the division manager can significantly influence
decisions affecting investment in divisional assets, the division should be considered an
investment center. If the division manager cannot influence investment decisions, the
division should be considered a profit center. Since Marie Greco, the manager of the
E v a l u a t i n g I n v e s t m e n t C e n t e r s w i t h R O I 457
LINK TO Practice
Subunits at Nordstrom center, depending on how much autonomy the managers
have over investments. The individual stores (e.g., the
Think about the subunits at Nordstrom. The company
Nordstrom store in San Francisco) are also profit centers
has 117 full-line stores selling apparel, shoes, and
or investment centers. The advertising, maintenance,
accessories for women, men, and children. In a ddition,
and accounting departments at Nordstrom are cost
the company operates 142 discount stores under the
centers. Managers in these subunits are responsible for
name Nordstrom Rack. There also are two Jeffrey bou-
controlling their costs, but they do not have responsibility
tiques and one Last Chance clearance store. Each of
for generating revenue.
these subunit groups is a profit center or an investment
Home Products division of Action Industries, is granted authority to make investment

decisions, her operation is an investment center.
Investment center managers generally play a major role in determining the level of
inventory, the level of accounts receivable, and the investment in equipment and other
assets held by the investment center. Thus, it seems reasonable to hold them responsible
for earning a return on these assets. However, although investment center managers play a
major role, they generally are not given complete autonomy in investing in assets. Typically,
central management has final approval of all major investments. Guidelines may specify
that investment center managers must have central management approval for all invest-
ments greater than some specified dollar amount (e.g., investments greater than $200,000).
T est y o u r K N O W LE D G E
Classify each of the following subunits as being (most likely) a cost center, a profit center,
or an investment center.
a. Kmart corporation, a subsidiary of Sears Holdings Corporation.
b. The unit responsible for physical security on the Microsoft campus in Redmond,
Washington.
c. The manager of men’s shoes at the Nordstrom store in Dallas.
Correct answers are: a. investment center; b. cost center; c. profit center.
LEARNING Evaluating Investment Centers with ROI

O BJECTIVE 2
One of the primary tools for evaluating the performance of investment centers is return
Calculate and interpret on investment (ROI). ROI is calculated as the ratio of investment center income to
return on investment invested capital. The idea of evaluating performance using ROI was developed in the
(ROI), residual income early part of the twentieth century by Du Pont (known then as the DuPont Powder
(RI), and economic value Company) and has now gained widespread acceptance.1
added (EVA). ROI has a distinct advantage over income as a measure of performance. It focuses
the attention of managers not only on income (the numerator of ROI) but also on
investment (the denominator of ROI). Suppose two business units earn the same
income—$100,000. A performance measure based solely on income would rate the two
units as equally successful. However, suppose the first business unit required an invest-
ment in assets of $1,000,000, while the second business unit required only $500,000.
The second unit has performed much better than the first because it required only half
1
See H. Thomas Johnson and Robert S. Kaplan, Relevance Lost: The Rise and Fall of Management Accounting
(Boston: Harvard Business School Press, 1987), Chapter 4.
Link to PRACTICE
The Focus on ROI and Shareholder Value and citizens of the cities where they operate in addition
Is Not the Same in France, Germany, and to investors/shareholders. This can lead to differing deci-
Japan as It Is in the United States and sions in these countries. For example, in the United States
Great Britain and Great Britain, managers may cut wages to increase
profit and ROI and pump up stock prices, increasing
Managers in the United States and Great Britain focus
the wealth of investors. In France, Germany, and Japan,
intensely on financial measures of performance such
however, such cuts may be viewed less favorably because
as ROI. They do so because they believe that actions
they hurt a major stakeholder group: employees. Thus, the
increasing ROI lead to increases in shareholder value, and
focus on ROI is much less in these countries compared to
increasing shareholder value is their primary responsibility.
the United States and Great Britain.
This is not the case, however, in France, Germany, and
Japan. In these countries, managers believe that they Source: “Companies Not for Shareholders Alone,” e
ditorial
should focus their attention on the welfare of all company from Yomiuri Shimbun, October 24, 2005. Reprinted by
stakeholders, including employees, customers, suppliers, permission of Yomiuri Shimbun.
the investment to earn the same level of income. This allows the company to invest the
funds not required by the second unit in another project and earn additional income:
Business Business
Unit 1 Unit 2
Income $100,000 .10, $100,000 .20,
ROI = = =
Invested capital $1,000,000 or 10% $500,000 or 20%
Note that unlike income, ROI does not rate these two units as equally successful.
The first unit has an ROI of only 10 percent while the second unit has a much higher
ROI of 20 percent.
Some companies break ROI down into two components: profit margin and invest-
ment turnover:
Profit Investment
Margin Turnover
Income Income Sales
ROI = = ×
Invested capital Sales Invested capital
Profit margin is the ratio of income to sales, while investment turnover is the ratio of sales
to invested capital. Breaking down ROI into these components clearly indicates to manag-
ers that there are two ways in which ROI can be improved. Managers can take actions to
improve the income earned on each dollar of sales (i.e., increase the margin), or managers
can take actions to generate more sales for each dollar invested (i.e., increase turnover).
Measuring Income and Invested Capital

When Calculating ROI
In calculating ROI, companies measure “income” in a variety of ways (net income,
income before interest and taxes, controllable profit, etc.). For purposes of this book, and
consistent with the practice of many companies, we’ll measure investment center income
as net operating profit after taxes, known by the abbreviation NOPAT.
Because NOPAT is focused on operating profit after taxes, it excludes interest expense,
which is a nonoperating expense. Therefore, to calculate NOPAT, we must add interest
expense back to net income and adjust tax expense accordingly. Consider the data in
Illustration 12-4, which relates to the Home Products division of Action Industries. As
indicated, net income is $3,900,000. We add back interest expense of $1,000,000, and we
subtract the tax savings on interest equal to the 35 percent tax rate times $1,000,000. The
Illustration 12-4
Net Income
Calculation of investment
center income and invested
Sales $40,000,000
capital for the Home Products Less cost of goods sold 25,000,000
division of Action Industries Gross margin 15,000,000
Less selling and administrative expenses 8,000,000
Income from operations 7,000,000
Less interest expense 1,000,000
Income before taxes 6,000,000
Less taxes 2,100,000
NOPAT
Plus interest expense 1,000,000
Less tax savings related to interest (equals .35 × $1,000,000) 350,000
NOPAT $ 4,550,000
Invested Capital
Book value of total assets $96,000,000
Less noninterest-bearing current liabilities 5,000,000
Invested capital $91,000,000
ROI = NOPAT ÷ Invested capital 0.05 or 5%
result is a NOPAT value of $4,550,000. A benefit of using NOPAT is that it does not hold
the investment center manager responsible for interest expense. This is appropriate because
investment center managers frequently do not have responsibility for decisions related to
financing their operations. Also, using NOPAT facilitates comparisons of multiple investment
centers because it is not influenced by differences in how the investment centers are financed.
As with “income,” companies measure “invested capital” in a variety of ways (total assets,
total assets after adding back accumulated depreciation, total assets less current liabilities,
etc.). We’ll measure invested capital as total assets less noninterest-bearing current liabilities
(NIBCL). NIBCL are current liabilities that do not require interest payments. Thus, they
include accounts payable, income taxes payable, accrued liabilities, and a number of other
items. Noninterest-bearing current liabilities are deducted from the total assets because they
are a “free” source of funds and reduce the cost of the investment in assets. As indicated in
Illustration 12-4, invested capital calculated as total assets less noninterest-bearing current
liabilities is $91,000,000. Thus, ROI (the ratio of NOPAT to invested capital) is only 5 percent,
which is likely to be less than the company’s cost of capital.
Q: In Illustration 12-4, NOPAT is calculated by adding interest back to net i ncome
and then subtracting the tax savings on interest. Why not just take income from
operations and then subtract related taxes? You get the same answer:
Income from operations (see Illustration 12-4) $7,000,000

Less taxes at 35% 2,450,000
NOPAT $4,550,000
A : It is perfectly fine to start with income from operations and then subtract related taxes.
As you can see, you get the same answer. However, some income statements do not break
out an “income from operations” number. In such cases, you have to first calculate income
from operations and then subtract related taxes. Either approach works—just remember
that NOPAT does not include interest expense.
Given the low ROI earned by the Home Products division, it is appropriate for
Alister Hurd, the chairman of the board, to question the performance of the operation.
While Home Products is generating a substantial profit, the profit is low relative to the
level of investment in the operation. That is the essential insight provided by ROI.
Problems with Using ROI

In spite of its advantages, using ROI can present problems. One problem with ROI is that
investment in assets typically is measured using historical costs. Recall that the historical
cost of total assets is affected by depreciation of plant and equipment. As assets become
fully depreciated, the measure of investment becomes very low, and ROI becomes quite
large. This makes comparison of investment centers using ROI difficult.
Consider two investment centers that are alike in all respects except one: Investment
Center 1 was started 5 years ago, and its investment in fixed assets is substantially
depreciated, whereas Investment Center 2 was started in the current year. Both earn
exactly the same level of net operating profit after taxes, $100,000. As indicated in
Illustration 12-5, the ROI of Investment Center 1 is 29.41 percent, while the ROI of
Investment Center 2 is 23.81 percent. The difference of 5.6 percent is due to the fact that
the fixed assets of Investment Center 1 are substantially depreciated. Thus, its investment
base is much lower than the investment base of Investment Center 2.
Now suppose additional funds become available to invest in either of the two busi-
ness segments. Will Investment Center 1 earn a higher return than Investment Center 2
on the incremental investment? Although Investment Center 1 has the higher ROI, the
two business segments are identical in all respects except for the age of their equipment.
Thus, we would expect both segments to generate the same income with the funds. The
point is that using ROI to rank the attractiveness of investment centers can be difficult
if the remaining useful lives of their depreciable assets are very different.
Some critics of ROI have suggested that undue emphasis on ROI may lead managers
to delay the purchase of modern equipment needed to stay competitive. Old equipment
has a low carrying value because it is substantially depreciated. Thus, the denominator
of ROI (total assets less noninterest-bearing current liabilities) is low, and ROI is high. If
new equipment is purchased, it may significantly raise the level of investment and reduce
ROI. If managers are evaluated in terms of ROI, they may fear that the decline in ROI
will lead to low ratings of their job performance. In situations like this, managers may
fail to purchase equipment necessary for the long-run success of the company.
Illustration 12-5
Investment Investment
Comparison of investment
Center 1 Center 2
centers with differences in
accumulated depreciation NOPAT $100,000 $100,000
Investment:
Cash $ 20,000 $ 20,000
Accounts receivable 80,000 80,000
Inventory 150,000 150,000
Plant and equipment
Cost $200,000 $200,000
Less accumulated depreciation 100,000 100,000 20,000 180,000
Total assets 350,000 430,000
Less noninterest-bearing
current liabilities 10,000 10,000
Invested capital $340,000 $420,000
ROI $ 29.41% $ 23.81%
Recall that in an earlier chapter, we recommended that investment alternatives

should be evaluated in terms of their net present values. Investment opportunities with
positive net present values should be undertaken while investment opportunities with
negative net present values should be rejected. However, if the performance of managers
is evaluated using ROI, they may not be motivated to invest in projects with positive net
present values. The reason is that, in the short run, projects with positive net present
values may have low levels of income and correspondingly low ROIs. If managers are
evaluated in terms of ROI, they will be quite concerned about how ROI will be affected
by additional investments. The result is that managers with currently high ROI may con-
sider the effect on ROI, instead of net present value, in evaluating investment alternatives.
LINK TO Practice
Did Boeing’s Focus on ROI Lead to (a decision made before he took over) may have been
Excessive Outsourcing? driven in part by focusing excessively on RONA (return
on net assets). This measure is very similar to the mea-
In developing the 787 Dreamliner, Boeing implemeted
sure we’ve been discussing, ROI.
a global outsourcing strategy of unprecedented scale.
Suppose you were a manager at Boeing in the
The plan was to drive down costs by having companies
late 1990s, when the Dreamliner was being conceived.
around the world design and build key components of
Why might you have wanted to engage in outsourcing if
the aircraft, which would then be assembled by Boeing in
your performance was going to be evaluated by using
the United States. Unfortunately, the strategy backfired.
ROI? One way to increase ROI is to reduce assets (the
Analysts estimate that the strategy cost Boeing $12 to
denominator in ROI). By outsourcing, Boeing thought it
$18 billion more than the company planned to invest in
could shift the cost of building facilities and other assets
the project.
to suppliers and thus increase ROI.
At a meeting with students at Seattle University, Jim
Albaugh, CEO of Boeing Commercial Airplanes, candidly Source: “A ‘Prescient’ Warning to Boeing on 787 Trouble,”
told them that the decision to outsource at such a scale The Seattle Times, February 6, 2011, pp. D1, D6.
Problems of Overinvestment and Underinvestment:

You Get What You Measure!
A related problem with ROI is that managers of investment centers with high ROIs
may be unwilling to invest in assets that will earn a return that is satisfactory to central
management if that return is less than their current, high, ROI. That is, managers with
currently high ROIs may underinvest. As illustrated later, this problem can be minimized
by evaluating managers using residual income or economic value added (EVA). For now,
let’s compare the tendency for underinvestment, which is related to the use of ROI as a
performance measure, to the tendency for overinvestment, which is related to the use of
profit as a performance measure.
You get what you Evaluation in Terms of Profit Can Lead to Overinvestment. As discussed in
M e a s u r e Chapter 9, we would like managers to invest in assets that earn a return in excess of the
cost of capital. But remember, “You get what you measure!” If we evaluate managers in
terms of growth in profit, they may be motivated to make investments that earn a return
that is less than the cost of capital—that is, they may overinvest in assets.
I may not be a very good manager, but I can increase the profit of any company as
long as shareholders will provide me with the assets to make investments. And while I’m
increasing profit, I’ll be decreasing shareholder value! How will I achieve these apparently
conflicting outcomes? I’ll do it by growing the company and investing in projects that
earn returns that are less than the cost of capital (i.e., I’ll do it by overinvesting). For
example, suppose the cost of capital relevant to my subunit is 9 percent, and the subunit
Illustration 12-6 Projects with returns greater

Subunits with high ROIs may than the cost of capital but
pass up investments with ROIs less than the current ROI will
greater than the cost of capital not appear attractive
if the return is less than their even though they increase
current high ROI shareholder value.
ROI
5% 10% 15%
Cost of Current
Capital ROI
currently earns a profit of $100,000 on an investment of $1,000,000. This means the sub-
unit is earning a 10 percent return. Now I’ll grow the subunit using funds provided by
shareholders (so there is no interest charge to reduce my profit!). Suppose I double the
size of the investment in my subunit to $2,000,000 and earn a profit of $150,000. Note
that I’ve had a 50 percent increase in profit, so my performance will look good if I’m
evaluated in terms of growth in profit. But what return have I earned on the incremental
investment of $1,000,000? The increase in profit is only $50,000, so I only earned a return
of 5 percent, which is less than the cost of capital.
Evaluation in Terms of ROI Can Lead to Underinvestment. Perhaps an obvious
solution to the overinvestment problem is to evaluate managers in terms of ROI. Managers
won’t want to take on projects that have a low return just to increase profit if they are
evaluated in terms of the return they earn. As we have just seen, however, ROI has its
own set of problems, and one of them is that it may lead managers to underinvest—that
is, they may pass up projects that earn a return that is greater than the cost of capital.
Suppose you were the manager of a subunit with an ROI of 15 percent and a cost
of capital of 10 percent. If you were evaluated in terms of ROI, would you take on a new
project that had a return of 12 percent? Probably not. Although the project has a return
greater than the cost of capital and will increase shareholder wealth, it will lower your
reported ROI and possibly reflect negatively on your performance. In fact, you may try
to get rid of some of your current projects that are earning a return greater than 10 per-
cent but less than 15 percent in an effort to increase your reported ROI. Note that ROI is
most likely to lead to underinvestment for high-performing subunits; those are the ones
that are earning returns much greater than the cost of capital. And these are exactly the
subunits that are good candidates for expansion! Shareholders want these managers to
invest in all projects that have returns greater than the cost of capital. But the managers
will not want to invest in projects that have returns higher than the cost of capital but
less than their current high returns. The reason: The investments will lower their current
high ROI, which suggests that their performance is declining (see Illustration 12-6).
Evaluation Using Economic

Value Added (EVA)
An approach to solving overinvestment and underinvestment problems involves the use
of a performance measure known as economic value added (EVA). Firms that use EVA
typically tie bonus compensation to the measure. Thus, managers become very focused on
achieving high levels of EVA. EVA was developed based on a concept known as residual
income, which was developed in the 1930s and is generally attributed to General Electric.
In the next section, we will review residual income and then consider the extension to EVA.
E v a l u a t i o n U s i n g E c o n o m i c V a l u e A d d e d ( E V A ) 463
Residual Income (RI)

Residual income (RI) is the net operating profit after taxes of an investment center
in excess of its required profit. And required profit is equal to the investment center’s
required rate of return times the level of investment in the center (i.e., RI = NOPAT–
Required profit). Generally, the required rate of return is the cost of capital for the
investment center. Although a number of alternative measures of investment exist, we’ll
use total assets minus noninterest-bearing current liabilities as a measure of investment.
Under these conditions, the formula for calculating residual income is:
Here NIBCL stands for noninterest-bearing current liabilities. Why is NIBCL deducted
from total assets to determine the level of investment? The answer is that these liabil-
ities are a free source of funds. Suppose you open an audio/video store and purchase
$1,000,000 of inventory. Further, suppose your suppliers agree that you do not have to
pay for the inventory until it is sold. Thus, you have total assets of $1,000,000 related to
inventory and $1,000,000 of accounts payable (a noninterest-bearing current liability).
But what is your investment in the inventory? The answer, of course, is zero, and this is
precisely what you will calculate if you measure investment as total assets less NIBCL.
Revisiting the Situation at Action Industries. Consider the situation of the Home
Products division of Action Industries presented at the start of the chapter. As we saw
in Illustration 12-4, it has NOPAT of $4,550,000 and invested capital (total assets minus
NIBCL) of $91,000,000. Assume that cost of capital for Home Products is 12 percent. In
this case, residual income is a loss of $6,370,000.
Residual income = NOPAT - Required profit
= NOPAT - Cost of capital × Investment
= NOPAT – Cost of capital × (Total assets - NIBCL)
= $4,550,000 - (12% × $91,000,000)
= $4,550,000 - $10,920,000
= ($6,370,000)
The Home Products division had a net operating profit after taxes of $4,500,000, but given
that the company had an investment of $91,000,000, it should have had net operating profit
after taxes of at least $10,920,000. Thus, the company has a negative residual income of
$6,370,000. So instead of helping improve the company’s economic well-being, the division
has destroyed more than $6,000,000 of shareholder value! This is clear only after we calcu-
late an appropriate level of income given the investment in the Home Products division.
Solving the Overinvestment and Underinvestment Problems

RI has the potential to solve the overinvestment problem and the underinvestment
problem. Let’s see how. Suppose a project comes along that will earn a return on its
incremental investment of 9 percent. Would the manager make the investment? Not if
the manager is evaluated using RI and the cost of capital is 10 percent. Since the manager
receives a capital charge on investments of 10 percent, the manager knows that residual
income will be reduced if the investment is made. Thus, there is no incentive for overin-
vestment. Now suppose a project comes along that will earn a return of 11 percent. Will
Link to Practice
Companies That Have Used EVA
Here are a number of well-known companies that have used EVA:
Bausch & Lomb Eli Lilly Rubbermaid
Best Buy Georgia-Pacific Sprint
Boise Cascade Herman Miller Steelcase
Briggs & Stratton JCPenney Toys “R” Us
Coca-Cola Monsanto U.S. Postal Service
Dresser Industries Olin Whirlpool
Whole Foods
An excellent website for information on EVA is by EVANOMICS, at

http://evanomics.com.
the manager make the investment? The answer is yes, since residual income will increase
(because the capital charge is less than the amount earned by the project). Thus, there is
no incentive to underinvest.
Economic Value Added (EVA)

Economic value added, better known as simply EVA, is a performance measure devel-
oped by the consulting firm Stern Stewart. In essence, EVA is simply residual income
adjusted for what Stern Stewart refers to as “accounting distortions” that arise from
following generally accepted accounting principles (GAAP). A primary distortion is
Link to Practice
Deere & Company Uses SVA company’s chief financial officer, this was done because
Rather Than EVA the company believes the focus on assets alone is more
intuitive to people who work in factories. For 2014, the
Several companies use measures that are similar to EVA.
company calculated SVA for its equipment operation to
For example, Deere & Company uses a measure it calls
be $2.437 billion:
shareholder value added or SVA. Its calculation is:
SVA billions: $4.297 – .12 × $15.493 = $2.438
Operating profit - (Cost of assets × Average assets)
Here operating profit is $4.297 billion, the cost of assets
Here operating profit is similar if not identical to
is 12 percent, and average assets is $15.493 billion.
NOPAT, and cost of assets is essentially the company’s
Neither EVA nor SVA is required under generally
weighted average cost of capital. What’s different is that
accepted accounting principles. Thus, Deere is some-
the cost of assets is multiplied by average assets rather
what unique in that it publishes SVA in the company’s
than assets less noninterest-bearing current liabilities.
annual report, which can be obtained at the company’s
Thus, the company does not take into account the ben-
website under Investor Relations.
efit of free sources of funds (NIBCL). According to the
related to research and development (R&D). GAAP requires that R&D be expensed in
the period incurred. However, in many if not most cases, R&D creates benefits for future
periods. Thus, with EVA, R&D is capitalized as an asset and amortized over the future
periods that benefit from the incurrence of the R&D. An advantage of this approach
is that managers are less tempted to cut R&D, an act that increases short-term income
but destroys shareholder value. Marketing programs that benefit future periods are also
capitalized under EVA although the cost of such programs is expensed under GAAP. In
total, there are more than 100 adjustments that Stern Stewart might make on a particular
EVA consulting engagement. However, in practice, the number of adjustments is likely
to be 5 or less.
The adjustments made using EVA affect both the computation of NOPAT and the
computation of investment. Thus, the formula for EVA is:
EVA = NOPAT adjusted - (Cost of capital × Investment adjusted)
EVA Example. Let’s review the calculation of EVA using the example of Spider
Connectivity Products, a company that manufactures and sells a variety of connectivity
products used in the audio/video, telecom, and computer industries (e.g., fiber-optic
cables, FireWire products, USB devices, high-definition video and audio cables, modular
plugs). The company’s financial information is presented in Illustration 12-7.
Note that between 2016 and 2017, net income increased from $3,266,000 to
$3,334,000. Is that increase consistent with good performance? Let’s calculate EVA for
both years to help us answer that question. In doing so, we’ll assume that research and
development (R&D) has a 3-year life with one-third amortized in the year it’s incurred.
The calculation of EVA is presented in Illustration 12-8. Basically, the calculation of
EVA is a three-step process. First we calculate adjusted NOPAT, then we calculate adjusted
investment, and third we calculate EVA as Adjusted NOPAT - (Cost of capital × Adjusted
investment). Note that in calculating adjusted NOPAT for 2017, we start with income
before taxes and add back interest and the current-period R&D. Unless we add back
interest, we will be double-counting a financing charge. (Interest would be deducted from
income, and it would be deducted again when we multiply the cost of capital times the
level of investment to calculate the return.) R&D is added back because we treat R&D as
an intangible asset in EVA. We then deduct R&D expense related to amortizing the current
and prior years’ R&D amounts over 3 years (i.e., we deduct one-third of R&D from 2017,
2016, and 2015). Note that this results in adjusted NOPAT of $3,359,000 for 2017.
Now let’s go on to the second step: calculation of adjusted investment. We start
with total assets and then add unamortized R&D. Only one-third of R&D in 2017
became an expense so two-thirds is still an intangible asset. Of the R&D in 2016, one-
third was expensed in 2016, and one-third was expensed in 2017, which means that
one-third remains an intangible asset at the end of 2017. In total, adjusted investment
is $19,122,000 for 2017.
The last step is to calculate EVA. Assuming a cost of capital of 18 percent (the
cost of capital for technology companies is often quite high), EVA is equal to a loss of
$83,000. A similar process is followed to calculate EVA for 2016. Here we find that EVA
is a positive $376,000.
Now, why is it that accounting profit is up in 2017 but EVA is down? Look at what
happened to the level of investment. It went from $16,940,000 to $19,122,000. Although
income is up in 2017, it’s not up enough given the increased investment, especially in
accounts receivable and inventory. This is an important insight provided by EVA: Firms
need to have earnings consistent with their cost of capital and their investment in assets.
Most likely, if the senior managers of Spider Connectivity Products were evaluated and
compensated based on EVA, they would have paid more attention to the investment the
company was making in additional assets and analyzing whether the investment was
likely to result in a payoff greater than the cost of capital.
Illustration 12-7
Comparative Income Statements (in thousands) 2017 2016
Financial information for
Spider Connectivity Products Sales $29,059 $27,287
Less:
Cost of sales 19,361 17,981
Research and development 1,400 1,600
Selling, general and administrative expense 3,031 2,537
Interest expense 138 144
Income before income taxes 5,129 5,025
Less income taxes 1,795 1,759
Net income $ 3,334 $ 3,266
Comparative Balance Sheets (in thousands) 2017 2016
Assets
Cash and cash equivalents $ 147 $ 1,286
Accounts receivable 4,588 2,568
Inventory 3,420 1,902
Prepaid expenses 47 45
Total current assets 8,202 5,801
Land 1,342 1,342
Building, furniture, fixtures (net) 8,438 8,523
Total noncurrent assets 9,780 9,865
Total assets $17,982 $15,666
Liabilities
Accounts payable $ 209 $ 199
Accrued liabilities 57 45
Taxes payable 60 49
Current portion of long-term debt 175 188
Total current liabilities 501 481
Long-term debt 795 863
Total liabilities 1,296 1,344
Common stock 5,080 5,080
Retained earnings 11,606 9,242
Total stockholders’ equity 16,686 14,322
Total liabilities and stockholders’ equity $17,982 $15,666
Note: Research and development was $1,500,000 in 2015 and $1,400,000 in 2014.
Link to Practice
Focus on EVA Affects Key Decisions of increases in EVA). According to Christopher Manuel,
across an Organization an analyst with KeyBanc Capital Markets, too many
companies don’t consider the cost of capital when
David Hoover is the CEO of Ball Corporation, a com-
they make decisions. He believes that Hoover, however,
pany that produces metal and plastic packaging for
has done all the right things to make the focus on EVA
beverages, foods, and household products. When the
work.
company experienced strong stock price appreciation,
For 2014, Bell reported EVA of $190.7 million in
Hoover attributed the result in part to a focus on EVA.
its annual report. This was an increase of 28 percent.
According to Hoover, the focus on EVA led the company
For purposes of its EVA calculation, Bell uses a capital
to divest from a glass business that was not earning a
charge of 9 percent. This was an increase of 28 percent
return in excess of the cost of capital. And even workers
over the previous year.
in the company’s beverage-can plants and people on
the line can explain EVA and actions they can take to Source: Based on Don Durfee, “The Top Spot,” CFO
increase NOPAT or reduce investments (the key drivers Magazine, October 2005.
Illustration 12-8
EVA calculations for Spider Connectivity Products
Step 1 Step 2 Step 3

2017
Income before taxes $5,129 Total assets $17,982 Adjusted NOPAT $3,359
Add interest expense 138 Plus unamortized R&D Less cost of capital ×
Add current period R&D 1,400 2017: 2/3 × $1,400 933 adjusted investment
Less amortization of prior R&D 2016: 1/3 × $1,600 533 (.18 × $19,122) (3,442)
2017: 1/3 × $1,400 (467) 19,448 EVA ($ 83)
2016: 1/3 × $1,600 (533) Less NIBCL
2015: 1/3 × $1,500 (500) Accounts payable (209)
5,167 Accrued liabilities (57)
Less taxes at 35% (1,808) Taxes payable (60)
Adjusted NOPAT $3,359 (326)
Adjusted Investment $19,122
2016
Income before taxes $5,025 Total assets $15,666 Adjusted NOPAT $3,425
Add interest expense 144 Plus unamortized R&D Less cost of capital ×
Add current period R&D 1,600 2016: 2/3 × $1,600 1,067 adjusted investment
Less amortization of prior R&D 2015: 1/3 × $1,500 500 (.18 × $16,940) (3,049)
2016: 1/3 × $1,600 (533) 17,233 EVA $ 376
2015: 1/3 × $1,500 (500) Less NIBCL
2014: 1/3 × $1,400 (467) Accounts payable (199)
5,269 Accrued liabilities (45)
Less taxes at 35% (1,844) Taxes payable (49)
Adjusted NOPAT $3,425 (293)
Adjusted Investment $16,940
Q : In our operations management class, we learned about inventory holding
costs and how some companies are using just-in-time methods to reduce them.
Obviously, evaluation in terms of EVA creates an incentive to reduce inventory and
related holding costs since reducing inventory reduces investment and increases
EVA. Is this also the case if managers are evaluated in terms of GAAP profit?
A : Students often wonder where inventory holding costs are on a traditional GAAP
income statement. The answer is that they show up on a traditional income statement only
to the extent that the investment in inventory is financed with debt. Then the company has
interest expense that reflects the cost of investment in inventory financed by the debt. But
if the investment in inventory is financed with equity, the income statement and the GAAP
measure of profit will not reflect the cost of holding inventory. That’s because a GAAP
measure of income does not show a capital charge for equity capital.
This is not the case with EVA. With EVA, the cost of capital (which includes the cost
of both debt and equity capital) is multiplied by the investment in inventory, so the cost of
holding inventory is reflected in EVA whether the inventory is financed with debt, equity, or,
as is most likely, a combination of the two. And managers have an incentive to control this
inventory-holding cost by reducing the investment in inventory.
Link to Practice
Use of EVA at Whole Foods a potential store’s EVA will be using 8 percent as the
weighted average cost of capital. New store projects are
In its 2014 annual filing with the Securities and Exchange
considered only if the estimated cumulative EVA of the
Commission (Form 10-K), Whole Foods notes that new
proposed store is positive in 5 years.
store projects must meet an economic value added
(EVA) hurdle. Essentially, the company estimates what
LEARNING Using a Balanced Scorecard

O BJECTIVE 3
to Evaluate Performance
Explain the potential
benefits of using a A problem with assessing performance with financial measures like profit, ROI, and EVA
balanced scorecard to is that these financial measures are backward looking. In other words, today’s financial
assess performance, measures tell you about the accomplishments and failures of the past. And the lag may
and discuss how a be quite long. Suppose you work for a biotech company and have a tremendous day at
strategy map can be the office: You develop a drug that cures the common cold. When will this tremendous
used to communicate accomplishment play out in accounting earnings? Given the regulatory process, it’s
the linkages among the likely that the drug will not be marketed and profit recognized for more than 10 years!
measures in a balanced Now suppose a new CEO is hired 10 years from now. Even if the executive performs
scorecard. poorly, it’s likely that profit, ROI, and EVA will be high. It won’t be because of the CEO’s
performance. It will be because of accomplishments that took place in the distant past.
Illustration 12-9 graphically presents the backward-looking nature of financial perfor-
mance measures.
An approach to performance measurement that also focuses on what managers are
doing today to create future shareholder value is the balanced scorecard, a technique
developed by Robert Kaplan, a Harvard professor, and David Norton, a consultant.2
Essentially, a balanced scorecard is a set of performance measures constructed for
four dimensions of performance. As indicated in Illustration 12-10, the dimensions
are financial, customer, internal processes, and learning and growth. Having financial
measures is critical even if they are backward looking. After all, they have a great effect
on the evaluation of the company by shareholders and creditors. Customer measures
examine the company’s success in meeting customer expectations. Internal process
measures examine the company’s success in improving critical business processes.
And learning and growth measures examine the company’s success in improving its
ability to adapt, innovate, and grow. The customer, internal processes, and learning and
growth measures generally are thought to be predictive of future success (i.e., they are
not backward looking).
Illustration 12-9
Financial performance Past Actions Reflected Today's Financial
easures are “backward
m Actions in the past that create Performance Measures
shareholder value in
looking”
2
Seminal articles on the balanced scorecard include Robert S. Kaplan and David Norton, “The Balanced
Scorecard—Measures That Drive Performance,” Harvard Business Review, January–February 1992, and
Robert S. Kaplan and David Norton, “Putting the Balanced Scorecard to Work,” Harvard Business Review,
September–October 1993.
U s i n g a B a l a n c e d S c o r e c a r d t o E v a l u a t e P e r f o r m a n c e 469
Illustration 12-10
The balanced scorecard
Financial Perspective
Customer Perspective Strategy Internal Process Perspective
Learning and Growth
Tying the Balanced Scorecard Measures to the Strategy for Success. Typically,

a company using a balanced scorecard will develop three to five performance measures
for each dimension. To the extent possible, the measures on a balanced scorecard should
be tied to a company’s strategy for success. For example, consider the customer dimen-
sion. If it is critical to success that the company’s product be easy to use, the company
may survey customers to measure this aspect of performance. If on-time delivery is
critical to customers, then it will be used as a performance measure. With respect to
internal processes, a company may decide that it needs to reduce the number of defec-
tive units produced. In this case, number of defects might be an appropriate measure
for the internal process dimension. With respect to the learning and growth dimension,
a company may decide that to remain innovative, it is crucial to retain its highly skilled
workforce. In this case, a measure of employee job satisfaction might be an appropriate
measure for the learning and growth dimension. Another potential learning and growth
measure is the number of new products developed.
As you well know, “You get what you measure!” and companies need measures that
drive behaviors consistent with their strategy for success. Let’s consider four scenarios for
a software company, to further illustrate how performance measures are tied to strategy
for each dimension of a balanced scorecard.
Scenario 1. Learning and Growth Dimension. At Mayfield Software, many of the
product managers are former programmers who have little or no training in business
management. The company believes that to continue to grow sales and adapt to changes
in the industry, these managers need to become more knowledgeable about business
concepts and practices. In this case, the company might develop a learning and growth
measure that assesses the average number of hours of business training received by a
product manager. Also, the company might survey product managers and have them
rate the quality of business training provided by the company.
Scenario 2. Internal Process Dimension. Mayfield Software has been severely
ampered by viruses that shut down all computer systems for 15 days in the prior year.
h
This led to delays and provided an advantage to a competitor that was first to market
with a product that was also under development by Mayfield. In this case, the company
might develop an internal process measure that assesses the company’s ability to detect
and block viruses. Such a measure might be number of hours computers are locked down
to prevent the spread of a virus.
Scenario 3. Customer Dimension. Critical to the success of Mayfield Software is
brand awareness. In this case, the company might commission a survey to measure brand
awareness from a random sample of potential customers. The results of the measure
would be posted to the company’s balanced scorecard under the customer dimension.
Scenario 4. Financial Dimension. At Mayfield Software, fixed costs such as R&D
are high, but variable costs are quite low. For example, its project management software
program sells for $200, but the variable cost per unit is only $5 (including the cost of
a CD, its packaging, and shipping). Thus, the contribution margin ratio of the product
(the amount of profit per dollar of sales) is 97.5 percent. In light of this cost structure,
the company’s strategy for success focuses on sales volume. In this case, an important
financial measure that will drive a focus on sales volume is growth in sales.
How Balance Is Achieved in a Balanced Scorecard

A variety of potential measures for each dimension of a balanced scorecard are indicated
in Illustration 12-11. After reviewing these measures, note how “balance” is achieved:
1. Performance is assessed across a balanced set of dimensions (financial, customer,
internal processes, and learning and growth).
2. Quantitative measures (e.g., number of defects) are balanced with qualitative
measures (e.g., ratings of customer satisfaction).
3. There is a balance of backward-looking measures (e.g., financial measures like
growth in sales) and forward-looking measures (e.g., number of new patents as a
learning and growth measure).
Illustration 12-11
Measures
Examples of measures for
the four perspectives of a Financial Is the company achieving its Operating income
balanced scorecard financial goals? Return on assets
Sales growth
Cash flow from operations
Reduction of administrative
expense
Customer Is the company meeting Customer satisfaction
customer expectations? Customer retention
New customer acquisition
Market share
Internal Processes Is the company improving On-time delivery
critical internal processes? Defect rate
Time to fill orders
Lead time
Number of suppliers
Material turnover
Percent of practical capacity
Learning and Growth Is the company improving its Amount spent on employee
ability to innovate? training
Employee satisfaction
Employee retention
Number of new products
New product sales as percent
of total sales
Number of patents
D e v e l o p i n g a S t r a t e g y M a p f o r a B a l a n c e d S c o r e c a r d 471
You get what you Underlying the balanced scorecard is an idea that we have emphasized throughout this
M e a s u r e book: “You get what you measure!” If you believe that customer satisfaction is critical for
success, then you had better measure it so that managers will focus their attention on it.
If you believe that reducing cycle time (the time it takes to make a product) is critical for
success, then drive your managers to reduce cycle time by evaluating their performance
in relation to this aspect of performance.
Developing a Strategy Map

for A Balanced Scorecard
A strategy map is a diagram of the relationships across the four dimensions of a bal-
anced scorecard (learning and growth, customer, internal process, and financial) of the
strategic objectives the company has developed to create shareholder value. It is useful
to test the soundness of the strategy and how it is linked to measures on the scorecard
(do the relationships make sense?), and it is useful to communicate strategic objectives
to employees.
As an example, suppose that Mayfield Software has determined that a key driver
of shareholder value is increased sales and has determined that increased sales will be
achieved only if customers are satisfied. In the past, customer satisfaction has been low
because they could not get accurate and fast responses to their questions at the company’s
customer call center. The problem is that employees at the call center are not well trained.
Let’s look at Illustration 12-12 to see how a strategy map works.
Starting with the learning and growth perspective, note that the goal is to improve
employee skills at the call center. The measure the company has chosen is the per-
centage of employees receiving training. Next look at the internal processes perspec-
tive. Here the goal is to have fast and accurate responses to customer questions. The
related measure is the time to answer customer calls with no additional follow-up.
Note that an arrow connects the strategic objective of the learning and growth per-
spective to the strategic objective of the internal process perspective. That’s because
the company anticipates a cause-and-effect relationship. More training will improve
accuracy and speed in the call center. Now look at the customer perspective. Here the
goal is to improve customer satisfaction, and the measure is obtained via a survey of
Illustration 12-12
Financial
Partial strategy map for
Strategic Objective Measure
Mayfield Software
Increase sales Percent increase in sales
Customer
Improve customer satisfaction Customer satisfaction survey
Internal Processes
Fast and accurate responses Time to answer customer calls with
to customer questions no additional follow-up needed
Learning and Growth

Improve employee skills at call center Percent of employees receiving training
customers. The arrow linking the objective of the internal processes perspective to the
customer perspective shows that the company expects satisfaction to increase because
of improvements at the call center. Finally, look at the financial perspective. Here the
objective is an increase in sales, and the measure is the percentage increase in sales
over the previous year. The arrow connecting the customer objective to the financial
objective indicates that the company expects that an increase in customer satisfaction
will lead to sales increases.
The partial strategy map in Illustration 12-12 is developed showing only one objec-
tive for each perspective. There are likely to be multiple objectives for each perspective
of the balanced scorecard, and a complete strategy map would show all of the linkages
among them.3
Keys to a Successful B alanced

Scorecard: Targets, Initiatives,
Responsibility, Funding,
Top Management Support
It’s probably pretty obvious that just having a number of performance measures is not
going to drive a company’s strategy for success. Here are some of the key items that are
necessary for a successful balanced scorecard.
Targets. For each measure, there should be a target so managers know what they are
expected to achieve. For example, for the financial measure “percent growth in sales,”
the target might be 15 percent.
Initiatives. For each measure, the company must identify actions that will be taken to
achieve the target. Refer to Illustration 12-12 and note the learning and growth measure
“Percent of employees receiving training.” Here the target might be 100 percent. But what
is the nature of the training? The company must develop a training program initiative to
make sure that the employees receive the right kind of training.
Responsibility. A particular employee must be given responsibility and be held
accountable for successfully implementing each initiative. Without this accountability,
successful implementation of key initiatives is unlikely.
Funding. Initiatives also must be funded appropriately or they will not be successful.
For example, unless funds are provided to develop an appropriate training program, it
would seem unlikely that the employees at Mayfield Software will gain the skills neces-
sary to improve performance at the call center.
Top Management Support. Finally, to have a successful balanced scorecard, one
that truly drives a company’s strategy for success, it is crucial to have the full support
of top management. Unless managers perceive that the president and the CEO are
committed to the balanced scorecard approach and are giving careful consideration to
performance on the various measures, employees are not likely to focus their attention
on the balanced scorecard.
3
For more information on strategy maps, see Robert Kaplan and David Norton, “Having Trouble with Your
Strategy? Then Map It,” Harvard Business Review, September 2000, and Christopher Ittner and David Larcker,
“Coming Up Short on Nonfinancial Performance Measurement,” Harvard Business Review, November 2003.
Also, a great deal of information on strategy maps can be found on the web.
K e y s t o a S u c c e s s f u l B a l a n c e d S c o r e c a r d 473
Link to Practice
Brigham and Women’s Hospital Receives efforts affect patient care and satisfaction as well as the
Award for Its Balanced Scorecard overall financial health of our organization.”
The hospital’s nearly 900 employees have access
Balanced scorecards are not just for profit-oriented
to 35 metrics on the hospital’s overall scorecard. Also,
businesses. In 2005, Brigham and Women’s Hospital (a
many of the hospital’s clinical specialties have their own
major teaching hospital affiliated with Harvard Medical
scorecards.
School in Boston) received an award for its scorecard
According to the hospital’s website, measures in
at a business intelligence and data warehousing con-
their balanced score card in 2015 included: quality of
ference. According to Sue Schade, chief information
care, safety and infection control, patient satisfaction,
officer for the hospital, the scorecard allows staff at every
and financial performance.
level to see how their efforts, “affect patient care and
satisfaction as well as the overall financial health of the
organization. Staff at every level—from administrators Source: Business Wire, Inc., Brigham and Women’s Hospital
and division chiefs to individual physicians, nurses, and Honored in 2005 World Class Solutions Awards, Las Vegas,
other front-line clinicians—can see how their day-to-day October 26, 2005.
Decision Making
In the chapter, we saw that various financial performance measures can cause man-
Insight agers to make poor investment decisions. Evaluation in terms of growth in profit can
lead to overinvestment (making investments that should not be made because the
return is too low). Evaluation in terms of return on investment (ROI) can lead to under-
investment (not making investments that earn an adequate return) for business units
with high current ROIs. Arguably, evaluation in terms of economic value added (EVA)
influences managers to make good investment decisions since EVA increases when
managers take on projects that earn a return in excess of the cost of capital.

LEARNING OBJECTIVE 1 Explain the advantages LEARNING OBJECTIVE 2 Calculate and interpret
and disadvantages of decentralization, explain why return on investment (ROI), residual income (RI), and
companies evaluate the performance of subunits economic value added (EVA).
and subunit managers, and identify cost centers, Return on investment is calculated as the ratio of investment
profit centers, and investment centers. center income to invested capital. We measure income as net
Decentralization may lead to better information, faster operating profit after taxes (NOPAT), and we measure invested
responses to changing circumstances, and increased motiva- capital as total assets less noninterest-bearing current liabilities.
tion of managers. Decentralized organizations also may provide Managers who are evaluated in terms of profit know that it is
excellent training for future top-level executives. However, easy to increase profit by growing their company and taking on
decentralization may lead to costly duplication of activities and projects that earn a low return (i.e., overinvesting). In this case,
problems of goal congruence. profit increases, but the return is not adequate. If managers are
Companies evaluate the performance of subunits to iden- evaluated in terms of ROI and their operation is already earning
tify successful operations and areas needing improvement. a high ROI, they may be reluctant to take on projects that earn a
Companies evaluate subunit managers to influence the behavior return greater than the cost of capital but lower than the current
of the managers (because you get what you measure). ROI. In this case, the managers are underinvesting.
Finally, managers of cost centers are responsible only for Residual income is equal to the net operating profit after
controlling costs. Managers of profit centers are responsible for taxes of an investment center in excess of the profit required for
generating revenue as well as for controlling costs. Investment the level of investment. EVA is conceptually similar, although
center managers are responsible for income and the level of adjustments are made for accounting distortions such as
assets used to generate income. expensing R&D costs.
LEARNING OBJECTIVE 3 Explain the potential to a company’s strategy for success. Whereas financial measures
benefits of using a balanced scorecard to assess focus on past performance, the other dimensions assess what
performance, and discuss how a strategy map can the company is doing to create future shareholder value.
be used to communicate the linkages among the A strategy map is a diagram of the relationships, across the
four dimensions of a balanced scorecard, of the strategic objec-
measures in a balanced scorecard.
tives the company has developed to create shareholder value. By
A balanced scorecard assesses performance with respect to identifying these linkages, top management can ensure that its
four dimensions: financial, customer, internal processes, and strategy makes sense. The map also is a useful tool to commu-
learning and growth. The specific measures should be linked nicate the company’s strategy to employees.
Appendix
Learning TRANSFER PRICING

Objective A1 In many cases, subunits of a company “sell” goods or services to other subunits within the same
Discuss the use of company. For example, a university print plant may sell printing services to other university
market price, variable departments. Similarly, a car manufacturing company may have one division that produces cars
cost, full cost plus and another division that produces a variety of auto batteries. Most likely the car-producing divi-
profit, and negotiation sion will use auto batteries produced by the battery division.
in setting transfer The price that is used to value internal transfers of goods or services is referred to as a trans-
fer price. If the battery division transfers 10,000 batteries to the car division at a transfer price
prices.
of $15 per unit, the battery division will have revenue of $150,000. However, this revenue is only
recognized for internal reporting purposes. For external financial reporting purposes, a company
cannot recognize revenue on the sale of goods between responsibility centers within the firm,
because the revenue has not been realized.
Revenue, for financial reporting purposes, is realized when goods or services are sold to cus-
tomers outside the firm. Sales within a company are not “arm’s length” transactions (transactions
entered into by unrelated parties). Without this restriction, companies could inflate sales and
income by engaging in numerous unnecessary internal sales transactions.
In practice, a number of different approaches are taken to setting transfer prices. The primary
alternatives in practice are transfer prices based on: (1) market prices, (2) variable costs, (3) full cost
plus profit, and (4) negotiated prices. These alternatives are discussed next. Which of the transfer
prices is most appropriate depends on the circumstances. What is desired is a transfer price that
will lead the subunit managers to make decisions that maximize firm value. The transfer price that
motivates the best decisions is the opportunity cost of producing an item and transferring it inside
the company. Recall that an opportunity cost is the forgone benefit (increased cost) of selecting
one alternative over another.
MARKET PRICE AS THE TRANSFER PRICE

For purposes of discussion, let’s assume that the subunits buying and selling internally are divisions
of a company. In some cases, the producing division transfers a product internally to a buying
division and also sells the same product outside the firm. For example, the battery division of the
auto company may sell batteries to various auto supply companies and also “sell” batteries inter-
nally to the car-producing division.
When the product is sold outside the firm, a market price exists, and it can be used as the
transfer price. The external market price is an excellent internal transfer price because it allows
both the buying division and the selling division to be treated as “stand-alone,” independent com-
panies. Generally, market prices are perceived as fair and reasonable by both the buying and the
selling divisions. The buying division cannot complain that the transfer price is too high, because
it represents the same price the buying division would have to pay in the open market. For the
same reason, the selling division cannot complain that the transfer price is too low.
A p p e n d i x 475
In some cases, the selling division experiences cost savings from selling internally rather
than in an external market. For example, shipping costs may be reduced if the buying division is
close to the selling division. Advertising costs may also be lower, and reduced production costs
may be achieved if the selling division finds it easier to schedule production for internal sales than
for external sales. If cost savings exist, the market price should be reduced by the cost savings to
arrive at the transfer price.
Consider an example. Suppose the Processor division of Tectron Manufacturing produces a
microprocessor that it sells to a large number of companies at a market price of $300 each. The
Computer division of Tectron produces personal computers that utilize the microprocessor pro-
duced by the Processor division. By selling the microprocessor internally, the Processor division
saves approximately $2 per unit in shipping costs and $1 per unit in manufacturing costs. In this
case, a reasonable transfer price would be $297 (i.e., $300 market price less the $3 cost savings):
Market price $300

Savings due to reduced shipping costs (2)
Savings due to reduced manufacturing costs (1)
Adjusted transfer price $297
MARKET PRICE AND OPPORTUNITY COST

Earlier, we suggested that the best transfer price should be the opportunity cost of producing an
item and transferring it to the buying division. When a market price exits, it is a good transfer price
because it is equal to the opportunity cost.
Suppose the Sweet Company is composed of two divisions. The Syrup division produces corn
syrup, and the Candy division produces a variety of candies using corn syrup as a sweetener. The
Syrup division can sell corn syrup to outside buyers for $8 per gallon. If the market price is used as
a transfer price for sales of corn syrup from the Syrup division to the Candy division, the transfer
price, too, will be $8. But is $8 the opportunity cost of transferring the corn syrup from the Syrup
division to the Candy division?
An opportunity cost is the forgone benefit or increased cost of selecting one alternative over
another. What benefit is forgone by transferring corn syrup internally? The answer is that the $8
that could be earned selling the corn syrup externally is forgone when the corn syrup is transferred
to the Candy division. Thus, the opportunity cost is equal to the market price of the transferred
product.
To illustrate, suppose that 1 gallon of syrup is used to produce every 10 pounds of rock
candy manufactured by the Candy division. The rock candy sells for $50 for a 10-pound container.
Variable costs are as follows:
10-Pound Container
Variable production cost excluding corn syrup $43

Transfer price of corn syrup 8
Total variable cost per container $51
In this situation, because the candy sells for $50 for a 10-pound container, the Candy division has
a negative contribution margin of $1 per container and will not be willing to produce rock candy.
Now suppose the Candy division argues that if the transfer price of corn syrup is reduced to
$5 (the variable cost of producing corn syrup), its variable costs will only be $48, and rock candy
will have a positive contribution margin. Should the transfer price be lowered? The answer is no.
The income of the Syrup division and the total income of the Sweet Company will be reduced
if the Candy division is subsidized by a transfer price lower than the market price. If the Candy
division cannot earn a profit paying a transfer price equal to what it would pay for syrup in the
open market, then consideration should be given to eliminating the product.
The effect on the company’s contribution margin of lowering the transfer price and transfer-
ring the syrup inside to the Candy division is presented in Illustration A12-1. If the transfer price
Illustration A12-1 Sell Syrup at Market Price

Analysis of lowering the Contribution Margin Contribution Margin
transfer price below the of Syrup Division of Candy Division Contribution Margin
market price per Gallon of Syrup per 10-Pound Container of Company
Selling price $ 8 P
Variable cost (5) RU
SY
a
Cont. margin $3 -0- $ 3
Transfer Syrup to Candy Division at $5

Contribution Margin Contribution Margin
of Syrup Division of Candy Division Contribution Margin
per Gallon of Syrup per 10-Pound Container of Company
Transfer price $ 5 Selling price $50

Variable cost (5) Own variable costs (43)
Cont. margin $-0- Transfer price (5)
Cont. margin $ 2 $ 2
a Contribution margin is zero because Candy division will not demand any corn syrup at a transfer price of $8
is the market price of $8, the Candy division will not find production of rock candy profitable.
No syrup will be demanded by the Candy division, and all syrup will be sold in the marketplace.
In this case, the Syrup division will earn $3 of contribution margin on every gallon of syrup, the
Candy division will earn no contribution margin, and the contribution margin of the company
as a whole will be $3. Alternatively, if the syrup is transferred to the Candy division at a transfer
price of $5, the Syrup division will earn no contribution margin because the transfer price will be
equal to the variable cost of producing the syrup. For each gallon of syrup, however, the Candy
division can produce a 10-pound container of rock candy that sells for $50. The Candy division
will have $43 of variable costs in addition to the $5 transfer price it must pay for each gallon of
syrup. Thus, the Candy division will earn a contribution margin of $2. The contribution margin
to the company will also be $2 because the Syrup division will have a contribution margin of
zero. Note that although the Candy division is certainly better off with a transfer price of $5, the
Syrup division is worse off, and the company as a whole is worse off by $1 for each gallon of syrup
transferred at the $5 transfer price.
VARIABLE COST AS THE TRANSFER PRICE

In some cases, the transferred product is unique and is not sold by the producing division in the
open market. Obviously, no market price exists, and some other transfer price must be chosen.
The variable cost of producing the transferred good may be the best transfer price in this situation.
The reason for selecting the variable cost of production as the transfer price is that it conveys
accurate opportunity cost information. When no external market exists, the opportunity cost of
producing and selling an item internally is simply the variable costs of producing the item.4 Each
time an additional unit is produced, the company must incur additional costs equal to the variable
cost of production.
Again, knowing the opportunity cost of the transferred product can lead the Buying divi-
sion to make well-informed decisions. For example, suppose the Buying division is considering
a request for a special order from a customer. To produce the product, the Buying division must
use a component that will be supplied by another division of the firm (the Selling division). In
4
This assumes that the Selling division has excess capacity. If I does not, the opportunity cost must include the
income lost on items that cannot be produced when capacity is used to produce goods for internal transfer.
A p p e n d i x 477
addition to the transfer price, the Buying division will incur variable production costs of $50 per
unit. Further, the Selling division will incur variable costs of $25 in producing the component.
What is the minimum price that could be accepted for the special order? The answer is $75, which
is equal to the $50 of variable cost incurred by the Buying division plus the $25 of variable cost
incurred by the Selling division. Any price above $75 will increase the overall contribution margin
of the company and its income.
But suppose the transfer price is set at an amount greater than the variable cost of the
Selling division. For example, suppose the transfer price is set at $40. In this case, the manager
of the Buying division will perceive that the minimum acceptable selling price for the special
order is $90, not $75. The $90 amount is equal to the $40 transfer price paid for each unit by
the Buying division plus the other variable costs incurred by the Buying division, which are
equal to $50. The special order would be turned down by the manager of the Buying division at
prices between $75 and $90, at a definite loss of income for the company as a whole. A failure
to know the real opportunity cost of production may thus lead to poor decisions by the Buying
division manager.
FULL COST PLUS PROFIT AS THE TRANSFER PRICE

A very significant problem with using variable cost as the transfer price is that the Selling divi-
sion cannot earn a profit on production of the transferred product. Thus, use of variable cost as
a transfer price may not be acceptable to division managers. For this reason, many companies
add a profit margin to the full cost of an item and use the resulting amount as the transfer price.
For example, suppose the variable cost of producing an item for internal sale to a Buying
division is $100 per unit. Further, 1,000 units are expected to be transferred in the coming
year, and fixed costs per year will amount to $200,000. The fixed costs relate to depreciation
on equipment that is not currently being used to capacity. In this case, the full cost per unit is
$300 ($100 variable cost and $200 fixed cost). At a transfer price of $300, the Selling division
will just break even on the internal transfer. However, suppose the company utilizes a transfer
pricing policy whereby the transfer price is equal to full cost plus 10 percent of full cost. In this
case, the transfer price will be $330, and the Selling division will earn income of $30 on each
item produced.
Although full cost plus profit may be more acceptable as a transfer price to division managers,
the transfer price may not measure the opportunity cost of producing the transferred product.
As we saw earlier, this can result in decisions that do not maximize the profitability of the whole
company. Suppose the Buying division of the company just described must incur $400 of variable
costs in addition to the transfer price. The market price for the item produced by the Buying
division is $690. The Buying division will not continue producing the product unless it makes a
positive contribution toward covering its fixed costs. With a transfer price of $330, the contribu-
tion margin faced by the Buying division is a negative $40 ($690 selling price less variable cost of
$400 and transfer price of $330). Thus, the Buying division will be inclined to drop the product.
However, the product does, in fact, make a positive contribution to firm income. The selling price
of $690 is greater than the variable cost of the Buying division ($400) plus the variable cost of the
Selling division ($100) by $190. Thus, the company as a whole is actually better off by $190 for
each unit sold:
Transfer Price Equals Transfer Price Equals

Full Cost Plus Profit Variable Cost
Selling price of final product $690 $690

Less: variable cost of the
Buying division except
for the transfer price 400 400
Less: transfer price 330 100
Contribution margin of
Buying division ($ 40) $190
NEGOTIATED TRANSFER PRICES

As discussed at the start of this chapter, one of the benefits of decentralization is that m
anagers who
are delegated significant decision-making responsibility tend to be highly motivated. To encourage
the sense of autonomy, some companies allow division managers to negotiate a transfer price. This
presents the subunit managers with the same situation faced by an independent business that
must negotiate a price for specialized items. However, the resulting transfer price may reflect the
relative negotiating skills of the subunit managers and fail to reflect the underlying opportunity
cost associated with producing goods and transferring them internally.
Link to PRACTICE
Transfer Pricing at Starbucks Switzerland, which has a low corporate tax rate, rather
than a country with a higher rate. European regulators
At Starbucks, the world’s largest coffee chain, all the
opened an investigation of Starbucks’ management of
coffee it uses worldwide is bought by a Starbucks’ sub-
international taxes in 2014.
sidiary in Switzerland. Although the coffee is never trans-
ported through Switzerland, the subsidiary then sells the
Source: Tom Fairless, “Huge Profit Stokes Concerns Over
coffee to Starbucks’ units operating in other countries at Starbucks’s Tax Practices in Europe,” The Wall Street Journal,
a transfer price including a 20 percent markup. That way, April 6, 2015. Available at: http://www.wsj.com/articles/
the profit related to the 20 percent markup gets taxed in starbuckss-tax-practices-draw-european-scrutiny-1428363189.
TRANSFER PRICING AND INCOME TAXES

IN AN INTERNATIONAL CONTEXT
When goods are transferred between profit centers in different countries, the income tax situa-
tions in the countries may create incentives for relatively high or relatively low transfer prices. For
example, suppose the tax rate in Country A is 10 percent, whereas the tax rate in Country B is
40 percent. Holding everything else constant, this creates an incentive to have high transfer prices
when goods are transferred from a profit center in Country A to a profit center in Country B. With
this approach, the profit center in Country A will have relatively high income (which is taxed at
a low rate), and the profit center in Country B will have relatively low income (which is taxed at
a high rate). Thus, overall taxes of company income for the two profit centers will be reduced. If
goods were to be transferred from a profit center in Country B to a profit center in Country A,
there would be an incentive for a relatively low transfer price. The Internal Revenue Service in the
United States and the taxing authorities in other countries are aware of these incentives and try
to make sure that transfer prices are not unreasonably high or low in response to the incentives
created by differences in income tax rates between countries.
Review Problem 1
Merlin Appliances, founded by Morgan D. Edwards in 1976, is a closely held company that
operates five stores in Michigan selling refrigerators, stoves, washers and dryers, and other
household appliances. The company’s stock is owned by various members of the Morgan D.
Edwards family, and five family members serve on the board of directors. The president and
CEO of Merlin is David Bell. David, who is not a family member, was hired in 2016 and is
responsible for all day-to-day company decisions. He reports to Brandon Edwards, who is
chairman of the board.
At the end of fiscal 2017, David was asked to prepare a brief memo to the board reviewing
the company’s performance. A copy of the memo is presented below along with comparative
financial statements. A board meeting is scheduled for early February at which time the board
will review company performance and David’s compensation including his performance bonus
for 2017.
January 26, 2018
TO: Board of Directors of Merlin Appliances

FROM: David Bell, President and CEO
SUBJECT: Financial performance in fiscal 2017
At the start of 2017 we discussed the fact that the market for appliances was likely to be soft due to
economic conditions in the state of Michigan. Specifically, at the start of 2017, unemployment was
high and several major companies had made plans for substantial job cuts. In light of this, I am
very happy to report that we have had an outstanding year. Sales have increased by 7.68 percent,
and profit is up by 14.11 percent.
How was this accomplished? Here’s a brief outline of the three strategies we employed—I’ll
review them in detail at the February 7 board meeting.
1. Market research indicated that sales could be increased if we held the line on prices,
displayed a wider selection of items at each store, and had more items available in our
warehouse so that we could offer 1- or 2-day delivery. This strategy was implemented, with
obvious good results, in early 2017.
2. We adjusted our quarterly sales events. In addition to offering our normal discounts
at these events, we also offered terms with no payments (and no interest charges) for
6 months. This strategy was successful in attracting customers who might have delayed
purchases in the current year.
3. We retired all short-term and all long-term debt. As you know, we had cash reserves of
approximately $1.6 million at the end of 2016. (The money had been accumulated in
anticipation of expansion, but expansion plans have been put on hold.) Paying down debt
reduces company risk and appears to be a good use of the funds.
I also want to note that our exceptional performance in fiscal 2017 could not have been achieved
without the support of the 138 Merlin team members whose hard work and dedication to the
company’s success is evident in every sale and every delivery!
Finally, as you know, we paid out approximately $1,000,000 in dividends in fiscal 2017—no
dividends were paid in 2015, and dividends in 2016 were only $500,000.
See you on February 7.

Comparative Income Statements 2017 2016 % Change
Sales $27,659,548 $25,687,240 7.68%

Less:
Cost of sales 19,361,684 17,981,068
Selling, general and administrative expense 5,531,910 5,137,448
Interest expense — 144,711
Income before income taxes $ 2,765,954 $ 2,424,013
Less income taxes 968,084 848,405
Net income $ 1,797,870 $ 1,575,608 14.11%
Comparative Balance Sheets 2017 2016
Assets
Cash and cash equivalents $ 147,636 $ 1,586,250
Accounts receivable 2,990,221 2,568,724
Inventory 2,420,211 1,997,896
Prepaid expenses 47,399 45,265
Total current assets 5,605,467 6,198,135
Land 1,342,350 1,342,350
Building, furniture, fixtures (net) 8,438,088 8,523,321
Total noncurrent assets 9,780,438 9,865,671
Total assets $15,385,905 $16,063,806
Liabilities
Accounts payable $ 210,240 $ 199,790
Accrued liabilities 57,010 45,685
Taxes payable 60,690 49,321
Current portion of long-term debt — 188,754
Total current liabilities 327,940 483,550
Long-term debt — 1,258,360
Total liabilities 327,940 1,741,910
Common stock 5,079,315 5,079,315
Retained earnings 9,978,650 9,242,581
Total stockholders’ equity 15,057,965 14,321,896
Total liabilities and stockholders’ equity $15,385,905 $16,063,806
Req u i red
a. Evaluate performance in fiscal 2017 and 2016 in terms of economic value added
(EVA). Assume a weighted average cost of capital of 15 percent in 2017 and 14 percent
in 2016. Briefly comment on whether this evaluation supports a significant bonus for
David Bell.
b. Suppose that the entire increase in net operating profit after taxes in 2017 is due to having
more inventory and “no payments or interest” for 6 months, which led to an increase in
accounts receivable. Evaluate the impact of these strategies in terms of their impact on EVA
using a 15 percent cost of capital.
An s w er
a.
2017 2016
Net income $ 1,797,870 $ 1,575,608

Add interest 144,711
Less taxes related to interest — (50,649)
NOPAT $ 1,797,870 $ 1,669,670
2017 2016
Investment
Total assets $15,385,905 $16,063,806
Less NIBCL:
Accounts payable (210,240) (199,790)
Accrued liabilities (57,010) (45,685)
Taxes payable (60,690) (49,321)
Investment 15,057,965 15,769,010
Cost of capital 0.15 0.14
Required NOPAT 2,258,695 2,207,661
EVA (NOPAT - Required NOPAT) ($ 460,825) ($ 537,991)
Note that, alternatively, NOPAT could have been calculated as:
2017 2016
Income before taxes $ 2,765,954 $ 2,424,013

Add interest –0– 144,711
2,765,954 2,568,724
Less taxes 968,084 899,053
NOPAT $ 1,797,870 $ 1,669,671
The slight difference between the calculation here and above for 2016 is due to rounding.
It does not appear that a substantial bonus is warranted since EVA is negative in 2017
indicating that shareholder value has actually declined. This follows because net operating
profit is less than the level required given the investment in the company. Note that EVA was
also negative in 2016. Also note that EVA and residual income are identical in this problem
since there are no adjustments for “accounting distortions.”
b. The company increased inventory. And the policy of no payments or interest for 6 months
increased accounts receivable. Together, these two items increased investment by $843,812.
With a 15 percent cost of capital, NOPAT would need to increase by $126,572 to break even.
In actuality, NOPAT increased by $128,200 for a net benefit of $1,628. While positive, this
rather small amount is hardly in line with the financial gains claimed in David Bell’s memo:
Increase in inventory ($2,420,211 - $1,997,896) $422,315
Increase in receivables ($2,990,221 - $2,568,724) 421,497
Increase in investment 843,812
Cost of capital × .15
Required additional NOPAT 126,572
Less actual additional NOPAT ($1,797,870.00 - $1,669,670.15) 128,200
Net benefit $ 1,628
Review Problem 2
Ransom Apparel is a men’s casual clothing company. The company has set aggressive targets
in both sales growth and return on investment for the coming year. The company’s strategy for
achieving these goals includes a campaign aimed at building brand recognition. It is also seeking
improvements in product quality and on-time delivery from manufacturers in China and Vietnam
as well as expansion of the product line to include three styles of jeans, which will complement
the company’s line of silk shorts and slacks. A number of limited edition items is also part of the
company’s strategy.
To bolster its brand, the company plans to provide limited edition items to celebrities in
Los Angeles, San Diego, Chicago, and New York. The company hopes that the celebrities will be
seen around town and in fashion magazines such as GQ.
Req u i red
Based on this limited information, provide two objectives and two measures for each perspective
of the balanced scorecard. Using a strategy map, show how the objectives are related across the
four dimensions of a balanced scorecard. Note that a number of alternative measures could be
appropriate—the ones provided in the answer are simply examples of such alternatives.
An s w er
Measures for the various objectives are shown below in the strategy map. The logic behind the
strategy map is:
1. Development of limited edition items should improve the odds of celebrities wearing the
company’s products and being highlighted in trend-setting magazines such as GQ.
2. Development of a new line of jeans should lead to an increase in sales as the product line is
expanded.
3. Improved on-time delivery from suppliers should increase sales since the company is more
likely to meet its own delivery schedules to customers.
4. Improved product quality should improve ROI since the company will have lower costs
associated with returns.
5. If trend-setters wear the brand, brand recognition is expected to improve.
Financial Increase sales Percent increase in sales
Improve ROI ROI
Customer Improve brand recognition Percent of target audience

who recognize brand
Brand worn by trend-setters Number of photos of celebrities
wearing brand in trendy
magazines
Internal Improve product quality Percent reduction in

Processes defect rate from plant
Improve on-time delivery Percent of supplier
by suppliers orders on time
Learning Develop new line of jeans New jeans developed

and Growth
Develop limited edition items Limited editions developed
Key Terms Balanced scorecard (468) Noninterest-bearing current Residual income (RI) (463)
Cost center (455) liabilities (NIBCL) (459) Responsibility centers (455)
Decentralized organization (452) Net operating profit after taxes Return on investment
Economic value added (NOPAT) (458) (ROI) (457)
(EVA) (464) Profit center (456) Strategy map (471)
Investment center (456) Profit margin (458) Transfer price (Appendix, 474)
Investment turnover (458) Relative performance
Lack of goal congruence (453) evaluation (456)

1. Which of the following is not a reason for having 7. Investment centers often are evaluated using:
decentralized organizations? a. Time and motion studies.
a. Better information at the local level leads to superi- b. Return on investment.
or decisions. c. Residual income/EVA.
b. Goal congruence is enhanced. d. Both (b) and (c) are used.
c. Quicker response to changing circumstances.
8. Which of the following is a problem in using return on
d. Increased motivation of managers. investment to evaluate managers?
2. An investment center is responsible for: a. Managers of investment centers with high ROIs
a. Investing in long-term assets. may not invest in some projects with returns greater
b. Controlling costs. than the required rate of return.
c. Generating revenues. b. Managers may overinvest in high-ROI projects.
d. All of these answer choices are correct. c. Managers’ morale may suffer from being
evaluated.
3. A cost center is responsible for:
a. Investing in long-term assets.
b. Controlling costs. 9. Which of the following is a true statement regarding the
evaluation of an investment center?
c. Generating revenues.
a. Return on investment may be high because of old
d. All of these answer choices are correct.
equipment that is fully depreciated.
4. Use of profit as a performance measure: b. Residual income does not take into account the
a. May lead to overinvestment in assets. level of investment in fixed assets.
b. Is appropriate for an investment center. c. Return on investment does not take into account
c. Is appropriate as long as profit is calculated using the level of investment in fixed assets.
GAAP. d. None of these answer choices is correct.
d. Encourages managers to finance operations with 10. (Appendix) The transfer price that motivates the best
debt rather than equity. decisions is one that measures:
5. Cost centers are often evaluated using: a. The full cost of goods produced.
a. Variance analysis. b. The opportunity cost of producing and transferring
b. Operating margin. an item.
c. Return on investment. c. The selling division’s variable cost.
d. Residual income. d. None of these answer choices is correct.
6. Profit centers often are evaluated using:
a. Investment turnover. Answers to Self-Assessment
b. Income targets or profit budgets. 1. b 2. d 3. b 4. a 5. a 6. b
c. Return on investment. 7. d 8. a 9. a 10. b
d. Residual income.
QUESTIONS 1. List four advantages related to decentralization of a firm’s operations.

2. List two disadvantages associated with decentralization of a firm’s operations.
3. What is empire building in a managerial context?
4. How could costly duplication of activities occur in a decentralized operating environment?
5. Discuss goal congruence and how it impacts the decision to decentralize.
6. Distinguish among cost centers, profit centers, and investment centers.
7. What is the difference between residual income and EVA?
8. What is the problem with using only financial measures of performance?
9. Provide two measures for each perspective of a balanced scorecard.
10. (Appendix) Explain the advantages of using market price as a transfer price.
Exercises EXERCISE 12-1. [LO 2] Explain why, in the calculation of EVA, the profit measure used (NOPAT)
excludes interest expense.
EXERCISE 12-2. [LO 2] Write a paragraph explaining why, in the calculation of a company’s
EVA, noninterest-bearing current liabilities are subtracted from total assets to determine
investment.
EXERCISE 12-3. Why Firms Decentralize [LO 1] The lyndstrom Glass Company is a manufac-
turer of automotive glass and glass products used in the home. Discuss the advantages of forming
two divisions (an Automotive division and a Home Products division) and allowing the division
managers substantial decision-making autonomy.
EXERCISE 12-4. Responsibility Centers and Performance Measures [LO 1] Department

managers at Nadaire Department Stores are allowed considerable discretion in sourcing and
pricing products based on local tastes and competition. They are also responsible for staffing
their departments.
Req u i r ed
Suggest two financial performance measures that would be useful in evaluating the performance
of department managers at Nadaire Department Stores.
EXERCISE 12-5. Responsibility Centers [LO 1] A major software company has established cus-
tomer service centers in India, Ireland, and Israel to provide support to its U.S. customers with
foreign operations. The prices that the company charges for software reflect estimated costs in
operating the centers (i.e., there is no separate charge for service).
Req u i r ed
How should these centers be organized: as cost centers, profit centers, or investment centers?
Support your answer.
EXERCISE 12-6. Responsibility Centers [LO 1] Samson Software operates a training facility that
offers classes in the use of its software products. Historically, the classes have been offered at a
modest charge that covers the cost of the instructor’s salary but not overhead related to the training
facility (e.g., janitorial cost, utilities, rent, and administration).
Latoya Johnsen had recently been named director of customer training, and she will be given
considerable freedom in operating the training facility and in marketing classes. Top management
at Samson, however, has told Latoya that they want her operation to earn a before-tax profit of at
least $500,000.
Req u i red
Discuss the wisdom of requiring the training operation to earn a profit.
EXERCISE 12-7. Calculating ROI [LO 2] Davenport Mills is a division of Iowa Woolen Products.
For the most recent year, Davenport had net income of $20,000,000. Included in income was in-
terest expense of $1,400,000. The operation’s tax rate is 40 percent. Total assets of Davenport Mills
are $235,000,000, current liabilities are $52,000,000, and $36,000,000 of the current liabilities are
noninterest bearing.
Req u i red
Calculate NOPAT, invested capital, and ROI for Davenport Mills.
EXERCISE 12-8. Calculating ROI [LO 2] For fiscal year 2017, LaundryMate Products had income
as follows:
Sales $55,000,000
Less:
Cost of goods sold 38,400,000
Selling and administrative expense 5,700,000
Interest expense 1,000,000
Income before taxes 9,900,000
Less income taxes 3,465,000
Total assets were $97,000,000, and noninterest-bearing current liabilities were $3,200,000. The
company has a required rate of return on invested capital equal to 10 percent.
Req u i red
Calculate NOPAT, invested capital, and ROI for LaundryMate Products, and comment on the
company’s profitability.
EXERCISE 12-9. Calculating Residual Income [LO 2] For fiscal year 2018, K
atherine’s Department
Store had net income of $6,000,000. Interest expense was $2,250,000, and the c ompany’s tax
rate on income was 40 percent. Total assets were $80,000,000, and n oninterest-bearing current
liabilities were $6,700,000. The company’s cost of capital (required rate of return) is 10 percent.
Req u i red
Calculate NOPAT, invested capital, and residual income for Katherine’s Department Store and
comment on the company’s profitability.
EXERCISE 12-10. Evaluating Investment Centers with Residual Income [LO 2] Lakeside Hos-
pital is a division of Superior Healthcare that is organized as an investment center. In the past year,
the hospital reported an after-tax income of $3,500,000. Total interest expense was $1,650,000, and
the hospital’s tax rate was 35 percent. Hospital assets totaled $35,000,000, and noninterest-bearing
current liabilities were $11,400,000. Superior has established a required rate of return equal to
18 percent of invested capital.
Req u ir ed
Calculate the residual income/EVA of Lakeside Hospital.
EXERCISE 12-11. Evaluating Investment Centers; ROI versus RI [LO 2] Consider the
following data, which relate to the two divisions of McIntyre Products:
Division 1 Division 2
Total assets $69,000,000 $23,000,000

Noninterest-bearing current liabilities 4,500,000 2,300,000
NOPAT 12,000,000 5,900,000
Required rate of return 11% 10%
Req u i r ed
Compare the two divisions in terms of return on investment and residual income. In the past year,
which division has created the most wealth for McIntyre shareholders?
EXERCISE 12-12. Overinvestment and Underinvestment [LO 2] Consider two companies:

Quantum Products and Aquafin Products. Senior managers at Quantum Products are evaluated
in terms of increases in profit. In fiscal 2017, Quantum Products had a net operating profit after
taxes of $4,600,000 and invested capital of $26,000,000. In fiscal 2018, the company had net op-
erating profit after taxes of $6,000,000 and invested capital of $47,500,000. Senior managers at
Aquafin Products are evaluated in terms of ROI. In fiscal 2018, ROI was 15 percent while the cost
of capital was only 10 percent. Near the end of fiscal 2018, managers had an opportunity to make
an investment that would have yielded a return of 14 percent. However, the senior managers did
not support making the investment.
Req u i r ed
a. Explain why the senior managers at Quantum Products have an incentive to overinvest.
b. Explain why the senior managers at Aquafin Products have an incentive to underinvest.
EXERCISE 12-13. Adjusting NOPAT and Adjusting Investment in the Calculation of EVA [LO 2]
The following income statements and other information are available for the Schneider Company:
2017 2016 2015
Sales $380,000,000 $250,000,000 $190,000,000

Gross margin 170,000,000 130,000,000 99,000,000
Less:
Selling and administrative costs 27,500,000 24,750,000 19,580,000
Research and development 15,600,000 12,400,000 9,450,000
Income from operations 126,900,000 92,850,000 69,970,000
Less taxes on income 38,070,000 27,855,000 20,991,000
Net income $ 88,830,000 $ 64,995,000 $ 48,979,000
Total assets $715,000,000 $665,000,000 $441,000,000
Noninterest-bearing current liabilities 14,000,000 11,300,000 9,880,000
Cost of capital 12% 12% 12%
Req u i r ed
Calculate EVA for 2017. Assume that for purposes of calculating EVA, the company capitalizes
research and development expenditures and amortizes them over 3 years, including the year they
are incurred. For external reporting purposes, research and development is expensed in the year
incurred, as indicated in the income statements above.
EXERCISE 12-14. Balanced Scorecard [LO 3] Some advocates of the balanced scorecard have
argued that managing a company with just financial performance measures is like driving a car
and just looking in the rearview mirror. That’s why they recommend customer, internal processes,
and learning and growth measures that, they believe, focus attention on what a company is doing
today to create future value.
P r o b l e m s 487
Req u i red
Explain the analogy between financial measures and driving using just the rearview mirror.
EXERCISE 12-15. Customer-Focused Measures for a Balanced Scorecard [LO 3] Major’s

itness Club operates a 20,000-square-foot facility in Dallas. For the coming year, the company is
F
considering development of a balanced scorecard.
R equ ired
Help the company by identifying three customer-focused measures that can be used on the bal-
anced scorecard. Discuss the key items related to a successful balanced scorecard.
EXERCISE 12-16. (Appendix) Transfer Pricing in Healthcare, Market Price [LO A1] Paramount
Medical Services has two outpatient clinics and a pathology laboratory, which are organized as
separate profit centers. When the pathology laboratory conducts tests ordered by the clinics, the
clinics are charged the basic market price of the tests. The managers of the clinics object to this
practice and argue that because they are all part of the same company, they should be charged for
the cost of the procedures rather than market price.
R equ ired
Support the use of market prices or cost-based prices for charging clinics for tests performed by
the pathology laboratory.
EXERCISE 12-17. (Appendix) Transfer Pricing, Full Cost Plus Profit [LO A1] The Champion
Chemical Company has a number of divisions that produce and market paints, varnishes, and
other chemical products. The company also has a small plant that manufactures metal containers
for the divisions’ various products. The plant, which has substantial excess capacity, is organized
as a cost center and transfers containers to the divisions at cost.
Eduardo Sanchez, the container plant manager, has approached the corporate executive com-
mittee with the suggestion that the plant he administers be organized as a profit center. This would
be accomplished by changing the transfer price to be equal to full cost plus a markup of 10 percent.
R equ i red
Comment on Eduardo’s suggestion. Could his proposal lead to suboptimal decisions from the
standpoint of the company as a whole?
Problems PROBLEM 12-1. Cost Centers and Performance Measures [LO 1, 3] Magellan Materials man-
ufactures metal and plastic gutters for use in commercial and residential construction. Production
occurs in two separate plants. Distribution is from a central warehouse, and there is a centrally
managed sales office. Both production plants are currently treated as cost centers, and their bud-
gets are prepared in close consultation with the central office. Analysis of standard cost variances
is used as a control mechanism in the two plants.
R equ i red
a. Explain how budgets and variance analysis provide a means of controlling cost in the produc-
tion plants.
b. List four nonfinancial performance measures that plant managers can use to assess the opera-
tions they control.
PROBLEM 12-2. Investment Centers and Performance Measures [LO 1, 2] LEO Corporation
has five divisions, each of which is managed by a divisional president who reports to the chief
executive officer of LEO. LEO is decentralized, and divisional presidents are granted authority to
make investments under $3,000,000 without prior approval by the CEO.
Req u i red
Suggest three financial performance measures that could be used to evaluate the divisions and the
divisional presidents.
PROBLEM 12-3. Return on Investment [LO 2] Consider the following information for McKinley
and Son:
12/31/2017 12/31/2018
Total assets $55,000,000 $62,000,000

Net income 3,300,000 3,426,000
Interest expense 726,000 770,000
Tax rate 35% 35%
Req u i r ed
a. Evaluate the company in terms of ROI.
b. While income has increased in fiscal 2018, is it clear that the company’s performance has
improved?
PROBLEM 12-4. Residual Income/Economic Value Added [LO 2] Consider the following
information for Executive Electronics:
12/31/2017 12/31/2018
Total assets $12,650,000 $12,100,000

Noninterest-bearing current liabilities 550,000 572,000
Net income 770,000 880,000
Interest expense 2,310,000 330,000
Tax rate 40% 40%
Req u i r ed
a. Evaluate the company in terms of residual income (RI), which is equivalent to EVA since there
are no adjustments for accounting distortions.
b. While income has increased in fiscal 2018, is it clear that the company’s performance has
improved?
c. (Optional) Explain why the required rate of return increased in fiscal 2018. (Hint: Note that
while total assets are approximately the same in both years, interest expense has declined sharply
in 2018.)
PROBLEM 12-5. Return on Investment, Effect of Depreciation [LO 2] The chief operating
officer of the Wisconsin Corporation is considering the effect of depreciation on the company’s
ROI. In the most recent year, net operating profit after taxes was $35,000,000 and investment
(total assets of $460,000,000 less noninterest-bearing current liabilities of $20,000,000) was
$440,000,000.
Req u i r ed
a. Assuming that total assets will decline each year by 6 percent due to depreciation of plant and
equipment but NOPAT will remain constant, calculate ROI for each of the next 5 years.
b. Explain why evaluation in terms of ROI may lead managers to delay purchases of equipment
that, in the long run, will be needed to remain competitive.
P r o b l e m s 489
PROBLEM 12-6. Return on Investment, Profit Margin, and Investment Turnover [LO 2] Con-
sider the following information for HandyCraft Stores for 2017 and 2018:
2017 2018
Total assets $59,500,000 $56,430,000

Net income 3,650,000 4,950,000
Interest expense 2,420,000 2,975,000
Sales 66,000,000 96,250,000
Tax rate 40% 40%
Req u i red
a. Compute ROI for both years.
b. Break ROI down into profit margin and investment turnover.
c. Comment on the change in financial performance between 2017 and 2018.
PROBLEM 12-7. ROI and EVA [LO 2, 3] ELN Waste Management has a subsidiary that disposes
of hazardous waste and a subsidiary that collects and disposes of residential garbage. Information
related to the two subsidiaries follows:
Hazardous Residential
Waste Waste
Total assets $15,300,000 $87,000,000

Net income 1,870,000 6,600,000
Interest expense 1,375,000 8,030,000
Tax rate 40% 40%
Req u ir ed
a. Calculate ROI for both subsidiaries.
b. Calculate EVA for both subsidiaries. Note that since no adjustments for accounting distortions
are being made, EVA is equivalent to residual income.
c. Which subsidiary has added the most to shareholder value in the last year?
d. Based on the limited information, which subsidiary is the best candidate for expansion? Explain.
PROBLEM 12-8. EVA [LO 2] Atomic Electronics is considering instituting a plan whereby m anagers
will be evaluated and rewarded based on a measure of economic value added (EVA). Before adopting
the plan, management wants you to calculate what EVA will be in 2018, based on financial forecasts
for 2018 and prior financial data.
Fiscal Forecast
2018
Total assets $ 60,500,000

Noninterest-bearing current liabilities 23,100,000
Sales 110,000,000
Net income 6,050,000
Interest expense 1,320,000
Research and development 2,640,000
Tax rate 35%
Cost of capital 15%
Research and development expenditures in 2016 and 2017 were $1,200,000 and $2,100,000,
respectively. In calculating EVA, prior research and development will be capitalized and amortized
assuming a 3-year life (i.e., one-third will be expensed in the year incurred, and two-thirds will be
capitalized and expensed in the following 2 years).
Req u i red
a. Explain why it is important to capitalize research and development if managers are to be
rewarded based on EVA.
b. Calculate forecasted EVA for 2018.
c. Will management be likely to support use of EVA as a financial performance measure?
PROBLEM 12-9. EVA and Control of the Investment in Company Assets [LO 2] Poseidon
Electronics operates 10 stores in Washington, Oregon, and California, selling consumer electron-
ics including stereo equipment and home theater systems. The following financial information is
available for 2018 and 2017:
2018 2017
Income from operations $ 990,000 $ 935,000

Net income 590,040 557,700
Total assets 4,400,000 3,850,000
Noninterest-bearing current liabilities 319,000 308,000
Tax rate 40% 40%
Cost of capital 12% 12%
Req u i r ed
a. Although net income has increased by 6 percent, a shareholder evaluating the company’s finan-
cial performance asserts that, in spite of the increase, financial performance has deteriorated in
2018. Support this assertion with appropriate calculations of EVA. Note that no adjustments are
needed for accounting distortions.
b. Management asserts that the increased investment in the company’s assets was clearly war-
ranted since income increased. Briefly evaluate this assertion.
c. Briefly explain why evaluation in terms of EVA will drive managers to focus on carefully eval-
uating the investment in assets while this will not be the case if managers are evaluated in terms
of growth in profit.
PROBLEM 12-10. Economic Value Added and the Balanced Scorecard [LO 2, 3] The Spectrum
Book Company has two divisions: The Brick and Mortar division sells books through more than
100 bookstores throughout the United States; the Internet division was formed 18 months ago and
sells books via the Internet. Data for the past year are:
Brick and Mortar Internet

Division Division
Total assets $162,000,000 $15,480,000

Interest expense 1,260,000 418,500
Net income (loss) 27,810,000 (1,125,000)
Tax rate 40% –0–
Cost of capital 10% 12%
Req u i r ed
a. Evaluate the two divisions in terms of economic value added (EVA).
b. Explain why it might be better to evaluate the Internet division in terms of a balanced scorecard
rather than just using EVA.
P r o b l e m s 491
c. Consider the customer and internal processes dimensions of the balanced scorecard. Suggest
two measures for each dimension that would be appropriate for the Brick and Mortar division and
two measures for each dimension that would be appropriate for the Internet division.
d. A strategy map diagrams the relationship across the dimensions of the balanced scorecard.
Identify the potential links between the customer and internal processes dimensions you identi-
fied in part c.
PROBLEM 12-11. Growth in Profit and Overinvestment [LO 2] Consider the following data
related to the financial performance of Royal Company:
000s 2015 2016 2017 2018
Net income $ 3,750 $ 4,313 $ 5,088 $ 6,105

% change in income –0– 15% 18% 20%
Total assets $37,500 $47,925 $63,750 $87,500
Between 2015 and 2018, income increased by 63 percent, showing a significant increase in income
each year. In light of this performance, the board of directors has awarded large bonuses to senior
executives. However, the stock price has fallen from $73 per share in 2015 to $56 per share at the
end of 2018.
Req u i r ed
a. Calculate ROI for each year. To simplify the calculation, assume that there is no interest expense
and there are no noninterest-bearing current liabilities (thus, net income equals NOPAT and total
assets are a reasonable measure of investment).
b. Explain why the stock price has dropped and why rewarding managers based on increases in
profit can lead to overinvestment.
c. Calculate economic value added for 2015 to 2018, using a cost of capital (required return) of
9.5 percent. Does performance measured in terms of EVA help explain the decline in stock price?
PROBLEM 12-12. The Balanced Scorecard [LO 3] The strategy for success at Sassy Jeans calls
for rapid growth, a limited number of units for each design to enhance exclusivity, perfect fit,
on-time delivery to customers, retaining employees who contribute to innovation, and control of
inventory.
Req u i r ed
a. Keeping in mind the Sassy Jeans’ strategy for success, suggest one performance measure for each
dimension of a balanced scorecard.
b. Identify the links between the measures (strategy map) you identified in part a.
PROBLEM 12-13. You Get What You Measure and a Balanced Scorecard [LO 3] Kasper Indus-
tries produces custom molds that are used by producers of molded products (e.g., ski boots and
snowboards). Many of its customers use just-in-time (JIT) manufacturing, and on-time delivery
of the molds is critical because production is halted if the molds are not available when needed.
In the past, managers (including Maria Patterson, the vice president of operations) at Kasper have
been rewarded based on financial performance. This has led to actions that are not consistent
with maximizing shareholder value. Near the end of each quarter, Maria evaluates expected profit
in relation to the company’s profit goal. If expected profit is below the goal, she rushes into pro-
duction customer orders that have a high profit margin, even if the orders are not due for two or
three weeks. Thus, deliveries of high-profit-margin jobs are often early and deliveries of low-
profit-margin jobs (displaced in Kasper’s production schedule) are often late. The company has
not performed well on a dimension of performance that is critical for long-run success.
Req u i red
a. A consultant to Kasper Industries has suggested that the company use a balanced scorecard.
Suggest a customer measure and an internal process measure that will help the company track
its performance with respect to on-time delivery and other improvements that meet the needs of
customers.
b. Suppose that Maria Patterson continues to manage production to meet short-run profit goals.
Explain how her actions will be detected by the customer and internal process measures you sug-
gested in part a.
PROBLEM 12-14. (Appendix) Transfer Pricing [LO A1] The Leviathan Steel Company has a
coal-mining subsidiary in West Virginia. A substantial amount of the coal produced by the sub-
sidiary is used by Leviathan’s steel foundries located in Pennsylvania.
R equ i r ed
a. Recommend and defend a transfer price (market price, variable cost, or full cost plus profit) for
the coal shipped by the mining subsidiary to the foundries.
b. Indicate how the price you recommended in part a compares with the opportunity cost related
to using the coal internally.
PROBLEM 12-15. (Appendix) Decentralization and Transfer Pricing [LO A1] The City of M edina
Park operates a plumbing and electrical maintenance department, responsible for maintaining
all water and electric service functions in buildings owned by the city. The city administration is
concerned about the rising costs of the maintenance department, which is currently organized
as a cost center. Charlotte Daugherty, the manager of the maintenance department, says that
many of the department’s service calls are strictly nuisance calls. She cites examples of numerous
calls for defective electrical outlets, which turn out to be unplugged equipment, burned-out
lightbulbs (which can easily be changed by the users), and drains clogged by coffee grounds.
In Charlotte’s opinion, these nuisance calls would be avoided if the departments using her
department’s services were “billed.” Essentially, Charlotte suggests that there be a transfer price
related to using her d
epartment’s services and that the price should approximate the cost of these
services in the m
arket ($50–$65 per hour of service time). This would turn her operation into a
profit center, and, she believes, her department would operate more efficiently because demand
for services would decline and she would need fewer employees.
Req u i red
Evaluate Charlotte’s proposal. Do you support use of a transfer price for maintenance services? If
so, should the price approximate the market price of service or should it be based on cost?
PROBLEM 12-16. (Appendix) Transfer Pricing [LO A1] Montana Woolen Products has two di-
visions: a Fabric division that manufactures woolen fabrics and a Clothing division that manu-
factures woolen dresses, coats, shirts, and accessories. All fabric used by the Clothing division is
supplied by the Fabric division, which also supplies fabric to outside companies.
Req u i red
a. Suggest a transfer price for the fabric assuming that the Fabric division is operating at only
60 percent of capacity due to a surge in popularity of “easy-care” fabrics made of polyester and rayon.
b. Suggest a transfer price for fabric assuming that the Fabric division is operating at capacity due
to a revival of consumer interest in natural products and development of lightweight, wrinkle-
resistant woolen fabrics.
c. Explain how your choices in parts a and b are related to the opportunity cost concept.
PROBLEM 12-17. ROI and Investment Decisions [LO 2] Sarah Jones, the manager of the Teen
division of the Eve Clothing Company, was evaluating the acquisition of a new embroidery machine.
C a s e 493
The budgeted operating income of the Teen division was $5,000,000 with total assets of $33,000,000
and noninterest-bearing current liabilities of $1,500,000. The proposed investment would add
$1,027,500 to operating income and would require an additional investment of $5,250,000. The
targeted rate of return for the Teen division is 14 percent. (Ignore taxes in this problem.)
Req u i red
a. Compute the ROI of:
1. The Teen division if the embroidery machine is not purchased.
2. The Teen division if the embroidery machine is purchased.
b. Compute the residual income of:
1. The Teen division if the embroidery machine is not purchased.
2. The Teen division if the embroidery machine is purchased.
c. Will Sarah decide to invest in the embroidery machine if her performance is evaluated in terms
of ROI? Why or why not?
PROBLEM 12-18. Comparing Performance Evaluation Methods [LO 2] Top management of the
Gates Corporation is trying to construct a performance evaluation system to use to evaluate each
of its three divisions. This past year’s financial data are as follows:
Division A Division B Division C
Total assets $927,500 $18,725,000 $11,156,250

Noninterest-bearing current liabilities 52,500 2,187,500 1,050,000
Net income 178,500 1,820,000 1,365,000
Interest expense 52,500 1,925,000 1,225,000
Tax rate 40% 40% 40%
Required rate of return 10% 12% 14%
Req u ir ed
a. How would the divisions be ranked (from best to worst performance) if the evaluation were
based on net income?
b. How would the divisions be ranked (from best to worst performance) if the evaluation were
based on ROI?
c. How would the divisions be ranked (from best to worst performance) if the evaluation were
based on residual income?
CASE
12-1 HOME VALUE STORES [LO2]
Home Value Stores operates 264 membership ware- and an income statement.) Both were pleased with the increase
house stores in the United States, Europe, and Asia. in profit and decided to recommend a contract extension and
The company offers low prices on a limited selection of house- a substantial six-figure bonus for the company’s CEO. They an-
hold and grocery products. In the past year, sales increased ticipated, however, that the third member of the compensation
by approximately 10.8 percent and net earnings increased by committee, Tanya Barrett, would object to the bonus. Tanya
6.4 percent. The company opened only two stores in 2017 and believes that accounting profit is a poor measure of future firm
2018 and closed one of its stores due to poor performance. Jack performance. In her opinion, the company should be focused
Davidson and Michael Prine are on the board of directors of on what it is doing today to create future value for shareholders.
Home Value and serve on the company’s compensation com- She has also pointed out that, although the company showed
mittee. At a recent lunch meeting, they discussed the company’s quarterly profit increases, its stock price remained flat.
performance. (See the table on the next page for a balance sheet
R e q uir e d b. In fiscal 2019, the CEO of Home Value Stores retired. His
successor is concerned that warehouse managers do not
a. To prepare for an upcoming board meeting, Tanya has asked
understand how their actions are linked to the company’s

you to evaluate financial performance for 2017 and 2018,
strategy and how they can affect future firm value. In his
taking into account both the level of investment and the cost of
opinion, while monthly earnings are important, managers are
capital. Specifically, she would like you to calculate the level of
focused almost exclusively on how their actions affect these
profit (loss) that was earned in excess of the amount required
numbers. Suggest a performance measurement technique that
given the investment in the company. Assume that the cost
can be used to address the new CEO’s concerns.
of capital is 15 percent. Is it clear that the company has had
superior financial performance?
Comparative Financial Statements: Home Value Stores (in thousands)
2018 2017
Sales $26,360,000 $23,800,000

Merchandise costs 20,680,000 17,900,000
Operating, general and administrative 3,220,000 3,600,000
Rent 235,000 220,000
Depreciation and amortization 211,000 200,500
Total 24,456,000 22,010,500
Earnings before taxes 1,904,000 1,789,500
Taxes 666,400 626,325
Net earnings $ 1,237,600 $ 1,163,175
Assets
Cash and temporary investments $ 90,000 $ 60,000
Receivables 358,000 202,000
Inventories 1,944,000 1,405,000
Prepaid and other current assets 193,000 118,000
Total current assets 2,585,000 1,785,000
Land 260,000 140,000
Buildings and equipment (net) 640,000 450,000
900,000 590,000
Total assets $ 3,485,000 $ 2,375,000
Liabilities and Shareholders’ Equity
Current portion of long-term debt 91,000 80,000
Accrued income taxes 98,000 89,000
Total current liabilities 729,000 669,000
Long-term debt 810,000 600,000
Total liabilities 1,539,000 1,269,000
Shareholders’ Equity
Common stock 775,000 674,000
Retained earnings 1,171,000 432,000
Total shareholders’ equity 1,946,000 1,106,000
Total liabilities and shareholders’ equity $ 3,485,000 $ 2,375,000
CASE
12-2 WIN TECH MOTORS [LO 2]
In 2016, five retired software developers opened an inventories of used Porsches on the West Coast. (Typically,
auto dealership in Redmond, Washington, which they 75 Porsches are in stock). The inventory is listed on the
named WinTechMotors. The company specializes in company’s website and the company has shipped cars to

high-end sports and luxury autos and has one of the largest online customers as far away as
Florida, although most
C a s e 495
c ustomers are located in Washington, Oregon, and California. R eq uired

In 2017, an industry publication (Motor Watch) listed WinTech
a. Calculate EVA for 2017 and 2016, using a cost of capital of
as the fastest-growing luxury auto dealership on the West
12 percent. No adjustments for accounting distortions are
Coast. Comparative income statements and balance sheets
needed. Explain why sales and income have increased
are presented in the table on the right. As indicated, the
substantially in 2017 and yet EVA is negative. What is not
company had sales of $15,120,000 in 2017 (a 25 percent in-
captured in income that is captured in EVA?
crease over 2016) and net income of $326,950 (a 91 percent
increase over 2016). The owners were delighted with the b. The owners realize they must cut back on inventory to earn
company’s financial performance and quite proud that they a zero or positive EVA in the coming year. To get a handle on
had developed a successful business. However, at a recent this, they would like you to calculate the maximum amount of
meeting, their company’s external accountants introduced inventory that could have been on hand at the end of 2017 for
them to the concept of EVA and noted that, with an assumed the company to achieve a zero level of EVA.
weighted average cost of capital of 12 percent, their EVA c. Assume the average car has a cost of $75,000. Also assume
had been negative in both years. Accordingly, the owners that sales, expenses, assets (except inventory), and liabilities are
have contracted with an EVA consultant to help them with roughly the same in 2018 as in 2017. How many cars must be
financial planning. cut from inventory to achieve zero EVA in 2018?
Comparative Financial Statements: Win Tech Motors
2017 2016
Sales $15,120,000 $12,105,000

Less cost of autos sold 13,618,000 10,894,000
Gross margin 1,502,000 1,211,000
Less selling and administrative expense 936,000 889,200
Interest 63,000 58,500
Income before taxes 503,000 263,300
Income taxes 176,050 92,155
Net income $ 326,950 $ 171,145
Increase in sales 24.91%
Increase in net income 91%
Assets
Cash and short-term investments $ 58,500 $ 63,000
Receivables 355,500 288,000
Inventory 5,625,000 5,040,000
Current assets 6,039,000 5,391,000
Building and equipment (net) 860,400 855,000
Other assets 48,600 54,000
Total assets $ 6,948,000 $ 6,300,000
Liabilities and Shareholders’ Equity
Short-term debt payable 81,000 67,500
Taxes payable 103,500 36,000
Current liabilities 460,800 220,500
Long-term debt payable 625,500 544,500
Total liabilities 1,086,300 765,000
Retained earnings 821,700 495,000
Common stock 5,040,000 5,040,000
Total liabilities and shareholders’ equity $ 6,948,000 $ 6,300,000
Glossary
A Allocation base (2) The measure of activity used to cal-

culate an overhead rate. Also referred to as a cost driver.
Ability to bear costs (6) The notion in cost allocation Attainable standards (11) A standard that takes into
that the allocation base should result in more costs being account the possibility that a variety of circumstances
allocated to products, services, or departments that are may lead to costs that are greater than ideal.
more profitable. Avoidable costs (7) Costs that can be avoided if a
Absorption costing (5) An approach to product cost- company takes a particular action.
ing that includes direct material, direct labor, and both
fixed and variable manufacturing overhead in product
cost. Also referred to as full costing. The alternative to B
absorption costing is variable costing, which includes
direct material, direct labor, and variable (but not fixed) Balanced scorecard (12) A set of performance
manufacturing overhead. measures (linked to a company’s strategy) for four

Account analysis (4) A method of estimating cost categories: financial, customer, internal processes, and
behavior that requires professional judgment to classify learning and growth.
costs as either fixed or variable. The total of the costs Batch-level activities (6) Activities required to produce
classified as variable are divided by a measure of activity another batch of a product.
to calculate the variable cost per unit of activity. The Break-even point (4) The number of units a company
total of the costs classified as fixed provides the estimate must sell to earn a zero profit.
of fixed cost. Budget (1, 10) A formal document that quantifies a
Accounting rate of return (9) The average after-tax company’s plan for achieving its goals.
income from a project divided by the average investment. Budget committee (10) The group responsible for
Activity-based costing (ABC) (2, 6) A method of preparing budgets.
assigning overhead costs that identifies key activities and Budget variance (10) The difference between bud-
accumulates the costs associated with them. Cost drivers geted and actual cost.
(volume- or nonvolume-related measure of activity) are Budgeted cost (11) The cost, at standard, for a number
used to assign the various cost categories to products of budgeted units.
or services.
Activity-based management (ABM) (6) A manage-
C
ment approach that involves analyzing and costing
activities with the goal of improving efficiency and Capital budget (9) The final list of approved investments.
effectiveness. See also activity-based costing. Capital budgeting decision (9) Investment decision
Activity-based pricing (8) An approach to pricing in involving the acquisition of long-lived assets. See also
which customers are presented with separate prices for capital expenditure decision.
services they request in addition to the cost of goods Capital expenditure decision (9) Investment decision
they purchase. Activity-based pricing is also referred to involving the acquisition of long-lived assets. See also
as menu-based pricing since customers are presented capital budgeting decision.
with a menu of prices related to the various services Cause-and-effect relationship (6) An allocation of
they request in addition to the products they purchase. cost to the cost objective that caused it to be incurred.
Administrative expenses (2) Expenses associated with Chief financial officer (CFO) (1) The senior executive
the firm’s general management. These include the sala- responsible for both accounting and financial operations.
ries of the company president and accounting personnel, Chief information officer (CIO) (1) The manager
depreciation of the general office building, depreciation responsible for a company’s information technology and
of office equipment, and the cost of supplies. computer systems.
G-1
G-2 G l o s s a r y
Committed fixed costs (4) Fixed costs that cannot be Cost-volume-profit (C-V-P) analysis (4) The analysis
easily changed in the short run. of how costs and profit change when volume changes.
Common costs (7) Costs incurred for the benefit of Customer profitability measurement (CPM) system (8)
multiple departments or products. A system in which the indirect costs of serving customers
Computer-controlled manufacturing system (2) including the cost of processing orders, the cost of
Highly automated manufacturing system that uses com- handling returns, the cost of shipments, etc., are assigned
puters to control equipment and generally increases the to cost pools. Using cost drivers, these costs are then
flexibility and accuracy of the production process. allocated to specific customers. Subtracting these costs
Contribution margin (4) The difference between sales as well as product costs from customer revenue yields a
and variable costs. measure of customer profitability.
Contribution margin ratio (4) The contribution mar- Customer relationship management (CRM) systems (1)
gin divided by sales or the contribution margin per unit Systems that automate call centers and customer ser-
divided by the selling price. vices. The systems also provide customer data analysis
Controllable cost (1, 6) A cost that a manager can and support of e-commerce storefronts.
influence by the decisions he or she makes.
Controllable overhead variance (11) The difference
D
between the amount of overhead that would be included
in a flexible budget for the actual level of production and Decentralized organization (12) A firm that grants
the actual amount of overhead. substantial decision-making authority to the managers
Controller (1) The top accounting executive responsi- of subunits.
ble for financial and managerial accounting information Depreciation tax shield (9) The tax savings resulting
and tax filings. from depreciation.
Conversion costs (3) Conversion costs include both Differential costs (7) Costs that differ between deci-
labor and overhead. Frequently, they are assumed to be sion alternatives.
added evenly throughout the production process. Direct cost (1) A cost that is directly traceable to a
Cost allocation (6) Cost allocation is the process of product, activity, or department.
identifying indirect costs and assigning them to cost Direct labor cost (2) The cost of labor that is directly
objectives such as departments or products. traced to items produced.
Cost center (12) A business segment responsible for Direct material cost (2) The cost of all materials and
controlling costs, not for generating revenues. parts that are directly traced to items produced.
Cost driver (2, 6) A measure of the activity, related to Direct method (13) Method of preparing the statement
a cost pool, that is used to allocate cost. of cash flows in which the operating activities section is
Cost objective (6) The object of cost allocation. in a format similar to that of an income statement.
Cost of capital (9) The weighted average of the costs Direct method of allocating cost (6) A method
of debt and equity financing used to generate capital for of allocating service department costs to production
investments. departments that does not allow for allocation of costs
Cost of goods available for sale (2) The sum of the among service departments.
beginning balance in Finished Goods plus the cost of Discretionary fixed costs (4) Fixed costs that manage-
goods manufactured. ment can easily change in the short run.
Cost of goods manufactured (2) The cost of items that
have been completed in the current accounting period.
E
Cost per equivalent unit (3) The sum of the cost in
beginning Work in Process and the cost incurred in the Economic value added (EVA) (12) A performance
current period divided by the sum of the units completed measure equal to net operating profit after taxes (adjusted
and the equivalent units in ending Work in Process. for accounting distortions) less a charge based on the
Cost pool (2, 6) A grouping of overhead costs based level of investment.
on the major activity that created them. Also, a grouping Enterprise resource planning (ERP) systems (1)
of individual costs whose total is allocated using one Systems that computerize inventory and production
allocation base. planning, support accounting, human resources, and
Cost-plus pricing (8) An approach to pricing in various e-commerce applications.
which a prespecified markup is added to cost in order Equity approach to allocation (6) An attempt to
to determine price. allocate costs in a way that is fair to interested parties.
G l o s s a r y G-3
Equivalent units (3) Partially completed units Indirect labor cost (2) All labor costs that are not
expressed as a comparable number of whole units. directly traced to items produced.
Indirect materials (2) Materials and parts that are not
F directly traced to items produced.
Indirect method (13) Method of preparing the state-
Facility-level activities (6) Activities that support all ment of cash flows in which the operating activities
other activities including unit-level, batch-level, and section is a reconciliation of net income and net cash
product-level activities. provided by operating activities.
Financial leverage (14) Portion of a firm’s assets Internal rate of return (IRR) (9) The rate of return
financed with debt as opposed to equity—the more debt, that equates the present value of future cash flows to the
the higher the financial leverage. investment outlay.
Financing activities (13) Classification in the state- Investing activities (13) Classification in the state-
ment of cash flows related to issuing and repurchasing ment of cash flows related to the buying and selling of
stock, issuing long-term debt, paying off loans to debt long-term assets.
holders, and making dividend payments. Investment center (12) A business segment respon-
Finished Goods Inventory (2) The cost of goods that sible for generating revenue, controlling costs, and
are completed and ready to sell. investing in assets.
Fixed cost (1, 4) Costs that do not change when there Investment turnover (12) A performance measure
is a change in business activity. equal to sales divided by invested capital.
Flexible budget (10) A budget that is adjusted for the
actual level of activity.
Full cost (2, 5) An approach to product costing that J
includes direct material, direct labor, and both fixed and Job cost sheet (2) A form used to accumulate the cost
variable manufacturing overhead in product cost. Also of producing an item for order or for inventory.
referred to as absorption costing. The alternative to full cost- Job-order costing system (2) A system of accounting
ing is variable costing which includes direct material, direct for product cost used by companies that produce indi-
labor, and variable (but not fixed) manufacturing overhead. vidual products or batches of products that are unique.
Joint costs (7) The costs of the common inputs that
H result in two or more products.
High-low method (4) A method of estimating fixed Joint products (7) Two or more products that arise
and variable cost components in which a straight line from common inputs.
is fitted to the data points representing the highest and Just-in-time (JIT) manufacturing (2) A manufac-
lowest levels of activity. turing system designed to minimize inventories of raw
Horizontal analysis (14) An analysis that focuses on materials and works in process. In a JIT system, goods
the dollar value and percentage changes in financial are manufactured just before they are sold and purchases
statement amounts across time. are made just before goods are needed in production.
I L
Ideal standards (11) Standards developed under the Labor efficiency variance (11) The difference between
assumption that no obstacles to the production process the standard labor hours allowed for the number of units
will be encountered. produced and the actual number of labor hours worked
Incremental analysis (1, 7) An analysis of the reve- times the standard labor wage rate.
nues and costs that will change if a decision alternative Labor rate variance (11) The difference between the
is selected. standard and actual wage rates times the actual number
Incremental cost (1, 7) Costs that increase or decrease of labor hours worked.
if a decision alternative is selected. Lack of goal congruence (12) A situation where man-
Incremental revenue (1, 7) Revenue that increases or agers pursue personal goals that are incompatible with
decreases if a decision alternative is selected. the goals of the company as a whole.
Indirect costs (1) A cost that either is not directly Lump-sum allocations (6) Allocations of fixed costs
traceable to a product, activity, or department or is not in which predetermined amounts are allocated regard-
worth tracing. less of changes in the level of activity.
G-4 G l o s s a r y
M O
Management by exception (1, 10) Policy by which Operating activities (13) Classification in the state-
managers investigate departures (or variances) from ment of cash flows related to the production and delivery
planned results that appear to be exceptional; they do of goods and services.
not investigate minor departures (or variances) from Operating leverage (4) Level of fixed versus variable
the plan. costs in a firm’s cost structure. Firms that have relatively
Management Discussion and Analysis (MD&A) high levels of fixed cost are said to have high operating
(14) The section of the annual report where firm leverage.
management discusses the reason for changes in the Opportunity cost (1, 7) The values of benefits fore-
results of operations, asset accounts, and other matters. gone by selecting one decision alternative over another.
Managerial accounting (1) Accounting that stresses Overapplied overhead (2) The excess of overhead
concepts and procedures relevant to preparing reports applied to inventory using a predetermined rate over
for internal users of accounting information. It focuses actual overhead incurred.
on information that is useful in planning, control, and Overhead allocation (2) The process of assigning
decision making. overhead to specific cost objectives (e.g., products or
Manufacturing costs (2) All costs associated with the departments).
production of goods (i.e., direct material, direct labor, Overhead allocation rate (2) A measure of overhead
and manufacturing overhead). cost divided by a measure of the overhead allocation
Manufacturing overhead (2) The costs of manufactur- base.
ing activities other than direct material and direct labor. Overhead applied (2) The amount of overhead assigned
Margin of safety (4) The difference between the to jobs.
expected level of sales and break-even sales. Overhead volume variance (11) The difference
Master budget (10) A comprehensive planning between the amount of overhead applied to production
document that incorporates a number of individual at standard and the amount of overhead included in a
budgets. flexible budget for the actual level of production.
Material price variance (11) The difference between
the standard and actual prices per unit of material times P
the actual quantity of material used.
Material quantity variance (11) The difference Payback period (9) The length of time it takes to
between the standard quantity of material allowed for recover the initial cost of an investment.
the number of units produced and the actual quantity Performance report (1) A report used to evaluate
of material used times the standard price of the material. managers and the operations they control. Frequently,
Material requisition form (2) A form used to authorize performance reports involve a comparison of planned
the release of materials for production. and actual results.
Mixed cost (4) Cost that contain both variable and Period cost (2) Cost identified with accounting periods
fixed cost elements. rather than with goods produced (i.e., nonmanufacturing
costs).
Predetermined overhead rate (2) The estimated level
N of overhead cost divided by the estimated level of the
Net present value (NPV) (9) The sum of the present allocation base.
values of all cash flows (alternatively, the present value Present value analysis (9) A method of investment
of future cash inflows less the cost of an investment). analysis that expresses future cash flows in terms of their
Noncontrollable costs (1) Costs that a manager can- value today.
not influence. Process costing system (2) A product costing system
Noninterest-Bearing Current Liabilities (NIBCL) used by companies that produce large numbers of
(12) Current liabilities that do not require interest identical items in a continuous production process.
payments (i.e., accounts payable, income taxes payable, Product costing systems (2) An integrated set of doc-
and accrued liabilities, among other items). uments, ledgers, accounts, and accounting procedures
Nonmanufacturing costs (2) Costs that are not asso- used to measure and record the cost of manufactured
ciated with the production of goods (e.g., selling and products.
administrative costs). Product costs (2) Costs assigned to goods produced
NOPAT (12) Net operating profit after taxes. (i.e., manufacturing costs).
G l o s s a r y G-5
Product-level activities (6) Activities required to initi- Return on investment (ROI) (12) A performance
ate production of a product regardless of the number of measure equal to investment center income divided by
units or batches of the product. invested capital.
Production cost report (3) A report in a process cost-
ing system that provides a reconciliation of units and a
reconciliation of costs as well as the details of the cost S
per equivalent unit calculations. Scattergraph (4) A graph of costs at various activity
Profit center (12) A business segment responsible levels.
for generating revenue and controlling costs. It is not Selling costs (2) Costs associated with securing and
responsible for investing in assets. filling customer orders.
Profit equation (4) Equation that states that profit is Slack (10) Amounts (padding) managers include in
equal to revenue (selling price times quantity) minus budgets to assure that budgeted goals can be easily
variable cost (variable cost per unit times quantity) achieved.
minus total fixed cost. Split-off point (7) Stage of production when joint
Profit margin (12) Net income divided by revenue. products are individually identifiable.
Standard cost (11) The cost that management believes
should be incurred to produce a good or service under
R anticipated conditions.
Raw Materials Inventory (2) An account that includes Standard cost variance (11) The difference between
the cost of materials on hand that are used to produce a standard cost and actual cost.
company’s products. Static budget (10) A budget that is not adjusted for the
Regression analysis (4) A statistical technique that actual level of activity.
can be used to estimate the intercept (an estimate of Step costs (4) Costs that are fixed for a range of vol-
fixed cost) and the slope (an estimate of variable cost) ume but increase to a higher level when the upper bound
of a cost equation. of the range is exceeded.
Relative benefits approach to allocation (6) The Step fixed costs (4) A step cost for which the range
notion in cost allocation that the allocation base should of activity is relatively large before there is an increase
result in more cost being allocated to the cost objectives in cost.
that benefit most from incurring the cost. Step variable costs (4) A step cost for which the range
Relative performance evaluation (12) The evaluation of activity is relatively small before there is an increase
of a subunit in comparison to similar subunits within a in cost.
company. Strategy map (12) A diagram of the relationships,
Relative sales value method (7) A method of allo- across the four dimensions of a balanced scorecard,
cating joint costs in which the allocation is based on among strategic objectives that create shareholder
the relative sales value of the products at the split-off value.
point. Sunk costs (1) Costs incurred in the past—they are
Relevant costs (7) The only cost items that managers irrelevant to current decisions.
need to consider when analyzing decision alternatives Supply chain management (SCM) systems (1)
because they differ between decision alternatives. Software systems that support the planning of the best
Relevant range (4) The range of activity for which way to fill orders and help tracking of products and
estimates and predictions are likely to be accurate. components among companies in the supply chain.
Required rate of return (9) The minimum acceptable
return on an investment; also referred to as a hurdle rate.
T
Residual income (RI) (12) A performance measure
equal to NOPAT less a charge for the level of investment. Target costing (8) An integrated approach to deter-
Responsibility accounting system (6) A system of mining product features, product price, product cost,
accounting that traces revenues and costs to organiza- and product design that helps ensure a company will
tional units and individuals with related responsibility earn a reasonable profit on new products. Target cost
for generating revenue and controlling costs. is equal to price less desired profit and the product is
Responsibility centers (12) Organizational units designed to achieve the target cost.
responsible for the generation of revenue or for the Time tickets (2) Forms completed by workers to keep
incurrence of costs. track of the amount of time spent on each job.
G-6 G l o s s a r y
Total quality management (TQM) (2) Programs Variable cost (1) A cost that increases or decreases in
designed to ensure high-quality products that involve response to increases or decreases in business activity.
listening to customers’ needs, making products right Variable costing (5) An alternative to full costing in
the first time, reducing defective products, and encour- which only variable production costs are included in
aging workers to improve their production processes inventory: Fixed production costs are treated as period
continuously. costs.
Transfer price (Appendix) (12) The price used to Variable costs (4) Those costs that increase or decrease
value internal transfers of goods or services. in proportion to increases or decreases in business
Transferred-in costs (3) The cost a preceding pro- activity.
cessing department incurs and transfers to the next Variance analysis (11) An analysis of the difference
processing department. between actual and standard cost.
Treasurer (1) Company official who has custody of Vertical analysis (14) An analysis that focuses on
cash and funds invested in various marketable securities. various financial statement account balances as a percent
In addition to money management duties, the treasurer of some base. The base is sales when analyzing income
is generally responsible for maintaining relationships statement accounts and total assets when analyzing
with investors, banks, and other creditors. balance sheet accounts. Vertical analysis is also referred
to as common size analysis.
U
Underapplied overhead (2) The amount by which W
actual overhead exceeds the amount applied to inventory
“What-if ” analysis (4) An examination of the results
using a predetermined overhead rate.
of various courses of action.
Unit-level activities (6) Activities required to produce
Work in Process Inventory (2) An account that
an incremental unit of output.
includes the cost of goods that are only partially
Unitized fixed costs (6) Fixed costs stated on a per
complete.
unit basis.
V Z
Value chain (1) The internal operations of a company Zero base budgeting (10) A method of budget prepa-
and its relationships and interactions with suppliers and ration that requires each department to justify budgeted
customers aimed at creating maximum value for the amounts at the start of each budget period, even if the
least possible cost. amounts were supported in prior periods.
INDEX
For entries on pages 496–570, please go to WileyPLUS to access Chapters 13 and 14.
A Assembly department, 431 Budget planning and control. See also

Ability to bear costs, 211 Asset turnover, 542, 546 Master budget
Absorption costing. See Full (absorption) Attainable standards, 417–418 budget development and, 370–373
costing Avoidable costs, 263, 267 budget padding and, 388–389
Account analysis, 129–131 budget variances and, 384
Accounting rate of return, 345–347 B budgets as standard for evaluation, 384
Accounts, recording standard costs in, 433–435 Balance sheet computer use in, 383
Accounts receivable turnover, 542, 546–547 horizontal and vertical analysis and, control process and, 370
Accrued salary and wages, 506–507 533–534 department consultation and, 371
Accumulated depreciation, 460 product costs and, 42 income shifting and, 388–389
Acid-test ratio, 543–544, 547 Balanced scorecard, 468–471 investigating budget variances, 386–387
Across-the-board cuts, 275 achieving balance using, 470 master budget and, 373–383
Activity-based costing (ABC), 218–225 backward looking approach and, 468 planning process and, 370
activity-based management compared, customer dimension and, 470 rolling budgets and, 387
227 financial dimension and, 470 spreadsheets for budgeting, 384–386
activity hierarchy and, 220 financial ratios in, 544 static and flexible budgets, 384–386
approach to, 219–221 funding and, 472 Budget slack, 388
batch-level activities and, 220–221 growth dimension and, 469 Budget variances, investigating, 386–387
comprehensive example of, 221–225 initiatives and, 472 Budgeted balance sheet, 382
cost control benefits and, 225 internal process dimension and, 469–470 Budgeted costs, 416
cost drivers and, 219 responsibility and, 472 Budgeted income statement, 377–378
cost pools and, 221 strategy map for, 471–472 Budgeted service department costs, 213
determining major activities and, targets and, 472 Buffer inventory, 65
229–230 top management support and, 472 Buffett, Warren, 298
effectiveness of activities and, 231 tying to strategy for success, 469 Business activity types, cash flow classifica-
evaluating performance of activities Ball Corporation, 466 tions and, 498–500
and, 230–231 Bank of America, 372 Business partners, 532, 545–546
expense of, 225 Bankruptcy, 533 Business sectors, cost of capital and, 340
facility-level activities and, 221 Banks, activity-based management and, 227
identifying efficiency improvements Baskin-Robbins, 146 C
and, 230–231 Batch-level activities, activity-based costing Capital budgeting
identifying resources using each activity and, 220–221 accounting rate of return and, 345–347
and, 229–230 Batch sizes, theory of constraints and, 275 payback period method and, 344–345
overhead costs and, 57 Bausch & Lomb, 464 performance evaluation and, 347–349
product-level activities and, 221 Bell, Jim, 372 short-run accounting profit and, 350
production volume and overhead Best Buy, 464 simplified approaches to, 344–346
allocation, 218–219 Bharti Airtel, 264 time value of money and, 328–330
unit-level activities and, 220 Blumer, Catherine, 270 Capital expenditure decisions, 328
Activity-based management (ABM), BMW, 328 Cash budget, 379–382
227–228, 229–231 Boeing Company, 262, 461 Cash collections estimate, 380
Activity-based pricing, 306–307 Boise Cascade, 464 Cash cows, 508
Activity duplication, 453 Borrowing, improving cash flow and, 382 Cash disbursements estimate, 381
Activity hierarchies, 221 Bottlenecks, 273 Cash flows. See also Statement of cash flows
Additional processing decisions, 259–261 Break-even point, 137–138 adjusting for inflation, 342
Adjusted investment, 465 Briggs & Stratton, 464 investment opportunities and, 340
Administrative budget, 377 Brigham and Women’s Hospital, 473 management of, 537–538
Administrative salaries, 215 Budget-based compensation, 387–389 Cash reserves, 379–380
Advertising campaigns, 344, 379–380 Budget committee, 370 Casinos, 17
Allocation base, 52, 56–57, 210–211 Budget development, 370–372 Cause-and-effect relationships, 211
Alternative payment plans, 343 five-year budgets, 372 Central accounting costs, 215
Amortization, prepaid insurance and, 380 people problems and, 372 Centrally provided services, charging for,
Anticipated profit, company goals and, 379 time period and, 372 207
Arbitrary cost allocations, 214–215 zero-based budgeting, 372–373 Chief financial officer (CFO), 22
Arkes, Hal, 270 Budget padding, 388–389 Chief information officer (IFO), 22
I-1
I-2 I n d e x
China, outsourcing to, 272 regression analysis, 134 Current liabilities

City Appliances, 532 relevant range and, 135–137 direct method (statement of cash flows)
Clerical costs, 215 scattergraphs and, 131 and, 501–502
Coase, Ronald H., 268 Cost flows through accounts, 90–92 indirect method (statement of cash
Coca-Cola, 464 Cost objectives, cost allocation and, 209 flows) and, 506–507
Committed fixed costs, 126 Cost of capital, 339 Current ratio, 543–544, 547
Common costs, 265–266 Cost of goods available for sale, 44 Customer dimension, balanced scorecard
Common resources, cost allocation and, 207 Cost of goods manufactured, 44, and, 470
Company plans, control process and, 5 Cost of goods sold, 44 Customer profitability measurement
Comparative ratio data, 545 Cost per equivalent unit, 93–94 system, 302–305
Computer-controlled manufacturing, 64–65 Cost-plus contracts, 208, 214 Customer relationship management
Computer use, budget planning process Cost-plus pricing, 299–300 systems, 17
and, 383 Cost pools Customer satisfaction, 456
Constraints. See Theory of constraints ABC approach and, 219 Customer service, excessive use of, 305
Construction techniques, as soft benefit, 337 activity-based costing and, 57 Customers, managerial financial analysis
Contribution margin, 139–140, 141 cost allocation and, 217–218 and, 532, 544–545
Contribution margin ratio, 140, 141–145 forming of, 209–210
Control process, 4–6 products using cost drivers and, 219 D
performance reports for, 5–6 Cost transferred out, process costing and, 95 Daily labor cost summary, 51
planning and, 370 Cost-volume-profit analysis Daniels, John, 372
Controllable costs, 11, 213 assumptions in, 145 Days’ sales in inventory, 542, 546
Controllable overhead variance, 422–426 break-even point and, 137–139 Days’ sales in receivables, 542, 546
Controller, as top management accountant, change in fixed and variable costs and, 141 Debt-related ratios, 543–544, 547
21–22 change in selling price and, 141 Debt-to-equity ratio, 543, 547
Conversion costs, 90 common cost behavior patterns and, Decentralization. See also Performance
Cost allocation 124–129 evaluation
ability to bear costs and, 211 constraints and, 149 advantages of, 452–453
allocation base and, 210–211 contribution margin and, 139–140, 141 disadvantages of, 453
arbitrary allocations, 213–214 contribution margin ratio and, 140, evaluating subunit managers and, 454
cause-and-effect relationships and, 211 141–145 evaluating subunits and, 454
common resources and, 207 cost estimation methods, 129–136 responsibility accounting and, 454–455
controllable costs and, 213–214 dollar sales needed to achieve profit transfer pricing and, 474–475
cost objective determination and, target, 140 Decision analysis, qualitative consider-
209–210 example, 146–147 ations in, 271–273
death spiral, 267 fixed costs and, 125–126 Decision making
decision making and, 206–207 incremental analysis and, 144–145, 147 cost allocation and, 206–208
disputes over, 215 making fixed costs variable, 149 in planning and control process, 6–7
equity approach to, 211 margin of safety and, 138–139 Deere & Company, 464
evaluation of services and, 207–208 mixed costs and, 126 Defect rates, 456
federal grants and contracts and, 212 multiproduct analysis, 141–145 Demand function, profit-maximizing price
forming cost pools and, 209–210 operating leverage and, 148–149 and, 297–299
full cost information and, 208 profit equation and, 137 Depreciation
lump-sum allocations and, 216 relevant range and, 127–129 cash outlay and, 380
problems with, 213–218 step costs and, 126–127 manufacturing overhead and, 377
process of, 209–211 units needed to achieve profit target, tax shield, 340–342
purposes of, 206–208 139–140 Differential costs, 256
relative benefits approach and, 211 using regression in Excel and, 150–152 Direct allocation method, service depart-
responsibility accounting and, 214 variable costs and, 124 ment costs and, 212–213
service department costs and, 212 “what if ” analysis, 140 Direct labor
too few cost pools and, 217–218 Costco, 300 budget, 376–377
unitized fixed costs and, 215–216 Costing systems costs, 38–39, 51, 210, 218
volume-related allocation bases, 218 job-order costing systems, 46 hours, 210, 218
Cost behavior patterns, 124–125 manufacturing firms and, 45 labor efficiency variance, 421–422
fixed costs and, 125–125 process costing system, 46 labor rate variance, 421
mixed costs and, 126 Costs of debt, 340 process costing and, 91
relevant range and, 127–128 Costs of goods sold, 435 standard quantity of, 416
step costs and, 126–127 Credit reports, 539 variances, 419–425
variable costs and, 122 Creditors, managerial financial analysis Direct material
Cost center evaluation, 455–456 and, 533, 546 costs, 38, 49–51
Cost classifications, manufacturing firms Cross-functional product development process costing and, 91
and, 38–42 teams, 302 purchases budget, 376–381
Cost control, activity-based costing and, 225 Current assets variance formulas, 419–425
Cost drivers, 57, 219–224 direct method (statement of cash flows) Direct method (statement of cash flows),
Cost estimation methods and, 501–502 500–504
account analysis and, 129–131 indirect method (statement of cash current asset and current liability
high-low method, 131–134 flows) and, 506, 507 accounts and, 501–504
I n d e x I-3
long-term asset accounts and, 504 Financial dimension, balanced scorecard Hotel check-ins, 229
long-term liabilities and stockholders’ and, 470–471 Huntsman, 372
equity and, 504 Financial leverage, 541 Hurdle bonuses, 388
Discount factors, 330 Financial ratios, 545 Hurdle rate, 331
Discretionary fixed costs, 125–126 Financial statement analysis, managerial.
Dollar sales needed to achieve profit See Managerial financial analysis J
target, 140 Financing activities, statement of cash flows JCPenney, 464
Dow Chemical, 416 and, 500 Job cost sheets, 49
Dresser Industries, 464 Finished goods inventory, 43 Job costs, financial statement accounts
Dropping product lines, 343 Finishing department, 431 and, 46
Dun & Bradstreet, 539 Firm and subunit environments, 452 Job-order costing systems, 48–53
Duplication, activity, 453 Five-year budgets, 372 daily labor cost summary, 51
DuPont, 457 Fixed costs, 9, 124–129 direct labor costs and, 50–51
Dynegy, 537 committed fixed costs, 126 direct material cost and, 49–50
discretionary fixed costs, 125–126 flow of costs in, 49
making them variable, 149 job cost sheets and, 48
E using regression in Excel and, 150–152 journal entry to record direct labor, 51
Earnings management, 537–538 Flexible budgets, 384–386 manufacturing overhead and, 52–53
Earnings management via production Flexible manufacturing systems, 338 material requisition forms and, 49
volume, 186 Flow of product costs in accounts, 42–43 process costing compared, 88–89
Earnings per share, 540, 546 Frivolous use of common resources, 206 for service companies, 60–63
Economic value added (EVA), 462–466 Full cost time tickets and, 51
companies that use, 464 cost allocation and, 208 Job tickets, 51
example of, 465–466 plus profit, transfer pricing and, 477–478 Jobs, relating product costs to, 47
organizational decisions and, 466 product cost information and, 41 Joint costs
residual income and, 463 Full (absorption) costing, 176–185 allocation of, 269–270
return on investment and, 461 compared to variable costing, 176–177 decisions involving, 269–270
Edison, Thomas, 301 just-in-time inventory management and, processing decisions and, 271
Eli Lilly, 464 185 relative sales value method, 270
Employee motivation, 418 production effects on income and, Joint products, 269
Employee requirements, 376–377 178–185 Just-in-time (JIT) inventory management,
Ending inventory, 376 quantity produced equals quantity sold, 185
Ending work in process, 95 179–181 Just-in-time (JIT) production, 63–64, 376
Endot Industries, 90 quantity produced is greater than quantity
Enron, 19, 537 sold, 181–182
Enterprise resource planning (ERP), 16, quantity produced is less than quantity
K
572 Kaplan, Robert, 468
sold, 182–184
Equipment breakdowns, 417 Kozlowski, Dennis, 18
Future emphasis, managerial accounting
Equipment purchases, 460 and, 8
Equipment setups, 210 L
Equity approach, cost allocation and, 211 Labor costs, recording of, 433
Equity financing, 339 G Labor efficiency variance, 421–422
Equivalent units, process costing and, General and administrative costs, 39 Labor rate variance, 421
92–93 General Electric, 66, 387 Labor variances, 421–422, 428–429
Ethical decision making, 18–19 General Motors, 416 Lack of goal congruence, 453
ethical and unethical behavior, 21 Generally accepted accounting principles Lay, Kenneth, 18
framework for, 20 (GAAP), 7, 41, 181, 388, 464 Lean manufacturing, 64
Institute of Management Accounting Georgia-Pacific, 464 Lexis-Nexis, 539
and, 20–21 German companies, variable costing and, Livengood Gold Mine, 333
Evans, Sir Harold, 301 177 Long-run decisions, 343
Excel, 131, 134, 150, 343 Goal congruence, 453 Long supply chains, opportunity costs
Excess production, variance analysis and, Goldratt, Eli, 273 and, 10
431–432 Gross margin percentage, 540, 546 Long-term asset accounts, direct method
Excessive cash balances, 382 Growth dimension, balanced scorecard (statement of cash flows) and, 503–504
Excessive outsourcing, 461 and, 469 Long-term liabilities, direct method (state-
External reporting, variable costing and, 182 ment of cash flows) and, 500–504
ExxonMobil, 88 H Lump-sum allocations, 216–217
Herman Miller, 464
F Hershey Company, 21 M
Facility-level activities, activity-based Hewlett-Packard, 64 Machine hours, 210, 218
costing and, 221 High-low method, 131–134 Make-or-buy decisions, 260–261
Favorable variances that are unfavorable, Historical costs, 460 Malcolm Baldrige National Quality Award,
430 Horizontal analysis 66
Federal grants and contracts, 211 balance sheet and, 533–535 Management by exception, 6, 386, 430
Financial accounting, managerial account- income statement and, 535–537 Management compensation, budget-based,
ing compared, 7–8 managerial perspective and, 533 387–388
I-4 I n d e x
Management discussion and analysis job costs and financial statement N

(MD&A), 538 accounts overview, 46 Negotiated transfer prices, 478
Manager evaluation, 4 job-order costing systems and, 48–52 Net operating profit after taxes (NOPAT),
Managerial accounting just-in-time production and, 63–64 458, 463, 464
control process and, 5–5 lean manufacturing and, 64 Net present value (NPV), 331–335
decision making and, 6–7 manufacturing costs and, 38–39 alternative projects and, 347
detail of information and, 8 manufacturing overhead and, 39 comparing alternatives with, 333–334
emphasis on future and, 8 merchandising firms compared, 39 example of, 331–332
financial accounting compared, 7–8 nonmanufacturing costs and, 39 required rate of return and, 331
generally accepted accounting principles overhead allocation base, 56–57 steps in, 331
and, 7 overhead allocation rates and, 56 taking taxes into account, 341
goal of, 4–8 period costs and, 40 use by CFOs, 338
information age and, 14–17 predetermined overhead rates and, 58–9 using Excel to calculate, 350–352
internal vs. external users and, 7 product costs and, 40–41 News articles, 539
key ideas in, 11–14 raw materials inventory and, 42 Noncontrollable costs, 11
nonmonetary information and, 8 selling costs and, 39 Noninterest-bearing current liabilities
planning and, 4 total quality management and, 65–67 (NIBCL), 459, 460, 464
Managerial decision making, ethical work in process inventory and, 42–43 Nonmanufacturing costs, 39
considerations in, 18–21 Manufacturing overhead, 52–53 Nonmonetary information, 8
Managerial financial analysis allocation base and, 56–57 Nordstrom, Inc., 457
appearance to investors and creditors budget, 377 Norton, David, 468
and, 533, 545 cost pools and, 210
balance sheet and, 533–535 costs, 39
balanced scorecard and, 545 journal entries to record, 52–53 O
cash-flow information and, 537–538 overhead allocation rate and, 52 Olin Corporation, 464
control of operations and, 532, 544 overhead applied, 52 Olis, Jamie, 537
credit reports and, 539 process costing and, 90 On-time delivery, 456
earnings management and, 537–538 recording of, 433–435 Operating activities, statement of cash flows
financial ratios and decision making, variance formulas, 422 and, 500
544 Margin of safety, 138–139 Operating leverage, 148–149
horizontal and vertical analyses and, Market price, transfer pricing and, 474 Operating profit, 464
533–537 Markup percent, cost-plus pricing and, Operational control, managerial financial
importance of, 532–533 299–300 analysis and, 532, 544
income statement analysis, 535–536 Marlow Industries, 65 Operations evaluation, 4
management discussion and analysis Master budget, 373–381 Opportunity costs
and, 538–539 budgeted balance sheet, 382 cost allocation and, 206
news articles and, 539 budgeted income statement, 377–379 definition of, 264
ratio analysis and, 540–544 capital acquisitions budget, 379 example of, 10
vendor, customer, and business partners cash budget, 379–381 summary of, 268
and, 532–533 direct labor budget, 376–377 transfer pricing and, 475–476
Managers, ideal standards and, 417 direct material purchases budget, 376 Optimizing a constraint, 274
Manufacturing firms manufacturing overhead budget, 377 Oracle, 383
activity-based costing and, 57–58 production budget, 375 Organization level, tracing costs to, 455
balance sheet presentation of product relationships among components of, Organizational chart, 22
costs, 42–43 373 Organizational decisions, economic value
buffer inventory and, 65 sales budget, 373–374 added and, 466
computer-controlled manufacturing selling and administrative budget, Outside suppliers, benefits and disadvan-
and, 52 377–378 tages of, 272
cost classifications for, 38–39 Material, standard quantity of, 416–417 Outsourcing, 262, 264, 285
cost of goods available for sale, 44 Material costs, recording of, 433–434 Outsourcing, excessive, 461
cost of goods manufactured, 43, 44 Material price variance, 419–420 Overapplied overhead, 59–60
cost of goods sold, 44–45 Material quantity variance, 420 Overhead
cost of job and cost flows, 55 Material requirements planning systems, 16 application of, 52
cost-plus pricing and, 300 Material requisition forms, 49–50 controllable overhead variances,
costing system types and, 46–48 Material variances, 419–420, 428 422–426
decision making/incremental analysis material price variance, 419–421 overhead allocation base, 56–57
and, 41 material quantity variance, 422 overhead allocation rates, 56
direct labor costs and, 39 Merchandising firms, manufacturing firms predetermined overhead rates, 58–60
direct material costs and, 38–39 compared, 38 standard costs for, 416–417
eliminating overapplied or underapplied Microsoft, 370 underapplied and overapplied, 59–60
overhead, 58–59 Mixed costs, 126 variances in, 421–422, 428–429
finished goods inventory and, 43 Money, time value of, 328–333 volume variances, 425–426
flow of product costs in accounts and, 43 Monsanto, 464 Overhead allocation
general and administrative costs and, 39 Multiproduct analysis, cost-volume-profit base, 56–57
income statement presentation of product analysis and, 141–142 production volume and, 218
costs and, 43–45 Multiyear advertising campaigns, 343 rates, 52, 56
I n d e x I-5
Overinvestment Procurement practices, 21 Relative sales value method, joint costs

profit evaluation and, 461–462 Product costing system, 36 and, 270
residual income and, 463 Product costs, 40–41 Relevant costs, 256
Overtime, needless, 390 balance sheet presentation of, 42 Relevant range, 127–128, 135–136
flow of in accounts and, 42–43 Reportable instances, 102
P income statement presentation of, 43–44 Reputation as soft benefit, 337
p-values, 152 Product defects, undetected, 430 Required rate of return, 331, 339
PACCAR, 264 Product features, cost and, 301 Research and development (R&D), 465
Part-time workers, 377 Product flows through departments, 89–90 Residual income (RI), 461–462
Payback period method, capital budgeting Product-level activities, activity-based Responsibility accounting
and, 344–345 costing and, 221 performance evaluation and, 454–455
People problems, budgeting and, 372 Product line termination, 265–267 system, 214
Perfection standards, 417 Product subcomponents, 343 Responsibility centers, 455
Performance evaluation Production budget, 4, 375 Retail firms, cost-plus pricing and, 300
balanced scorecard and, 468–471 Production cost report, process costing Return on common stockholders’ equity,
capital budgeting and, 347–348 and, 95–97 540, 547
cost centers and, 455–456 Production departments, 456 Return on investment (ROI), 457–462
economic value added and, 462–468 Production line, starting up of, 218–219 excessive outsourcing and, 461
evaluating subunit managers, 454 Production volume income and invested capital and,
evaluating subunits, 454 earnings management via, 186 458–459
investment centers and, 456–457 overhead allocation and, 218–219 investment turnover and, 458
profit centers and, 456 Profit budget, 4 overinvestment and, 461–462
responsibility accounting and, 454–455 Profit center evaluation, 456 problems with using, 460–461
return on investment and, 457–462 Profit equation, 137 profit margin and, 458
Performance measures, 13–13 Profit evaluation, overinvestment and, underinvestment and, 461, 462
Performance reports, 5, 384 461–462 Return on total assets, 540, 546
Period costs, 40 Profit margin, return on investment and, Robotics, 338
Planned capacity, operating at, 426–429 458 Rolling budgets, 387
Planning process, budgeting and, 4, 370 Profit-maximizing price, 296–297 Royal Caribbean International, 329
Poor management decisions, favorable Profit target Rubbermaid, 464
variances and, 430 dollar sales needed to achieve, 140 Rush orders, 390
Poor performance, unfavorable variances units needed to achieve, 139–140
and, 431 Profitability ratios, 540–541, 546 S
Porter, Michael, 15 Safety measures, 102
Predetermined overhead rates, 58–60 Sales budget, 373–374
Q SAP, 383
Prepaid insurance, amortization of, 380
Qualitative considerations, decision analysis
Present value factors, 330 Sarbanes-Oxley Act, 19
and, 271–272
Present value tables, 330, 353 Scattergraphs, 131
Quantity produced equals quantity sold,
Price-earnings ratio, 540, 546 Sears, 146
full vs. variable costing and, 179–181
Price variances, material, 419–420 Selling and administrative budget, 377
Quantity produced is greater than quantity
Pricing power, 298 Selling costs, 39
sold, full vs. variable costing and,
Pricing special orders, 297–299 Semivariable costs, 126
181–183
Process costing Service companies
Quantity produced is less than quantity
basic steps in, 97 activity-based management and, 226
sold, full vs. variable costing and,
calculating unit cost and, 92–93 job-order costing for, 60–61
183–184
conversion costs and, 90 Service department classification, 455–456
Quantity variances, material, 418
cost flows through accounts and, 90–91 Service department costs
Quick ratio, 543–544, 547
cost per equivalent unit and, 93–94 allocating budgeted and actual costs, 213
cost transferred out and, 95 allocation of, 212–213
direct labor and, 91 R direct allocation method and, 212–213
direct material and, 91 Ratio analysis, 540–543 Services evaluation, cost allocation and, 207
ending work in process and, 95 comparative ratio data and, 545 Shareholder value, 458
equivalent units and, 92–93 debt-related ratios, 543–544 Shareholder value added (SVA), 464
incremental analysis and, 100–101 meanings of ratios, 546–547 Shipping goods to stores, 229–231
job-order costing compared, 88–89 profitability ratios, 540–541 Short-run profitability, managers concen-
manufacturing overhead and, 91 summary of ratio formulas, 546 tration on, 350
product flows through departments, turnover ratios, 541–542 Slack, budget, 388
89–90 Raw materials inventory, 42 Small companies
production cost report and, 95–97 Reconciliation of costs, process costing investment decisions of, 328
reconciliation of costs and, 97 and, 96 sales budget and, 374
reconciliation of units and, 96–97 Reconciliation of units, process costing Soft benefits in investment decisions,
transferred-in costs and, 90, 98–100 and, 97 337–339
Process costing system, 46 Regression analysis, 134–135 calculating value of, 338–339
Process improvements, unfavorable vari- Regression in Excel, 150–152 enterprise resource planning systems
ances and, 431 Relative benefits approach to allocation, 211 and, 339
Procter & Gamble (P&G), 17 Relative performance evaluation, 456 Software systems, 16–17
I-6 I n d e x
Special order pricing, 297–298 identifying the binding constraint and, external reporting purposes and, 181
Special-purposes entities, 18 273–274 full (absorption) costing and, 176–185
Spider Connectivity Products, 465 inspections and, 275 just-in-time inventory management and,
Split-off point, 269 optimizing use of the constraint, 274 185
Spreadsheets for budgeting, 383 subordinating everything else to production effects on income and,
Sprint, 305, 464 constraint, 275 178–184
Standard costs, 416–418. See also Variance Time-and-motion studies, 417 quantity produced equals quantity sold,
analysis Time period, budgetary, 372 179–181
budgets and, 416 Time tickets, 50 quantity produced is greater than quantity
closing of accounts and, 435 Time value of money, 328–337 sold, 181–182
development of, 417 basic calculations regarding, 329–330 quantity produced is less than quantity
ideal vs. attainable standards, 417–418 internal rate of return method, 334–337 sold, 182–183
recording cost of goods sold, 435–436 net present value method, 331–333 transfer pricing and, 476–477
recording in accounts, 433–435 Times interest earned, 533, 543, 547 using regression in Excel and, 150–152
recording labor costs, 433 Total production cost, mixed costs and, 126 variable costing income statement,
recording manufacturing overhead, 434 Total quality management (TQM), 65 177–178
recording material costs, 433 Toyota, 63 Variance analysis. See also Standard costs
Starbucks use of, 416 Toys “R” Us, 464 closing of accounts, 435
updating of, 417 Tracing costs to organization level, 455 direct labor variances, 421–422
Standard labor hours, 417 Trade journals or magazines, 374 employee performance and, 431
Starbucks, 416 Transfer pricing, 474–478 excess production and, 431
Statement of cash flows full cost plus profit and, 477 favorable variances that are unfavorable,
business activity types and, 498–500 income taxes and, 478 430
direct method and, 500–504 market price and, 474–475 general approach to, 418
financing activities and, 500 negotiated transfer prices, 478 investigation of standard cost variances,
incremental analysis and, 509–510 opportunity cost and, 475–476 429
indirect method and, 504–508 variable costs and, 476–477 management by exception and, 430
interpreting information in, 509–510 Transferred-in costs, process costing and, material variances, 419–420
investing activities and, 500 91, 98–99 overhead variances, 422–426
need for, 498 Treasurer, 22 process improvements and unfavorable
operating activities and, 500 Tribune Company, 544 variances, 430
Static budgets, 384–385 Turnover ratios, 541–543, 546–547 responsibility accounting and, 432
Steelcase Inc., 464 Tyco, 18 temporary accounts and, 433
Step costs, 126–127 Variances, budget, 384, 386
Step fixed costs, 126–127 U Vendors, managerial financial analysis and,
Step variable costs, 126–127 Underapplied overhead, 59–60 532, 545
Stockholders’ equity, direct method (state- Underinvestment Vertical analysis
ment of cash flows) and, 504 residual income and, 463 balance sheet and, 533–534
Strategic partners, 547 return on investment and, 461, 462 income statement and, 535–536
Strategy map, balanced scorecard and, Unequal cash flows, internal rate of return managerial perspective and, 532–533
471–472 and, 336–337 Video game consoles, 297
Subunit environments, 452 Unit cost calculation, process costing and, Volume-related allocation bases, 218
Subunit managers, evaluating, 454 92 Volume variance, overhead, 424–426
Subunits, evaluating, 454 Unit-level activities, activity-based costing
Success factors, quantifying, 389
Sunk costs, 10, 261, 263, 267
and, 220 W
Units needed to achieve profit target, Walmart, 19
Sunk costs effect, 270 139–140 Wallace Company, 66
Supply chain management systems, 16 Unprofitable customers, fixing, 305 Watson, Chuck, 537
U.S. Postal Service, 464 “What if ” analysis, 140
T Utilized fixed costs, cost allocation and, Whirlpool, 302, 464
Target costing, 301–302 215–216 Whitmore, John, 418
Taxes Whole Foods, 464, 468
depreciation tax shield, 340–342 V Work in process inventory, 43, 434
investment opportunities and, 342–343 Value chain, information technology impact WorldCom, 18
net present value and, 342 on, 15–16
tax loss carry-forwards, 342 Variable costing Y
Temporary accounts, 433 behavior patterns and, 124 Yahoo! Finance, 539, 545
Theory of constraints, 273–275 benefits for internal reporting, 185
across-the-board cuts and, 275–276 characteristics of, 8–9
batch sizes and, 275 earnings management via production Z
breaking the constraint, 275 volume and, 186 Zero-based budgeting, 372–373
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sixth edition

A little time with ORION goes a long way.

Dear Students of Managerial Accounting,

• First, skim the chapter for a quick overview.

With my best wishes for success,

Vice President & Director George Hoffman

Tape measure icon credit: Image Source/Getty Images

This book is printed on acid free paper.

Printed in the United States of America

JAMES JIAMBALVO, Dean of the Michael G. Foster

Updated Design and Content

WileyPLUS Solution Walkthrough Videos

Additional WileyPLUS Practice

Revised Excel Templates

Recognizes that most students will become managers, not accountants.

Focuses more attention on decision making. Instructors want their students

Recognizes the growing importance of service businesses. In the last 20 years,

Clear, concise (can be covered in one semester), and current. According

Provides students with ample oppourtunities to test their knowledge. In

Prior Edition Reviewers

Equivalent Units 92 Process Costing and incremental

EFFECTS OF PRODUCTION ON INCOME FOR FULL Summary of Learning Objectives 186

PROBLEMS WITH COST ALLOCATION 213 Appendix Activity-Based Management 229

Link to Practice: Review Problems 231

Summary of Learning Objectives 307 Review Problems 308

THE MASTER BUDGET 373 Why Budget-Based Compensation Can Lead

Link to Practice: Self-Assessment438

Why Companies Evaluate the ­Performance Developing a Strategy Map For a

Chapters 13 & 14 Available in WileyPlus

A MANAGERIAL PERSPECTIVE ON THE ­ Link to Practice:

Financial Ratios in a Balanced Scorecard: You Get Review Problems 548

10–2: ABRUZZI OLIVE OIL COMPANY 12–2: Win Tech Motors

2 Define cost terms used in planning, control, and decision making.

3 Explain the two key ideas in managerial accounting.

Learning GOAL OF MANAGERIAL ACCOUNTING

Decisions to change Action taken to

Decisions to reward Comparison of planned

Cost of bottles $1,650,000

*Red numbers indicate differences deemed deserving of investigation.

A Comparison of Managerial and Financial Accounting

Internal versus External Users. Financial accounting is aimed primarily at external

Detail of Information. Financial accounting presents information in a highly summa-

Similarities between Financial and Managerial Accounting

Learning Cost Terms Used in Discussing Planning,

Variable and Fixed Costs

Prior Month Current Month

Production 400,000 Bottles Per Unit 480,000 Bottles Per Unit

Prior Month Current Month

Production 400,000 Bottles Per Unit 480,000 Bottles Per Unit

Direct and Indirect Costs

Direct Cost Indirect Cost to Various Drinks

Surge Original Green

Surge Blue with

Surge Red with

Controllable and Noncontrollable Costs

Learning Two Key Ideas in Managerial Accounting

1. Decision making relies on incremental analysis—an analysis of the

Decision Making/ Decision Making Relies on Incremental Analysis. Incremental analysis is the

Comparison of Decision Alternatives

Equivalent Units 92 Process Costing and incremental

EFFECTS OF PRODUCTION ON INCOME FOR FULL Summary of Learning Objectives 186

PROBLEMS WITH COST ALLOCATION 213 Appendix Activity-Based Management 229

Link to Practice: Review Problems 231

Summary of Learning Objectives 307 Review Problems 308

THE MASTER BUDGET 373 Why Budget-Based Compensation Can Lead

Link to Practice: Self-Assessment438

Why Companies Evaluate the Performance Developing a Strategy Map For a

A MANAGERIAL PERSPECTIVE ON THE Link to Practice:

Financial Ratios in a Balanced Scorecard: You Get Review Problems 548

1. Decision making relies on incremental analysis—an analysis of the