SUMMARY

The term cost is ambiguous when used alone; it has meaning only in a specific context. The adjectives used to modify cost
constitute that context. Exhibit 2.16 summarizes definitions of the word. It is important to consider how the use of these
terms in cost accounting differs from common usage. For example, in common usage, a variable cost may vary with anything
(geography, temperature, and so forth). In cost accounting, variable cost depends solely on volume.

Exhibit 2.16
Exhibit 2.16Summary of Cost Terms and Definitions

The following summarizes key ideas tied to the chapter's learning objectives.

LO 2-1 Explain the basic concept of “cost.” A cost is a sacrifice of resources, and an expense is a cost charged against
revenue in an accounting period, typically for external reporting purposes.

LO 2-2 Explain how costs are presented in financial statements. Cost of goods sold in a merchandising organization simply
includes the costs of purchase and incoming transportation of the goods. Cost of goods sold for manufacturing organizations
is much more complicated and includes direct materials (raw materials), direct labor, and manufacturing overhead. Cost of
goods (i.e., services) sold in a service organization primarily includes labor and overhead.

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LO 2-3 Explain the process of cost allocation. Cost allocation is required to assign, or allocate, costs recorded in various
accounts (the cost pools) to the cost objects (product, department, customer) of interest. An allocation rule specifies how this
is done because there is generally no economically feasible way of associating the costs directly with the cost objects.

LO 2-4 Understand how materials, labor, and overhead costs are added to a product at each stage of the production process.
Manufacturing organizations have three stages of production: direct materials, work in process, and finished goods. All items
not sold at the end of the period are included in inventory as an asset on the balance sheet. All finished goods sold at the end
of the period are included as cost of goods sold in the income statement.

LO 2-5 Define basic cost behaviors, including fixed, variable, semivariable, and step costs. Cost behavior can be classified in
one of four ways: fixed, variable, semivariable, or step costs.

LO 2-6 Identify the components of a product's costs.

Variable cost per unit.

Full absorption cost per unit, which is the inventoriable amount under GAAP.
 Full cost per unit of making and selling the product.

Gross margin, which equals sales price minus full absorption cost.

Contribution margin, which equals sales price minus variable cost.

Profit margin, which equals sales price minus full cost.

LO 2-7 Understand the distinction between financial and contribution margin income statements. The traditional income
statement format is used primarily for external reporting purposes, and the contribution margin income statement format is
used more for internal decision-making and performance evaluation purposes. A third alternative is the value approach,
which categorizes costs into value- and nonvalue-added activities.

KEY TERMS

administrative costs, 46

contribution margin, 58

conversion costs, 45

cost, 40

cost allocation, 47

cost allocation rule, 47

cost flow diagram, 47

cost object, 47

cost of goods sold, 44

cost pool, 47

direct cost, 48

direct labor, 45

direct manufacturing costs, 45

direct materials, 45

expense, 40

finished goods, 49

fixed costs, 53

full absorption cost, 55

full cost, 55

gross margin, 58

indirect cost, 48

indirect manufacturing costs, 45

inventoriable costs, 49

manufacturing overhead, 45
marketing costs, 46

operating profit, 41

opportunity cost, 40

outlay cost, 40

period costs, 44

prime costs, 45

product costs, 44

relevant range, 54

semivariable cost, 54

step cost, 54

variable costs, 53

work in process, 48

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REVIEW QUESTIONS

1. 2-1. What is the difference in meaning between the terms cost and expense?

2. 2-2. What is the difference between product costs and period costs?

3. 2-3. What is the difference between outlay cost and opportunity cost?

4. 2-4. Provide a business example illustrating opportunity costs.

5. 2-5. Is “cost-of-goods sold” an expense?

6. 2-6. Is “cost-of-goods” a product cost or a period cost?

7. 2-7. What are the similarities between the Direct Materials Inventory account of the manufacturer and the Merchandise
Inventory account of the merchandiser? Are there any differences between the two accounts? If so, what are they?

8. 2-8. What are the three categories of product cost in a manufacturing operation? Describe each element briefly.

9. 2-9. What is the difference between gross margin and contribution margin?

10. 2-10. To a manager making a decision, which is likely more important: gross margin or contribution margin? Why?

11. 2-11. What do the terms step costs and semivariable costs mean?

12. 2-12. What do the terms variable costs and fixed costs mean?

13. 2-13. How does a value income statement differ from a gross margin income statement? From a contribution margin
income statement?

14. 2-14. Why is a value income statement useful to managers?

CRITICAL ANALYSIS AND DISCUSSION QUESTIONS

1. 2-15. “Materials and labor are always direct costs, and supply costs are always indirect.” What is your opinion of this
statement?
 2. 2-16. The cost per seat-mile for a major U.S. airline is 14.1¢. Therefore, to estimate the cost of flying a passenger from
Detroit to Los Angeles, we should multiply 1,980 miles by 14.1¢. Do you agree? Explain.

3. 2-17. In evaluating product profitability, we can ignore marketing costs because they are not considered product costs.
Do you agree?

4. 2-18. You and two friends drive your car to Texas for spring break. A third friend asks if you can drop her off in
Oklahoma. How would you allocate the cost of the trip among the four of you?

5. 2-19. The friend in question 2-18 decides that she does not want to go to Oklahoma after all. How will the costs of your
trip change? Was your choice of allocation in question 2-18 incorrect? Why?

6. 2-20. Consider a digital music service such as those provided by Amazon or Apple. What are some of the major cost
categories? Are they mostly fixed or mostly variable?

7. 2-21. Consider a ride-sharing service such as Uber or Lyft. What are some of the major cost categories? Are they
mostly fixed or mostly variable? How are the costs different from those incurred by the drivers?

8. 2-22. Pick a unit of a hospital (for example, intensive care or maternity). Name one example of a direct materials cost,
one example of a direct labor cost, and one example of an indirect cost.

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9. 2-23. The dean of Midstate University Business School is trying to understand the costs of the school's two degree
programs: Bachelor's (BBA) and Master's (MBA). She has asked you for recommendations on how to allocate the
costs of the following services, which are used by students in both programs: cafeteria, library, and career placement.
How would you respond?

10. 2-24. Currently, generally accepted accounting principles (GAAP) in the United States require firms to expense
research and development (R&D) costs as period costs. Therefore, when the resulting product is sold, R&D costs are
not part of reported product costs. Does this mean that R&D costs are irrelevant for decision making?

11. 2-25. If value income statements are useful for decision making, why are value income statements not used in financial
reporting?

EXERCISES All applicable Exercises are included in Connect.

(LO 2-1, 5)

For each of the following statements, indicate whether it is true, false, or uncertain. Explain why. Give examples in your
answer.

1. A cost is something used up to produce revenues in a particular accounting period.

2. Variable costs are direct costs; only fixed costs are indirect costs.

3. The cost of direct materials is fixed per unit but variable in total.

2-27. Basic Concepts

(LO 2-1, 5)

For each of the following costs incurred in a manufacturing firm, indicate whether the costs are most likely fixed (F) or
variable (V) and whether they are most likely period costs (P) or product costs (M) under full absorption costing:

1. Depreciation on the building for administrative staff offices.

2. Cafeteria costs for the factory.

3. Overtime pay for assembly workers.

5. Salaries of top executives in the company.

6. Sales commissions for sales personnel.

7. Assembly line workers’ wages.

8. Controller's office rental.

9. Administrative support for sales supervisors.

10. Energy to run machines producing units of output in the factory.

2-28. Basic Concepts

(LO 2-1, 2)

For each of the following costs incurred in a manufacturing operation, indicate whether they are included in prime costs (P),
conversion costs (C), or both (B):

1. Assembly line worker's salary.

2. Direct materials used in the production process.

3. Property taxes on the factory.

4. Lubricating oil for plant machines.

5. Transportation-in costs on materials purchased.

2-29. Basic Concepts

(LO 2-1, 2, 5)

Place the number of the appropriate definition in the blank next to each concept.

Concept Definition

____Period cost 1. Sacrifice of resources.

____Indirect cost 2. Cost that cannot be directly related to a cost object.

____Fixed cost 3. Cost that varies with the volume of activity.

____Opportunity cost 4. Cost used to compute inventory value according to GAAP.

____Outlay cost 5. Cost charged against revenue in a particular accounting period.

____Direct cost 6. Cost that can be directly related to a cost object.

____Expense 7. Past, present, or near-future cash flow.

____Cost 8. Lost benefit from the best forgone alternative.

____Variable cost 9. Cost that can more easily be attributed to time intervals.

____Full absorption cost 10. Cost that does not vary with the volume of activity.

____Product cost 11. Cost that is part of inventory.

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2-30. Basic Concepts

(LO 2-1, 5)

For each of the following costs incurred in a manufacturing firm, indicate whether the costs are fixed (F) or variable (V) and
whether they are period costs (P) or product costs (M) under full absorption costing:

1. Power to operate factory equipment.

2. Chief financial officer's salary.

3. Commissions paid to sales personnel.

4. Office supplies for the human resources manager.

5. Depreciation on pollution control equipment in the plant.

2-31. Basic Concepts

(LO 2-1, 2, 6)

The following data apply to the provision of psychological testing services:

Required

Give the amount for each of the following (one unit = one test):

1. Variable production cost per unit.

2. Variable cost per unit.

3. Full cost per unit.

4. Full absorption cost per unit.

5. Prime cost per unit.

6. Conversion cost per unit.

7. Contribution margin per unit.

8. Gross margin per unit.

9. Suppose the number of units decreases to 1,250 tests per month, which is within the relevant range. Which parts of (a)
through (h) will change? For each amount that will change, give the new amount for a volume of 1,250 tests.

2-32. Basic Concepts

Intercontinental, Inc., provides you with the following data for its single product:

Required

Give the amounts for each of the following:

1. Prime cost per unit.

2. Contribution margin per unit.

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3. Gross margin per unit.

4. Conversion cost per unit.

5. Variable cost per unit.

6. Full absorption cost per unit.

7. Variable production cost per unit.

8. Full cost per unit.

9. Suppose the number of units increases to 400,000 units per month, which is within the relevant range. Which of
amounts (a) through (h) will change? For each that will change, give the new amount for a volume of 400,000 units.

2-33. Cost Allocation—Ethical Issues

(LO 2-3)

In one of its divisions, an aircraft components manufacturer produces experimental navigational equipment for spacecraft and
for private transportation companies. Although the products are essentially identical, they carry different product numbers.
The XNS-12 model is sold to a government agency on a cost-reimbursed basis. In other words, the price charged to the
government is equal to the computed cost plus a fixed fee. The JEF-3 model is sold to the private transportation companies
on a competitive basis. The product development cost, common to both models, must be allocated to the two products in
order to determine the cost for setting the price of the XNS-12.

Required

1. How would you recommend the product development cost be allocated between the two products?

2. What incentives do managers have to allocate product development costs? Why?

2-34. Cost Allocation—Ethical Issues

Star Buck, a coffee shop manager, has two major product lines—drinks and pastries. If Star allocates common costs on any
objective basis discussed in this chapter, the drinks are profitable, but the pastries are not. Star is concerned that her boss will
pull the plug on pastries. Star's brother, who is struggling to make a go of his new business, supplies pastries to the coffee
shop. Star decides to allocate all common costs to the drinks because, “Drinks can afford to absorb these costs until we get
the pastries line on its feet.” After assigning all common costs to drinks, both the drinks and pastries product lines appear to
be marginally profitable. Consequently, Star's manager decides to continue the pastries line.

Required

1. How would you recommend Star allocate the common costs between drinks and pastries?

2. You are the assistant manager and have been working with Star on the allocation problem. What should you do?

2-35. Prepare Statements for a Manufacturing Company

(LO 2-2, 4)

The following balances are from the accounts of Tappan Parts:

Direct materials used during the year amount to $1,196,000 and the cost of goods sold for the year was $1,378,000.

Required

Find the following by completing a cost of goods sold statement:

1. Cost of direct materials purchased during the year.

2. Cost of goods manufactured during the year.

3. Total manufacturing costs incurred during the year.

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2-36. Prepare Statements for a Service Company

(LO 2-2)

Chuck's Brokerage Service (CBS) is a discount financial services firm offering clients investment advice, trading services,
and a variety of mutual funds for investment. Chuck has collected the following information for October:
Required

Prepare an income statement for October for CBS.

2-37. Prepare Statements for a Service Company

(LO 2-2)

Where2 Services is a small service firm that advises high school students on college opportunities. Joseph Kapp, the founder
and president, has collected the following information for March:

Required

Prepare an income statement for March for Where2 Services.

2-38. Prepare Statements for a Service Company

(LO 2-2)

The following data are available for Remington Advisors for the month just ended:

Required

Find the following by completing a cost of goods sold statement:

1. Marketing and administrative costs.

2. Cost of services sold.

2-39. Prepare Statements for a Service Company

(LO 2-2)
Lead! Inc. offers executive coaching services to small business owners. Lead!'s operating profits average 20 percent of
revenues and its marketing and administrative costs average 25 percent of the cost of services sold.

Required

Lead! Inc. expects revenues to be $600,000 for April. Prepare an income statement for April for Lead! Inc. assuming its
expectations are met.

2-40. Prepare Statements for a Manufacturing Company

(LO 2-2, 4)

The following balances are from the accounts of Crabtree Machining Company:

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Direct materials purchased during the year amount to $717,600, and the cost of goods sold for the year was $2,606,880.

Required

Reconstruct a cost of goods sold statement and fill in the following missing data:

1. Cost of direct materials used during the year.

2. Cost of goods manufactured during the year.

3. Total manufacturing costs incurred during the year.

2-41. Basic Concepts

(LO 2-1, 2)

The following data refer to one year for Monroe Fabricators. Fill in the blanks.
2-42. Basic Concepts

(LO 2-1, 2)

The following data refers to one month for Talmidge Company. Fill in the blanks.

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2-43. Prepare Statements for a Merchandising Company

(LO 2-2)

The cost accountant for Angie's Apparel has compiled the following information for last month's operations:

Required

Prepare an income statement with a supporting cost of goods sold statement.

2-44. Prepare Statements for a Merchandising Company

(LO 2-2)

University Electronics has provided the following information for last year:

Required
Prepare an income statement for last year with a supporting cost of goods sold statement.

2-45. Cost Behavior and Forecasting

(LO 2-5)

Dayton, Inc. manufactured 30,000 units of product last month and identified the following costs associated with the
manufacturing activity:

Required

Unit variable costs and total fixed costs are expected to remain unchanged next month. Calculate the unit cost and the total
cost if 36,000 units are produced next month.

2-46. Components of Full Costs

(LO 2-6)

Madrid Corporation has compiled the following information from the accounting system for the one product it sells:

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Required

Determine each of the following unit costs:

1. Variable manufacturing cost.

2. Variable cost.

3. Full absorption cost.

4. Full cost.

2-47. Components of Full Costs

(LO 2-6)

Refer to Exercise 2-46.

Compute:

1. Product costs per unit.

2. Period costs for the period.

2-48. Components of Full Costs

(LO 2-6)

Larcker Manufacturing's cost accountant has provided you with the following information for January operations:

Required

Determine each of the following:

1. Variable cost.

2. Variable manufacturing cost.

3. Full absorption cost.

4. Full cost.

5. Profit margin.

6. Gross margin.

7. Contribution margin.

2-49. Gross Margin and Contribution Margin Income Statements

(LO 2-7)

Refer to Exercise 2-48.

Required

Prepare:

1. A gross margin income statement.

2. A contribution margin income statement.

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2-50. Gross Margin and Contribution Margin Income Statements

(LO 2-7)

The following data are from the accounting records of Niles Castings for year 2:
Required

Prepare:

1. A gross margin income statement.

2. A contribution margin income statement.

2-51. Gross Margin and Contribution Margin Income Statements

(LO 2-7)

Alpine Coffee Roasters reports the following information for November:

Required

Prepare:

1. A gross margin income statement.

2. A contribution margin income statement.

2-52. Value Income Statement

(LO 2-7)

Ralph's Restaurant has the following information for year 2, when several new employees were added to the waitstaff:
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Required

1. Using the traditional income statement format, prepare a value income statement.

2. What value would there be to Ralph from preparing the same information in year 3?

2-53. Value Income Statement

(LO 2-7)

DeLuxe Limo Service has the following information for March:

Required

1. Using the traditional income statement format, prepare a value income statement.

2. What value would there be to the managers at DeLuxe from preparing the same information in April?

PROBLEMS All applicable Problems are included in Connect.

(LO 2-1, 6)

The following information comes from the accounting records for Chelsea, Inc., for May:
Required

Compute for the month of May:

1. Total prime costs.

2. Total conversion costs.

3. Total manufacturing costs.

4. Cost of goods manufactured.

5. Cost of goods sold.

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2-55. Cost Concepts

(LO 2-1, 6)

The controller at Lawrence Components asks for your help in sorting out some cost information. She is called to a meeting,
but hands you the following information for April:

Required

Compute:

1. Direct materials used, April.

2. Direct materials inventory, April 1.

3. Conversion costs, April.

4. Work-in-process inventory, April 30.

5. Manufacturing overhead, April.

6. Finished goods inventory, April 1.

2-56. Cost Concepts

(LO 2-1, 6)
Columbia Products produced and sold 900 units of the company's only product in March. You have collected the following
information from the accounting records:

Required

1. Compute:

1. Variable manufacturing cost per unit.

2. Full cost per unit.

3. Variable cost per unit.

4. Full absorption cost per unit.

5. Prime cost per unit.

6. Conversion cost per unit.

7. Profit margin per unit.

8. Contribution margin per unit.

9. Gross margin per unit.

2. If the number of units produced increases from 900 to 1,200, which is within the relevant range, cost per unit will
decrease (you can check this by redoing requirement [a] above). Therefore, we should recommend that Columbia
Products increase its production to reduce its costs. Do you agree? Explain.

2-57. Prepare Statements for a Manufacturing Company

(LO 2-2, 4)

Yolo Windows, a manufacturer of windows for commercial buildings, reports the following account information for last year
(all costs are in thousands of dollars):

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Required

Prepare an income statement with a supporting cost of goods sold statement.

2-58. Prepare Statements for a Manufacturing Company

(LO 2-2, 4)

Mesa Designs produces a variety of hardware products, primarily for the do-it-yourself (DIY) market. As part of your job
interview as a summer intern at Mesa, the cost accountant provides you with the following (fictitious) data for the year (in
$000):

Required

Prepare the income statement with a supporting cost of goods sold statement.
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2-59. Prepare Statements for a Manufacturing Company

(LO 2-2, 4)

The administrative offices and manufacturing plant of Billings Tool & Die share the same building. The following
information (in $000s) appears in the accounting records for last year:

Required

Prepare an income statement with a supporting cost of goods sold statement.

2-60. Cost Allocation with Cost Flow Diagram

(LO 2-3)

Coastal Computer operates two retail outlets in Oakview, one on Main Street and the other in Lakeland Mall. The stores share
the use of a central accounting department. The cost of the accounting department for last year was $180,000. Following are
the operating results for the two stores for the year:

Required

1. Allocate the cost of the central accounting department to the two stores based on:

1. Number of computers sold.

2. Store revenue.

2. Draw a cost flow diagram to illustrate your answer to requirement (a), part (2).

2-61. Cost Allocation with Cost Flow Diagram

(LO 2-3)

Wayne Casting, Inc., produces a product made from a metal alloy. Wayne buys the alloy from two different suppliers,
Chillicothe Metals and Ames Supply, in approximately equal amounts because of supply constraints at both vendors. The
material from Chillicothe is less expensive to buy, but more difficult to use, resulting in greater waste. The metal alloy is
highly toxic and any waste requires costly handling to avoid environmental accidents. Last year the cost of handling the
waste totaled $300,000. Additional data from last year's operations are shown below.

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Required

1. Allocate the cost of the waste handling to the two suppliers based on:

1. Amount of material purchased.

2. Amount of waste.

3. Cost of material purchased.

2. Draw a cost flow diagram to illustrate your answer to requirement (a), part (1).

2-62. Cost Allocation with Cost Flow Diagram

(LO 2-3)

The library at Pacific Business School (PBS) serves both undergraduate and graduate programs. The dean of PBS is
interested in evaluating the profitability of the degree programs and has asked the head of the library, Rex Gilmore, to
allocate the annual library cost of $4,035,000 to the two programs.

Rex believes that two cost drivers explain most of the costs: number of students and credit hours. Using information from a
previous analysis, he split the annual library budget as follows:

Required

1. Allocate the cost of the library to the two programs (undergraduate and graduate).

2. Draw a cost flow diagram to illustrate your answer to requirement (a).

2-63. Find the Unknown Information

(LO 2-1, 6)
After a computer failure, you are trying to reconstruct some financial results for the year just ended. While you know that
backups are available, it will take too long to get the information you want. You have been able to collect the following
information:

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Required

Find the following:

1. Finished goods inventory, January 1.

2. Direct materials used for the year.

3. Sales revenue.

2-64. Find the Unknown Information

(LO 2-1, 6)

Just before class starts, you realize that you have mistakenly recycled the second page of your cost accounting homework
assignment. Fortunately, you still have the first page of the printout from your spreadsheet (shown below) and you remember
that you were able to determine the items on the recycled page from this information.

Required

Find the following:

1. Cost of goods sold.

2. Direct materials used.

3. Purchases of direct materials.

4. Sales revenue.
2-65. Cost Allocation and Regulated Prices

(LO 2-3)

The City of Imperial Falls contracts with Evergreen Waste Collection to provide solid waste collection to households and
businesses. Until recently, Evergreen had an exclusive franchise to provide this service in Imperial Falls, which meant that
other waste collection firms could not operate legally in the city. The price per pound of waste collected was regulated at 20
percent above the average total cost of collection.

Cost data for the most recent year of operations for Evergreen are as follows:

Data on customers for the most recent year are:

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The City Council of Imperial Falls is considering allowing other private waste haulers to collect waste from businesses, but
not from households. Service to businesses from other waste collection firms would not be subject to price regulation. Based
on information from neighboring cities, the price that other private waste collection firms will charge is estimated to be $0.04
per pound (= $80 per ton).

Evergreen's CEO has approached the city council with a proposal to change the way costs are allocated to households and
businesses, which will result in different rates for households and businesses. She proposes that administrative costs and
truck operating costs be allocated based on the number of customers and the other collection costs be allocated based on
pounds collected. The total costs allocated to households would then be divided by the estimated number of pounds collected
from households to determine the cost of collection. The rate would then be 20 percent above the cost. The rate for
businesses would be determined using the same calculation.

Required

1. Based on cost data from the most recent year, what is the price per pound charged by Evergreen for waste collection
under the current system (the same rate for both types of customers)?

2. Based on cost and waste data from the most recent year, what would be the price per pound charged to households and
to businesses by Evergreen for waste collection if the CEO's proposal were accepted?

3. As a staff member to one of the council members, would you support the proposal to change the way costs are
allocated? Explain.

2-66. Reconstruct Financial Statements

(LO 2-1, 2, 6)

San Ysidro Company manufactures hiking equipment. The company's administrative and manufacturing operations share the
company's only building. Eighty percent of the building is used for manufacturing and the remainder is used for
administrative activities. Indirect labor is 8 percent of direct labor.

The cost accountant at San Ysidro has compiled the following information for the year ended December 31:

Required

Prepare a cost of goods manufactured and sold statement and an income statement.

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2-67. Finding Unknowns

(LO 2-2)

Mary's Mugs produces and sells various types of ceramic mugs. The business began operations on January 1, year 1, and its
costs incurred during the year include these:

On December 31, year 1, direct materials inventory consisted of 3,750 pounds of material. Production in that year was 20,000
mugs. All prices and unit variable costs remained constant during the year. Sales revenue for year 1 was $73,312. Finished
goods inventory was $6,105 on December 31, year 1. Each finished mug requires 0.4 pounds of material.

Required

Compute the following:

1. Direct materials inventory cost, December 31, year 1.

2. Finished goods ending inventory in units on December 31, year 1.

3. Selling price per unit.

2-68. Finding Unknowns

(LO 2-2)

BS&T Partners has developed a new hubcap with the model name Spinnin’ Wheel. Production and sales started August 3. As
of August 2, there were no direct materials in inventory. Data for the month of August include the following:

Required

Complete the table.

INTEGRATIVE CASE
2-69. Analyze the Impact of a Decision on Income Statements

(LO 2-2)

You were appointed the manager of Drive Systems Division (DSD) at Tunes2Go, a manufacturer of portable music devices
using the latest developments in hard drive technology, on December 15 last year. DSD manufactures the drive assembly, M-
24, for the company's most popular product. Your bonus is determined as a percentage of your division's operating profits
before taxes.

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One of your first major investment decisions was to invest $3 million in automated testing equipment for the M-24. The
equipment was installed and in operation on January 1 of this year.

This morning, J. Bradley Finch III, the assistant manager of the division (and, not coincidentally, the grandson of the
company founder and son of the current CEO) told you about an offer by Pan-Pacific Electronics. Pan-Pacific wants to rent
to DSD a new testing machine that could be installed on December 31 (only two weeks from now) for an annual rental
charge of $690,000. The new equipment would enable you to increase your division's annual revenue by 7 percent. This new,
more efficient machine would also decrease fixed cash expenditures by 6 percent.

Without the new machine, operating revenues and costs for the year are estimated to be as shown below. Sales revenue and
fixed and variable operating costs are all cash.
If you rent the new testing equipment, DSD will have to write off the cost of the automated testing equipment this year
because it has no salvage value. Equipment depreciation shown in the income statement is for this automated testing
equipment. Equipment losses are included in the bonus and operating profit computation.

Because the new machine will be installed on a company holiday, there will be no effect on operations from the changeover.
Ignore any possible tax effects. Assume that the data given in your expected income statement are the actual amounts for this
year and next year if the current equipment is kept.

Required

1. Assume the new testing equipment is rented and installed on December 31. What will be the impact on this year's
divisional operating profit?

2. Assume the new testing equipment is rented and installed on December 31. What will be the impact on next year's
divisional operating profit?

3. Would you rent the new equipment? Why or why not?

SOLUTIONS TO SELF-STUDY QUESTIONS

3. Fixed manufacturing = $7.50 (= $12,000 ÷ 1,600)

Fixed marketing and administration = $8.75 (= $14,000 ÷ 1,600)

4. Gross margin = Sales price − Full absorption cost = Sales price − (Variable manufacturing + Fixed manufacturing) =
$45 − ($23 + $6) = $16

Contribution margin = Sales price − Variable costs = Sales price − (Variable manufacturing + Variable marketing and
administrative) = $45 − ($23 + $3) = $19

Operating profit = Sales price − Full cost to make and sell product = Sales price − (Variable manufacturing + Fixed
manufacturing + Variable marketing and administrative + Fixed marketing and administrative) = $45 − ($23 + $6 + $3
+ $7) = $6

(Note: The gross margin does not change from Exhibit 2.12 because marketing and administrative costs are subtracted
after gross margin.)

5. Gross margin = $45 − ($23 + $5) = $17

Contribution margin = $45 − ($23 + $4) = $18

Operating profit = $45 − ($23 + $5 + $4 + $7) = $6

(Note: The contribution margin does not change from Exhibit 2.13; however, the gross margin changes from Exhibit
2.12.)