Accounting 1-8

Prepare, Apply, and Confirm

!.----------:~.:.., 1- ~

• Auto-Graded Excel Projects-Using proven, field-tested technology, MyAccountingLab's new auto-graded Excel Projects allow instructors to seamlessly integrate Excel content into their course without having to manually grade spreadsheets. Students have the opportunity to practice important Accounting skills in Microsoft Excel, helping them to master key concepts and gain proficiency in Excel. Students simply download a spreadsheet, work live on an accounting problem in Excel, and then upload that file back into MyAccountingLab, where they receive reports on their work that provide personalized, detailed feedback to pinpoint where they went wrong on any step of the problem. Available with select titles.

• Enhanced eText- The Pearson eText gives students access to their textbook anytime, anywhere. In addition to note- taking, highlighting, and bookmarking, the Pearson eText offers interactive and sharing features. Students actively read and learn through auto-graded practice, author videos, and more. Instructors can share comments or highlights, and students can add their own, for a tight community of learners in any class.

·I • Keep students engaged in learning on their own time, while helping them achieve greater conceptual understanding of course material through author-created solutions videos, opportunities to Try It!, and live exhibits.

• Dynamic Study Modules-With a focus on key topics, these modules work by continuously assessing student performance and activity in real time and, using data and analytics, provide personalized content to reinforce concepts that target each student's particular strengths and weakness.

1' Pearson •

with MyAccountinglab ®

• Hallmark Features-Personalized Learning Aids, like Help Me Solve This, Demo Docs, and instant feedback are available for further practice and mastery when students need the help most!

• Learning Catalytics-Generates classroom discussion, guides lecture, and promotes peer-to-peer learning with real-time analytics. Now, students can use any device to interact in the classroom.

• Personalized Study Plan-Assists students in monitoring their own progress by offering them a customized study plan based on Homework, Quiz, and Test results. Includes regenerated exercises with unlimited practice, as well as the opportunity to earn mastery points by completing quizzes on recommended learning objectives.

• Worked Solutions-Provide step-by-step explanations on how to solve select problems using the exact numbers and data that were presented in the problem. Instructors will have access to the Worked Out Solutions in preview and review mode.

ALWAYS LEARNING

Prepare, Apply, and Confirm with MyAccountinglab ®

• Algorithmic Test Bank-Instructors have the ability to create multiple versions of a test or extra practice for students.

• Reporting Dashboard-View, analyze, and report learning outcomes clearly and easily. Available via the Gradebook and fully mobile-ready, the Reporting Dashboard presents student performance data at the class, section, and program levels in an accessible, visual manner.

• LMS Integration-Link from any LMS platform to access assignments, rosters, and resources, and synchronize Mylab grades with your LMS gradebook. For students, new direct, single sign-on provides access to all the personalized learning Mylab resources that make studying more efficient and effective.

0

1' Pearson ALWAYS LEARNING •

This page intentionally left blank

Accounting in the Headlines.

One of the biggest challenges for accounting instructors is that students often feel disengaged from the course material, which can seem abstract and unrelated to their personal experiences. But by incorporating real-life exam- ples, instructors can spark student interest and engagement, especially when teaching accounting at the introductory level.

Accounting in the Headlines, an award-winning blog by renowned author Wendy Tietz, does just that with stories about real companies and events that can be used in the accounting classroom to illustrate introductory financial and managerial accounting concepts.

Concise, tailorable, and updated on a weekly basis, these articles easily fit into the typical introductory accounting curriculum, whether the course is delivered in-person or online. Accounting in the Headlines articles, along with multiple-choice and polling questions, can be assigned through MyAccounting lab and Learning Catalytics™. Instructors are also provided with discussion questions, PowerPoint slides, and handout files, to support learning initiatives.

http://accountingintheheadlines.com

This page intentionally left blank

Managerial Accounting

Fifth Edition

Karen Wilken Braun, PhD, CPA, CGMA Case Western Reserve University

Wendy M. Tietz, PhD, CPA, CGMA, CMA Kent State University

@ Pearson New York, NY

Vice President, Business Publishing: Donna Batt ista Director of Portfolio Management: Adrienne D'Ambros io Senior Portfolio Manager: Ellen Geary

Vice President, Product Marketing: Roxanne McCarley Director of Strategic Marketing: Brad Parkins

Strategic Marketing Manager: Deborah Strick land Product Marketer: Tric ia Murphy Field Marketing Manager: Nata lie Wagner Field Marketing Assistant: Kristen Compton Product Marketing Assistant: Jess ica Ouazza Vice President, Production and Digital Studio, Arts and

Business: Etain O'Dea Director of Production, Business: Jeff Holcomb

Managing Producer, Business: Ashley Santora Content Producer: Dan iel Edward Petr ino Operations Specialist: Caro l Melvi lle Creative Director: Bla ir Brown

Manager, Learning Tools: Brian Surette Content Developer, Learning Tools: Sarah Peterson Managing Producer, Digital Studio, Arts and Business: Diane

Lombardo

Digital Studio Producer: Reg ina DaSilva Digital Studio Producer: Alana Co les Digital Content Team Lead: Noe l Lotz Digital Content Project Lead: Martha LaChance Full-Service Project Management and Composition: Kathy

Sm ith, Cenveo® Publ isher Services

Interior Design: Jer ilyn Bockorick, Cenveo® Publ isher Services Cover Design: Cenveo® Publ isher Services

Cover Art: style-photography/shutterstock & niko lae/ shutterstock

Printer/Binder: LSC Communicat ions

Cover Printer: Phoenix

M icrosoft and/or its respect ive suppl iers make no representat ions abo ut the suitabi lity of the informat ion

contained in the documents and related graphics pub lished as part of the serv ices for any purpose. Al l such

documents and related graphics are provided "as is" without warranty of any kind. Microsoft and/or its re-

spective suppl iers hereby d isclaim al l warranties and cond it ions w ith regard to this information, includ ing all

warranties and conditions of merchantabi lity, whether express, impl ied or statutory, fitness for a part icu lar

purpose, tit le and non-infringement. In no event shal l Microsoft and/or its respective supp liers be liab le for

any specia l, ind irect or consequent ial damages or any damages whatsoever result ing from loss of use, data

or prof its, whether in an action of contract, negl igence or other tort ious act ion, ar ising o ut of or in connect ion

with the use or performance of informat ion ava ilable from the serv ices.

T he documents and related graphics contained here in cou ld include techn ical inaccuracies or typographical

errors. Changes are per iodical ly added to the information herein. Microsoft and/or its respect ive suppl iers

may make improvements and/or changes in the product(s) and/or the program(s) descr ibed herein at any

time. Partia l screen shots may be viewed in ful l with in the software version specified.

M icrosoft® and W indows® are reg istered trademarks of the Microsoft Corporat ion in the U.S.A. and other

countr ies. T his book is not sponsored or endorsed by or affi liated w ith the Microsoft Corporat ion.

Copyr ight© 2018, 2015, 2013 by Pearson Education, Inc. or its aff iliates. Al l Rights Reserved. Manufactured

in the Un ited States of America. This pub licat ion is protected by copyright, and permiss ion shou ld be ob-

ta ined from the pub lisher prior to any prohibited reproduction, storage in a retr ieva l system, or transmiss ion

in any form or by any means, electronic, mechanica l, photocopying, recording, or otherw ise. For informat ion

regarding perm issions, request forms, and the appropriate contacts within the Pearson Educat ion G lobal

Rights and Perm issions department, p lease vis it www.pearsoned.com/permiss ions/.

Acknowledgments of third-party content appear on the appropriate page w ith in the text.

PEARSON, ALWAYS LEARNING, and MYACCOUNTINGLAB® are exclus ive trademarks owned by Pearson

Education, Inc. or its aff iliates in the U.S. and/or other countries.

Un less otherwise indicated herein, any th ird-party trademarks, logos, or icons that may appear in th is work are

the property of the ir respective owners, and any references to th ird-party trademarks, logos, icons, or other trade

dress are for demonstrative or descr ipt ive purposes only. Such references are not intended to imply any spon-

sorship, endorsement, author ization, or promotion of Pearson's products by the owners of such marks, or any

relationsh ip between the owner and Pearson Educat ion, Inc., or its affiliates, authors, licensees, or distributors.

Cataloging-in-Publication Data is on file at the Library of Congress

16

@Pearson ISBN 13: 978-0-13-412852-8 ISBN 10: 0-13-412852-4

BRIEF CONTENTS

1 Introduction to Managerial Accounting 1 2 Building Blocks of Managerial Accounting 48 3 Job Costing 104 4 Activity-Based Costing, Lean Operations, and the Costs of Quality 175 5 Process Costing 245 6 Cost Behavior 307 7 Cost-Volume-Profit Analysis 381 8 Relevant Costs for Short-Term Decisions 443 9 The Master Budget 507

1 Q Performance Evaluation 583 11 Standard Costs and Variances 653 1 2 Capital Investment Decisions and the Time Value of Money 71 o 1 3 Statement of Cash Flows 779 1 4 Financial Statement Analysis 838 1 5 Sustainability 894

Glossary/Index 1-1

V

CONTENTS

1

2

vi

Introduction to Managerial Accounting 1

What Is Managerial Accounting? 2

Managers' Three Primary Responsibilities 2

A Road Map: How Managerial Accounting Fits In 3

Differences Between Managerial Accounting and Financial Accounting 4

What Role Do Management Accountants Play? 6

The Role of Management Accountants 6

The Skills Required of Management Accountants 7

Managerial Accounting Is Important to All Careers 8

Accounting within the Organizational Structure 9

Professional Associations 10

Average Salaries of Management Accountants 12

Professional Ethics 12

Examples of Ethical Dilemmas 14

What Business Trends and Regulations Affect Management Accounting? 18

Big Data, Data Analytics, and Critical Thinking 18

Shifting Economy 20

Globalization 20

Lean Thinking and Focus on Quality 21

Sustainability, Social Responsibility, and the Triple Bottom Line 21

Integrated Reporting 22

The Sarbanes-Oxley Act of 2002 23

End of Chapter 27

Building Blocks of Managerial Accounting 48

What Are the Most Common Business Sectors and Their Activities? 49

Service, Merchandising, and Manufacturing Companies 49

Which Business Activities Make Up the Value Chain? 51

Coordinating Activities Across the Value Chain 52

How Do Companies Define Cost? 55

Cost Objects, Direct Costs, and Indirect Costs 55

Costs for Internal Decision Making and External Reporting 57

Merchandising Companies' Product Costs 58

Manufacturing Companies' Product Costs 60

Prime and Conversion Costs 61

Additional Labor Compensation Costs 62

Recap: Product Costs Versus Period Costs 62

How Are Product Costs and Period Costs Shown in the Financial Statements? 65

Service Companies 65

Merchandising Companies 65

Manufacturing Companies 67

Comparing Balance Sheets 70

What Other Cost Terms Are Used by Managers? 71

Controllable Versus Uncontrollable Costs 71

Relevant and Irrelevant Costs 71

Fixed and Variable Costs 72

How Manufacturing Costs Behave 73

Calculating Total and Average Costs 73

End of Chapter 78

3 Job Costing 104 What Methods Are Used to Determine the

Cost of Manufacturing a Product? 105

Process Costing 105

Job Costing 106

How Do Manufacturers Determine a Job's Cost? 107

Overview: Flow of Inventory Through a Manufacturing System 107

4

Scheduling Production 108

Purchasing Raw Materials 109

Using a Job Cost Record to Keep Track of Job Costs 110

Tracing Direct Materials Cost to a Job 112

Tracing Direct Labor Cost to a Job 114

Allocating Manufacturing Overhead to a Job 116

Completing the Job Cost Record and Using It to Make Business Decisions 119

How Can Job Costing Information Be Enhanced for Decision Making? 121

Non-Manufacturing Costs 121

Direct or Variable Costing 123

How Do Managers Deal with Underallocated or Overallocated Manufacturing Overhead? 127

What Journal Entries Are Needed in a Manufacturer's Job Costing System? 129

APPENDIX 3A 143

How Do Service Firms Use Job Costing to Determine the Amount to Bill Clients? 143

What Costs Are Considered Direct Costs of Serving a Client? 143

What Costs Are Considered Indirect Costs of Serving a Client? 144

Finding the Total Cost of the Job and Adding a Profit Markup 145

Invoicing Clients Using a Professional Billing Rate 145

What Journal Entries Are Needed in a Service Firm's Job Costing System? 146

End of Chapter 147

Activity-Based Costing, Lean Operations, and the Costs of Quality 175

Why and How Do Companies Refine Their Cost Allocation Systems? 176

Simple Cost Allocation Systems Can Lead to Cost Distortion 17 6

Review: Using a Plantwide Overhead Rate to Allocate Indirect Costs 177

Contents vii

Using Departmental Overhead Rates to Allocate Indirect Costs 179

Using Activity -Based Costing to Allocate Indirect Costs 184

How Do Managers Use the Refined Cost Information to Improve Operations? 191

Activity-Based Management (ABM) 191

Passing the Cost-Benefit Test 193

What Is Lean Thinking? 198

The Eight Wastes of Traditional Operations 198

Characteristics of Lean Operations 200

Lean Operations in Service and Merchandising Companies 205

How Do Managers Improve Quality? 206

Costs of Quality (COO) 206

Relationship Among Costs 207

Using Costs of Quality Reports to Aid Decisions 208

End of Chapter 213

5 Process Costing 245 Process Costing: An Overview 246

Two Basic Costing Systems: Job Costing and Process Costing 246

How Does the Flow of Costs Differ Between Job and Process Costing? 247

What Are the Building Blocks of Process Costing? 250

Conversion Costs 250

Equivalent Units 250

Inventory Flow Assumptions 251

How Does Process Costing Work in the First Processing Department? 252

Step 1: Summarize the Flow of Physical Units 254

Step 2: Compute Output in Terms of Equivalent Units 254

Step 3: Summarize Total Costs to Account For 256

Step 4: Compute the Cost per Equivalent Unit 256

Step 5: Assign Total Costs to Units Completed and to Units in Ending Work in Process Inventory 257

Average Unit Costs 257

viii Contents

What Journal Entries Are Needed in a Process Costing System? 259

How Does Process Costing Work in a Second or Later Processing Department? 264

Process Costing in SeaView's Insertion Department 264

Steps 1 and 2: Summarize the Flow of Physical Units and Compute Output in Terms of Equivalent Units 266

Steps 3 and 4: Summarize Total Costs to Account for and Compute the Cost per Equivalent Unit 267

Step 5: Assign Total Costs to Units Completed and to Units in Ending Work in Process Inventory 268

Unit Costs and Gross Profit 268

Production Cost Reports 269

Journal Entries in a Second Processing Department 270

End of Chapter 275

6 Cost Behavior 307 Cost Behavior: How Do Changes in Volume Affect Costs? 308

Variable Costs 308

Fixed Costs 311

Mixed Costs 314

Relevant Range 316

Other Cost Behaviors 317

How Do Managers Determine Cost Behavior? 322

Account Analysis 322

Scatterplots 322

High-Low Method 324

Regression Analysis 326

Data Concerns 330

What Are the Roles of Variable Costing and the Contribution Margin Income Statement? 331

Comparing Absorption Costing and Variable Costing 331

7

The Contribution Margin Income Statement 333

Comparing Operating Income: Variable Versus Absorption Costing 336

Reconciling Operating Income Between the Two Costing Systems 338

End of Chapter 346

Cost-Volume-Profit Analysis 381

How Does Cost-Volume-Profit Analysis Help Managers? 382

Data and Assumptions Required for CVP Analysis 382

The Unit Contribution Margin 383

The Contribution Margin Ratio 385

How Do Managers Find the Breakeven Point? 386

The Income Statement Approach 387

The Shortcut Approach Using the Unit Contribution Margin 388

The Shortcut Approach Using the Contribution Margin Ratio 388

How Do Managers Find the Volume Needed to Earn a Target Profit? 389

How Much Must We Sell to Earn a Target Profit? 389

Graphing CVP Relationships 391

How Do Managers Use CVP to Make Decisions When Business Conditions Change? 396

Changing the Sales Price and Volume 396

Changing Variable Costs 398

Changing Fixed Costs 399

Changing the Mix of Products Offered for Sale 402

What Are Some Common Indicators of Risk? 406

Margin of Safety 406

Operating Leverage 407

Choosing a Cost Structure 409

End of Chapter 415

8 Relevant Costs for Short-Term Decisions 443

How Do Managers Make Decisions? 444

Relevant Information 444

Keys to Making Short-Term Special Decisions 445

Decision Pitfalls to Avoid 446

How Do Managers Make Pricing and Special Order Decisions? 448

Regular Pricing Decisions 448

Special Order Decisions 453

How Do Managers Make Other Special Business Decisions? 460

Decisions to Discontinue Products, Departments, or Stores 460

Product Mix Decisions When Resources Are Constrained 464

Outsourcing Decisions (Make or Buy) 467

Decisions to Sell As Is or Process Further 472

End of Chapter 477

9 The Master Budget 507 How and Why Do Managers Use

Budgets? 508

How Are Budgets Used? 508

How Are Budgets Developed? 508

What Are the Benefits of Budgeting? 510

What Is the Master Budget? 511

How Are the Operating Budgets Prepared? 512

Sales Budget 512

Production Budget 513

Direct Materials Budget 515

Direct Labor Budget 516

Manufacturing Overhead Budget 517

Operating Expenses Budget 518

Budgeted Income Statement 519

How Are the Financial Budgets Prepared? 524

Capital Expenditures Budget 524

Cash Collections Budget 524

Cash Payments Budget 525

Combined Cash Budget 527

Budgeted Balance Sheet 528

Sensitivity Analysis and Flexible Budgeting 530

Contents ix

How Do the Budgets for Service and Merchandising Companies Differ? 531

Service Companies 531

Merchandising Companies 531

Impact of Credit and Debit Card Sales on Budgeting 533

End of Chapter 540

1 Q Performance Evaluation 583 How Does Decentralization Affect

Performance Evaluation? 584

Advantages and Disadvantages of Decentralization 584

Performance Evaluation Systems 585

What Is Responsibility Accounting? 585

Types of Responsibility Centers 586

Responsibility Center Performance Reports 588

Evaluation of Investment Centers 590

What Is Transfer Pricing? 597

Strategies and Mechanisms for Determining a Transfer Price 598

How Do Managers Use Flexible Budgets to Evaluate Performance? 603

Creating a Flexible Budget Performance Report 604

Underlying Causes of the Variances 607

How Do Companies Incorporate Nonfinancial Performance Measurement? 609

The Balanced Scorecard 609

End of Chapter 617

x Contents

11 Standard Costs and Variances 653

What Are Standard Costs? 654

Types of Standards 654

Information Used to Develop and Update Standards 655

Computing Standard Costs 655

How Do Managers Use Standard Costs to Compute DM and DL Variances? 658

Using Standard Costs to Develop the Flexible Budget 658

Direct Materials Variances 658

Direct Labor Variances 664

Summary of Direct Materials and Direct Labor Variances 666

Advantages and Disadvantages of Using Standard Costs and Variances 666

How Do Managers Use Standard Costs to Compute MOH Variances? 671

Variable Manufacturing Overhead Variances 671

Fixed Manufacturing Overhead Variances 673

Standard Costing Systems 675

APPENDIX 11A 679

Standard Costing 679

Standard Costing Income Statement 682

End of Chapter 683

12 Capital Investment Decisions and the Time Value of Money 71 o

What Is Capital Budgeting? 711

Four Popular Methods of Capital Budgeting Analysis 711

Focus on Cash Flows 712

Capital Budgeting Process 712

How Do Managers Calculate the Payback Period and Accounting Rate of Return? 714

Payback Period 714

Accounting Rate of Return (ARR) 717

How Do Managers Compute the Time Value of Money? 723

Factors Affecting the Time Value of Money 723

Future Values and Present Values: Points Along the Time Continuum 724

Future Value and Present Value Factors 725

Calculating Future Values of Single Sums and Annuities Using FV Factors 726

Calculating Present Values of Single Sums and Annuities Using PV Factors 727

How Do Managers Calculate the Net Present Value and Internal Rate of Return? 730

Net Present Value (NPV) 731

Internal Rate of Return (IRR) 736

How Do the Capital Budgeting Methods Compare? 739

APPENDIX 12A 743

Present Value Tables and Future Value Tables 743

Table A Present Value of $1 743

Table B Present Value of Annuity of $1 744

Table C Future Value of $1 745

Table D Future Value of Annuity of $1 746

APPENDIX 12B 747

Solutions to Chapter Examples Using Microsoft Excel 747

APPENDIX 12C 751

Using a Tl-83, Tl-83 Plus, Tl-84, or Tl-84 Plus Calculator to Perform Time Value of Money Calculations 751

End of Chapter 757

1 3 Statement of Cash Flows 779

What Is the Statement of Cash Flows? 780

Three Types of Activities That Generate and Use Cash 781

Two Methods of Presenting Operating Activities 783

How Is the Statement of Cash Flows Prepared Using the Indirect Method? 788

Information Needed to Prepare the Statement of Cash Flows 788

Preparing the Cash Flows from Operating Activities 788

Preparing the Cash Flows from Investing Activities 794

Preparing the Cash Flows from Financing Activities 796

Interpreting the Statement of Cash Flows 798

Recap: Steps to Preparing the Statement of Cash Flows Using the Indirect Method 798

How Is the Statement of Cash Flows Prepared Using the Direct Method? 799

Overview 799

Determining Cash Payments and Receipts 800

End of Chapter 808

14 Financial Statement Analysis 838

What Are the Most Common Methods of Analysis? 839

What Is Horizontal Analysis? 839

Horizontal Analysis of the Income Statement 841

Horizontal Analysis of the Balance Sheet 841

Trend Percentages 841

What Is Vertical Analysis? 843

How Do We Compare One Company with Another? 845

Using Microsoft Excel 845

What Are Some of the Most Common Financial Ratios? 849

Contents xi

Measuring Ability to Pay Current Liabilities 849

Measuring Ability to Sell Inventory and Collect Receivables 850

Measuring Ability to Pay Long-Term Debt 852

Measuring Profitability 853

Analyzing Stock Investments 857

Red Flags in Financial Statement Analysis 858

End of Chapter 865

1 5 Sustainability 894 What Is Sustainability, and How Does It

Create Business Value? 895

Historical Overview 896

The Business Case for Sustainability 897

What Is Sustainability Reporting? 902

Current State of Sustainability Reporting 902

Reasons for Sustainability Reporting 903

Framework for Sustainability Reporting 903

What Is Environmental Management Accounting (EMA)? 908

EMA Systems 908

Uses of Environmental Management Accounting Information 909

Challenges to Implementing EMA Systems 911

Future of Environmental Management Accounting 912

End of Chapter 914

Glossary/Index 1-1

Visual Walk-Through

Technology Makes it Simple Expanded to include several new topics , these features give students step-by-step directions on how to use Microsoft Excel 2016 to perform the accounting task with more efficiency. Examples ----- include: scatterplots, regression analysis, capital budgeting, CVP graphs, budgeting, and sensitivity analysis.

Assume the local fitness d ub di arges a membership fee of $30 per month for unlimited use of the exercise equipment plus an additional fee of $5 for every instructo.--led exercise class you attend .

1. Express the monthly cost of belonging to the fitness dub as a cost equation . 2. What is you r expected cost for a month in which you attend five instructor-led classes? 3. If your attendance doubles to 10 dasses per month. will your tota l cost for the month

double? Explain.

Please see page 380 for solutions .

Video Solutions Found in the eText and MyAccountingLab , the video solutions feature the author walking through the Try It! problems on a white board. Designed to give students detailed help when they need it.

<

Try It! Interactive Questions Found throughout the chapter, Try It! interactive questions give students the opportunity to apply the concept they just learned. Linking in the eText will allow students to practice in MyAccountingLab ® without interrupting their interaction with the eText. Students' performance on the questions creates a precise adaptive study plan for additional practice.

Try lt!

~ ........ ~lllfl,J,)JO>,J(it'tlUlflfA~nt

nnn, cnt Dt It·• artrwail 11• ~ pa,Tl _1 l21!a..Aama •uh SC-ll[H.11 n.L la.i qa.u.11r.UM9 Lu1 ulluaal•Nh

.-.,....,..11:,._'lill'IWnc1 ;i l":al'~Ul

•. Wail.•Uwcff*1~Ntnill"ilnK"I'"- it

1.....tll.a...c:ualblaUllnlrQt'l ... 11.:J,

l"'""tdoprnl11ncon1ru- ,,. M111h1111'N: RH MI H II

1#.IJIIV: f•

'N"Ul.h

~~ hA ,1 -, ;m,,rd .,J./,,ntir1 c,!,b - 1.!J)() C..,,.I o/; u,.:.>. JuJrl. ../""" ~ ,~ ~'-' p--,u ~l!.w. I.,~&,. • ~,;J.-,,

s>'/.~-.-1. $::. • VC/ ..... .t

1,.,.. ~_.., o. :''

>

Excel Exhibits To give students a glimpse into the real world presentation of managerial accounting topics, all financial statements and schedules are presented in Excel. In the eText, a video link on selected exhibits will teach students how to create the same schedule using Excel.

Sustainability Within every chapter is a section on how sustain- ability relates to the main chapter topic.

............... ~.,.. .... ~~· --. -:._..= .................... ..,,~ · -"...... ..... ...... ui .. ,...._,...... · =..t•.-.wa,a.w .... ~ ......... .-: ., .. ,..,. u:=.-.r=.=:-.::~ ..... ~.,-- . .. ,......... ..... .,... .... _~ ... - a,p~ .. ... .. "' ....................... ... ... ...,,"" ................. . ........... ·-t--~-- -~-,...... .................... ...._.. .....

Susta i nabi I ity

------.......... ... m.m-......., ...... -~a----, __ ,.,... ___ _ ill Dl.rt.MII .... _..._ _ _,...._

Souttr....,.t ""11n • ......,. • _... • .._....,...._..,,.. ............................. LWl;f ................ , .. .. ---~----... ___,_ .,. ....... ... _.._.,u _ ___.._....... ----~ ,. ·------.......... - --'--~---.... ~--.....,.._,.... .. _.._ ~ .......... - _,._____ ............ _,.. ..

u. ............. , ................. tw . .. ~ .......... l!!W ... ~ ....... .................. ~ .. ....... .,. ......................... ~,.._ .. ..... !ll!'l,,•ilwwwi!all! .............. ftill ............... ~ ... ....... -............. -.--. ... ---............. _ _ ...__. ... _....__.. ........... ._.. __ ._,_ -a.a.~~-----~~------~....,.__._...,_,_..., ............ .,,....., .......... ......,__...._,. .. _.._....,.._....,.n.,..,..,_~~

Also included is a quick reference on which end-of-chapter problems correspond to the sustainability concept .

---._~ _ _._..._....,~i,a, 1.1.a,-'""""""' ............ . ~..:=:::e..-=..-~~...!:...--___ .........,_.__ __ -... ~ u.a ............. .. ,....._~a.1...., =-==-:F=-.,.a-.--~-...... ~ .. ~---~--...-.... ~ ..

*',:::-1:.1-!'::::~~--·-,- __ ...._ w. ...... ,,,. ...

~.... lliiiNlll••--••u ..... ..,..,. -'-~__._,..,_,_,.,_._ ......... __ _ ......... ~bt~~- l. M:9_,,j .................................. ...,.. -----

Sustainability Chapter This chapter provides a deeper dive into how sustainability can generate business value. It also includes sections on sustainability reporting, the Sustainability Accounting Standards Board, and environmental man- agement accounting systems .

C.-,1~ ... -.v- .. .._,

~==~.=.:::;.== 5=.=:..=~.t.EE!~:.:: ---11 .... -- .... -~-·-- ..... ........ t... ....... ......_ ........... ...... ----.-----~,,,,--...... --~.,1;::.:. R=-==-~:----,.:

·--==-=--

Decision Guidelines

Why is this important? Found throughout the chapter, this feature connects accounting with the business environment so that students can better understand the business sig- nificance of managerial accounting.

=·==-~~# -- • .,..,. ~ ........ -~~ .. ..am ..

.---t--- ~.::.T-=:c=:...-=..

Found at the midpoint and end of each chapter, this feature uses a business decision context to summarize key terms, concepts, and formulas from the chapter in question and answer format.

-~ .......... ___.,....., - ---...-~---.-----=------:--.::-.-~-=-.. ..._~.,_,.._ __ ~ .... ..,,-~-___ ..._ .. .--... =-=-·=:.:::::=::.--==-~ _ ___..,..._.......,._..,. ... ...,... .... =E:EE=;---__;:t-..:=-~::c:-

o...-...:n..t~lh't'lllllh•~JylfMw.

::.;=:~:'.:=i.1=?~-.::.1 ::* • ..........,~ ..... Qlil .. ~ .. tJ..---•..., ...... ~~·---..... , ...... _....,_. ----~--_....,..... ·-· ~~-;=~=== =-::..~· ...... -::--•a..o.:..•= .... ~~=--.. ---~--==~ __ ._......,.__ =

Stop &Think Found at various points within each chapter, this feature includes a question-and-answer snapshot ask- ing students to critically examine a concept they just learned.

t..-..,oti;.,ot .. . • ,~._...,._., ... -.ma • .....,.. •aa-....-. ...... ~..,.._...,.. Jc.-..--·-........... .......... .....,. .. .....,.,,_,,...-:, .... .-..-i- .,c..,i... ..... .-....i..-. • IIC.... ... _...~--.d-...... 1'........,~_,......,,._,....,.

_,. __ ___,, __ _...,_ :":"'=:=..:::.."::::.: ........ ....,_, ...... .... :::-_.-.::_.,z_..,. ... ___. ... ...: ._,.__,....._ .. _,.__,.

_,......_.. ___ ._.._... -------_.........,. ............. __ .__

··"---..--~-.... ............ ~~ ............ ---- Serial Case

.......... -------· ---------...._.._. ..... __ _ -------.... -. . .,,.. ... ~.,... ................... _.,_....._.,_ __ ~ --ie..·-~----.._._ _ _., ___ _ ............ ---__ ., _____ ., =-~---·- --... ----.... --........ ~-....

End-of-Chapter Problems The end-of-chapter content for short exercises, exercises, and problems has been refreshed for this edition. End-of-chapter items are structured to allow students to progress from simple to more rigorous as they move from item to item .

New short exercises based on real world situations have been added to every chapter to help students make the connec- tion between the real world and the concepts being studied.

• ,...,.c:. .. A serial (continuing) case that focuses on one real world company has been added to the end-of-chapter material. The serial case consists of several small cases, one per chapter. These cases are meant to inspire critical thinking and to connect the content with real life by following one company through all of the chapters in managerial ac- counting.

......_,_...,_,._ -~-----::=--..-,;~-= ---__ ._.,__..,..__ =---..:.~--. ==_.__._,. ...... .._o..._......,.».11.

.. -.. -.....-~ ............... ~ . r-,:;:::::-;,.~~"l;.--~ :-T..!:~---~

=-===-i= . c:6.= ... ~ . -- " -·------·-------,llloal....._ __ .__. ______ _ ·--- ....... .......,... ' --" ........... ..........____,.. ~=="'..:=---------

" =--=-=.:::..~.:==.:.::.~

Critical Thinking Problems are included to provide students with the opportunity for applied critical thinking. These problems include ethical topics, mini cases, and decision-making cases in real companies.

• Ethics Mini Cases based on the IMA Statement of Professional Practice are highlighted with an icon.

(~~ ) • Real Life Mini Cases focusing on a real company and the

decisions presented in business are highlighted with an icon.

•iJU+!iii

• Excel in MyAccountinglab • Students will download and

complete problem in Micro- soft Excel. - ._,,

• Students receive personal- ized, detailed feedback upon uploading their com- pleted spreadsheets .

• Questions will be auto- graded and reported to the grade book.

• • •

Directed Reading Guides

Preparlrtt: a CVP Chart l<OPl.

-0-lhoAies-

... ,-~ ··-i l' tt, ·IOt - ,_ ,..__ , ..__ ..

• liH t,,NIIII 1,NCI

Test Bank and PowerPoints Test bank includes algorithmic questions and 30% new material. PowerPoints have been updated and refreshed for the new edition. Worked-out problems contain the entire problem statement .

Directed reading guides, which have been prepared by the authors, help students take thorough notes while reading the text and glean the most important information from each chapter. Each chapter's reading guide follows the text, paragraph-by-paragraph, asking students to answer questions and fill in the blanks, thereby keeping students actively engaged while preparing for class.

Accounting in the Headlines Blog Accounting in the Headlines, www.accountingintheheadlines.com is a blog written by Wendy Tietz. New stories are added to the blog each week. The blog contains short stories about real-life companies and cur- rent events that can be used in the accounting classroom to illustrate introductory accounting concepts. The blog posts contain discussion questions, PowerPoint slides, and handout files, making it a turnkey solution for instructors wanting to use real-life examples in their classes. All content is intended to be brief and fit eas- ily into the typical introductory accounting class. In addition to the content found on the blog site, multiple- choice questions related to each blog post can be found in MyAccountingLab and in Learning Catalytics.

Concept Videos for Students Short videos focusing on key concepts are available in MyAccountingLab to further emphasize major con- cepts. These videos can be assigned in homework or used as part of a flipped classroom strategy.

CONTENT CHANGES TO THE FIFTH EDITION Both students and instructors will benefit from a variety of new content in the fifth edition.

New and updated content within the text:

• Refreshed chapter opening stories attract student attention and lay the groundwork for the chapter using recognizable, real-world companies.

• Updated sustainability features in each chapter show how sustainability

relates to the chapter content.

• Select modifications and enhancements were made to each chapter to make it easier for students to grasp difficult concepts. Some of these

modifications include the following:

Chapter 1

Chapter 2

Chapter 3

Chapter 5

Chapter 7

Chapter 8

Redesigned to focus on the professional nature of management accounting, including the American

Accounting Association's Vision Model, IMA's definition of management accounting, technical and soft skills required by professionals, summary of CMA exam requirements,

and a step-by-step model for critical thinking that can be referenced and used throughout the course. The chapter also includes a section on why management accounting is important to students majoring in other fields of study.

Simplified language used for product costs (rather than inventoriable product costs) now used throughout the book; revised discussion of direct and indirect costs.

Introduction and illustration of manufacturing overhead as a cost pool; Decision Guidelines now include job costing journal entries.

Red arrows and speech bubbles on Exhibits help students better understand process costing calculations.

Learning objective 3 expanded to illustrate the impact of changing business conditions on operating income as well

as on the breakeven point.

Streamlined introduction on relevant data; new company example for pricing, special order, and product

discontinuation decisions; new "pitfalls to avoid" section with each decision; additional summary problem with worked out solution.

xvii

xviii Content Changes to the Fifth Edition

Chapter 10 To provide continuity between budgeting and performance evaluation, the flexible budgeting example now includes the entire income statement using the company featured in Chapter 9; updated PepsiCo data illustrates responsibility accounting.

Chapter 11 Company example tied to Chapters 9 and 10 to provide continuity between chapter topics; variance exhibits are more specifically labeled to better serve as references for students.

Chapter 14 Updated with the latest financial information from Target, Macy's, Kohl's, and Wal mart; revised description of horizontal and vertical analysis; two additional profitability ratios included in the chapter.

Chapter 15 Updated for recent company examples and new data on sustainability reporting; new sections on the Sustainability Accounting Standards Board and inclusion of the landmark 2015 Paris Agreement.

New and updated content within the end-of-chapter material:

Quick Checks

Short Exercises

Exercises

Problems

Ethics Mini Cases

Updated quick checks in each chapter. These questions are conceptual in nature.

All short exercises have been updated. In addition, a new real world short exercise is included in every chapter.

All exercises have been updated.

All problems have been updated.

Updated case at the end of each chapter based on the IMA Statement of Professional Practice.

Real Life Mini Cases Updated case at the end of each chapter focusing on a real company situation.

Serial Case An all-new serial case has been added to the end-of- chapter material. All of these cases focus on the same real world company and continue throughout the text.

ABOUT THE AUTHORS

Karen Wilken Braun is a professor for the Department of Accountancy in the Weatherhead School of Management at Case Western Reserve University. Dr Braun is also the Beta Alpha Psi adviser and the director of the undergraduate accounting program. Professor Braun was on the faculty of the J.M. Tull School of Accounting at the University of Georgia before her appoint- ment at Case Western Reserve University. She has received several student-nominated Outstanding Teacher of the Year awards at both business schools, and is regularly asked to speak to student clubs and organizations about personal financial planning.

Professor Braun is a Certified Public Accountant and holds membership in the American Accounting Association (AAA), the Institute of Management Accountants, and the American Institute of Certified Public Accountants. She also holds the Chartered Global Management Accountant designation, and is a member of the AANs Management Accounting Section as well as the Teaching, Learning and Curriculum Section. Dr. Braun has has regularly held lead- ership positions with the AANs Conference on Teaching and Learning in Accounting (CTLA) including co-chairing the 2015 and 2016 conferences. She was awarded the 2016 Bea Sand- ers/AICPA Teaching Innovation Award for her development of Excel-based active-learning resources for introductory managerial accounting courses. Dr. Braun's research and teaching interests revolve around lean operations, sustainability, corporate responsibility, and account- ing education. Dr. Braun's work has been published in Contemporary Accounting Research, Issues in Accounting Education, and Journal of Accounting Education.

Dr. Braun received her Ph.D. from the University of Connecticut and her B.A., summa cum laude, from Luther College, where she was a member of Phi Beta Kappa. Dr. Braun gained public accounting experience while working at Arthur Andersen & Co. and accumu- lated additional business and management accounting experience as a corporate controller.

Professor Braun has two daughters who are both in college. In her free time, she enjoys biking, gardening, hiking, skiing, and spending time with family and friends.

To my children, Rachel and Hannah, who are the joy of my life, and to my students, who inspire me daily.

Karen W. Braun

Wendy M. Tietz is a professor for the Department of Accounting in the College of Business Administration at Kent State University. She teaches introductory financial and managerial ac- counting in a variety of formats, including large sections, small sections, and web-based sections. She has received numerous college and university teaching awards while at Kent State University.

Dr. Tietz is a Certified Public Accountant, a Certified Management Accountant, and a Chartered Global Management Accountant. She is a member of the American Accounting Association (AAA), the Institute of Management Accountants and the American Institute of Certified Public Accountants. She is a member of the AANs Management Accounting Section as well as the Teaching, Learning and Curriculum Section. She has published in Strategic Finance, IMA Educational Case Journal, Issues in Accounting Education, Ac- counting Education: An International Journal, and Journal of Accounting & Public Policy. She regularly presents at AAA regional and national meetings.

Dr. Tietz authors a blog, Accounting in the Headlines, which has real-world news sto- ries and resources for use in the introductory accounting classroom. Dr. Tietz was awarded the Bea Sanders/AICPA Teaching Innovation Award for her blog in 2014 and the Jim Bull- och/IMA Award for Innovations in Management Accounting Education in 2016. She was also awarded the Best Educational/Case Award for the Teaching, Learning and Curriculum Section (AAA, Ohio Region) in 2016. Dr. Tietz earned her Ph.D. from Kent State University. She received both her M.B.A. and B.S.A. from the University of Akron. She worked in in- dustry for several years, both as a controller for a financial institution and as the operations manager and controller for a recycled plastics manufacturer.

Dr. Tietz and her husband, Russ, have two grown sons. In her spare time, she enjoys walking, reading, and spending time with family and friends. She is also intensely interested in using technology and social media in education.

To my husband, Russ, who steadfastly and enthusiastically supports every new project.

Wendy M. Tietz xix

ACKNOWLEDGMENTS

We'd like to ext~nd a special_ thank you to our reviewers who took the time to help us develop teachmg and learmng tools for Managerial Accounting courses to come. We value and appreciate their commitment, dedication, and passion for their students and the classroom:

Managerial Accounting, Se and prior editions Arinola Adebayo , University of South Carolina Aiken, Nasrollah Ahadiat, California State Polytechnic University, Markus Ahrens, St. Louis Community College, Dave Alldredge, Salt Lake Community College; Natalie Allen, Texas A&M University; Vern Allen, Central Florida Community College; Lynn Almond, Virginia Tech; Felix E. Amenkhienan, Radford University; Arnold I. Barkman, Texas Christian University; Gary Barnett, Salt Lake Community College; Scott Berube, University of New Hampshire; Michael T. Blackwell, West Liberty State College; Phillip A . Blanchard, The University of Arizona; Charles Blumer, St. Charles Community College; Kevin Basner, SUNY Genesco; Anna Boulware, St. Charles Community College; Ann K . Brooks, University of New Mexico; Molly Brown , James Madison University; Nina E. Brown, Tarrant County College; Helen Brubeck, San Jose State University; Janet B. Butler, Texas State University-San Marcos; Jennifer Cainas, University of South Florida; David Centers, Grand Valley State University; Sandra Cereo/a, James Madison University; Mike Chatham, Radford University; Julie Chenier, Louisiana State University; Robert Clarke, Brigham Young University-Idaho; Thomas Clevenger, Washburn University; Jay Cohen, Oakton Community College; Cheryl Copeland, California State University Fresno; Robert Cornell, Oklahoma State University; Deb Cosgrove, University of Nebraska at Lincoln; Patrick Cunningham , Dawson Community College; Alan B. Czyzewski, Indiana State University; Kreag Danvers, Clarion University; David L. Davis, Tallahassee Community College; Mike Deschamps, MiraCosta College; Patricia A. Doherty, Boston University School of Management; Jimmy Dong, Sacramento City College; Kevin Dooley, Kapiolani Community College;Jan Duffy, Iowa State University; Barbara Durham, University of Central Florida; Lisa Dutchik, Kirkwood Community College; Darlene K. Edwards, Bellingham Technical College; Robert S. Ellison, Texas State University-San Marcos; Anita Ellzey, Harford Community College; Gene B. Elrod, The University of North Texas; Jame M . Emig, Villanova University; Martin Epstei, Central New Mexico Community College; Diane Eure, Texas State University; Robert Everett, Lewis & Clark Community College; Dr. Kurt Fanning, Grand Valley State University; Amanda Farmer, University of Georgia; Janice Fergusson, University of South Carolina; Richard Filler, Franklin University; Jean Fornasieri, Bergen Community College; Ben Foster, University of Louisville; Faith Fugate, University of Nevada, Reno; Mary Anne Gaffney, Temple University; Karen Geiger, Arizona State University; Lisa Gillespie, Loyola University-Chicago; Shirley Glass, Macomb Community College; Marina Grau, Houston Community College; Timothy Griffin, Hillsborough Community College; Michael R. Hammond, Missouri State University; Michael R. Hammond, Missouri State University; Fei Han, Robert Morris University; Sheila Handy, East Stroudsburg University; Christopher Harper, Grand Valley State University; Sueann Hely, West Kentucky

xx

Community & Technical College; Pamela Hopcroft, Florida State College at Jacksonville; Audrey S. Hunter, Broward College; Frank Ilett, Boise State University; Ron Jastrzebski, Penn State Univer~ity-Berks; Catherine Jeppson, California State University, Northndge; Nancy Jones, California State University-Chico; Mark T. Judd, University of San Diego; David Juriga, St. Louis Community College; Thomas Kam, Hawaii Pacific University; Ken Koerber, Bucks County Community College; Emil Koren, Saint Leo University; Ron Lazer, University of Houston-Bauer College; Pamela Legner, College of DuPage; Elliott Levy, Bentley University; Harold T. Little, Western Kentucky University; William Lloyd, Lock Haven University D . Jordan Lowe, Arizona State University, West Campus; Lois S. Mahoney, Eastern Michigan University; Diane Ma_rker,_ Univ~rsity of Toledo; Linda Marquis, Northern Kentucky Umvers1ty; Lizbeth Matz, University of Pittsburgh at Bradford; David Mautz, University of North Carolina-Wilmington; Florence McGovern, Bergen Community College; Noel McKean, Florida State College at Jacksonville; Mallory Mc Williams, San Jose State University; Robert Meyer, Parkland College; Michael Newman, University of Houston; Kitty O'Donnell, Onondaga Community College; Mehmet Ozbilgin, Baruch College, City University of New York; Abbie Gail Parham, Georgia Southern University; Glenn Pate, Palm Beach Community College; Paige Paulsen, Salt Lake Community College; Deborah Pavelka, Roosevelt University; Sheldon Peng, Washburn University; Tamara Phelan, Northern Illinois University; Letitia Pleis, Metropolitan State College of Denver; Cindy Powell, Southern Nazarene University; Will Quilliam, Florida Southern College; Paulette A. Ratliff-Miller, Grand Valley State University; Donald Reynolds, Calvin College; Christina M . Ritsema, University of Northern Colorado; Doug Roberts, Appalachian State University; Amal Said, University of Toledo; Anwar Salimi, California State Polytechnic University; Kathryn Savage, Northern Arizona University; Christine Schalow, California State University-San Bernadino; Tony Scott, Norwalk Community College; Lloyd Seaton, University of Northern Colorado; David Skougstad , Metropolitan State College of Denver; John Stancil, Florida Southern College;Jenny Staskey, Northern Ar~ona University; Dennis Stovall, Grand Valley State University; Olm Scott Stovall, Abilene Christian University; Gloria Stuart, Georgia Southern University; Iris Stuart, California State University, Fullerton; Gracelyn V. Stuart-Tuggle, Palm Beach State College, Boca Raton; Jan Sweeney, Baruch College, City University of New York; Pavani Tallapally, Slippery Rock University; Lloyd Tanlu, University of Washington; Diane Tanner, University of North Florida; Linda Hayden Tarrago, Hillsborough Community College; Steven Thoede, Texas State University; Geoffrey Tickell, Indiana University of Pennsylvania; Don Trippeer, SUNY Oneonta; Igor Vaysman, Baruch College; John Virchick, Chapman University; Terri Walsh, Seminole State; Andy Williams, Edmonds Community Co!lege! Jeff Wong, University of Nevada Reno; Michael Yampuler, Umvers1ty of Houston (Main Campus); Jeff Jiewei Yu, Southern Methodist University; Judith Zander, Grossmont College; James Zeigler, Bowling Green State University

Pickture / Alamy

Sources: St arbuck s 2015 10-K filing www

.sta rb ucks.co m/ about-us /c omp a ny-informati on / starbucks-comp a ny-time line ; starbu cks.com / respon sib ility

Introduction to Managerial Accounting

Learning Objectives

• 1 Identify managers' three primary responsibilities

• 2 Distinguish financial accounting from managerial accounting

• 3 Describe the roles and skills required of management accountants within the organization

• 4 Describe the role of the Institute of Management Accountants (IMA) and apply its ethical standards

• 5 Discuss the business trends and regulations affecting management accounting

Starbucks Corporation, which began operations in 1971 as a sole coffee bean shop in Seattle's well-known Pike Street Market, now has over 23,000 company-owned and

licensed stores in 68 countries around the world . The company's success can be attributed to

innovative thinking, carefully disciplined expansion, and a focus on corporate responsibility . The

company believes that its commitment to ethically sourced coffee, contributions to local com-

munities, and superior employee benefits to part-time as well as full-time employees contribute

to the company's objective of being one of the most recognized and respected brands in the

world . Management accounting plays a role in implementing the company's strategy . Without

information on the costs and benefits of different beverages, programs, distribution channels,

and geographic areas, Starbucks would not be able to make responsible, yet profitable, deci-

sions . Starbucks uses management accounting to make operating decisions that focus on cor-

porate responsibility, while also keeping the company financially strong . Case in point : $100

invested in Starbucks's stock in 2010 would have been worth $480 at the end of fiscal 2015, a

return well above the S&P 500 .

2 CHAPTER 1

1 _identify managers' -: ---three primary

· responsibilities

As the Starbucks story shows, managers use accounting information for much more than preparing annual financial statements. They use managerial accounting information to guide their actions and decisions. For Starbucks, these decisions might include opening new stores, adding new products, or even providing new employee benefits, such as Starbucks's new tuition reimbursement plan. Management accounting information helps management decide whether any or all of these actions will help accomplish the company's ultimate goals. In this chapter, we'll introduce managerial accounting, describe how it differs from financial accounting, and discuss the skills and ethics management accountants need. We will also discuss the regulatory and business environment in which today's managers and management accountants operate.

What Is Managerial Accounting? Managerial accounting, also referred to as management accounting, focuses on the finan- cial insight needed for an organization to achieve success. In the words of the Institute of Management Accountants,

Management accounting is a profession that involves partnering in manage- ment decision making, devising planning and performance management systems, and providing expertise in financial reporting and control to assist management in the formulation and implementation of an organization's strategy. 1

As you will see throughout the book, managerial accounting is very different from finan- cial accounting. Financial accounting focuses on providing stockholders and creditors with the information they need to make investment and lending decisions. This informa- tion takes the form of financial statements: the balance sheet, income statement, statement of shareholders' equity, and statement of cash flows. On the other hand, managerial ac- counting focuses on identifying, interpreting, analyzing, and implementing the financial information internal management needs to run the company efficiently, effectively, and profitably. This information takes many forms depending on management's needs.

To understand the kind of information managers need, let's first look at their primary responsibilities.

Managers' Three Primary Responsibilities Managerial accounting helps managers fulfill their three primary responsibilities, as shown in Exhibit 1-1: planning, directing, and controlling. Integrated throughout these responsibil- ities is decision making (identifying alternative courses of action and choosing among them).

EXHIBIT 1-1 Managers' Three Primary Responsibilities

Decision making Feedback

1Statement on Management Accounting, " Definition of Management Accounting," Institute of Management Accountants, 2008.

Introduction to Managerial Accounting 3

• Planning involves setting goals and objectives for the company and determining how to achieve them. For example, one of Starbucks's goals is to generate more sales. One strategy to achieve this goal is to open more retail locations. For example, the company opened 731 new company-operated stores in fiscal 2015, roughly half in the United States and half in China and the Asia-Pacific. 2 Another strategy is to develop new products and new distribution channels (such as selling coffee through grocery stores and warehouse clubs). Managerial accounting translates these plans into budgets-the quantitative expression of a plan. Management analyzes the budgets before proceeding to determine whether its expansion plans make financial sense.

• Directing means overseeing the company's day-to-day operations. Management uses sales and costs information by store, region, and distribution channel, to run daily business operations. For example, Starbucks managers use sales data to determine which beverages on the menu and products in the stores are generating the most sales. They use that information to adjust product offerings, marketing strategies, and retail expansion decisions.

• Controlling means evaluating the results of business operations against the plan and making adjustments to keep the company pressing toward its goals. Starbucks uses performance reports to compare each store's actual performance against the budget and then based on that feedback take corrective actions if needed. If actual costs are higher than planned, or actual sales are lower than planned, then management may revise its plans or adjust operations.

Management is continually making decisions while it plans, directs, and controls operations. Starbucks management must decide where to open new stores, which stores to refurnish, what prices to set for beverages and other products in the store, and so forth. Managerial accounting provides the financial insight needed to help make these decisions.

A Road Map: How Managerial Accounting Fits In This book will show you how managerial accounting helps managers fulfill their respon- sibilities. The rest of the text is organized around the following themes:

1. Managerial Accounting Building Blocks Chapter 1 helps you understand more about the management accounting profession and today's business environment. Chapter 2 teaches you some of the language that is commonly used in managerial accounting. Just as musicians must know the notes to the musical scale, management accountants and managers must have a common understanding of these terms to communicate effectively with one another.

2. Determining Unit Cost (Product Costing) To run a business profitably, manag- ers must be able to identify the costs associated with manufacturing its products or delivering its services. For example, Starbucks's managers need to know the cost of producing each beverage on the menu as well as the cost of operating each retail location. Managers must have this information so that they can set prices high enough to cover costs and generate an adequate profit. Chapters 3, 4, and 5 show you how businesses determine these costs. Chapter 4 also shows how managers can effectively control costs by eliminating wasteful activities and focusing on quality.

3. Making Decisions Before Harold Schultz opened the first Starbucks coffee house, he must have thought about the volume of sales needed just to break even-that is, just to cover costs. In order to do so, he had to first identify and estimate the types of costs the coffee house would incur, as well as the profit that would be generated on each beverage served. These topics are covered in Chapters 6 and 7. Chapter 6 shows how managers identify different types of cost behavior, while Chapter 7 shows how managers determine the profitability of each unit sold as well as the

2Starbucks 2015 10-K filing.

4 CHAPTER 1

2 .Distinguish financial -: .:accounting from

manageria l accounting

company's breakeven point. Chapter 8 continues to use cost behavior information to walk through common business decisions, such as outsourcing and pricing deci- sions. Finally, Chapter 12 shows how managers decide whether to invest in new equipment, new projects, or new locations.

4. Planning Budgets are management's primary tool for expressing its plans. Chapter 9 discusses all of the components of the master budget and the way companies like Starbucks use the budgeting process to implement their business goals and strategies.

5. Controlling and Evaluating Management uses many different performance evalu- ation tools to determine whether individual segments of the business are reaching company goals. Chapters 10 and 11 describe these tools in detail. Chapters 13 and 14 describe how the statement of cash flows and financial statement analysis can be used to evaluate the performance of the company as a whole. Finally, Chapter 15 discusses how companies are beginning to address the sustainability of their operations, by measuring, reporting, and minimizing the negative impact of their operations on people and the environment. As you saw in the opening story, some of Starbucks's primary business concerns are to use ethically sourced coffee, contribute to local communities, and provide superior employee benefits to part-time as well as full-time employees.

Differences Between Managerial Accounting and Financial Accounting Managerial accounting information differs from financial accounting information in many respects. Exhibit 1-2 summarizes these differences. Take a few minutes to study the exhibit (on page 5), and then we'll apply it to Starbucks.

Starbucks's financial accounting system is geared toward producing annual and quarterly consolidated financial statements that will be used by investors and credi- tors to make investment and lending decisions. Since Starbucks is a publicly traded company, its financial statements can be easily found on the Internet by searching for its 10-K (annual) and 10-Q (quarterly) SEC filings. The financial statements, which must be prepared in accordance with Generally Accepted Accounting Prin- ciples (GAAP), objectively summarize the transactions that occurred between Star- bucks and external parties during the previous period. The Securities and Exchange Commission (SEC) requires that the annual financial statements of publicly traded companies, such as Starbucks, be audited by independent certified public accoun- tants (CPAs). Starbucks's financial statements are useful to its investors and creditors, but they do not provide management with enough information to run the company effectively.

Starbucks's managerial accounting system is designed to provide internal managers with the accounting information needed to plan, direct, and control operations. Since managerial accounting information is specifically designed to help internal management, it is confidential information that is generally not available to the public. There are no GAAP-type standards or audits required for managerial accounting. To provide Starbucks's management with the information needed to make good business decisions, managerial accounting reports focus on smaller segments of the company (such as individual retail locations, geographic areas, and specific beverages and products) rather than the company as a whole. Rather than preparing reports just once a year, Starbucks prepares manage- rial accounting reports as often as needed, which could be as frequently as daily or even hourly. Many companies even use "real-time performance dashboards" that constantly update so that managers have the financial information they need to control operations and make timely decisions. Since managerial accounting revolves around planning and decision making, much of it focuses on the future rather than on the past. Any informa- tion that is relevant to management will be included. Finally, since every company is dif- ferent, managerial accounting systems will vary from company to company. In designing

EXHIBIT 1-2 Manageria l Accounting Versus Financial Accounting

MANAGERIAL ACCOUNTING

Internal users such as managers.

To help managers plan, direct, and control business operations and

make business decisions.

Any internal accounting report deemed worthwhile by management.

Management determines what it wants in a report, and how it wants it formatted. Reports are

prepared only when management believes the benefit of using the

report exceeds the cost of preparing the report

While some information is based on pasttransactions, managerial accounting focuses on the future.

It provides information on both external and internal transactions.

The information must be relevant

Segments of the business, such as products, customers, geographical regions,

departments, and divisions.

It depends on management's needs. Some reports are prepared

daily, while others may be prepared only one time.

There are no independent audits. However, the company's internal audit function may examine the procedures used in preparing

the reports.

No authoritative body requires managerial accounting reports.

Management carefully considers behavioral implications when

designing the managerial accounting system.

ISSUE

Introduction to Managerial Accounting 5

FINANCIAL ACCOUNTING

External users, such as creditors, stockholders, and government

regulators.

To help external users make investing and lending decisions.

Financial statements.

Generally Accepted Accounting Principles (GAAP) determine the

content and format of financial statements.

The information is based on historical transactions with

external parties.

The information must be reliable and objective.

The company as a whole (consolidated financial

statements). Limited segment data is provided in the footnotes.

Annually and quarterly.

Yes, the Securities and Exchange Commission (SEC) requires publicly traded companies to issue annual

audited financial statements.

The concern is about adequacy of disclosure; behavioral

implications are secondary.

the system, management will weigh the costs of collecting and analyzing information with the benefits they expect to receive. Management will also consider how the system will affect employees' behavior. Employees try to perform well on the parts of their jobs that the accounting system measures and rewards.

.... -·

6 CHAPTER 1

3 .Describe the roles -: .-·and skills required

· of management accountants within the organization

What Role Do Management Accountants Play? In this section, we'll look at the role of management accountants within the organization and the skills they need to help their organizations succeed.

The Role of Management Accountants When you think of accountants, what do you picture? Many people picture accountants the way they were 50 to 100 years ago, before the widespread use of computers when every- thing about measuring business transactions was relatively simplistic. As shown on the left in Exhibit 1-3, many people have the erroneous conception that accountants are nothing more than "bean counters," plugging numbers into set formulas and using a black and white set of rules to churn out information for others to use. If this were true, being an accountant would be tedious and noncreative work indeed. Thankfully, nothing could be farther from the truth.

EXHIBIT 1-3 The Perception and the Reality

What is Accounting?

The perception he rea lity

ThlJ-k i.tl)'Tlle~C-mlJ!lonand 1111ct- .. nc11i,.~COfll-Mllti.lllaft~)b""'-'" UColil

Source:© Amer ican Account ing Associat ion. Used w ith permiss ion.

As shown on the right in Exhibit 1-3, today's accountants are professionals who use an immense amount of critical thinking, insight, and judgment to capture the reality of today's complex economic events. As valued financial advisors, managerial accountants partner with management to make critical business decisions that have widespread and significant consequences for the business and for society. Let's face it: the business world is much more complex than it was in your grandparents' day. With rapidly changing technology and continual business innovation, the role of accountants has drastically changed from what it used to be. In fact, management accountants are rarely referred to by that name any more; instead, they are usually referred to as business advisors, analysts, or finance professionals.

Introduction to Managerial Accounting 7

As you go through each topic in this book, keep the blue picture in Exhibit 1-3 in mind, and ask yourself the following questions:

1. What is the business issue, event, or problem, and how can accounting help to solve it? Management accounting always begins with some relevant business issue that man- agement is facing or some economic event that occurred in the past or might occur in the future. Management accounting is used to shed light on the issue and direct management's path.

2. What are the "gray areas"? In other words, what differences in methods, assump- tions, estimates, measurement choices, and judgment calls might impact the infor- mation that is used for decision making? Because of the gray areas and judgment involved, accounting numbers are rarely as precise as they may seem.

3. What are the implications for the business if the accounting information used in the decision is "wrong"? Because of the gray areas, it's difficult to say that accounting information is ever "wrong." However, judgment in these gray areas could lead to financial estimates that are on the high side or on the low side. What are the conse- quences of numbers that are too high or too low? Would estimates that are "off" in one direction be worse than the other direction?

Since you are studying management accounting for the first time, the topics in the book may at first appear very straightforward and immutable. However, if you consider the three questions listed above, you'll begin to see the significance of the judgment calls that go into management accounting and the ramifications to the business decisions that are consequently made.

The Skills Required of Management Accountants To understand the skills required of management accountants, let's go back to the defini- tion of management accounting with which we started the chapter:

Management accounting is a profession that involves partnering in manage- ment decision making, devising planning and performance management systems, and providing expertise in financial reporting and control to assist management in the formulation and implementation of an organization's strategy. 3

First and foremost, management accounting is a profession (in a later section, we'll describe the professional organizations that represent management accountants). Since management accountants work in a professional advisory role, they need a vast array of

EXHIBIT 1-4 Technical and Nontechnical Competencies Needed by Management Accountants

Technical Competencies

• Planning, budgeting, and forecasting • Ethics

• Internal financial reporting • Communication

• Performance management • Customer service

• Cost management • Adaptability

• Internal controls • Strategic thinking

• Technology • Process improvement

• Decision analysis • Leadership

• Financial statement analysis • Collaboration

• Investment decision making • Business acumen

• Enterprise risk management • Change management

3Statement on Management Accounting, "Definition of Management Accounting," Institute of Management Accountants, 2008.

8 CHAPTER 1

skills. Some of these skills are technical, whereas others are nontechnical competencies, which are often referred to as "soft-skills." A recent survey of management accounting professionals revealed some of the top skills they need to help their organizations achieve success. Exhibit 1-4 summarizes some of these competencies. 4

This book will introduce you to most of the technical competencies listed in Exhibit 1-4, as well as give you the opportunity to advance many of your nontechnical skills. As you can see in the exhibit, the ability to use technology and common software, such as Microsoft Excel, is a critical skill management accountants need to possess. Because Excel is used so per- vasively in business, you will see many of the exhibits in this book featured in Excel. You will also see features in several chapters that teach you how to use Excel to perform various tasks. Regardless of your future career path, becoming as proficient as you can with Excel during this course will help you become more marketable and more valuable to your future employer.

Managerial Accounting Is Important to All Careers As you can see, management accountants don't fit the stereotypical accountant portrayed in movies and shows. Because of their expanding role, management accountants have truly become trusted and valued internal business advisors. But what if you don't plan to major in accounting? How can this course be of use to you? Here are just a few specific ways this course can help you prepare for your future business career:

• Entrepreneurs If you are planning to be an entrepreneur, you'll first want to know if your business idea makes financial sense. How high will volume have to be for your busi- ness to at least break even? How high will it have to be for your business to earn the level of profit that you want to achieve? As you begin to implement your business plan, should you negotiate sales contracts that are more fixed (flat fee) or variable (fee per activity)? What about costs? Would having more fixed costs or variable costs be better? How sensi- tive will your profits be to changes in volume if the economy booms or if it takes a turn for the worse? How will you decide whether to invest in new equipment and technology? As your business grows in size, how will you divide it into manageable segments and relinquish oversight of day-to-day operations to others, while at the same time retain con- trol? How can you design systems to ensure your managers will make decisions that are consistent with your goals? And if you decide to raise capital or sell your business, what will potential investors want to see when they analyze your financial statements and study your statement of cash flows? All of these topics are addressed in this book.

• Business Management If you are planning to be a general business manager, not a day will go by in which you don't consider the financial ramifications of your decisions. You'll need to have a firm grasp on the costs of obtaining or manufacturing every product you sell and/or every service you deliver. You'll also want to understand how costly every activity within the company is to perform and have specific strategies in hand for controlling and reducing those costs. You'll need to understand which costs will increase as your volume increases and which costs will be unaffected by changes in volume. Cost information will drive many, if not all, of your decisions about where to locate, what to produce, which suppliers to use, whether to outsource, which products to emphasize, whether to implement quality improvement initiatives, whether to auto- mate some of your processes, how to price your products or bid for jobs, whether to discontinue certain products or operations, and so forth. Every business decision you make will be rooted in revenue and cost information, so it will be important for you to understand how those costs were obtained and what they include. Different costs will be used for different purposes. All of these topics are addressed in this book.

• Marketing and Sales If you are planning to be in marketing and sales, your marketing strategy, assumptions, and predictions will be the driving force behind the company's entire budget. As a result, you will be intimately involved with developing the budget. Product-line profitability reports will show you which products are most profitable and will guide your decisions about which products to emphasize. Cost information

4 "The Skills Gap in Entry-level Management Accounting and Finance, " Institute of Management Accountants and American Quality and Productivity Center, 2014 .

Introduction to Managerial Accounting 9

will drive many of your pricing decisions, as well as decisions about whether to accept special orders at reduced sales prices or give volume discounts. The company's stance on sustainability may impact your ability to attract various customers and target dif- ferent markets. All of these topics are addressed in this book.

• Nonbusiness Majors Even if you are planning to be a nurse, engineer, musician, or fashion designer, the information you learn in this course will be of consequence to you. All organizations, including nonprofits and governmental agencies, use cost and revenue information to guide their plans, actions, and decisions. No matter what your career path, every activity you engage in will impact the costs and revenues of your organization. That holds true, whether you are tending to sick patients, designing bridges, managing a symphony orchestra, or designing clothes. Management will ex- pect you to operate under limited resources and will often look to you for revenue and expense estimates for specific projects or for specific periods of time. Management may also hand you budgets, cost data, and performance reports and expect you to understand it and use it for making decisions. The more you understand the underlying financial information, the better prepared you will be.

We've chosen to highlight just a few specific business career tracks here, but many of the same issues will pertain to all business careers, including those in logistics, supply chain man- agement, production, and finance. There is such a huge overlap in business between mana- gerial accounting and finance that both are often referred to as the "finance function," and the people who work in this function, regardless of whether they were accounting or finance majors, are often referred to as analysts. No matter what your eventual career, you will be using managerial accounting information. As is often said, accounting is the language of business, so the more you know about it, the more valuable you will be to your organization.

Accounting within the Organizational Structure Most corporations are too large to be governed directly by their stockholders. Therefore, stockholders elect a board of directors to oversee the company. Exhibit 1-5 shows a typi- cal organizational structure, with the green boxes representing employees of the firm and the orange and blue boxes representing nonemployees.

The board members meet only periodically, so they hire a chief executive officer (CEO) to manage the company on a daily basis. The CEO hires other executives to run various aspects

EXHIBIT 1-5 Typical Organizational Structure

Audit Committee

Chief Executive Officer (CEO) ----------------------,

Chief Opereting Officer (COOi

Vice Presidents of various operations

Treasurer

Chief Financial Officer (CFO)

I I I I I I -------------,

Controller

I I I I

Internal Audit

1 0 CHAPTER 1

of the organization, including the chief operating officer (COO) and the chief financial officer (CFO). The COO is responsible for the company's operations, such as research and develop- ment (R&D), production, and distribution. The CFO is responsible for all of the company's financial concerns. The treasurer and the controller report directly to the CFO. The treasurer is primarily responsible for raising capital (through issuing stocks and bonds) and investing funds. The controller is usually responsible for general financial accounting, managerial accounting, and tax reporting. Many organizations have other C-Suite personnel not pictured in Exhibit 1-5, such as Chief Information Officer (in charge of the company's technology infrastructure) and the Chief Sustainability Officer (in charge of devising, implementing, and reporting on the company's sustainability initiatives). The CFO, controller, and others within the accounting function work closely with these individuals since technology plays a significant role in col- lecting managerial accounting information, and, as you'll see later in the chapter and book, managerial accounting both impacts, and is impacted by, sustainability initiatives.

Let's now turn our attention to the right side of Exhibit 1-5. The New York Stock Exchange requires that listed companies have an internal audit function. The role of the internal audit function is to ensure that the company's internal controls and risk manage- ment policies are functioning properly. The Internal Audit Department reports directly to a subcommittee of the board of directors called the audit committee. The audit committee oversees the internal audit function as well as the annual audit of the financial statements by independent CPAs. Both the Internal Audit Department and the independent CPAs report directly to the audit committee for one very important reason: to ensure that man- agement will not intimidate them or bias their work. However, since the audit committee meets only periodically, it is not practical for the audit committee to manage the internal audit function on a day-to-day basis. Therefore, the internal audit function also reports

to a senior executive, such as the CFO or CEO, for administrative

II Why is this important? matters.

When you look at the organizational chart pictured in Exhibit 1-5, where do you think management accountants work? It depends on the company. Management accountants used to work in account- ing departments and reported directly to the controller. Now, over half of management accountants are located throughout companies and work on cross-functional teams. Cross-functional teams consist of employees representing various functions of the company, such as R&D, design, production, marketing, distribution, and customer ser- vice. Cross-functional teams are effective because each member can address business decisions from a different viewpoint. These teams

"Management accountants act as internal business advisors. They

provide the financial information and in-depth analysis needed to make good business decisions ."

4 .Describe the role -: .: of the Institute

of Management Accountants (IMA) and apply its ethical standards

often report to various vice presidents of operations. Management accountants frequently take the leadership role in cross-functional teams since financial impact is the driving force in almost all business decisions.

Professional Associations The Institute of Management Accountants (IMA) is the professional association for manage- ment accountants in the United States. Its mission is to provide a forum for research, practice development, education, knowledge sharing, and advocacy of the highest ethical and best practices in management accounting and finance. The IMA also educates society about the role management accountants play in organizations. According to the IMA, about 85 to 90% of accountants work in organizations, performing the roles discussed earlier. The IMA publishes a monthly journal called Strategic Finance that addresses current topics of interest to management accountants and helps them keep abreast of recent techniques and trends.

The IMA also issues the Certified Management Accountant (CMA) certification. Over 50,000 people around the globe have become CMAs. To become a CMA, you must pass a rigorous examination, gain two years of relevant professional experience, and maintain continuing professional education. You must also have a baccalaureate degree, although the degree does not need to be in accounting. One nice feature of the CMA exam is that you don't have to wait until you graduate from college to take it. Thus, you can start working on valuable credentials that will earn you a higher salary even before you

Introduction to Managerial Accounting 11

graduate from college. A recent global survey conducted by the IMA revealed that, glob- ally, CMAs earn 61 % higher salaries than their non-CMA peers.

The CMA exam consists of two parts. Each part of the exam is 4 hours long and consists of 100 multiple-choice questions as well as two essay questions. As shown in the following, most of the topics on the exam are introduced in this textbook:

Part 1-Financial Reporting, Planning, Performance and Control-Financial Reporting (the financial statements, including the Statement of Cash Flows, Chapter 13); Plan- ning, Budgeting and Forecasting (Chapters 9 and 6), Performance Management (Chap- ters 10 and 11); Cost Management (Chapters 2, 3, 4, 5, and 6); and Internal Controls.

Part 2-Financial Decision Making-Financial Statement Analysis (Chapter 14); Corpo- rate Finance; Risk Management; Decision Analysis (Chapters 7 and 8); Investment Decisions (Chapter 12); and Professional Ethics (Chapter 1).

The CMA exam topics reinforce the technical skills, shown in Exhibit 1-4, that man- agement accountants are expected to have. If you like the material in this course as well as in your finance course, you should strongly consider taking the CMA exam. You can also become a student member of the IMA for a significantly reduced annual fee, which will give you access to its job posting website as well as all of its publications. Finally, the IMA hosts an annual three-day student leadership conference at a different location in the United States each year. You can find out more about the IMA at its website: www.imanet.org.

In 2012, the American Institute of Certified Public Accountants IAICPA), the world's largest association representing the accounting profession, joined forces with England's Chartered Institute of Management Accountants (CIMA) to launch a separate specialized credential geared toward members who work, or have worked, in accounting roles in busi- ness, industry, or government. The Chartered Global Management Accountant /CGMA) designation, which is available to qualifying AICPA and CIMA members, is meant to recognize the unique business and accounting skill set possessed by those certified public accountants (CPAs) who fill, or have filled, accounting roles within an organization, as opposed to strictly public accounting roles. The CGMA has issued a "Competency Frame- work" that covers many of the same technical and nontechnical skills shown in Exhibit 1-4. Currently, 36% of AICPA members work in management accounting rather than public accounting. 5 Qualification for the CGMA designation is based on examination and professional experience. You can find out more about the CGMA designation, qualifica- tions, and benefits at www.CGMA.org.

Throughout each chapter you will see several "Try It!" features. These features will allow you to see if you understand something you just learned about in the reading . Click the Try It! Icon to practice and get immediate feedback in the etext.

Determine whether each of the following statements is true or false:

1. Managers' three primary responsibilities are planning, directing, and controlling.

2. Management accounting is geared toward external stakeholders, such as investors and creditors.

3. Management accountants often work in cross-functional teams throughout the organization.

4. The internal audit function reports to the audit committee of the board of directors.

5. Management accountants are now more often looked upon as internal business advisors rather than "bean counters" recording historical transactions.

6. Management accountants should be technically proficient, but they don't need strong oral and written communica- tion skills.

7. Management accountants should be proficient in Excel.

8. The AICPA (American Institute of Certified Public Accountants) issues the CMA (Certified Management Accountant) certification.

Please see page 47 for solutions.

5www .aicpa.org/ About/Pages/ About.aspx

1 2 CHAPTER 1

Average Salaries of Management Accountants The average salaries of management accountants reflect their large skill set. Naturally, salaries will vary with the accountant's level of experience, his or her specific job responsibilities, and the size and geographical location of the company. However, to give you a general idea, in 2015, the average base salary (before benefits, profit sharing, or bonuses) of all IMA members in the United States was $115,022, while the median base salary of IMA members in the United States with only one to five years of experience was $64,900. Those professionals in the United States with the CMA or CPA certification earned 31 % more in total compensation than mem- bers with no certification, while those who held both the CMA and CPA certifications earned 45% more than noncertified members. You can obtain more specific salary information in the IMA's 2015 Salary Survey.6

Robert Half International, Inc., is another good source for salary information. Robert Half publishes a free yearly guide to average salaries for all types of finance professionals. The guide also provides information on current hiring trends. In addition, Robert Half offers a free online interactive salary calculator, which allows you to drill down to salary information by zip code, years of experience, job title, and company size. To explore sala- ries in the fields of accounting and finance, do a web search on the phrase, "Robert Half Salary Guide and Calculator."

Professional Ethics Management accountants continually face ethical challenges. The IMA has developed principles and standards to help management accountants deal with these challenges. The principles and standards remind us that society expects professional accountants to exhibit the highest level of ethical behavior. The IMA's Statement of Ethical Professional Practice requires management accountants to do the following:

• Maintain their professional competence.

• Preserve the confidentiality of the information they handle.

• Uphold their integrity.

• Perform their duties with credibility.

These ethical standards are summarized in Exhibit 1-6, while the full Statement of Ethical Professional Practice appears in Exhibit 1-7.

EXHIBIT 1-6 Summary of Ethical Standards

Maintain professional COMPETENCE

Uphold their INTEGRITY

Preserve CONFIDENTIALITY

of information

Perform duties with CREDIBILITY

6IMA 2015 U.S. Salary Survey, May 2016. http://www.imanet.org/resources-publications/ thought-leadership-new/salary-survey

Introduction to Managerial Accounting 13

EXHIBIT 1-7 IMA Statement of Ethical Professional Practice

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:

1. Keep information confidential except when disclosure is authorized or legally required.

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.

ill. 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:

1. Communicate information fairly and objectively.

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.

Institute of Management Accountants. Adapted with permission (2006) .

Source: Courtesy of IMA (Inst itu t e of Management Accountants, www.imanet.org). Adapted w ith permiss ion .

To resolve ethical dilemmas, the IMA suggests that management accountants first follow their company's established policies for reporting unethical behavior. If the conflict is not resolved through the company's procedures, the management accountant should:

• Discuss the unethical situation with the immediate supervisor unless the supervisor is involved in the unethical situation. If so, notify the supervisor at the next higher managerial level. If the immediate supervisor involved is the CEO, notify the audit committee or board of directors.

• Discuss the unethical situation with an objective advisor. The IMA offers a confidential "Ethics Hotline" to its members . Members may call the hotline and discuss their ethical di- lemma. The ethics counselor will not provide a specific resolution but will clarify how the di- lemma relates to the IMA's Statement of Ethical Professional Practice shown in Exhibit 1-7.

• Consult an attorney regarding legal obligations and rights.

14 CHAPTER 1

Examples of Ethical Dilemmas Because professional ethical behavior is so critical, we have included short exercises and cases related to ethical behavior in each chapter of the book. An ethics icon will mark each of these exercises so that they are readily identifiable to you and your instructor.

Unfortunately, the ethical path is not always clear. You may want to act ethically and do the right thing, but the consequences can make it difficult to decide what to do. Let's consider several ethical dilemmas in light of the IMA Statement of Ethical Professional Practice.

Dilemma #1 Sarah Baker is examining the expense reports of her staff, who counted inventory at Top-Flight's warehouses in Arizona. She discovers that Mike Flinders has claimed but not included hotel receipts for over $1,000 of accommodation expenses. Other staff, who also claimed $1,000, did attach hotel receipts. When asked about the receipts, Mike admits that he stayed with an old friend, not in the hotel, but he believes that he deserves the money he saved. After all, the company would have paid his hotel bill.

By asking to be reimbursed for hotel expenses he did not incur, Flinders violated the IMA's integrity standards (conflict of interest in which he tried to enrich himself at the company's expense). Because Baker discovered the inflated expense report, she would not be fulfilling her ethical responsibilities of integrity and credibility if she allowed the reimbursement.

Dilemma #2 As the accountant of Entree Computer, you are aware of your company's weak financial condition. Entree is close to signing a lucrative contract that should ensure its future success. To do so, the controller states that the company must report a profit this year (ending December 31). He suggests, "Two customers have placed orders that are really not supposed to be shipped until early January. Ask produc- tion to fill and ship those orders on December 31 so we can record them in this year's sales."

The resolution of this dilemma is less clear-cut. Many people believe that following the controller's suggestion to manipulate the company's income would violate the stan- dards of competence, integrity, and credibility. Others would argue that because Entree Computer already has the customer orders, shipping the goods and recording the sale in December is still ethical behavior. In this situation, you might discuss the available alterna- tives with the next managerial level or the IMA ethics hotline counselor.

Dilemma #3 As a new accounting staff member at Central City Hospital, your supervisor has asked you to prepare the yearly Medicare Cost Report, which the government uses to determine its reimbursement to the hospital for serving Medicare patients. The report requires specialized knowledge that you don't believe you possess. Your supervisor is busy planning for the coming year and cannot offer much guidance while you prepare the report.

This situation is not as rare as you might think. You may be asked to perform tasks that you don't feel qualified to perform. The competence standard requires you to perform professional duties in accordance with laws, regulations, and technical standards; but laws and regulations are always changing. For this reason, the competence standard also requires you to continually develop knowledge and skills. CPAs and CMAs are required to complete annual continuing professional education (about 40 hours per year) to fulfill this responsibility. However, even continuing professional education courses will not cover every situation you may encounter.

In the Medicare cost report situation, advise your supervisor that you currently lack the knowledge required to complete the Medicare report. By doing so, you are complying

with the competence standard that requires you to recognize and communicate any limitations that would preclude you from ful- filling an activity. You should ask for training on the report prep- aration and supervision by someone experienced in preparing the report. If the supervisor denies your requests, you should ask him or her to reassign the Medicare report to a qualified staff member.

Dilemma #4 Your company is negotiating a large multiyear sales con- tract that, if won, would substantially increase the com- pany's future earnings. At a dinner party over the weekend, your friends ask you how you like your job and the com- pany you work for. In your enthusiasm, you tell them not only about your responsibilities at work, but also about the contract negotiations. As soon as the words pop out of your mouth, you worry that you've said too much.

This situation is difficult to avoid. You may be so excited about your job and the company you work for that information unin- tentionally "slips out" during casual conversation with friends and family. The confidentiality standard requires you to refrain from disclosing information or using confidential information for unethical or illegal advantage. Was the contract negotiation con-

Introduction to Managerial Accounting 15

Ill why is this important? "At the root of all business relationships is trust. Would you put your money in a bank that you didn't trust, invest in a company you

knew was ·cooking the books,' or lend money to someone you

thought would never pay you back? As

a manager , your trust in the other party's ethical behavior, and vice versa, will be a vital component of the

business decisions you make."

fidential? If so, would your friends invest in company stock in hopes that the negotiations increase stock prices? Or were the negotiations public knowledge in the financial com- munity? If so, your friends would gain no illegal advantage from the information. Recent cases in the news remind us that insider trading (use of inside knowledge for illegal gain) has serious consequences. Even seemingly mundane information about company opera- tions could give competitors an advantage. Therefore, it's best to disclose only informa- tion that is meant for public consumption.

Unethical Versus Illegal Behavior Finally, is there a difference between unethical and illegal behavior? Not all unethical behavior is illegal, but all illegal behavior is unethical. For example, consider the com- petence standard. The competence standard states that management accountants have a responsibility to provide decision support information that is accurate, clear, concise, and timely. Failure to follow this standard is unethical but in most cases not illegal. Now, consider the integrity standard. It states that management accountants must abstain from any activity that might discredit the profession. A management accountant who commits an illegal act is violating this ethical standard. In other words, ethical behavior encom- passes more than simply following the law. The IMA's ethical principles include honesty, fairness, objectivity, and responsibility-principles that are much broader than what is codified in the law.

16 CHAPTER 1

• Decision Guidelines

Managerial Accounting and Management Accountants Starbucks had to consider the following in designing its managerial accounting system .

Decision

What is the primary purpose and focus of managerial accounting?

What should managers take into consider- ation when designing managerial accounting systems?

Where should management accountants be placed within the organizational structure?

What skills should management accountants possess?

What professional associations advocate for management accountants in the United States?

By what ethical principles and standards should management accountants abide?

Guidelines

Managerial accounting provides informa- tion that helps managers plan, direct, and control operations . By focusing on relevant information, managerial accounting assists managers in formulating and implement- ing the organization's strategy and making good business decisions .

Managers need to weigh the costs of the system (for example, collecting and ana- lyzing data) with the benefits that are ex- pected from using the information to make better decisions . Managers must carefully consider the behavioral effects of the sys- tem since employees tend to focus on those aspects of performance that are measured .

In the past, most management accountants worked in accounting departments . Now, over 50% of management accountants work on cross-functional teams across the organi- zation, where they serve in an advisory role .

Because of their expanding role within the organization, management accountants need both technical skills (such as manage- rial and financial accounting knowledge and technology skills) and nontechnical skills (such as ethics, communication, critical thinking, and leadership) .

The Institute of Management Accountants (IMA) is the premier organization advocat- ing strictly for the advancement of the management accounting profession . The IMA also issues the CMA certification . In addition, the American Institute of Certified Public Accountants (AICPA) has launched a specialized credential (the CGMA) for CPAs who have experience in industry, business, and government .

The IMA's overarching ethical principles include the following :

• Honesty

• Objectivity

• Fairness

• Responsibility The IMA's ethical standards include the following :

• Competence

• Integrity

• Confidentiality

• Credibility

Introduction to Managerial Accounting 17 - SUMMARY PROBLEM 1 . • _.

Requirements

1. Each of the following statements describes a responsibility of management . Match each statement to the management responsibility being fulfilled .

Statement Management Responsibility

1. Identifying alternative courses of action and a. Planning choosing among them

2. Running the company on a day-to-day basis b. Decision making

3. Determining whether the company's units are c. Directing operating according to plan

4. Setting goals and objectives for the company and d. Controlling determining strategies to achieve them

2. Are the following statements more descriptive of managerial accounting or financial accounting information?

a. Describes historical transactions with external parties b. Is not required by any authoritative body, such as the SEC c. Reports on the company's subunits, such as products, geographical areas, and

departments

d. Is intended to be used by creditors and investors e. Is formatted in accordance with GAAP

3. Each of the following statements paraphrases an ethical responsibility . Match each statement to the standard of ethical professional practice being fulfilled . Each stan- dard may be used more than once or not at all.

Responsibility

1. Do not disclose company information unless authorized to do so.

2. Continue to develop skills and knowledge .

3. Don't bias the information and reports presented to management .

4. If you do not have the skills to complete a task correctly, do not pretend that you do .

5. Avoid actual and apparent conflicts of interest .

• SOLUTIONS

Standard of Ethical Professional Practice

a. Competence

b. Confidentiality

c. Integrity

d. Credibility

Requirement 1 Requirement 3 1. (b) Decision making 1. (b) Confidentiality

2. (c) Directing 2. (a) Competence

3. (d) Controlling 3. (d) Credibility

4. (a) Planning 4. (a) Competence

5. (c) Integrity Requirement 2 a. Financial accounting b. Managerial accounting c. Managerial accounting

d. Flnancialaccounting e. Flnancialaccounting

1 8 CHAPTER 1

5 .Discuss the business - -.-trends and regulations

affecting management accounting

What Business Trends and Regulations Affect Management Accounting? Business trends and regulations are continually changing. To remain competitive, compa- nies need to be nimble and adaptable. In this section, we'll describe some of the business trends and regulations that are significantly affecting management accounting.

Big Data, Data Analytics, and Critical Thinking The collection of data from sensors, social media, GPS signals, texts, pictures, customer reward cards, and so forth is increasing at an unprecedented rate. In fact, over 90% of the world's data has been created in the last two years. 7 Big, unstructured data, coupled with traditional business transaction data, are changing the ways in which companies operate. Although the power of much of this data still remains untapped, companies are using data visualization software, such as Tableau, and predictive modeling to become more cost- efficient, to better target their sales markets, to uncover fraud, and to innovate.

For business transaction data, many small businesses use ready-to-use accounting soft- ware packages, such as QuickBooks or Sage 50, to track their costs and to develop the infor- mation that owners and managers need to run the business. But large companies use enterprise resource planning (ERP) systems that can integrate all of a company's worldwide functions, departments, and data. ERP systems such as SAP and Oracle gather company data into a centralized data warehouse. The system feeds the data into software for all of the company's business activities, from budgeting and purchasing to production and customer service.

Advantages of ERP systems include the following:

• Companies streamline their operations before mapping them into ERP software. Streamlining operations saves money.

• ERP helps companies respond quickly to changes. A change in sales instantly ripples through the ERP's purchases, production, shipping, and accounting systems.

• An ERP system can replace hundreds of separate software systems, such as different software in different regions, or different payroll, shipping, and production software.

Gone are the days when decisions are made based on gut feelings. Data-driven decision making is here to stay. What can you do to prepare yourself for a data-driven business career? Data are only data, unless they are turned into useful information. The way to turn big data into information is to use critical thinking skills in conjunction with tech- nological skills, such as competency in Excel, SAP, and Tableau. As mentioned earlier in the chapter, management accountants are expected to possess both technical and critical thinking skills. In other words, data cannot stand on their own; they require analysis and interpretation if they are to be of use to management.

Critical Thinking You will need to use critical thinking throughout this course and throughout your career. But what does critical thinking really entail? Critical thinking can be described as improv- ing the quality of thought by skillfully analyzing, assessing, and reconstructing it. 8 Critical thinking can be improved by asking yourself the following series of questions about any issue or problem you encounter: 9

1. What is the purpose, goal, or objective? In other words, what am I trying to accomplish?

2. What is the specific question I'm trying to address? The question will guide your thought process.

3. What data will I need to answer the question? With the sheer magnitude of data available, you'll need to hone in solely on the data that will help you answer the question at hand.

7www-Ol.ibm.com/software/data/bigdata/what-is-big-data.html 8Criticalthinking.org 9www.criticalthinking.org/ctmodel/logic-model l .htm

Introduction to Managerial Accounting 19

4. What concepts am I using, and what assumptions might I be taking for granted? Make sure you clearly identify the concepts and assumptions you are using, since a change in assumption might impact your conclusions.

5. What conclusions am I coming to, and are my inferences logical? Always check for logic.

6. What are the implications and consequences of these conclusions? All decisions have repercussions. Think ahead to what the outcome might be.

7. What is my point of view or reference point through which I have viewed the prob- lem? Could I look at the problem from another equally valid point of view? Recog- nize that your point of view, which is the lens through which you view an issue, might be only one of several equally valid viewpoints.

Often in business, school, and life, you may be faced with problems you don't feel you know how to attack. By asking yourself the series of questions listed above, you can put a thoughtful, intellectual framework around the problem that will help guide your journey toward a solution.

li(• 1=>:~ Companies are constantly faced with decisions about investing in technological innovations that could potentially save money. While Chapter 12 discusses investment decisions in more detail, we'll consider a simple one-year cost-benefit analysis here. Faced with rising pres- sure for a $15 per hour minimum wage rate, the fast-food industry is currently exploring the possible use of robotics for order-taking and food preparation tasks. Assume the following facts:

1. By investing in one robotic arm, a fast-food restaurant could potentially save $15 per hour plus 7.65% payroll tax. While the tasks performed by a human associate are more flexible and adaptable than those performed by a robot, assume the robot would replace 10 hours of human labor, 365 days per year.

2. The robotic arm is estimated to cost $35,000 plus $5,000 for installation. While the equip- ment itself may be in workable condition for up to five years, the company is viewing its implementation as a one-year experiment.

3. The annual cost of running the robotic arm, including utilities and servicing, is expected to be $1,500.

Perform a cost-benefit analysis for the first year of implementation to determine whether the robotic arm would be a financially viable investment if the minimum wage were to be raised to $15 per hour.

Answer:

_J B C 1 Total 2 3 $ 54,750 4 4,188 5 $ 58,938 6 7 $ 40,000 8 1,500 9 41,500 10 $ 17,438 11

Based on this one-year cost-benefit analysis, the fast-food restaurant would expect to benefit from investing in the robotic technology . This analysis is based on several key assumptions (hours of labor replaced, hourly wage rate, and equipment fully expensed in one year) . As with most decisions, the projected financial impact would vary under different assumptions .

20 CHAPTER 1

Shifting Economy The U.S. economy is becoming a "knowledge economy" in which more and more people are being employed for their intellectual capital than for their ability to provide manual labor in agricultural and manufacturing roles. Outside of government, more people are now employed in the service sector of the U.S. economy (77 million) than in retail and whole- sale merchandising (21 million); manufacturing, construction, and mining (19 million); and agriculture (2 million) combined. 10 Service companies provide health care, communi- cation, transportation, banking, professional consulting, education, hospitality and leisure activities, and other important benefits to society. The critical thinking framework outlined earlier highlights the importance of these skills to knowledge workers in the new economy.

Many managerial accounting practices were first developed to meet the needs of manufacturers during the industrial age of the early twentieth century. However, since the U.S. economy has shifted away from manufacturing, managerial accounting has expanded to meet the needs of merchandising companies and service firms as well as manufacturers. For example, consider the following:

1. Manufacturers still need to know how much each unit of their product costs to produce. In addition to using this information for inventory valuation and pric- ing decisions, manufacturers also use cost information to determine whether they should outsource production to another company or to an overseas location, or even whether they should reshore (relocate) it back in the United States.

2. Because such a large percentage of goods are now produced overseas rather than do- mestically, retailers must now consider foreign currency translation, shipping costs, and import tariffs when determining the cost of imported products. Managers of merchandising companies also need cost and revenue information about operating their brick and mortar locations as well as their online sales platforms. All of this information helps managers make more strategic and profitable decisions.

3. Service companies also need cost information to make decisions. For example, health care providers need to know the cost of performing procedures and running lab tests; hotel managers need to know the cost of providing rooms and amenities to guests; cell phone carriers and Internet service providers need to know the cost of providing texts, data, and cloud computing services; and entrepreneurs that develop apps, such as Uber and Airbnb, need to have a good understanding of their cost structure and how they will monetize the site. No matter what the service, cost information helps managers make vital business decisions, such as pricing decisions, marketing deci- sions, decisions to invest in new technology, and market expansion decisions.

Globalization The barriers to international trade have fallen over the past decades, allowing foreign companies to compete with domestic companies. Firms that are not highly efficient, inno- vative, and responsive to business trends will vanish from the global market. However, global markets also provide highly competitive domestic companies with great opportuni- ties for growth.

Globalization has several implications for managerial accounting:

• Stiffer competition means managers need more accurate and timely information to make wise business decisions. Companies can no longer afford to make decisions by the "seat of their pants." Detailed, accurate, and real-time cost information has be- come a necessity for survival.

• Companies must decide whether to expand sales and/or production into foreign countries. To do so, managers need comprehensive estimates of the costs of running international operations and the benefits that can be reaped. They also need to be aware of regulations and laws in other countries that could impact their operations. For example, England

10www.hls.gov/emp/ep_tahle_201 .htm

and Europe tend to have much stricter environmental protection laws than the United States.

• Companies can learn new management techniques by ob- serving their international competitors. For example, lean thinking, which is discussed next, was developed in Japan by Toyota. Lean practice has now been adopted, expanded upon, and refined by U.S. companies.

Lean Thinking and Focus on Quality To be competitive in the global market, companies need to be acutely aware of their costs, customer response time, and quality. Market share goes to any company that can do the same thing cheaper, faster, or better. To address these issues, many companies

Introduction to Managerial Accounting 21

II Why is this important? "To survive in the global marketplace , businesses must quickly respond to customer

demand , providing high-quality products and services at a reasonable price."

espouse lean thinking. which is both a philosophy and a business strategy of operating without waste. The more wasteful activities that can be eliminated, the lower the com- pany's costs. The more wasted time that can be removed between receiving an order and delivering the product or service, the faster the customer response time. And the more defects that can be prevented or removed from the process, the less costly the production process and the higher the customer satisfaction. Six Sigma-the goal of producing near perfection (with less than 3.4 defects per million opportunities)-often goes hand in hand with lean thinking. In the second half of Chapter 4, we'll look at some of the unique char- acteristics of lean operations which companies in every sector of the economy are using with great success. We'll also show how companies analyze the costs associated with their current level of quality as well as make decisions about quality improvement initiatives.

Sustainability, Social Responsibility, and the Triple Bottom Line Recent years have witnessed an increasing awareness and growing interest in sustainabil- ity and social responsibility by both consumers and corporations. The dictionary defini- tion of sustainability refers to the ability of a system to maintain its own viability, endure without giving way, or use resources so that they are not depleted or permanently dam- aged.11 In other words, it's the ability of a system to operate in such a manner that it is able to continue indefinitely. The United Nations has defined sustainability as "the ability to meet the needs of the present without compromising the ability of future generations to meet their own needs." 12 Others have defined sustainability as an expansion of the golden rule: "Do unto others, including future generations, as you would have done unto you." 13

As pictured in Exhibit 1-8, sustainability has three pillars: environmental, social, and economic. A company will be viable in the long run only if all three of these factors are

EXHIBIT 1-8 The Three Pillars of Sustainabi lity

Sustainability

11www .merriam-webster.com;http://dictionary.reference.com 12 1987 World Commission on Environment and Development, www.un.org/documents/ga/res/42/ares42-187.htm 13Gary Langenwalter, "Business Sustainability: Keeping Lean but with More Green for the Company's Long Haul," 2010, AICPA, Lewisville, Texas.

22 CHAPTER 1

considered when making business decisions. For example, a company will not be able to survive in the long run if the natural resources (e.g., air, water, soil, minerals, plants, fuel supplies, etc.) or people (e.g., suppliers, customers, employees, communities) it relies on are put in jeopardy. Thus, sustainability is also viewed as the intersection of all three factors, as pictured in Exhibit 1-9. As a result, many companies are beginning to adhere to the notion of a triple bottom line. The triple bottom line recognizes that a company's performance should be viewed not only in terms of its ability to generate economic profits for its owners, as has traditionally been the case, but also in terms of its impact on people and the planet.

EXHIBIT 1-9 Sustainabi lity as the Intersection of Three Factors

Sustainable

To move toward sustainability, companies are introducing "green initiatives"-ways of doing business that have fewer negative consequences for the earth's resources. They are innovating new products and manufacturing processes that use recycled materials to reduce the amount of waste going to landfills. The drive is toward a circular economy, where nothing goes to waste. Companies have also recognized the need to be socially responsible-carefully considering how their business affects employees, consumers, citi- zens, and entire communities. Many companies have introduced means of giving back to their local communities by supporting local schools, employee volunteerism, and charities. Most of the leading companies in the world are now issuing Corporate Social Respon- sibility (CSR) reports through which they communicate their social and environmental impacts. Businesses are now viewing sustainability and social responsibility as opportuni- ties for innovation and business development. These initiatives not only allow a company to "do the right thing," but they also can lead to economic profits by increasing demand for a company's products and services and reducing costs.

In every chapter of this text, you will see a special section illustrating how man- agement accounting can help companies pursue sustainable, socially responsible busi- ness practices. These sections will be marked with a green recycle symbol and will also point you to corresponding homework problems. In addition, Chapter 15 is devoted to sustainability, examining the reasons sustainability makes good business sense and the framework and methods companies use to measure and report on their social and envi- ronmental impact.

Integrated Reporting The corporate reporting landscape is constantly changing. One of the most notable recent global movements is toward integrated reporting. According to the Interna- tional Integrated Reporting Committee (IIRC), integrated reporting (symbolized as <IR>) "is a process that results in communication, most visibly a periodic 'integrated report,' about value creation over time. An integrated report is a concise communica- tion about how an organization's strategy, governance, performance and prospects lead to the creation of value over the short, medium and long term. " 14 As such, it is a

14www .theiirc.org

Introduction to Managerial Accounting 23

broader, more holistic, balanced, and future-looking report than traditional financial statements, which tend to focus on short-term financial measures of past performance. An integrated report essentially describes and measures all material elements of value creation, not just those relating to financial capital. In addition to financial capital, the report considers manufactured, intellectual, human, social, and natural (environ- mental) capital, which are often more difficult for investors to access through tradi- tional financial reporting.

Integrated reporting, which is still in its infancy, is being driven by businesses and institu- tional investors who want more information for better decision making than that offered by traditional financial statements. Several well-known companies, including Microsoft, Pru- dential, and Coca-Cola, as well as the Big Four accounting firms, the Chartered Financial Analyst (CFA) Institute, and Goldman Sachs, are working closely with the IIRC to help further develop and refine the< IR> reporting framework. You may keep abreast of cur- rent developments in < IR > by visiting www.theiirc.org.

The Sarbanes-Oxley Act of 2002 As a result of corporate accounting scandals, such as those at Enron and WorldCom, the U.S. Congress enacted the Sarbanes-Oxley Act of 2002 /SOX). The purpose of SOX is to restore trust in publicly traded corporations, their management, their financial statements, and their auditors. SOX enhances internal control and financial reporting requirements and establishes new regulatory requirements for publicly traded compa- nies and their independent auditors. Publicly traded companies have spent millions of dollars upgrading their internal controls and accounting systems to comply with SOX regulations.

As shown in Exhibit 1-10, SOX requires the company's CEO and CFO to assume responsibility for their company's financial statements and disclosures. The CEO and CFO must certify that the financial statements and disclosures fairly present, in all mate- rial respects, the operations and financial condition of the company. Additionally, they must accept responsibility for establishing and maintaining an adequate internal control structure and procedures for financial reporting. The company must have its internal controls and financial reporting procedures assessed annually.

EXHIBIT 1-10 Some Important Features of SOX

CEO and CFO assume responsibility for the company's financial statements, internal control system, and procedures for financial reporting.

New requirements for CPA firms, including limited non-audit services for audit clients and periodic quality review.

Audit committee must be independent and should include a financial expert.

Stiffer imprisonment and monetary fines for white-collar crimes. Previously paid CEO and CFO bonuses can be recovered if financial statements were improperly stated due to misconduct.

Source: Based on information from http ://fmcenter .aicpa.org/Resources/Sarbanes-Oxl ey+Act/Summary +of+the +Provisions+of+the+Sarbanes-Oxle y+Act+of+2002 .htm

24 CHAPTER 1

II Why is this important? "SOX puts more pressure on

SOX also requires audit committee members to be indepen- dent; that is, they may not receive any consulting or advisory fees from the company other than for their service on the board of direc- tors. In addition, at least one of the members should be a financial expert. The audit committee oversees not only the internal audit function but also the company's audit by independent CPAs. companies, their managers ,

and their auditors to ensure that

investors get financial information that fairly reflects the company's operations ."

To ensure that CPA firms maintain independence from their client company, SOX does not allow CPA firms to provide certain nonaudit services (such as bookkeeping and financial informa- tion systems design) to companies during the same period of time in which they are providing audit services. If a company wants to obtain such services from a CPA firm, it must hire a different firm to do the nonaudit work. Tax services may be provided by the same CPA firm if pre-approved by the audit committee. The audit partner

must rotate off the audit engagement every five years, and the audit firm must undergo qual- ity reviews every one to three years.

SOX also increases the penalties for white-collar crimes such as corporate fraud. These penalties include both monetary fines and substantial imprisonment. For example, knowingly destroying or creating documents to "impede, obstruct, or influence" any fed- eral investigation can result in up to 20 years of imprisonment. 15

SOX also contains a "clawback" provision in which previously paid CEO's and CFO's incentive-based compensation can be recovered if the financial statements were misstated due to misconduct. The Dodd-Frank Wall Street Reform and Consumer Pro- tection Act of 2010 further strengthens the clawback rules, such that firms must recover all incentive compensation paid to any current or former executive, in the three years preceding the restatement, if that compensation would not have been paid under the restated financial statements. In other words, executives will not be allowed to profit from misstated financial statements, even if the misstatement was not due to misconduct. 16

Since its enactment in 2002, SOX has significantly affected the internal operations of publicly traded corporations and their auditors. SOX will continue to play a major role in corporate management and the auditing profession.

Determine whether each of the following statements is true or false:

1. The Sarbanes-Oxley Act of 2002 (SOX) imposes stricter requirements for financial re- porting and internal controls and stricter consequences for those who engage in finan- cial statement misconduct and other white-collar crimes.

2. Most business decisions are now based on gut feelings and hunches, rather than being data-driven.

3. Critical thinking can be improved by asking yourself a series of questions about any issue or problem you encounter. These questions, for example, include: What is the objective? What data will I need? What assumptions am I making? Is my conclusion logical?

4. The triple bottom line assesses company performance on three factors: people (social impact), planet (environmental impact), and profit (economic impact).

5. Manufacturing makes up the largest sector of the U.S. economy.

6. The globalization of business has little bearing on management accounting.

7. Computer systems that integrate all of a company's worldwide functions into one data- base are known as Integrated Worldwide Systems (IWSs).

8. Lean thinking focuses on eliminating waste from operations.

Please see page 47 for solutions.

15Go to www.AICPA.org to learn more about SOX. 16http://www.pwc.com/us/en/cfodirect/publications/in-brief/sec-dodd-frank-clawback-rule-954 .htrnl

Introduction to Managerial Accounting 25

The Changing Business and Regulatory Environment . . . . . . . . . . Successful companies have to respond to changes in the business and regulatory environment . Managers have many decisions to make as they adapt to current business trends .

Decision

What impact will big data and data analytics have on our organization?

How can we use critical thinking to help solve business issues?

Is management accounting useful in the growing knowledge economy, or is it only applicable to manufacturers?

How do companies compete in a global economy?

How does the concept of sustainabil- ity affect business?

Which companies need to comply with SOX?

Guidelines

The abundance of data allows managers to make data-driven decisions, rather than decisions that are made on a hunch . However, critical thinking is needed to turn data into useful information .

The following steps provide a framework for critically examining any issue or problem :

1. What is the purpose, goal, or objective? In other words, what am I trying to accomplish?

2. What is the specific question I'm trying to address? The question will guide your thought process .

3. What data will I need to answer the question? With the sheer magnitude of data available, you'll need to hone in solely on the data that will help you an- swer the question at hand .

4. What concepts am I using, and what assumptions might I be taking for granted? Make sure you clearly identify the concepts and assumptions you are using, since a change in assumption might impact your conclusions .

5. What conclusions am I coming to, and are my inferences logical? Always check for logic .

6. What are the implications and consequences of these conclusions? All deci- sions have repercussions . Think ahead to what the outcome might be .

7. What is my point of view or reference point through which I have viewed the problem? Could I look at the problem from another equally valid point of view? Recognize that your point of view, which is the lens through which you view an issue, might be only one of several equally valid viewpoints .

Managerial accounting has expanded to meet the needs of companies in all sectors of the economy . Managers in service industries need detailed cost and revenue data to plan, control, and direct operations just as much as manufactur- ers do .

The globalization of business means more competition but more opportunity as well. To remain competitive, companies must constantly focus on costs, cus- tomer response times, and quality . Companies use lean thinking and Six Sigma to reduce wasted resources, reduce wasted time, and improve quality .

Businesses will be viable in the long run only if they take a sustainable approach to operations, carefully considering the impact of the company's operations on people and the planet as well as on profit . Thus, company performance is often evaluated using a triple-bottom-line approach . Businesses are viewing sustain- ability as an opportunity to "do the right thing" while simultaneously increasing the company's value through innovation, risk minimization, and cost reduction .

Publicly traded companies must comply with SOX. To better ensure the legiti- macy of companies' financial information, many of the law's specific require- ments focus on implementing adequate internal controls, employing better financial reporting procedures, and maintaining independence from the com- pany's auditors .

26 CHAPTER 1 - •. _ . . SUMMARY PROBLEM 2

EZ-Rider Motorcycles is considering whethe r to expand into Germany . If gas prices increase, the company expects more interest in fuel-efficient transportation such as motorcycles . As a result, the company is considering setting up a motorcycle assembly plant on the outskirts of Berlin.

EZ-Rider Motorcycles estimates that it will cost $850,000 to convert an existing building to motorcycle production . Workers will need training , at a total cost of $65,000 . The additional cost to organize the business and to establish relationships is estimated to be $150,000 .

The CEO believes the company can earn profits from this expansion (before considering the costs in the preceding paragraph) of $1,624,000 .

Requirement

Use cost-benefit analysis to determine whether EZ-Rider should expand into Germany .

• SOLUTION The following cost-benefit analysis indicates that the company should expand into Germany because expected benefits exceed expected costs:

_J A B C D 1 Cost-Benefit Analysis Total 2 Exaected Benefits: 3 Expected profits from increase in sales $ 1,624,000 4 Exaected Costs: 5 Conversion of building $ 850,000 6 Workforce traininE1: 65,000 7 Organizing and establishing relationships 150,000 8 Total expected costs 1,065,000 9 Net expected benefit $ 559,000 10

·· ········ ······

Learning Objectives • 1 Identify managers' three primary responsibilities

• 2 Distinguish financial accounting from managerial accounting

• 3 Describe the roles and skills required of management accountants within the organization

• 4 Describe the role of the Institute of Management Accountants (IMA) and apply its ethical standards

• 5 Discuss the business trends and regulations affecting management accounting

Accounting Vocabulary American Institute of Certified Public Accountants (AICPA). (p. 11) The world's largest association representing the accounting profession; together with the Chartered Institute of Management Accountants (CIMA), offers the Chartered Global Management Accountant (CGMA) designation.

Audit Committee. (p. 10) A subcommittee of the board of directors that is responsible for overseeing both the internal audit function and the annual financial statement audit by independent CPAs.

Board of Directors. (p. 9) The body elected by shareholders to oversee the company.

Budget. (p. 3) Quantitative expression of a plan that helps managers coordinate and implement the plan.

Certified Management Accountant (CMA). (p. 10) A profes- sional certification issued by the IMA to designate expertise in the areas of managerial accounting, economics, and business finance.

Chartered Global Management Accountant (CGMA). (p. 11) A designation available to qualifying American Insti- tute of Certified Public Accountants (AICPA) members that is meant to recognize the unique business and accounting skill set possessed by those CPAs who work, or have worked, in business, industry, or government.

Chief Executive Officer (CEO). (p. 9) The position hired by the board of directors to oversee the company on a daily basis.

Chief Financial Officer (CFO). (p. 10) The position responsi- ble for all of the company's financial concerns.

Chief Operating Officer (COO). (p. 10) The position respon- sible for overseeing the company's operations.

Controller. (p. 10) The position responsible for general finan- cial accounting, managerial accounting, and tax reporting.

Controlling. (p. 3) One of management's primary responsi- bilities; evaluating the results of business operations against the plan and making adjustments to keep the company press- ing toward its goals.

Cost-Benefit Analysis. (p. 19) Weighing costs against ben- efits to help make decisions.

Critical Thinking. (p. 18) Improving the quality of thought by skillfully analyzing, assessing, and reconstructing it.

Cross-Functional Teams. (p. 10) Corporate teams whose members represent various functions of the organization, such as

R&D, design, production, marketing, distribution, and customer service.

Decision Making. (p. 2) Identifying possible courses of action and choosing among them.

Directing. (p. 3) One of management's primary responsibili- ties; running the company on a day-to-day basis.

Enterprise Resource Planning (ERP). (p. 18) Software sys- tems that can integrate all of a company's worldwide func- tions, departments, and data into a single system.

Institute of Management Accountants (IMA). (p. 10) The professional organization that promotes the advancement of the management accounting profession.

Integrated Reporting. (p. 22) A process resulting in a report that describes how a company is creating value over time using financial, manufactured, intellectual, human, social, and natural capital.

Internal Audit Function. (p. 10) The corporate function charged with assessing the effectiveness of the company's internal controls and risk management policies.

Lean Thinking. (p. 21) A philosophy and business strategy of operating without waste.

Management Accounting (p. 2) A profession that involves partnering in management decision making, devising planning and performance management systems, and providing expertise in financial reporting and control to assist management in the formulation and implementation of an organization's strategy.

Planning. (p. 3) One of management's primary responsibili- ties: setting goals and objectives for the company and decid- ing how to achieve them.

Sarbanes-Oxley Act of 2002 (SOX). (p. 23) A congressional act that enhances internal control and financial reporting requirements and establishes new regulatory requirements for publicly traded companies and their independent auditors.

Six Sigma. (p. 21) The goal of producing near perfection with less than 3.4 defects per million opportunities.

Sustainability. (p. 21) The ability to meet the needs of the present without compromising the ability of future generations to meet their own needs.

Treasurer. (p. 10) The position responsible for raising the firm's capital and investing funds.

Triple Bottom Line. (p. 22) Evaluating a company's perfor- mance not only by its ability to generate economic profits, but also by its impact on people and on the planet.

27

28 CHAPTER 1

MyAccounting lab Go to http://myaccountinglab.com/ for the following Quick Check, Short Exercises, Exercises, and Problems. They are available with immediate grading, explanations of correct and incorrect answers, and interactive media that acts as your own online tutor.

Quick Check 1. (Learning Objective 1) Which of the following manage-

ment responsibilities often involves evaluating the re- sults of operations against the budget?

a. Planning

b. Directing

c. Controlling

d. None of the above

2. (Learning Objective 2) Managerial accounting differs from financial accounting in that managerial accounting

a. tends to report on the company as a whole rather than segments of the company.

b. emphasizes data relevance over data objectivity .

c. is used primarily by external decision makers .

d. is required by Generally Accepted Accounting Principles (GAAP).

3. (Learning Objective 3) Which of the following corporate positions is responsible for general financial accounting, managerial accounting, and tax reporting?

a. Controller

b. Treasurer

c. Internal audit

d. Chief operating officer (COO)

4. (Learning Objective 3) Of the following skills, which are needed by today's management accountants?

a. Strategic thinking

b. Cost management

c. Decision analysis

d. All of the above

5. (Learning Objective 4) Which of the following organiza- tions is the professional association specifically for man- agement accountants?

a. FASB

b. AICPA

C. IMA

d. IFRS

6. (Learning Objective 4) Which of the following profes- sional standards requires management accountants to continually develop their knowledge and skills?

a. Competence

b. Confidentiality

C. Integrity

d. Credibility

7. (Learning Objective 4) Which of the following pro- fessional standards requires management accoun- tants to not disclose private information about their organizations?

a. Competence

b. Confidentiality

c. Integrity

d. Credibility

8. (Learning Objective 5) Which of the following requires the company's CEO and CFO to assume responsibility for the company's financial statements and disclosures?

a. Sarbanes-Oxley Act of 2002 (SOX) b. Institute of Management Accountants (IMA)

c. Enterprise Resource Planning (ERP)

d. Lean operations

9. (Learning Objective 5) Which of the following is false?

a. Globalization has increased the necessity for more detailed and accurate cost information .

b. The triple bottom line focuses on three items: net income, net assets, and return on investment .

c. ERP systems integrate information from all company functions into a centralized data warehouse.

d. Lean operations is a philosophy and business strategy of operating without waste .

10. (Learning Objective 5) All of the following are business trends affecting management accounting except:

a. shifting economy.

b. sustainability .

c. big data .

d. all of the above.

Quick Check Answers

P ·o ~ q . 6 e ·g q . L e ·9 :> ·s P ·p e "£ q ·z :> • ~

Introduction to Managerial Accounting 29

Short Exercises

51-1 Managers' responsibilities (Learning Objective 1) Categorize each of the following activities as to which management responsibility it fulfills: planning, directing, or controlling . Some activities may fulfill more than one responsibility .

a. Management decides to increase sales growth by 20% next year .

b. Management analyzes the impact of a recent advertising campaign by comparing budgeted sales to actual sales .

c. Management reviews hourly sales reports to determine the level of staffing needed to staff the customer service desk .

d. Management uses information on product costs to determine sales prices .

e. To lower production costs, management moves production to China .

51-2 Contrast managerial and financial accounting (Learning Objective 2) Managerial accounting differs from financial accounting in several areas . Specify whether each of the following characteristics relates to managerial accounting or financial accounting .

a. Reports are usually prepared quarterly and annually .

b.

C.

d.

e.

f.

g.

h.

i.

j.

k.

I.

m.

51-3

Information is verified by external auditors .

Focus is on the past .

Main characteristic of information is that it must be relevant .

Reports tend to be prepared for the parts of the organization rather than the whole organization.

Primary users are internal (i.e., company managers) .

It is governed by Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS).

The primary characteristics of information are that it must be reliable and objective .

Reports are prepared as needed .

It is not governed by legal requirements .

Primary users are external (i.e., creditors, investors).

Focus is on the future .

Reporting is based mainly on the company as a whole .

Accounting roles in the organization (Learning Objective 3) The following is a list of job duties or descriptions . For each item, specify whether it would be most likely to describe the duties or responsibilities of someone working for the treasurer, the controller, or the Internal Auditing Department .

a. Check to make sure that company risk management procedures are being followed .

b. Oversee accounts payable activities .

c. Report to the audit committee of the board of directors and to a senior executive, such as the CFO or CEO .

d. Ensure that the company's internal controls are functioning properly .

e. Issue company stock.

f. Perform cash counts at branch offices.

g. Work with various departments in preparing operating budgets for the upcoming year .

h. Create an analysis about whether to lease or buy a delivery truck.

i. Prepare journal entries for month-end closing .

j. Calculate the cost of a product .

k. Prepare company tax returns .

I. Invest company funds.

m. Issue company bonds .

30 CHAPTER 1

51-4 Role of internal audit function (Learning Objective 3) The following table lists several characteristics . Place a check mark next to those items that pertain directly to the internal audit function and its role within the organization .

Characteristic Check (,/) if related to internal auditing

a . Reports directly to the audit committee

b . Reports to treasurer or controller

c. Is part of the Accounting Department

d . Helps to ensure that the company's internal controls are functioning properly

e . Performs the same function as independent certified public accountants

f. Usually reports to a senior executive (CFO or CEO) for administrative matters

g . External audits can be performed by the Internal Auditing Department

h. Required by the New York Stock Exchange (NYSE) if company stock is publicly traded on the NYSE

i. Ensures that the company achieves its profit goals

51 -5 Classify roles within the organization (Learning Objective 3) Complete the following statements with one of the terms listed here . You may use a term more than once, and some terms may not be used at all.

Audit committee

Treasurer

Board of directors

Controller

a. The CEO is hired by the __ _

CEO

Cross-functional teams

b. A subcommittee of the board of directors is called the __ _

CFO

coo

c. Raising capital and investing funds are the direct responsibilities of the __ _

d. The ___ and the ___ report to the CEO .

e. Financial accounting, managerial accounting, and tax reporting are the direct respon- sibilities of the ___ _

f. Management accountants often work on __ _

g. The internal audit function reports to the CFO or the ___ and the ___ _

h. The company's operations are the direct responsibility of the __ _

51-6 Professional organizations and certifications (Learning Objective 4) Complete the following sentences:

1. The Institute of Management Accountants (IMA) issues the _______ _ ____ certification .

2. The certification offered by IMA focuses on ____ and ____ topics .

3. The monthly professional magazine published by the Institute of Management Ac- countants is called __ _

4. The certification launched in 2012 jointly by the American Institute of Certified Public Accountants (AICPA) and the Chartered Institute of Management Accountants (CIMA) is called the __ _

5. To earn CMA certification, a candidate must have a(n) ____ degree . The CMA exam can be taken, however, before finishing this degree .

Introduction to Managerial Accounting 31

51-7 Violations of ethical standards (Learning Objective 4) The IMA's Statement of Ethical Professional Practice (Exhibit 1-7) requires management accountants to meet standards regarding the following : . Competence . Confidentiality . Integrity . Credibility Consider the following situations . Which guidelines are violated in each situation?

a. You do not provide top managers with the detailed job descriptions they requested because you fear they may use this information to cut a position from your department.

b. You tell your sister that your company will report earnings significantly above financial analysts' estimates .

c. You failed to read the detailed specifications of a new software package that you asked your company to purchase . After it is installed, you are surprised that it is incompatible with some of your company's older accounting software .

d. You see that other employees take office supplies for personal use. As an intern, you do the same thing, assuming that this is a "perk ."

e. At a financial reporting seminar, you skip the afternoon session and go sightseeing . Your company paid for the registration fee, and you are getting paid for the day .

51 -8 Identify current competitive tools (Learning Objective 5) Companies are facing a great amount of change in every facet of their operations today . To remain competitive, companies must keep abreast of current developments in several areas . You recently got together with a group of friends who work for different compa- nies . Your friends share information about their current challenges in adopting new tools or complying with new regulations . Excerpts from the conversation are presented in the following section . Tell whether each excerpt describes data analytics, Six Sigma, sustain- ability, the Sarbanes-Oxley Act (SOX}, or enterprise resource planning (ERP) systems .

a. Jordan : My company has a new initiative at work . All employees are encouraged to recycle paper and other materials . Employees are also given one work day a year to volunteer to help local nonprofit organizations. Employees are also urged to think outside the box to find ways to reduce the company's carbon footprint . The company has also begun an internal reporting system that reports on its triple bottom line.

b. Kate: I just started a new job in the Auditing Department . My new duties include assisting in the development of testing procedures and methods for determining internal controls effectiveness . I also oversee the testing for assurance of compliance with corporate policies. I am coordinating the review of SEC filings with our external auditors. I also am responsible for preparing periodic compliance status reports for management, the audit committee, and the external auditors .

c. Yiang: My company is working to demonstrate its commitment to continuous quality improvement . We are currently undergoing an extensive audit of our quality manage- ment processes and are striving to produce with a defect level of less than 3.4 defects per million parts produced . We hope to gain a competitive advantage through this process.

d. Christopher: We have just installed a system at our company that integrates all of our company's data across all systems . We have one central data warehouse that contains information about our suppliers, our customers, our employees, and our financial information . The software retrieves information from this single data warehouse and all systems are integrated. The process of implementing this system has been very expensive and time consuming, but we are reaping the benefits of being more streamlined, of being able to respond more quickly to changes in the market, and of not having several different software systems operating independently.

e. Emma : Our company is considering whether to set up a sales division in India where we feel there is untapped market potential. However, we have to carefully consider the costs of such an expansion against the increased sales we would see from the new division.

3 2 CHAPTER 1

51 -9 Identify ethical standards violated (Learning Objective 4) For each of the situations listed, identify the primary standard from the IMA Statement of Ethical Professional Practice that is violated (competence, confidentiality, integrity, or credibility .) Refer to Exhibit 1-7 for the complete standard .

a. Jack, an accountant for a smartphone manufacturer, told his friends about a new model of smartphone being released by the company in the following quarter . For competitive reasons, the company keeps its models shrouded in secrecy until the release date .

b. The CFO directed that certain expenses be reclassified as assets, so that target profit could be achieved . The CFO rationalized that jobs would be saved by reaching the targeted income figures .

c. Even though Meagan's company is adopting a new ERP system that impacts the accounting system, Meagan (a management accountant) has not completed the required ERP training from the vendor .

d. Oliver provides an analysis of the profitability of a company-owned store that is man- aged by Oliver's best friend, Bob . Oliver neglects to include allocated fixed costs in Bob's report . If Oliver includes those allocated fixed costs, the store will show a loss and Bob's job could be in danger .

e. Yimeng, a purchasing agent for her company, received two tickets from a supplier to the upcoming Ohio State versus University of Michigan football game . These tickets sell for over $500 each .

51-10 Define key terms (Learning Objectives 1, 2, 3, 4, and 5) Complete the following statements with one of the terms listed here .

CEO

CFO

Controlling

Controller

Critical thinking

Directing

Economic

Environmental

ERP

Financial accounting system

Integrated report

Internal audit

Planning

Sarbanes-Oxley Act of 2002

Six Sigma

Social

Sustainability

Treasurer

a. The _______ is geared toward producing periodic financial statements that will be used by investors and creditors to make investment and lending decisions .

b. ______ improves the quality of thought by skillfully analyzing, assessing, and reconstructing initial thoughts .

c. The goal of producing near perfection with less than 3.4 defects per one million opportunities is called _______ _

d. The ______ is the person responsible for raising the firm's capital and invest- ing its funds .

e. The three pillars of sustainability are:---~---~ and ___ _ f. The _______ is the person responsible for general financial accounting, mana-

gerial accounting, and tax reporting .

g. The role of the ____ function is to ensure that the company's internal controls and risk management policies are functioning properly .

h. The ____ was enacted to restore trust in publicly traded corporations, their man- agement, their financial statements, and their auditors .

i. ____ is a broad holistic report that describes all material elements of value cre- ation, not just the financial elements .

j. ____ is the management process of evaluating the results of business operations against the plan and making adjustments to keep the company pressing toward its goals .

k. ____ is the management process of overseeing the company's day-to-day operations .

I. ____ serves the information needs of people in accounting as well as people in marketing and in the warehouse .

m. __ is the ability to meet the needs of the present without compromising the ability of future generations to meet their own needs .

n. The ____ manages the company on a daily basis .

o. ____ is the management process of setting goals and objectives for the company and determining how to achieve them .

p. Typically, the treasurer and the controller report directly to the ___ _

Introduction to Managerial Accounting 33

EXERCISES Group A E1 -11 A Define key terms (Learning Objectives 1 & 2)

Complete the following statements with one of the terms listed here . You may use a term more than once, and some terms may not be used at all.

Budget

Controlling

Creditors

Financial accounting

Managerial accounting

Managers

Planning

Shareholders

a. Information on a company's past performance is provided to external parties by

b. ____ systems are chosen by comparing the costs versus the benefits of the sys- tem and are not restricted by GAAP (or International Financial Reporting Standards, IFRS, in the case of companies headquartered in many countries outside of the United States) .

c. ____ systems report on various segments or business units of the company .

d. Financial accounting develops reports for external parties such as ____ and

e. When managers evaluate the company's performance compared to the plan, they are performing the ____ role of management .

f. CPAs audit the ____ statements of public companies .

g. Companies must follow GAAP (or International Financial Reporting Standards, IRFS, in the case of companies headquartered in many countries outside of the United States) in their ____ systems .

h. Choosing goals and the means to achieve them is the ____ function of management .

i. Decision makers inside a company are the ___ _

E1 -12A Identify skills needed by management accountants (Learning Objective 3) Management accountants need a wide variety of skills for their roles in organizations . These skills can be classified as either technical or nontechnical.

Requirement For each of the following skills, indicate whether it is a technical competency or a non- technical competency for a management accountant.

a. Planning, budgeting, and forecasting

b. Leadership

C. Financial statement analysis

d. Adaptability

e. Strategic thinking

f. Change management

g. Investment decision making

h. Cost management

i. Technology

j. Internal financial reporting

k. Collaboration

I. Process improvement

m. Performance management

n. Customer service

o. Enterprise risk management

p. Decision analysis

q. Communication

r. Ethics

s. Internal controls

t. Business acumen

34 CHAPTER 1

E1-13A Identify users of accounting information (Learning Objective 3) For each of the following users of financial accounting information and managerial accounting information, specify whether the user would primarily use financial accounting information or managerial accounting information or both .

1. Reporter from The Wall Street Journal

2. Regional division managers

3. Potential investors

4. Bookkeeping Department

5. Manager of the Service Department

6. Wall Street analyst

7. Division controller

8. State tax agency auditor

9. External auditor (public accounting firm)

10. Loan officer at the company's bank

11. Boa rd of directors

12. Internal auditor

13. SEC examiner

14. Current stockholders

E1 -14A Classify ethical responsibilities (Learning Objective 4) According to the IMA's Statement of Ethical Professional Practice (Exhibit 1-7), manage- ment accountants should follow four standards : competence, confidentiality, integrity, and credibility . Each of these standards contains specific responsibilities . Classify each of the following responsibilities according to the standard it addresses .

Responsibility:

1. Keep information confidential except when disclosure is authorized or legally required .

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 con- trols in conformance with organization policy and/or applicable law.

4. Communicate information fairly and objectively .

5. Refrain from using confidential information for unethical or illegal advantage .

6. Inform all relevant parties regarding the appropriate use of confidential information . Monitor subordinates' activities to ensure compliance .

7. Mitigate actual conflicts of interest . Regularly communicate with business associates to avoid apparent conflicts of interest . Advise all parties of any potential conflicts .

8. Maintain an appropriate level of professional expertise by continually developing knowledge and skills.

9. Recognize and communicate professional limitations that would preclude responsible judgment or successful performance of an activity .

10. Perform professional duties in accordance with relevant laws, regulations, and techni- cal standards .

11. Abstain from engaging in or supporting any activity that might discredit the profession .

12. Refrain from engaging in any conduct that would prejudice carrying out duties ethically .

13. Provide decision support information and recommendations that are accurate, clear, concise, and timely .

Introduction to Managerial Accounting 35

E1 -1 SA Equipment purchase cost-benefit analysis (Learning Objective 5) Faced with rising pressure for a $15 per hour minimum wage rate, the farming industry is currently exploring the possible use of robotics to replace some farm workers . The Lettuce Bot is one such robot; its job is to thin out a field of lettuce, removing the least promising buds of lettuce . By removing these weaker plants, the stronger lettuce plants have more room to grow. Assume the following facts:

1. One Lettuce Bot would do the work of 20 farm workers .

2. Each farm worker typically works 40 hours on the lettuce thinning process each year .

3. Each farm worker would earn $15 per hour plus 7.65% payroll tax.

4. The Lettuce Bot is estimated to cost $8,000 plus $500 for delivery .

5. Annual costs of operating the Lettuce Bot are expected to be $1,500 .

While the Lettuce Bot itself may be in workable condition for up to five years, assume that the farm would view its implementation as a one-year experiment.

Requirement Perform a cost-benefit analysis for the first year of implementation to determine whether the Let- tuce Bot would be a financially viable investment if the minimum wage is raised to $15 pe r hour.

E1 -16A Lean production cost-benefit analysis (Learning Objective 5) McIntyre Industries manufactures iPhone case covers . Sarabeth Anderson, the CEO, is trying to decide whether to adopt a lean thinking model. She expects that adopting lean production would save $77,000 in warehousing expenses and $39,600 in spoilage costs . Adopting lean production will require several one-time up-front expenditures : $25,000 for an employee training program, $89,000 to streamline the plant's production process, and $7,000 to identify suppliers that will guarantee zero defects and on-time delivery .

Requirements

1. What are the total costs of adopting lean production?

2. What are the total benefits of adopting lean production?

3. Should the company adopt lean production? Why or why not?

E1 -17 A Identify sustainability efforts as impacting people, planet, or profit (Learning Objective 5)

Sustainability involves more than just the impact of actions on the environment . The triple bottom line recognizes that a company has to measure its impact on its triple bottom line for its long-term viability. To follow are examples of green initiatives recently undertaken at PepsiCo ., Inc. For each example, indicate whether this initiative would primarily impact environmental, social, or economic factors.

a. In 2015, PepsiCo increased its dividend to shareholders .

b. It created a new global ingredient standard in 2014 that helps to ensure ingredient safety and integrity .

c. In 2014, PepsiCo used 23% less water (considered to be a scarce resource) per unit of production than in 2006 .

d. Almost 60% of beverage launches qualified as "Better-For-You" or "Good-For-You" products in 2014 (as opposed to PepsiCo's "Fun-For-You" category) .

e. From 2008 to 2014, PepsiCo held its greenhouse gas emissions stable despite increasing production .

f. PepsiCo strengthened its Responsible Advertising to Children policy . g. The return on PepsiCo's invested capital was above 13% for the fifth year in a row. h. In 2014, PepsiCo increased its amount of recycled content in its packaging by 23% . i. In 2014, 93% of PepsiCo's waste was not sent to landfills. j. In 2014, approximately 20% of PepsiCo's net revenue came from its nutrition business since

it has been making a concerted effort to promote more healthy food and beverage choices . k. During 2014, 95% of PepsiCo's manufacturing sites underwent an independent food

safety audit by the American Institute of Baking . I. Since 2006, PepsiCo has reached more than 1.92 million children in 477 schools in

India through its programs promoting nutrition and physical activity . m. PepsiCo provided access to safe water for 6 million people . n. Forty of PepsiCo's buildings have achieved LEED certification (LEED certification is a

measure of energy efficiency) .

SUSTAINABILITY

36 CHAPTER 1

EXERCISES Group B E1 -18B Define key terms (Learning Objectives 1 & 2)

Complete the following statements with one of the terms listed here . You may use a term more than once, and some terms may not be used at all.

Budget

Controlling

Creditors

Financial accounting

Managerial accounting

Managers

Planning

Shareholders

a. U.S. companies must follow GAAP (or International Financial Reporting Standards, IFRS, in the case of companies headquartered in many countries outside of the United States) in their ____ systems.

b. Financial accounting develops reports for external parties such as ____ and

c. When managers evaluate the company's performance compared to the plan, they are performing the ____ role of management .

d. ____ are decision makers inside a company .

e. ____ provides information on a company's past performance to external parties .

f. ____ systems are not restricted by GAAP (or International Financial Reporting Standards, IFRS, in the case of companies headquartered in many countries outside of the United States) but are chosen by comparing the costs versus the benefits of the system .

g. Choosing goals and the means to achieve them is the ____ function of

h.

i.

management . ____ systems report on various segments or business units of the company .

____ statements of public companies are audited annually by CPAs.

E1-19B Identify skills needed by management accountants (Learning Objective 3)

Management accountants need a wide variety of skills for their roles in organizations . These skills can be classified as either technical or nontechnical.

Requirement

For each of the following skills, indicate whether it is a technical competency or a non- technical competency for a management accountant .

a. Leadership

b. Communication

C. Collaboration

d. Internal controls

e. Change management

f. Cost management

g. Investment decision making

h. Technology

i. Customer service

j. Financial statement analysis

k. Business acumen

I. Performance management

m. Adaptability

n. Enterprise risk management

o. Planning, budgeting, and forecasting

p. Decision analysis

q. Internal financial reporting

r. Ethics

s. Process improvement

t. Strategic thinking

Introduction to Managerial Accounting 37

E1 -20B Identify users of accounting information (Learning Objective 3) For each of the following users of financial accounting information and managerial accounting information, specify whether the user would primarily use financial accounting information or managerial accounting information, or both .

1. Internal auditor

2. Potential shareholders

3. Loan officer at the company's bank

4. Manager of the Sales Department

5. Bookkeeping Department

6. Managers at regional offices

7. IRS agent

8. Current shareholders

9. Wall Street analyst

10. News reporter

11. Company controller

12. Board of directors

13. SEC employee

14. External auditor (public accounting firm)

E1 -21 B Classify ethical responsibilities (Learning Objective 4) According to the IMA's Statement of Ethical Professional Practice (reproduced in the chapter}, management accountants should follow four standards: competence, confiden- tiality, integrity, and credibility . Each of these standards contains specific responsibilities . Classify each of the following responsibilities according to the standard it addresses.

1. Communicate information fairly and objectively .

2. Recognize and communicate professional limitations that would preclude responsible judgment or successful performance of an activity .

3. Mitigate actual conflicts of interest. Regularly communicate with business associates to avoid apparent conflicts of interest. Advise all parties of any potential conflicts.

4. Provide decision support information and recommendations that are accurate, clear, concise, and timely.

5. Abstain from engaging in or supporting any activity that might discredit the profession .

6. Disclose all relevant information that could reasonably be expected to influence an intended user's understanding of the reports, analyses, or recommendations .

7. Inform all relevant parties regarding the appropriate use of confidential information . Monitor subordinates' activities to ensure compliance .

8. Perform professional duties in accordance with relevant laws, regulations, and techni- cal standards .

9. Refrain from engaging in any conduct that would prejudice carrying out duties ethically .

10. Keep information confidential except when disclosure is authorized or legally required.

11. Disclose delays or deficiencies in information, timeliness, processing, or internal con- trols in conformance with organization policy and/or applicable law.

12. Refrain from using confidential information for unethical or illegal advantage .

13. Maintain an appropriate level of professional expertise by continually developing knowledge and skills.

3 8 CHAPTER 1

SUSTAINABILITY

E1 -22B Equipment purchase cost-benefit analysis (Learning Objective 5) Faced with rising pressure for a $15 per hour minimum wage rate, the farming industry is currently exploring the possible use of robotics to replace some farm workers . The Lettuce Bot is one such robot; its job is to thin out a field of lettuce, removing the least promising buds of lettuce . By removing these weaker plants, the stronger lettuce plants have more room to grow. Assume the following facts:

1. One Lettuce Bot would do the work of 25 farm workers .

2. Each farm worker typically works 50 hours on the lettuce thinning process each year .

3. Each farm worker would earn $15 per hour plus 7 .65% payroll tax .

4. The Lettuce Bot is estimated to cost $9,500 plus $1,000 for delivery .

5. Annual costs of operating the Lettuce Bot are expected to be $2,500 .

While the Lettuce Bot itself may be in workable condition for up to five years, assume that the farm would view its implementation as a one-year experiment .

Requirement Perform a cost-benefit analysis for the first year of implementation to determine whether the Lettuce Bot would be a financially viable investment if the minimum wage is raised to $15 per hour.

E1 -23B Lean production cost-benefit analysis (Learning Objective 5) Pittinger Industries manufactures iPhone case covers . Jeanne Thompson, the CEO, is trying to decide whether to adopt a lean thinking model. She expects that adopting lean production would save $63,000 in warehousing expenses and $39,600 in spoilage costs . Adopting lean production will require several one-time up-front expenditures: $11,500 for an employee training program, $41,500 to streamline the plant's production process, and $7,500 to identify suppliers that will guarantee zero defects and on-time delivery .

Requirements

1. What are the total costs of adopting lean production?

2. What are the total benefits of adopting lean production?

3. Should the company adopt lean production? Why or why not?

E1 -24B Identify sustainability efforts as impacting people, planet, or profit (Learning Objective 5)

Sustainability involves more than just the impact of actions on the environment . The triple bottom line recognizes that a company has to measure its impact on its triple bottom line for its long-term viability . Following are examples of green initiatives recently undertaken at The Coca-Cola Company . For each example, indicate whether this initiative would pri- marily impact environmental, social, or economic factors .

a. Increased the number of countries where reduced-, low-, or no-calorie products rep- resent more than 20% of the local product lineup.

b. For the twelfth consecutive year, improved overall water efficiency in manufacturing . c. Achieved a 21% improvement in energy efficiency as compared to 2004 . d. Generated a profit for Coca-Cola's shareholders .

e. Worked with partners to recover and recycle the equivalent of 48% of bottles and cans used for finished beverages .

f. Exceeded the 2014 goal of 89% of direct suppliers' compliance with Coca-Cola's Sup- plier Guiding Principles (for human and workplace rights) .

g. By 2014, Coca-Cola reduced the weight of its products sold by 15% since 2008 . h. By the end of 2014, 98% of Coca-Cola-owned facilities had achieved compliance with

its Human Rights Policy. i. Replaced a significant portion of the plastic used in its bottles with a plant-based material. j. As of the end of 2014, 43% of Coca-Cola's U.S. workforce was multicultural.

k. Generated a positive economic benefit in every community in which Coca-Cola has facilities in the United States .

I. By the end of 2014, almost 80% of Coca-Cola's plants had achieved both the ISO 9001 Qual- ity Management standard and the FSSC 22000 Food Safety Management System standard .

m. Reduced emissions from manufacturing in developed countries by 13% since 2004 . n. Lost-time incident (accident) rate fell from 4 .1 incidents per 200,000 hours worked in

2010 to 1.9 incidents per 200,000 hours worked in 2014 .

Introduction to Managerial Accounting 39

PROBLEMS Group A P1 -25A Management processes and accounting information (Learning

Objectives 1 & 2)

Sarah Miracle has her own chain of music stores, Miracle Music . Her stores sell musical instruments, sheet music, and other related items . Music lessons and instrument repair are also offered through the stores . Miracle Music also has a website that sells music merchandise . The store has a staff of 80 people working in six departments: Sales, Repairs, Lessons, Web Development, Accounting, and Human Resources . Each depart- ment has its own manager .

Requirements

1. For each of the six departments, describe at least one decision/action for each of the three stages of management (planning, directing, and controlling) . Prepare a table similar to the following for your answer:

Sales

Repairs

Lessons

Web Development

Accounting

Human Resources

Planning Directing Controlling

2. For each of the decisions/actions you described in Part 1, identify what information is needed for that decision/action. Specify whether that information would be gen- erated by the financial accounting system or the managerial accounting system at Miracle Music .

P1 -26A Ethical dilemmas (Learning Objective 4) Barb Perot is the new controller for EduTechno Software, which develops and sells edu- cational software . Shortly before the December 31 fiscal year-end, Tony Cattrall, the com- pany president, asks Perot how things look for the year-end numbers. He is not happy to learn that earnings growth may be below 15% for the first time in the company's five-year history. Cattrall explains that financial analysts have again predicted a 15% earnings growth for the company and that he does not intend to disappoint them . He suggests that Perot talk to the assistant controller, who can explain how the previous con- troller dealt with this situation. The assistant controller suggests the following strategies:

a. Persuade suppliers to postpone billing until January 1.

b. Record as sales certain software awaiting sale that is held in a public warehouse.

c. Delay the year-end closing a few days into January of the next year so that some of next year's sales are included as this year's sales .

d. Reduce the allowance for bad debts (and bad debts expense) .

e. Postpone routine monthly maintenance expenditures from December to January .

Requirement Which of these suggested strategies are inconsistent with IMA standards? What should Perot do if Cattrall insists that she follow all of these suggestions?

40 CHAPTER 1

P1 -27 A ERP cost-benefit analysis (Learning Objective 5) As CEO of Aqua Marine, Ca rrie Easton knows it is important to control costs and to respond quickly to changes in the highly competitive boat-building industry . When Rose Consulting proposes that Aqua Marine invest in an ERP system, she forms a team to evaluate the proposal : the plant engineer, the plant foreman, the systems specialist, the human resources director, the marketing director, and the management accountant .

A month later, management accountant Mark Cole reports that the team and Rose estimate that if Aqua Marine implements the ERP system, it will incur the following costs :

a. $435,000 in software costs

b. $95,000 to customize the ERP software and load Aqua Marine's data into the new ERP system

c. $105,000 for employee training

The team estimates that the ERP system should provide several benefits :

a. More efficient order processing should lead to savings of $105,000 .

b. Streamlining the manufacturing process so that it maps into the ERP system will cre- ate savings of $125,000 .

c. Integrating purchasing, production, marketing, and distribution into a single system will allow Aqua Marine to reduce inventories, saving $225,000 .

d. Higher customer satisfaction should increase sales, which, in turn, should increase profits by $155,000 .

Requirements

1. If the ERP installation succeeds, what is the dollar amount of the benefits? 2. Should Aqua Marine install the ERP system? Why or why not? Show your calculations . 3. Why did Easton create a team to evaluate Rose's proposal? Consider each piece of

cost-benefit information that management accountant Cole reported . Which person on the team is most likely to have contributed each item? (Hint: Which team member is likely to have the most information about each cost or benefit?)

P1 -28A Online order system cost-benefit analysis (Learning Objective 5) Ferguson Gas wants to move its sales order system on line . Under the proposed system, gas stations and other merchants will use a secure site to check the availability and cur- rent price of various products and place an order . Currently, customer service representa- tives take dealers' orders over the phone; they record the information on a paper form, then manually enter it into the firm's computer system .

CFO Stacey Wilson believes that dealers will not adopt the new on line system unless Ferguson Gas provides financial assistance to help them purchase or upgrade their com- puter systems . Wilson estimates this one-time cost at $760,000 . Ferguson Gas will also have to invest $160,000 in upgrading its own computer hardware . The cost of the soft- ware and the consulting fee for installing the system will be $220,000 . The on line system will enable Ferguson Gas to eliminate 25 clerical positions . Wilson estimates that the benefits of the new system's lower labor costs will have saved the company $1,340,000 .

Requirement Use a cost-benefit analysis to recommend to Wilson whether Ferguson Gas should proceed with the online ordering system . Give your reasons, showing supporting calculations .

P1 -29A Continuation of P1 -28A: revised estimates (Learning Objective 5) Wilson revises her estimates of the benefits from the new system's lower labor costs as calculated in P1-28A. She now thinks the savings will be only $935,000 .

Requirements

1. Compute the expected benefits of the on line ordering system .

2. Would you recommend that Ferguson Gas accept the proposal?

3. Before Wilson makes a final decision, what other factors should she consider?

Introduction to Managerial Accounting 41

PROBLEMS Group B P1 -30B Management processes and accounting information (Learning

Objectives 1 & 2)

Bryan Haas has his own electronics retail chain, TechnoGeek . His stores sell computer parts, audiovisual equipment, consumer electronics, and related items . Custom computer building and electronics repair are also offered . In addition, TechnoGeek has a website to sell its merchandise . The store has a staff of 90 people working in six departments: Sales, Customization, Repairs, Web Development, Accounting, and Human Resources . Each department has its own manager .

Requirements

1. For each of the six departments, describe at least one decision/action for each of the three stages of management (planning, directing, and controlling) . Prepare a table similar to the following for your answer:

Sales

Repairs

Customization

Web Development

Accounting

Human Resources

Planning Directing Controlling

2. For each of the decisions/actions you described in Part 1, identify what information is needed for that decision/action. Specify whether that information would be gen- erated by the financial accounting system or the managerial accounting system at TechnoGeek .

P1 -31 B Ethical dilemmas (Learning Objective 4) Maria Dees is the new controller for Harmony Tennis, a designer and manufacturer of ten- nis attire . Shortly before the December 31 fiscal year-end, Harmony Sapp (the company president) asks Dees how things look for the year-end numbers . Sapp is not happy to learn that earnings growth may be below 10% for the first time in the company's five-year history . Sapp explains that financial analysts have again predicted a 12% earnings growth for the company and that she does not intend to disappoint them . She suggests that Dees talk to the assistant controller, who can explain how the previous controller dealt with this situation . The assistant controller suggests the following strategies :

a. Postpone planned advertising expenditures from December to January .

b. Do not record sales returns and allowances on the basis that they are individually immaterial.

c. Persuade retail customers to accelerate January orders to December .

d. Reduce the allowance for bad debts (and bad debts expense) .

e. Harmony Tennis ships finished goods to public warehouses across the country for temporary storage until it receives firm orders from customers . As Harmony Tennis receives orders, it directs the warehouse to ship the goods to nearby customers . The assistant controller suggests recording goods sent to the public warehouses as sales .

Requirement Which of these suggested strategies are inconsistent with IMA standards? What should Dees do if Sapp insists that she follow all of these suggestions?

42 CHAPTER 1

P1 -32B ERP cost-benefit analysis (Learning Objective 5) As CEO of Riverside Marine, Rachel Moore knows it is important to control costs and to respond quickly to changes in the highly competitive boat-building industry . When Ger- big Consulting proposes that Riverside Marine invest in an ERP system, she forms a team to evaluate the proposal: the plant engineer, the plant foreman, the systems specialist, the human resources director, the marketing director, and the management accountant .

A month later, management accountant Miles Cobalt reports that the team and Ger- big estimate that if Riverside Marine implements the ERP system, it will incur the follow- ing costs :

a. $390,000 in software costs

b. $85,000 to customize the ERP software and load Riverside Marine's data into the new ERP system

c. $112,000 for employee training

The team estimates that the ERP system should provide several benefits :

a. More efficient order processing should lead to savings of $185,000 .

b. Streamlining the manufacturing process so that it maps into the ERP system will cre- ate savings of $255,000 .

c. Integrating purchasing, production, marketing, and distribution into a single system will allow Riverside Marine to reduce inventories, saving $215,000 .

d. Higher customer satisfaction should increase sales, which, in turn, should increase profits by $150,000 .

Requirements

1. If the ERP installation succeeds, what is the dollar amount of the benefits?

2. Should Riverside Marine install the ERP system? Why or why not? Show your calculations .

3. Why did Moore create a team to evaluate Gerbig's proposal? Consider each piece of cost-benefit information that management accountant Cobalt reported . Which person on the team is most likely to have contributed each item? (Hint: Which team member is likely to have the most information about each cost or benefit?)

P1 -33B Online order system cost-benefit analysis (Learning Objective 5) Union Gas wants to move its sales order system online. Under the proposed system, gas stations and other merchants will use a secure site to check the availability and current price of various products and place an order . Currently, customer service representatives take dealers' orders over the phone; they record the information on a paper form, then manually enter it into the firm's computer system .

CFO Kate Bronson believes that dealers will not adopt the new online system unless Union Gas provides financial assistance to help them purchase or upgrade their computer network . Bronson estimates this one-time cost at $765,000. Union Gas will also have to invest $150,000 in upgrading its own computer hardware. The cost of the software and the consulting fee for installing the system will be $240,000 . The on line system will en- able Union Gas to eliminate 25 clerical positions . Bronson estimates that the new system's lower labor costs will have saved the company $1,370,000.

Requirement Use a cost-benefit analysis to recommend to Bronson whether Union Gas should proceed with the on line ordering system . Give your reasons, showing supporting calculations .

P1 -34B Continuation of P1 -33B: revised estimates (Learning Objective 5) Consider the Union Gas proposed entry into the on line ordering system in P1-33B . Bronson revises her estimates of the benefits from the new system's lower labor costs . She now thinks the savings will be only $936,000 .

Requirements

1. Compute the expected benefits of the on line ordering system .

2. Would you recommend that Union Gas accept the proposal?

3. Before Bronson makes a final decision, what other factors should she consider?

Introduction to Managerial Accounting 43

Serial Case C1 -35 Discuss how managerial accounting can be used at Caesars Palace

(Learning Objectives 1, 2, 3, 4, and 5)

Note: This story is the first part of the Caesars Entertainment Corporation serial case contained in every chapter in this textbook.

Caesars Palace® Las Vegas, owned and operated by Caesars Entertainment Corporation (CZR}, opened in 1966 . The Nevada hotel-and-casino complex has been featured in several movies includ- ing Rain Man, Iron Man, and The Hangover Part Ill. Caesars Palace is the twelfth largest hotel in the world .17 Caesars Palace® Las Vegas, at the start of 2015, included six towers (named Augustus, NOBU Hotel, Julius (formerly named Roman), Palace, Octavius, and Forum) containing almost 4,000 guest rooms. Beyond guest accommodations, the complex also included casinos, retail shops, restaurants, nightclubs, a 4,296-seat entertainment venue, and a large convention facility.

Caesars Palace ® Las Vegas made headlines when it undertook a $75 million renovation . In mid-September 2015, the hotel closed its then-named Roman Tower, which was last updated in 2001, and started a major renovation of the 567 rooms housed in that tower . On January 1, 2016, the newly renamed Julius Tower reopened, replacing the Roman Tower. In addition to renovating the existing rooms and suites in the former Roman Tower, 20 guest rooms were added to the tower.

Each guest room in the Julius Tower features designer furniture, including beds boasting a custom-upholstered headboard, thick carpet, contemporary paint colors, a 55-inch flat-screen TV, and upscale artwork . Each guest room has a stocked minibar, likely offering such stan- dard favorites as gummy bears, candy bars, beer, vodka, water, carbonated soft drinks, chips, and other assorted snacks and beverages . Each bathroom has a double-sink floating vanity, custom-lighted vanity mirrors, a stone shower with two glass sides, and both a rain shower and a hand-held showerhead . In-room toiletries boast the luxurious Gilchrist & Soames-branded soap and shampoo .

With the renovation completed, Caesars expects the Julius Tower room rate to aver- age around $149 per night . This increase, a $25 or 20 .2% increase, reflects, in part, the room improvements .

Requirement What types of decisions might the management of Caesars Palace® Las Vegas need to make over the next several years? In other words, how might managerial accounting information be useful to the management of Caesars Palace ® Las Vegas?

17Source: https://en.wikipedia.org/wik i/List_of_largest_hotels_in_the_world, as of January 8, 2016.

44 CHAPTER 1

CRITICAL THINKING Discussion & Analysis A 1-36 Discussion Questions

1. What are the three main areas of management's responsibility? How are these three areas inter- related? How does managerial accounting support each of the responsibility areas of managers?

2. What is the Sarbanes-Oxley Act of 2002 (SOX)? How does SOX affect financial accounting? How does SOX impact managerial accounting? Is there any overlap between financial and managerial accounting in terms of the SOX impact? If so, what are the areas of overlap?

3. Why is managerial accounting more suitable for internal reporting than for financial accounting?

4. How can what is taught in managerial accounting help you in other careers other than accounting?

5. A company currently has all of its managerial accountants reporting to the controller . What might be inefficient about this organizational structure? How might the company restructure? What benefits would the restructuring offer?

6. What skills are required of a management accountant? In what college courses are these skills taught or developed? What skills would be further developed in the workplace?

7. What is the Institute of Management Accountants (IMA)? What is the American Institute of Certified Public Accountants? How could being a member of a professional organiza- tion help a person's career?

8. How might a Certified Management Accountant (CMA) certification benefit a person in his or her career? What skills are assessed on the CMA exam?

9. What are the four ethical standards in the Institute of Management Accountants' State- ment of Ethical Professional Practice? Describe the meaning of each of the four stan- dards. How does each of these standards impact planning, directing, and controlling?

10. What business trends are influencing managerial accounting today? How do these trends impact management accountants' roles in the organization?

11. The effect of sustainability on the planet (environment) is probably the most visible com- ponent of the triple bottom line. For a company with which you are familiar, list two ex- amples of its sustainability efforts related to the planet .

12. One controversial area regarding sustainability is whether organizations should use their sustainability progress and activities in their advertising . Do you think a company should publicize its sustainability efforts? Why or why not?

Application & Analysis Mini Cases

A 1-37 Accountants and Their Jobs

Basic Discussion Questions

1. When you think of an accountant, whom do you picture? Do you personally know anyone (family member, friend, relative) whose chosen career is accounting? If so, does the person "fit" your description of an accountant or not?

2. Before reading this chapter, what did you picture accountants doing, day-in and day-out, at their jobs? From where did this mental picture come (e.g ., movies, first accounting class, speaking with accountants, etc .)?

3. What skills do employers value highly? What does that tell you about "what accountants do" at their companies?

4. Many accounting majors start their careers in public accounting. Do you think most of them stay in public accounting? Discuss what you consider to be a typical career track for accounting majors .

5. If you are not an accounting major, how do the salaries of accountants compare with those of your chosen field? How do the opportunities compare (i.e., demand for accountants)?

Introduction to Managerial Accounting 45

A 1-38 Ethics at Enron Watch the movie Enron: The Smartest Guys in the Room (Magnolia Home Entertainment, 2005, Los Angeles, California) .

Basic Discussion Questions

1. Do you think such behavior is common at other companies, or do you think this was a fairly isolated event?

2. How important is the "tone at the top" (the tone set by company leadership)?

3. Do you think you could be tempted to follow along if the leadership at your company had the same mentality as the leadership at Enron, or do you think you would have the cour- age to "just say no" or even be a "whistle-blower"?

4. Why do you think some people can so easily justify (at least to themselves) their unethical behavior?

5. In general, do you think people stop to think about how their actions will affect other people (e.g ., the elderly in California who suffered due to electricity blackouts) or do they just "do their job"?

6. What was your reaction to the psychology experiment shown in the DVD? Studies have shown that unlike the traders at Enron (who received large bonuses), most employees really have very little to gain from following a superior's directive to act unethically . Why then do some people do it?

7. Do you think people weigh the potential costs of acting unethically with the potential benefrts?

8. You are a business student and will someday work for a company or own a business . How will watching this movie impact the way you intend to conduct yourself as an employee or owner?

9. The reporter from Fortune magazine asked the question, "How does Enron make its money?" Why should every employee and manager (at every company) know the answer to this question?

10. In light of the "mark-to-market" accounting that enabled Enron to basically record any profit it wished to record, can you understand why some of the cornerstones of financial accounting are "conservatism" and "recording transactions at historical cost"?

11. How did employees of Enron (and employees ofthe utilities company in Oregon) end up losing billions in retirement funds?

A 1-39 Interviewing a local company about sustainability (Learning Objective 5) In this project, you will be conducting an interview about sustainability efforts at a local organiza- tion . Find a local company or organization with which you are familiar . Arrange an interview with a manager from that organization . Before the interview, do a search on the Internet about sustainability efforts of companies in that same industry so that you can ask related questions. Use the following questions to start your interview; add relevant questions related to what you discover through your Internet search about sustainability efforts at similar companies . After the interview, write up a report of what you found during the interview . Conclude your report with your overall assessment of that organization's sustainability efforts .

1. What is the company's primary product or service? (Note: You should be able to answer this question BEFORE your interview .)

2. Does your company have a stated policy on sustainability? (Note: The company might refer to "green" practices or use some other similar term rather than using the exact term of "sustainability .") What is the policy?

3. How would this manager define "sustainability"? Is the manager's definition similar to the definition of "sustainability" in this chapter?

4. Regardless of whether the company has a sustainability policy, what sustainability efforts does the company make with respect to the environment? For example, does the com- pany recycle its waste? What specific types of waste are recycled? Does the company purchase recycled-content products?

5. Is the amount (or percentage) of waste that is recycled tracked in a reporting system? Who gets reports on the organization's recycling efforts?

SUSTAINABILITY

46 CHAPTER 1

REAL LIFE

6. How does the company measure its impact on the environment (if it does)? (For example, does it measure its carbon footprint in total? Does it measure the carbon footprint of indi- vidual projects?)

7. Does the company do any external reporting of sustainability? If so, how long has the company been reporting on its sustainability efforts? If the company does not do any sustainability reporting at the current time, does it anticipate starting to report on its sustainability efforts in the near future?

8. In the manager's opinion, is sustainability important within that organization's industry? Why or why not?

A 1-40 Ethics and casual conversations (Learning Objective 4)

Jane is an accountant at Merelix, a large international firm where she works on potential acqui- sitions . When Merelix is preparing to acquire a company, Jane is involved in filing the neces- sary paperwork with the Securities and Exchange Commission (SEC).

Jane has been dating Tom for two years; they are now discussing marriage. Tom works as a salesperson for a golf equipment distributor .

Over the past two years, Jane has talked with Tom about what she's doing at work . She does not go into great detail, but does occasionally mention company names . Jane has given her phone passcode to Tom so he can answer calls for her or look things up for her when she's the one driv- ing . Tom has read some of her emails by using the phone passcode . He has also eavesdropped on a few phone conversations she has had when a colleague calls her from work with a question .

Unbeknownst to Jane, Tom has been sharing the information he has gotten from her with his stockbroker friend, Allen . Tom will call Allen to give him a "heads up" that Jane's company is going to be acquiring another company soon . Allen will then place an order to buy the stock of the company and will later split the profits with Tom .

Jane has not shared any information intentionally, nor has she directly profited from it.

Requirements Using the IMA Statement of Ethical Professional Practice as an ethical framework, answer the following questions :

1. What is (are) the ethical issue(s) in this situation?

2. What are Jane's responsibilities as a management accountant?

3. Has Jane violated any part of the IMA Statement of Ethical Professional Practice? Sup- port your answer .

A 1-41 Using managerial accounting information to manage a Broadway production (Learning Objectives 1 and 2)

The Shubert Organization operates 20 theaters, including 17 on Broadway . It has brought hun- dreds of shows to Broadway over the decades, including The Phantom of the Opera, Cats, and Les Miserables. Several of its shows have been in the news in recent yea rs including :

Mamma Mia! The Broadway musical Mamma Mia! moved from the Winter Garden Theatre to the Broad- hurst Theatre, both of which are on Broadway in New York City. Mamma Mia! will save up to $100,000 per week 18 in operating costs due to the Broadhurst's smaller size; the Broadhurst seats 1,160, while the Winter Garden seats 1,530 . Theatre experts estimate the show's weekly costs to be approximately $600,000 to $700,000, and its weekly ticket sales are usually in the mid- to high-six-figure range .

Once Once is a Tony Award-winning show on Broadway also produced by the Shubert Organization . Once is a musical about an Irish musician and a Czech immigrant who are drawn together by their shared love of music . Once opened on Broadway in March 2012. The show earned back the amount that the Shubert Organization had invested in it after just 21 weeks (169 perfor- mances) .19 The show continues its run on Broadway .

18 "'Mamma Mia!' to Move, " The New York Times , Apr il 18, 2013, retr ieved from http ://artsbeat .blogs .nytimes. com/2013/04/18/mamma-mia-to-move/ on Ju ly 1, 2013. 19

" http:/ /evamere .com/screen-to-stage-musical-transfer-once-recoups-i n-record-time/

Introduction to Managerial Accounting 47

Memphis

Another Shubert-produced musical, Memphis, is loosely based on the story of a Memphis disc jockey (DJ) who was one of the first white DJs to play black music in the 1950s. Memphis was composed by David Bryan, the keyboard player of the band Bon Jovi. The show opened on Broadway in the Shubert Theatre in October 2009 and won several awards, including four Tony Awards. The Shubert Organization had planned to run Memphis through November 2012, but closed the show in August 2012 because ticket revenues could not support the longer run. Instead of finding another show to use the Shubert Theatre between August 2012 and April 2013, when the show Matilda was scheduled to open, the Shubert Organization decided to use the time to renovate the theater.

Questions

1. For each show that the Shubert Organization produces, what type of financial ac- counting information would be generated or recorded?

2. What information would producers of Mamma Mia! have needed to make the deci- sion to move the show to a different theatre? What information would be provided by the financial accounting system? What information would be provided by the man- agement accounting system?

3. What information would the producers of Once have needed to calculate that the original investment of the show had been earned? What information would producers need to decide to keep the show open? What information would be provided by the financial accounting system? What information would be provided by the manage- ment accounting system?

4. What information would the producers of Memphis have needed to decide to close the show early? What information would the Shubert Organization management have needed to decide to renovate the theater rather than produce another show after Memphis closed its run? What information would be provided by the financial ac- counting system? What information would be provided by the management account- ing system?

Try It Solutions page 11:

1. True

2. False. Management accounting is geared toward helping internal managers run the company efficiently and effectively.

3. True

4. True

5. True

6. False. Management accountants must be able to effectively communicate with people throughout the organization. As a result, they need to have strong oral and written communication skills.

7. True

8. False. The IMA (Institute of Management Accountants) issues the CMA certification. However, the AICPA has recently instituted the CGMA designation for qualified CPAs who have experience in business and industry.

page 24:

1. True

2. False. Big data is driving most business decisions.

3. True

4. True

5. False. Service makes up the largest sector of the U.S. economy.

6. False. Globalization has several significant implications for management accounting.

7. False. These types of systems are known as enterprise resource planning (ERP) systems.

8. True

Building Blocks of Managerial Accounting

Learning Objectives

lev rad in/Alamy

Source: http://www .toyota-global.com/company/vision _philosophy/ toyota _globa l_vision _2020.htm l; http://www.statista .com/ statistics/275520/ranking-okar-manufacturers-based-on-globa l-sales/

• 1 Distinguish among service, merchandising, and manufacturing companies

• 2 Describe the value chain and its elements

• 3 Distinguish between direct and indirect costs

• 4 Identify product costs and period costs

• 5 Prepare the financial statements for service, merchandising, and manufacturing companies

• 6 Describe costs that are relevant and irrelevant for decision making

• 7 Classify costs as fixed or variable and calculate total and average costs at differ- ent volumes

As the world's largest automotive manufacturer, Toyota has been guided by a global vision designed "to lead the way to the future of mobility, enriching

lives around the world with the safest and most responsible ways of moving people ." In order

to achieve this vision, company managers must focus on researching and developing new, safe,

and environmentally friendly technologies, and on designing, marketing, and distributing new

models that will appeal to a diverse array of global markets . Toyota must also produce vehicles

in the most efficient manner possible and provide customers with exceptional post-sales service .

All of these business activities, which cost money to perform, impact Toyota's bottom line by

driving market share and sales revenue . Toyota's keys to financial success include its focus on

performing these business activities as cost efficiently as possible and using cost and revenue in-

formation to make profitable business decisions. In this chapter, we discuss the costs incurred by

these different business activities: costs that both managers and accountants must understand

in order to make profitable business decisions .

Building Blocks of Managerial Accounting 49

So far, we have seen how managerial accounting provides information that managers use to run their businesses more efficiently. Managers must understand basic mana- gerial accounting terms and concepts before they can use the information to make good decisions. This terminology provides the common ground through which managers and accountants communicate. Without a common understanding of these concepts, man- agers may ask for (and accountants may provide) the wrong information for making decisions. As you will see, different types of costs are useful for different purposes. Both managers and accountants must have a clear understanding of the types of costs that are relevant to the decision at hand.

What Are the Most Common Business Sectors and Their Activities? Before we talk about specific types of costs, let's consider the three most common types of companies and the business activities they perform.

Service, Merchandising, and Manufacturing Companies Recall from Chapter 1 that many companies are beginning to adhere to the notion of a triple bottom line, in which the company's performance is evaluated not only in terms of profitability, but also in terms of its impact on people and the planet. Even so, for a busi- ness to flourish and grow in the long run, it will need to generate economic profits that are sufficiently large to attract and retain investors, as well as fuel future business expan- sion. Companies typically generate profit through one of three basic business models: they provide a service, they sell merchandise, or they manufacture products.

Service Companies Service companies are in business to sell intangible services-such as health care, insur- ance, banking, and consulting. Recall from Chapter 1 that service firms now make up the largest sector of the U.S. economy. Because these types of companies sell services, they generally don't carry inventory. Some service providers carry a minimal amount of sup- plies inventory; however, this inventory is typically used for internal operations-not sold for profit. Service companies incur costs to provide services, advertise, and develop new services. For many service providers, salaries and benefits make up the majority of their costs.

Merchandising Companies

Merchandising companies such as Walmart and Best Buy resell tangible products they buy from manufacturers and suppliers. For example, Walmart buys clothing, toys, and elec- tronics and resells them to customers at higher prices than what it pays for these goods. Merchandising companies include retailers (such as Walmart) and wholesalers. Retailers sell to consumers like you and me. Wholesalers, often referred to as "middlemen," buy products in bulk from manufacturers, mark up the prices, and then sell those products to retailers.

Because merchandising companies are in business to sell tangible goods, they carry a substantial amount of inventory. The cost of inventory includes the cost merchan- disers pay for the goods plus all costs necessary to get the merchandise in place and ready to sell, such as freight-in costs and any import duties or tariffs paid on merchan- dise purchased from overseas suppliers. A merchandiser's balance sheet has just one inventory account called "Inventory" or "Merchandise Inventory." Besides incurring inventory-related costs, merchandisers also incur costs to operate their retail stores and websites, advertise, research new products and new store locations, and provide customer service.

1 Distinguish among '-._ - service, merchandisiri·g,

and manufacturing ·. companies

50 CHAPTER 2

Manufacturing Companies

Manufacturing companies use labor, plant, and equipment to convert raw materials into new finished products. For example, Toyota converts steel, tires, and fabric into high-performance vehicles using production labor and advanced manufacturing equipment. The vehicles are then sold to car dealerships at a price that is high enough to cover costs and generate a profit.

As shown in Exhibit 2-1, manufacturers carry three types of inventory:

1. Raw materials inventory: All raw materials that will be used in manufacturing. Toy- ota's raw materials include steel, glass, tires, upholstery fabric, engines, and other automobile components. They also include other physical materials used in the plant, such as machine lubricants and janitorial supplies.

2. Work in process inventory: Goods that are partway through the manufacturing pro- cess but not yet complete. At Toyota, the work in process inventory consists of par- tially completed vehicles.

3. Finished goods inventory: Completed goods that have not yet been sold. Toyota is in business to sell completed cars, not work in process. Once the vehicles are com- pleted, they are no longer considered work in process, but rather they become part of finished goods inventory.

EXHIBIT 2-1 Manufacturers' Three Types of Inventory

Raw materials inventory Finished goods inventory

- - *!IP -~j

Exhibit 2-2 summarizes the differences among service, merchandising, and manufac- turing companies.

EXHIBIT 2-2 Serv ice, Merchandis ing, and Manufactur ing Companies

Examples

Primary Output

Type(s) of Inventory

Service Companies

Southwest Airlines

Bank of America

Progressive Insurance

Goldman Sachs

Intangible services

None

Merchandising Companies

Amazon.com

Best Buy

Walman

The Home Depot

Tangible products purchased

from manufacturers and

suppliers

Inventory ( or Merchandise

Inventory)

Manufacturing Companies

Procter & Gamble

General Mills

Apple

Toyota

New tangible products made

using raw materials,

labor, and production

equipment

Raw materials inventory

Work in process inventory

Finished goods inventory

Building Blocks of Managerial Accounting 51

lil•U•: What type of company is Chipotle?

Answer: Some companies don't seem to fit nicely into one of the three categories previously discussed. For example, Chipotle has some elements of a service company (it serves hungry patrons), some elements of a manufacturing company (employees convert raw ingredients into finished meals}, and some elements of a merchandising company (it sells ready-to-serve bottled drinks) . Despite all of these different operating activities, restaurants are considered to be in the service sector.

As the "Stop & Think" feature shows, not all companies are strictly service, merchandising, or manufacturing firms. Recall from Chapter 1 that the U.S. economy is shifting more toward service-based companies. Many traditional manufacturers, such as General Electric (GE) and Ford, have developed profitable service segments that add additional profit to the company's bottom line. Even merchandising firms are getting into the "service game." For example, retailers often sell extended warranties on products rang- ing from furniture and major appliances to sporting equipment and consumer electronics. While the merchandiser recognizes a liability for these warranties, the price charged to customers for the war- ranties greatly exceeds the company's cost of fulfilling its warranty obligations, thus providing additional profit to the merchandiser.

II Why is this important?

Which Business Activities Make Up the Value Chain?

"All employees should have an

understanding of their company's basic business model. The Enron scandal was finally brought to light as a result of someone seriously asking, "How does this company actually

make money?" If the business model does not make logical sense,

Many people describe Toyota, General Mills, and Apple as man- ufacturing companies. But it would be more accurate to say that

something fishy may be going on."

these are companies that do manufacturing. Why? Because companies that do manu- facturing also do many other things. For example, even though Apple is a manufactur- ing company, it may be best known for its technological design innovations. Likewise, although Toyota is a manufacturer, it also conducts research to determine what type of new technology to integrate into next year's models. Toyota designs the new models based on its research and then produces, markets, distributes, and services the cars. These activi- ties form Toyota's value chain-the activities that add value to the company's products and services. The value chain is pictured in Exhibit 2-3.

EXHIBIT 2-3 The Value Chain

Value Chain

The value chain activities also cost money. To set competitive, yet profitable selling prices, Toyota must consider all of the costs incurred along the value chain, not just the costs incurred in manufacturing vehicles. Let's briefly consider some of the costs incurred in each element of the value chain. 1

1 Toyota Motor Corp 2014 Annual report and Toyota.corn.

2 Describe the value · ... chain and its elemen t's

52 CHAPTER 2

Research and Development IR&D): Researching and developing new or improved products or services and the processes for producing them. Toyota continually en- gages in researching and developing new technologies to incorporate in its vehicles (such as fuel cells, artificial intelligence, and pre-crash safety systems). Much of the R&D is aimed at safety and accessibility; improving how machines and humans work together. Toyota also researches and develops new technologies to use in its manufacturing plants (such as advanced manufacturing robotics). In 2014, Toyota spent 910.5 billion yen (approximately $7.7 billion) on R&D.

Design: Detailed engineering of products and services and the processes for produc- ing them. Toyota's goal is to design vehicles that create total customer satisfaction, including satisfaction with vehicle style, features, safety, and quality. As a result, Toyota updates the design of older models (such as the Corolla) and designs new prototypes on a regular basis (such as the i-Road, a three-wheel electric commuter vehicle, and the Mirai, the first fuel cell vehicle for the mass market). Part of the design process also includes determining how to mass-produce the vehicles. Because Toyota produces over 8 million vehicles per year, engineers must design production plants that are efficient, yet flexible enough to allow for new features and models.

Production or Purchases: Resources used by manufacturers to produce a product or by merchandising companies to purchase finished merchandise intended for resale. For Toyota, the production activity includes all costs incurred to make the vehicles. These costs include raw materials (such as steel), plant labor (such as machine opera- tors' wages), and manufacturing overhead (such as factory utilities and depreciation). As you can imagine, factories are very expensive to build and operate.

For a merchandiser such as Best Buy, this value chain activity includes the cost of purchasing the inventory that the company plans to sell to customers. It also in- cludes all costs associated with getting the inventory to the store, including freight-in costs and any import duties and tariffs that might be incurred if the merchandise was purchased from overseas.

Marketing: Promotion and advertising of products or services. The goal of marketing is to create consumer demand for products and services. Toyota uses print adver- tisements in magazines and newspapers, billboards, television commercials, and the Internet to market its vehicles in both existing and emerging global markets. Some companies use star athletes and sporting events to market their products. Each method of advertising costs money but adds value by reaching different target customers.

Distribution: Delivery of products or services to customers. On the one hand, Toyota sells most of its vehicles through traditional brick-and-mortar dealerships. On the other hand, Amazon sells and distributes its products almost entirely using a web-based sales platform and then ships the products directly to customers. Other industries use differ- ent distribution mechanisms, such as catalog sales and home-based parties.

Customer Service: Support provided for customers after the sale. Toyota incurs substantial customer service costs, especially in connection with warranties on new car sales. Toyota generally warranties its vehicles for the first three years and/or 36,000 miles, whichever comes first. Historically, Toyota has had one of the best reputations in the auto industry for excellent quality. However, 2009-2010 proved to be costly and difficult years for the company, as recalls were made on over 14 million vehicles. In addition to the cost of repairing the vehicles, the company incurred millions of dollars in costs related to govern- ment fines, lawsuits, and public relations campaigns. However, as a result of the compa- ny's commitment to building safe and reliable vehicles, Toyota once again regained the title of the number-one carmaker in the world in 2012 and has continued to hold the number one position for the last four years, selling over 10 million vehicles per year.

Coordinating Activities Across the Value Chain Many of the value chain activities occur in the order discussed here. However, managers cannot simply work on R&D and not think about customer service until after selling the car. Rather, cross-functional teams work on R&D, design, production, marketing, distribu- tion, and customer service simultaneously. As the teams develop new model features, they

also plan how to produce, market, and distribute the redesigned vehicles. They also consider how the new design will affect war- ranty costs. Recall from the last chapter that management accoun- tants typically participate in these cross-functional teams. Even at the highest level of global operations, Toyota uses cross-functional teams to implement its business goals and strategy.

The value chain pictured in Exhibit 2-3 also reminds manag- ers to control costs over the value chain as a whole. For example, Toyota spends more in R&D and product design to increase the quality of its vehicles, which in turn reduces customer service costs. Even though R&D and design costs are higher, the total cost of the vehicle-as measured throughout the entire value chain-is potentially lower as a result of this trade-off. Enhanc- ing its reputation for safe, high-quality, innovative products has also enabled Toyota to increase its market share.

SustainabilitY.

Building Blocks of Managerial Accounting 53

II Why is this important? "All activities in the value chain are important, yet each costs

money to perform. Managers must understand how decisions made in one area of the value chain will

affect the costs incurred in other areas of the value chain."

Progressive companies will incorporate sustainability throughout every function of the value chain. However, experts estimate that 90% of sustainability occurs at the design stage. At the design stage, companies determine how the product will be used by customers, how easily the product can be repaired or eventually recycled, and the types of raw materials and manufacturing processes necessary to produce the product. Thus, good design is essential to the creation of envi- ronmentally friendly, safe products that enhance people's lives. For example, companies can integrate sustainability throughout the value chain by:

• Researching and developing environmentally safe packaging. Many companies are actively researching ways to reduce the amount of packaging used with their products as well as developing new types of packaging that are less harmful to the environment. In 2015, McDonald's achieved the goal of sourcing 100% of its packaging for its European operations from recycled sources or from forests certified by the Forest Stewardship Council. That same year, the company also pledged to end deforestation across the com- pany's entire global supply chain. 2

• Designing products using life-cycle assessment and biomimicry. Life-cycle assessment means the company analyzes the environmental impact of a prod- uct, from "cradle-to-grave," in an attempt to minimize negative environmental consequences throughout the entire lifespan of the product. For example, after studying the life cycles of its products, Procter & Gamble (P&G) discovered that about three-quarters of the energy used by consumers in washing their clothes comes from heating the water. As a result, the company developed Coldwater Tide, which is effective for laundering in cold water, thereby conserving energy. This product is a win-win for the environment and the company: the product is saving energy while also generating millions in annual sales revenue.3

Biomimicry means that a company tries to mimic, or copy, natural bio- logical features and processes. For example, Ford Motor Company and P&G are studying the gecko, nature's perfect example of a creature able to stick to surfaces without any liquids or adhesive substances, and then release from the surface, without any leaving sticky residue. The companies envision innova- tive adhesive applications from this research that will generate revenue, save money, and be more environmentally friendly. 4 Another aspect of biomimicry

2http://www.environmentalleader.com/2015/11/1O/mcdonalds-achieves-100-sustainable-packaging-goal/ 3http://www.nytimes.com/2011/09/17/business/cold-water-detergents-get-a-chilly-reception .html?pagewanted=l&_r=0 4http ://www.environmentalleader.com/2015/10/21/ford-looks-to-lizards-to-increase- recycla bility- improve-adhesi ves/

54 CHAPTER 2

See Exercises E2-20A and E2-32B

revolves around eliminating the concept of waste by creating "cradle-to-cradle" product life cycles. For example, Ricoh's copiers were designed so that at the end of a copier's useful life, Ricoh would collect and dismantle the product for usable parts, shred the metal casing, and use the parts and shredded material to build new copiers. The entire copier was designed so that nothing is wasted, or thrown out, except the dust from the shredding process. PT Tirta Marta has developed a "plastic" bag made from tapioca that can biodegrade in as little as two weeks,5 whereas traditional plastic bags, according to the Environmental Protection Agency (EPA), can take as long as 1,000 years. 6

• Adopting sustainable purchasing practices. Many of the world's largest companies, such as Walmart, Costco, and The Home Depot, are now actively assessing the sustainability level of potential suppliers as a factor in selecting suppliers. As leading retailers in the world, these companies' purchasing poli- cies are forcing other companies to adopt more sustainable business practices.

• Marketing with integrity. Consumers are driving much of the sustain- ability movement by demanding that companies produce environmentally friendly products and limit or eliminate operational practices that have a detrimental impact on the environment and society. The LOHAS (Lifestyles of Health and Sustainability) market segment is estimated at $355 billion per year. 7 Thus, many companies are successfully spotlighting their sustain- ability initiatives in order to increase market share as well as attract potential investors and employees. However, greenwashing, the unfortunate practice of overstating a company's commitment to sustainability, can ultimately back- fire as investors and consumers learn the truth about company operations. Hence, honesty and integrity in marketing are imperative.

• Distributing using fossil-fuel alternatives and carbon offsets. While the biofuel industry is still in its infancy, the production and use of biofuels, es- pecially those generated from nonfood waste, are expected to grow exponen- tially in the near future. Companies whose business is heavily reliant upon fossil fuels, such as oil companies (Valero), airlines (United), and distribution companies (UPS), are especially interested in the development of sustainable fuel sources. In fact, many companies, such as UPS and Walmart, are invest- ing in hybrid fleets in order to reduce energy consumption, which thereby re- duces their costs. In addition, many companies are investing in carbon offsets through such measures as reforestation projects. For example, in 2013 UPS planted 1.3 million trees, and in 2014 it pledged to plant 2 million trees as part of its efforts to offset greenhouse gas emissions. 8 United Airlines offers a carbon-offset program that allows customers, as soon as they purchase their ticket, to offset the carbon emissions resulting from their air travel by donat- ing to reforestation and renewable energy projects. The website automatically calculates the donation amount needed to offset the greenhouse gas emissions.

• Providing customer service past the warranty date. Environmentally conscious companies don't want customers discarding products that are in need of repair, or no longer serve the customer's needs or wants, thus, they provide the customer with other options. REI Co-op and Patagonia provide customers with free repair tips and offer repair services at a nominal charge. Best Buy recycles any electronic equipment regardless of where the customer bought it, and Apple buys back iPhones, iPads, and iPods by issuing credit toward the purchase of a new device.

If you are interested in learning more about what companies are doing to become more sustainable, visit the Environmentalleader.com website and sign up for its daily e-mail.

5http://www.tirtamarta.com/green-plastic-solutions/about-us/ 6http://www.nytimes .com/2007/04/01/weekinreview/O 1 basics .html 7http://www.lohas .com/whos-changing 8http://compass .ups.com/how-ups-helps-turn-world-greener

Building Blocks of Managerial Accounting 55

How Do Companies Define Cost? Now that you understand the most common types of companies and the primary business activities they perform, let's consider some of the specialized language that accountants use when referring to costs.

Cost Objects, Direct Costs, and Indirect Costs A cost object is anything for which managers want to know the cost. Toyota's cost objects may include the following:

• Individual units (a specific, custom-ordered Prius)

• Different models (the Prius, Rav4, and Corolla)

• Alternative marketing strategies (television advertising, sponsorship of athletic events)

• Geographic segments of the business (United States, Europe, Japan)

• Departments (human resources, R&D, legal)

• Sustainability initiatives ("Toyota TogetherGreen" conservation programs)

Costs are classified as either direct or indirect with respect to the cost object.

• A direct cost is a cost that can be traced to the cost object, meaning the company can readily identify or associate the cost with the cost object. For example, say the cost object is one Prius. Toyota can easily trace, or associate, the cost of four tires with one specific Prius. Therefore, the tires are a direct cost of the vehicle.

• An indirect cost, in contrast, is a cost that relates to the cost object but cannot be traced specifically to it. Think of an indirect cost as a cost that is jointly used or shared by several cost objects. For example, Toyota incurs substantial cost to run a manufac- turing plant, including utilities, property taxes, and depreciation. Toyota cannot build a Prius without incurring these costs, so the costs are related to the Prius. However, it's impossible to trace a specific amount of these costs to one Prius. These costs are shared by all of the vehicles produced in the plant during the period. Therefore, these costs are considered indirect costs of a single Prius.

Another example might help. Think about your university's football team. Direct costs of the football team would include their uniforms, footballs, coach's salary, and travel to away games. These costs are easily identifiable with and traceable to the football team, so they are considered direct costs of the football team. Indirect costs would include costs shared by the football team and other university athletic teams, such as the athletic director's salary, shared training facilities, and shared locker rooms. Since these resources are jointly used or shared by several athletic teams, not just the football team, they are considered indirect costs of the football team.

As shown in Exhibit 2-4, the same costs can be indirect with

3 Distinguish between ·. direct and indirect · costs

respect to one cost object, yet direct with respect to another cost object. For example, plant depreciation, plant property taxes, and plant utilities are indirect costs of a single Prius. However, if management wants to know how much it costs to operate the Prius manufacturing plant, the plant becomes the cost object; so the same depreciation, tax, and utility costs are direct costs of the manufacturing facility. Whether a cost is direct or indirect depends on the specified cost object. In this chapter, we'll be talking about a unit of product (such as one Prius) as the cost object.

II Why is this important?

If a company wants to know the total cost attributable to a cost object, it must assign all direct and indirect costs to the cost object. Assigning a cost simply means that you are "attaching" a cost to the cost object. For example, if Toyota wants to know the entire cost of manufacturing a Prius, it will need to assign both direct costs (such as the tires on the car) and indirect costs (such as

"As a manager making decisions, you'll need different types of cost information for different types of decisions. To get

the information you really want, you'll have to communicate with the accountants using precise

definitions of cost."

56 CHAPTER 2

EXHIBIT 2-4 The Same Cost Can Be Direct or Indirect, Depending on the Cost Object

Cost object One Prius

Indirect cost

Cost object: Prius manufacturing plant

factory utilities) to the vehicle. Similarly, if the university wants to know the total cost of having a football team, it will have to consider both the direct and indirect costs related to the team.

The manner in which Toyota assigns costs depends on whether the costs are direct or indirect costs of the cost object. In our example, a specific vehicle is the cost object. Toyota can easily identify direct costs, such as tires, with specific vehicles. Therefore Toyota is able to trace direct costs to each vehicle manufactured in the plant. This results in a very precise cost figure, giving managers great confidence in the the amount of direct cost assigned to each vehicle. However, Toyota cannot trace indirect costs, such as utilities, to specific vehicles. Therefore, Toyota must allocate these indirect costs among all of the vehicles produced at the plant. The allocation process results in a less precise cost figure being assigned to each vehicle. We will discuss the allocation process in more detail in the following two chapters; but for now, think of allocation as dividing up the total indi- rect costs over all of the units produced, just as you might divide a pizza among friends. Exhibit 2-5 illustrates these concepts.

EXHIBIT 2-5 Assign ing Direct and Ind irect Costs to Cost Objects

J_ l Trace

direct costs to cost objects

Amount of cost assigned to the cost object

is very precise

Allocate indirect costs to cost objects

Amount of cost assigned to the cost object

is less precise

Building Blocks of Managerial Accounting 57

Assume a grocery store manager wants to know the cost of running the Produce Depart- ment . Thus, the Produce Department is the cost object. Which of the following would be considered direct costs of the Produce Department?

1. Wages of checkout clerks

2. Wages for workers in the Produce Department

3. Depreciation on refrigerated produce display cases

4. Cost of weekly advertisements in local newspaper

5. Cost of bananas, lettuce, and other produce

6. Baggies and twist ties available for shoppers in the Produce Department

7. Monthly lease payment for grocery store retail location

8. Cost of scales hanging in the Produce Department

Please see page 103 for solutions.

Costs for Internal Decision Making and External Reporting Let's now consider how managers define the cost of one of their most important cost objects: their products. Managers need this information to determine the profitability of each product as well as to make other important business decisions. Managers define costs based on how the information will be used. Will the information be used for 1) internal decision making, or for 2) external reporting?

Costs for Internal Decision Making

When making internal decisions, managers must consider all costs incurred across the value chain. For example, when determining a suitable selling price for a Prius, Toyota must consider the cost to research, design, manufacture, market, distribute, and service that model. A Prius's total cost includes the costs of all resources used throughout the value chain. For Toyota, the total cost of a particular model, such as the Prius, is the total cost to research, design, manufacture, market, distribute, and service that model. Before launch- ing a new model, managers predict the total cost of the model to set a selling price that will cover all costs plus return a profit. By comparing each model's sales revenue with its total cost across the value chain, Toyota can determine which models are most profitable. Per- haps Rav4s are more profitable than Corollas. Marketing can then focus on advertising and promoting the most profitable models. We'll talk more about total costs in Chapter 8, where we discuss many common business decisions.

Costs for External Reporting For external reporting purposes, management must follow Generally Accepted Account- ing Principles (GAAP). For external reporting purposes, GAAP requires that certain costs of the company be attached, or assigned, to units of product in inventory, while other costs are treated as operating expenses of the period. Let's define each of these types of costs.

• Product costs are the costs incurred by manufacturers to produce their products or incurred by merchandisers to purchase their products. Notice how these costs relate to obtaining inventory, either through manufacturing the products or purchasing them. Thus, these costs are incurred in the production or purchases function of the value chain. For external financial reporting, GAAP requires that these costs be assigned to inventory until the related products are sold. When the products are sold, these costs are removed from the company's inventory and expensed as Cost of Goods Sold.

• Period costs are the costs incurred by the company that do not get treated as inventory, but rather, are expensed immediately in the period in which they are incurred. These costs do not relate to manufacturing or purchasing product. Rather, they include costs

~ Identify product costs and period costs

58 CHAPTER 2

incurred in every other function of the value chain, including R&D, design, marketing, distribution, and customer service. In essence, any cost that is not treated as inventory, is treated as a period cost. While accountants refer to these costs as "period costs," most other people refer to them as "operating expenses" or "selling, general, and ad- ministrative expenses" (SG&A). These terms are essentially synonymous and arise from the fact that these are costs of operating the business over a specific period of time.

Keep the following two important rules of thumb in mind:

Product costs are costs assigned to the company's inventory on the balance sheet. In essence, they are the costs of manufacturing or purchasing the company's products.

Period costs are often called "operating expenses" or "selling, general, and admin- istrative expenses" (SG&A) on the company's income statement. Period costs are always expensed in the period in which they are incurred and never become part of an inventory account.

Exhibit 2-6 shows that a company's total costs can be divided into two categories: product costs (those costs treated as part of inventory until the product is sold) and period costs (those costs expensed in the current period regardless of when inventory is sold). GAAP requires this distinction for external financial reporting. Study the exhibit carefully to make sure you understand how the two types of costs affect the income statement and balance sheet.

EXHIBIT 2-6 Tota l Costs, Product Costs, and Period Costs

Product costs

Production or purchases- initially recorded as inventory

Period costs

R&D Design Marketing Distribution Customer service- all recorded as operating expenses

{ Inventory sold

in 2017

Inventory not sold until 2018

• • --Cost of goods sold Operating expenses

Inventory --Cost of goods sold

Now that you understand the difference between product costs and period costs, let's take a closer look at the specific costs that are treated as product costs in merchandising and manufacturing companies.

Merchandising Companies' Product Costs Merchandising companies' product costs include only the cost of purchasing the inven- tory from suppliers plus any costs incurred to get the merchandise to the merchandiser's

Building Blocks of Managerial Accounting 59

place of business and ready for sale. Typically, these additional costs include freight-in costs and import duties or tariffs, if the products were purchased from overseas. Why does the cost of the inventory include freight-in charges? Think of the last time you made a purchase from an online website, such as Amazon.com. The website may have shown the product's price as $15, but by the time you paid the shipping and handling charges, the product really cost you around $20. Likewise, merchandising companies pay freight-in charges to get the goods to their place of business. If they purchased the goods from overseas, there is a good chance they also had to pay import duties to bring the goods into the United States. As shown in Exhibit 2-7, these charges become part of the cost of their inventory.

EXHIBIT 2-7 Summary of a Merchandising Company's Total Costs

Cost of Merchandise

Itself

_[_

Freight-in Customs/Duties

Period Costs ("Operating Expenses")

All Other Costs Incurred by the

Company

For example, The Home Depot's product costs include what the company paid for its store merchandise plus freight-in and import duties. The Home Depot records these costs in an asset account-Inventory-until it sells the merchandise. Once the merchandise is sold, it belongs to the customer, not The Home Depot. Therefore, The Home Depot takes the cost out of its inventory account and records it as an expense-the cost of goods sold. The Home Depot expenses all other costs incurred during the period, such as salaries, utilities, advertising, and property lease payments, as "operating expenses."

Which of the following costs are treated as product costs by a merchandising company, such as Walmart? Which costs are treated as period costs?

1. Cost of leasing the retail locations

2. Cost of managers' and sales associates' salaries

3. Cost of merchandise purchased for resale

4. Cost of designing and operating the company's website

5. Cost of shipping merchandise to the store

6. Cost of providing free shipping to customers who buy product online

7. Cost of utilities used in running the retail locations

8. Cost of import duties paid on merchandise purchased from overseas suppliers

9. Depreciation on store shelving and shopping carts

Please see page 103 for solutions.

60 CHAPTER 2

Manufacturing Companies' Product Costs Manufacturing companies' product costs include only those costs related to producing, or manufacturing, their products. As shown in Exhibit 2-8, manufacturers such as Toyota incur three types of manufacturing costs when making a vehicle: direct materials, direct labor, and manufacturing overhead.

EXHIBIT 2-8 Summary of the Three Types of Manufacturing Costs

Direct materials

+

Manufacturing overhead Product cost

Direct Materials (DM) Manufacturers convert raw materials into finished products. Direct materials are the pri- mary materials that become a physical part of the finished product. The Prius's direct materials include steel, tires, engines, upholstery, and so forth. Toyota can trace the cost of these materials (including freight-in and any import duties) to specific units or batches of vehicles; thus, they are considered direct costs of the vehicles.

Direct Labor (DL)

Although many manufacturing facilities are highly automated, most still require some direct labor to convert raw materials into a finished product. Direct labor is the cost of compensating employees who physically convert raw materials into the company's prod- ucts. At Toyota, direct labor includes the wages and benefits of machine operators and technicians who build and assemble the vehicles. Toyota can trace the time each of these employees spends working on specific units or batches of vehicles; thus, the cost of this labor is considered a direct cost of the vehicles.

Manufacturing Overhead (MOH) The third production cost, manufacturing overhead, includes all manufacturing costs other than direct materials and direct labor. In other words, manufacturing overhead in- cludes all indirect manufacturing costs. Manufacturing overhead is also referred to as factory overhead because all of these costs relate to the factory. Manufacturing overhead has three components: indirect materials, indirect labor, and other indirect manufacturing costs.

• Indirect materials include materials used in the plant that are not easily traced to indi- vidual units. For example, indirect materials often include janitorial supplies, oil and lubricants for the machines, and any physical components of the finished product that are very inexpensive. For example, Toyota might treat the invoice sticker placed on each vehicle's window as an indirect material rather than a direct material. Even though the cost of the sticker (roughly 10 cents) could be traced to the vehicle, it wouldn't make much sense to do so. Why? Because the cost of tracing the sticker to the vehicle out- weighs the benefit management receives from the increased accuracy of the information.

• Indirect labor includes the cost of all employees working in the plant other than those employees directly converting the raw materials into the finished product. For exam- ple, at Toyota, indirect labor includes the salaries, wages, and benefits of plant forklift operators, plant security officers, plant janitors, and plant supervisors.

Building Blocks of Managerial Accounting 61

• Other indirect manufacturing costs include such plant-related costs as depreciation on the plant and plant equipment, plant property taxes and insurance, plant repairs and maintenance, and plant utilities. Indirect manufacturing costs have grown tremen- dously in recent years as manufacturers automate their plants with the latest advanced manufacturing technology.

Exhibit 2-9 summarizes how manufacturers classify their costs.

EXHIBIT 2-9 Summary of a Manufactur ing Company's Total Costs

'. ' -J-11

Direct Material

Product Costs (only production costs)

Direct Labor

Indirect Materials

Prime and Conversion Costs

Manufacturing Overhead

Indirect Labor

Period Costs roperating Expenses")

All Other Costs along Value Chain

Other Indirect Manufacturing Costs

Managers and accountants sometimes talk about certain combinations of manufacturing costs. As shown in Exhibit 2-10, prime costs refer to the combination of direct materials and direct labor. Prime costs used to be the primary costs of production. However, as com- panies have automated production with expensive machinery, manufacturing overhead has become a greater cost of production. Conversion costs refer to the combination of direct labor and manufacturing overhead. These are the costs of converting raw materials into finished goods.

EXHIBIT 2-10 Prime and Conversion Costs

Prime costs

Conversion colbl Manufacturing overhead

62 CHAPTER 2

What is the difference between raw materials, direct materials, and indirect materials?

Raw materials are materials that have not yet been used. Once used, materials can be classi- fied as direct or indirect. Direct materials are the primary physical components of a product . Indirect materials are materials used in the production plant that don't become part of the product (such as machine lubricants) or materials that do become part of the product but are insignificant in cost (such as the price sticker on a car) .

Additional Labor Compensation Costs The cost of labor, in all areas of the value chain, includes more than the salaries and wages paid to employees. The cost also includes company-paid fringe benefits such as health insurance, retirement plan contributions, payroll taxes, and paid vacations. These costs are very expensive. Health insurance premiums, which have seen double-digit increases for many years, often amount to $500-$1,500 per month for each employee electing cov- erage. Many companies also contribute an amount equal to 3 % to 6% of their employ- ees' salaries to company-sponsored retirement 401(k) plans. Employers must pay Federal Insurance Contributions Act (FICA) payroll taxes to the federal government for Social Security and Medicare, amounting to 7.65% of each employee's gross pay. In addition, most companies offer paid vacation and other benefits. Together, these fringe benefits usually cost the company an additional 35% beyond gross salaries and wages. Thus, an employee making a $40,000 salary actually costs the company about $54,000 to employ ($40,000 X 1.35). These fringe-benefit costs are expensed as period costs for all non- manufacturing employees. However, they are treated as a product cost if they relate to employees working in the manufacturing plant. In Chapter 3 we'll discuss how these additional labor costs get assigned to products.

Recap: Product Costs Versus Period Costs In this half of the chapter, you have learned about the activities and costs incurred by three different types of companies. You have also learned the difference between direct and indi- rect costs. Finally, you have learned the difference between product costs and period costs. Exhibit 2-11 summarizes some of these concepts for you.

EXHIBIT 2-11 Summary of Product Costs Versus Period Costs

Total Costs Across the Value Chai-

Product Costs Period costs

Service Companies None All costs across value chain

Merchandising Cost of merchandise itself All costs across value chain except product costs Companies Freight-in

Import duties and customs, if any

Manufacturing Direct materials All costs across value chain except product costs Companies Direct labor

Manufacturing overhead

Accounting Treatment Treat as inventory until product is sold. Expense in period incurred as "Operating Expenses· or When sold, expense as "Cost of Goods Sold.· "Selling, General, and Administrative Expenses."

Building Blocks of Managerial Accounting 63

Building Blocks of Managerial Accounting Dell engages in manufacturing when it assembles its computers, merchandising when it sells them on its website, and support services such as start-up and implementation services . Dell had to make the following types of decisions as it developed its accounting systems.

Decision

How do you distinguish among service, merchandising, and manufacturing companies? How do their balance sheets differ?

What business activities add value to companies?

What costs should be assigned to cost objects such as products, departments, and geographic segments?

Which costs are useful for internal deci- sion making, and how are costs classified for external reporting?

What costs are treated as product costs under GAAP?

How are product costs treated on the financial statements?

Guidelines

Service companies:

• Provide customers with intangible services

• Have no inventories on the balance sheet

Merchandising companies:

• Resell tangible products purchased ready-made from suppliers

• Have only one category of inventory

Manufacturing companies:

• Use labor, plant, and equipment to transform raw materials into new finished products

• Have three categories of inventory :

1. Raw materials inventory

2. Work in process inventory

3. Finished goods inventory

All of the elements of the value chain, including the following :

• R&D

• Design

• Production or purchases

• Marketing

• Distribution

• Customer service

Both direct and indirect costs are assigned to cost objects . Direct costs are traced to cost objects, whereas indirect costs are allocated to cost objects.

Managers use total costs for internal decision making . However, GAAP requires companies to distinguish between product costs and period costs for external reporting purposes.

• Service companies: Usually no product costs since they don't carry inventory

• Merchandising companies: The cost of mer- chandise purchased for resale plus all of the costs of getting the merchandise to the com- pany's place of business (for example, freight-in and import duties)

• Manufacturing companies: Direct materials, direct labor, and manufacturing overhead

Product costs are initially treated as an asset (inventory) on the balance sheet. These costs are expensed (as cost of goods sold) on the income statements when the products are sold.

. . . . . . . . . .

64 CHAPTER 2 - •. _ . . SUMMARY PROBLEM 1

•

Requirements

1. Classify each of the following business costs into one of the six value chain elements:

a. Costs associated with warranties and recalls b. Cost of shipping finished goods to overseas customers c. Costs a pharmaceutical company incurs to develop new drugs

d. Cost of a 30-second commercial during the SuperBowl™ e. Cost of making a new product prototype f. Cost of assembly labor used in the plant

2. For a manufacturing company, identify the following as either a product cost or a period cost . If it is a product cost, classify it as direct materials, direct labor, or manufacturing overhead .

a. Depreciation on plant equipment b. Depreciation on salespeoples' automobiles c. Insurance on plant building

d. Marketing manager's salary e. Cost of major components of the finished product f. Assembly-line workers' wages g. Costs of shipping finished products to customers h. Plant forklift operator's salary

SOLUTIONS Requirement 1 a. Customer service

b. Distribution

c. Research and development

d. Marketing

e. Design

f. Production

Requirement 2 a. Product cost; manufacturing overhead

b. Period cost

c. Product cost; manufacturing overhead

d. Period cost e. Product cost; direct materials

f. Product cost; direct labor

g. Period cost

h. Product cost; manufacturing overhead

Building Blocks of Managerial Accounting 65

How Are Product Costs and Period Costs Shown in the Financial Statements? The difference between product costs and period costs is important because these costs are treated differently in the financial statements. All product costs remain in inventory accounts until the merchandise is sold; then, these costs become the cost of goods sold. In contrast, all period costs are expensed as "operating expenses" in the period in which they are incurred. Keep these differences in mind as we review the in- come statements of service firms (which have no inventory), merchandising companies (which purchase their inventory), and manufacturers (which make their inventory). We'll finish the section by comparing the balance sheets of these three different types of companies.

Service Companies Service companies have the simplest income statement. Exhibit 2-12 shows the income statement of WSC Consulting, an e-commerce consulting firm. The firm has no inventory and thus, no product costs. Therefore, WSC Consulting's income statement has no Cost of Goods Sold. Rather, all of the company's costs are period costs, so they are expensed in the current period as "operating expenses."

EXHIBIT 2-12 Service Company Income Statement

_J A I B I C D 1 WSC Consultine: 2 Income Statement 3 Vear Ended December 31 4 5 Revenues $ 160 000 6 Less ooeratine: exoenses : 7 Salarv exoense 5 106,000 8 Office rent exoense 18,000 9 Deoreciation exoense 3,500 10 Marketing exoense 2 500 11 Total operating exoenses 130000 12 Operating income $ 30 000 13

In this textbook, we will always be evaluating the company's "operating income" rather than its "net income." Why? Because internal managers are particularly concerned with the income generated through the company's ongoing, primary operations. To arrive at net income, we would need to add or subtract non-operating income and expenses, such as interest, and subtract income taxes. In general, operating income is simply the company's earnings before interest and income taxes.

Merchandising Companies In contrast with service companies, a merchandiser's income statement features Cost of Goods Sold as the major expense. Exhibit 2-13 illustrates the income statement for Whole- some Foods, a regional grocery store chain. Notice how Cost of Goods Sold is deducted from Sales Revenue to yield the company's gross profit. Next, all operating expenses (all period costs) are deducted to arrive at the company's operating income.

5 Prepare the financial\ statements for · service, merchandising ;· .. and manufacturing · companies

66 CHAPTER 2

EXHIBIT 2-13 Merchandiser's Income Statement

_J

2 3 4 5 6 7 8 9 10 11 12 13 14 15

A B

Wholesome Foods Income Statement

For the Year Ended December 31 (all ures shown in thousands o dollars)

5000 3 000 1000

150 000 106 500 43 500

9000 34 500

But how does a merchandising company calculate the Cost of Goods Sold?

• Most likely, the company uses bar coding to implement a perpetual inventory system during the year. If so, all inventory is labeled with a unique bar code that reflects (1) the sales price that will be charged to the customer, and (2) the "product cost" of the merchandise to the store. Every time a bar-coded product is scanned at the check- out counter, the company's accounting records are automatically updated to reflect (1) the sales revenue earned, (2) the cost of goods sold, and (3) the removal of the product from merchandise inventory.

• However, at the end of the period, merchandisers must also calculate Cost of Goods Sold using the periodic inventory method. Why? Because the company's accounting records only reflect those products that were scanned during checkout. Thus, the records would not reflect any breakage, theft, input errors, or obsolescence that oc- curred during the year. Exhibit 2-14 shows how to calculate Cost of Goods Sold using the periodic method.

EXHIBIT 2-14 Calculation of Cost of Goods Sold for a Merchandising Firm

_J A I B C D 1 Calculation of Cost of Goods Sold 2 Beginning inventory s 9,500 3 Plus: Purchases, freieht-in, and anv imoort duties 110,000 4 Cost of eoods available for sale $ 119 500 5 Less: Endine inventorv 13,000 6 Cost of eoods sold $ 106 500 7

In this calculation, we start with the beginning inventory and add to it all of the company's product costs for the period: the cost of the merchandise purchased from suppliers, freight- in, and any import duties. The resulting total reflects the cost of all goods that were avail- able for sale during the period. Then we subtract the cost of the products still in ending inventory to arrive at the Cost of Goods Sold.

Building Blocks of Managerial Accounting 6 7

Compute Cost of Goods Sold for Ralph's Sporting Goods, a merchandising company, given the following information :

Advertising expense ........................................ $ 25,000

Purchases of merchandise ........ ........... ....... ..... 400,000

Salaries expense ........ ............... ........ ............ ... 80,000

Freight-in and import duties ............ ............... 20,000

Lease of store ..... .......... ............ ........... ....... ..... 75,000

Beginning inventory ........................................ 35,000

Ending inventory .... .......... .......... ................. .... 38,000

Please see page 103 for solutions .

Manufacturing Companies Exhibit 2-15 show s the income statement for Proquest, a manufacturer of tennis balls. As you can see, the income statement for a manufacturer is essentially identical to that of a merchandising company. The only real difference is that the company is selling product that it has mad e, rather th an merch andise th at it has purchas ed. As a result, the calcula- tion of Cost of Goods Sold is different from that shown in Exhibit 2-14.

EXHIBIT 2-15 Manufacturer's Income Statement

_J A B C D 1 Proauest 2 Income Statement 3 For the Year Ended December 31 4 (all f1Ewres shown in thousands of dollars) 5 6 Sales revenues s 65 000 7 Less: Cost of e:oods sold 40000 8 Gross profit s 25000 9 Less operating expenses: 10 Sellim:i: and marketim:i: exoenses s 8 000 11 General and administrative exPenses 2 000 12 Total operating expenses 10000 13 Operating income $ 15 000 14

Calculating Cost of Goods Manufactured and Cost of Goods Sold Exhibit 2-16 illustrates how the manufacturer 's product costs (direct material used, direct labor , and manufacturing overhead) flow through the three inventory accounts before they become part of Cost of Goods Sold. In order to calculate Cost of Goods Sold, a manufacturer must first figure out the amount of direct material s used and the Cost of Goods Manufactured.

As you see in Exhibit 2-16, the Cost of Goods Manufactured represents the cost of those good s that were completed and moved to Finished Goods Inventory during the period.

68 CHAPTER 2

EXHIBIT 2-16 Flow of Costs Through a Manufacturer's Financial Statements

Product costs

Balance Sheet

Purchases of • direct materials · · plus freight-in -- · · · and import duties · '

:' -~i-re~; - ·-_

: materials ;

•

'---~~e~~--: ,------- Direct labor -- :/ cost of ·\

Manufacturing goods ........-

overhead -- \ f:1~~~:a_c~~r~?Y

Finished Goods

Inventory

when

Income Statement

Sales Revenue

minus

occur :: . sales •

equals Gross Profit minus

R&D expenses Design expenses Marketing expenses Distribution expenses Customer service expenses

Operating expenses (period costs)

• Direct materials used and cost of goods manufactured are not accounts, but calculations made by the company. These calculations are described in Exhibits 2-17 and 2-18. equals Operating Income

Using Exhibit 2-16 as a guide, let's walk through the calculation of Cost of Goods Sold. We'll use three steps. Each step focuses on a different inventory account: Raw Mate- rials, Work in Process, and Finished Goods.

STEP 1: Calculate the cost of the direct materials used during the year Step 1 simply analyzes what happened in the Raw Materials Inventory ac-

count during the year. As shown in Exhibit 2-17, we start with the beginning balance in the Raw Materials Inventory account and add to it all of the direct materials purchased during the year, including any freight-in and import duties. This tells us the cost of materials that were available for use during the year. Finally, by subtracting out the ending balance of Raw Materials Inventory, we are able to back into the cost of the direct materials that were used. 9

EXHIBIT 2-17 Calculation of Direct Materials Used

-- -_J A B C 1 Calculation of Direct Materials Used 2 (Analvze Raw Materials lnventorv account) 3 4 Beginning Raw Materials Inventory $ 9,000 5 Plus: Purchases of direct materials, freight-in, and import duties 27,000 6 Materials available for use $ 36,000 7 Less: Ending Raw Materials Inventory 22,000 8 Direct materials used $ 14,000 9

9In this chapter, we'll assume that the Raw M aterials account only contains direct materials becau se the compan y uses indirect materials as soon as they are purchased. In Chapter 3, we expand the discussion to include manufacturers who store both direct and ind irect materials in the Raw Materials Inventory account .

Building Blocks of Managerial Accounting 69

STEP 2: Calculate the cost of goods manufactured Step 2 simply analyzes what happened in the Work in Process account

during the year. As shown in Exhibit 2-18, we start with the beginning balance in Work in Process and then add to it all three manufacturing costs that were incurred during the year (direct materials used, direct labor, and materials over- head). Finally, by subtracting out the goods still being worked on at year-end (ending Work in Process Inventory), we are able to back into the Cost of Goods Manufactured (CGM). This figure represents the cost of manufacturing the units that were completed and sent to Finished Goods Inventory during the year.

EXHIBIT 2-18 Calculation of Cost of Goods Manufactured

_J A B C 1 Calculation of Cost of Goods Manufactured 2 (Analyze Work in Process Inventory account) 3 4 Beginning Work in Process Inventory $ 2,000 5 Plus manufacturing costs incurred: 6 Direct materials used 14,000 7 Direct labor 19,000 8 Manufacturing overhead 12,000 9 Total manufacturing costs to account for $ 47,000 10 Less: Ending Work in Process Inventory 5,000 11 Cost of goods manufactured (CGM) $ 42,000 12

STEP 3: Calculate the cost of goods sold Step 3 simply analyzes what happened in the Finished Goods Inventory

account during the year. As shown in Exhibit 2-19, we start with the beginning balance of Finished Goods Inventory and add to it the product that was manu- factured during the year (CGM) to arrive at the cost of the total goods available for sale. Finally, just like with a merchandiser, we subtract what was left in Fin- ished Goods Inventory to back into the Cost of Goods Sold.

EXHIBIT 2-19 Calculat ion of Cost of Goods Sold

_J A B C 1 Calculation of Cost of Goods Sold 2 (Analyze Fm1shed Goods Inventory account) 3 4 Beginning Finished Goods Inventory $ 6,000 5 Plus: Cost of goods manufactured (CGM) 42,000 6 Cost of goods available for sale 5 48,000 7 Less: Ending Finished Goods Inventory 8,000 8 Cost of goods sold $ 40,000 9

By analyzing, step by step, what occurred in each of the three inventory accounts, we were able to calculate the Cost of Goods Sold shown on the company's Income Statement (see Exhibit 2-15). Some companies combine Steps 1 and 2 into one schedule called the Schedule of Cost of Goods Manufactured. Others combine all three steps into a Schedule of Cost of Goods Sold.

You may be wondering where all of the data come from. The beginning inventory balances were simply last year's ending balances. The purchases of direct materials and the incurrence of direct labor and manufacturing overhead would have been captured in the company's accounting records when those costs were incurred. Finally, the ending inven- tory balances come from doing a physical inventory count at the end of the year. In the coming chapters, we'll show you different systems manufacturers use to keep track of the product cost associated with the units still in the three inventory accounts.

70 CHAPTER 2

Comparing Balance Sheets Now that we've looked at the income statement for each type of company, let's consider their balance sheets. The only difference relates to how inventory is shown in the current asset section:

• Service companies show no Inventory.

• Merchandising companies show Inventory or Merchandise Inventory.

• Manufacturing companies show Raw Materials, Work in Process, and Finished Goods Inventory.

Sometimes manufacturers just show "Inventories" on the face of the balance sheet but disclose the breakdown of the inventory accounts (Raw Materials, Work in Process, and Finished Goods) in the footnotes to the financial statements.

In addition to generating a full set of financial statements for external users, many companies are now preparing and issuing Corporate Social Responsibility, or CSR, reports. These reports provide sustainability-related information to a variety of stake- holders, including investors and creditors, customers, government regulators, non- governmental organizations (NGOs), and the general public. Although these reports are still voluntary in the United States, the move toward providing stakeholders with more sustainability-related data is growing. For example, the following issued CSR reports:

• 92% of the world's 250 largest companies (2015) 10

• 75% of the S&P 500 companies (2014) 11

Although sustainability reporting is still in its infancy, the Global Reporting Initiative, or GRI, has become the dominant framework for sustainability reporting. The GRI report follows the triple-bottom-line approach {people, planet, profit) by specifying metrics that companies should report on related to each of the three pillars of sustainability:

• Social performance metrics-for example, fair labor and human rights practices

• Environmental performance metrics-for example, greenhouse gas emissions and total water use

• Economic performance metrics-for example, revenues, operating costs, and so forth.

Sustainability reporting is not just for external reporting; companies also use it as a tool for internal change management . The GRI reporting process helps an orga- nization illuminate areas of social and environmental impact that need improvement. It also helps management track the company's social and environmental progress by comparing baseline performance metrics with those achieved over time. The old ad- age proves just as true for nonfinancial data as it does for financial data: "You can't manage what you don't measure."

Finally, in a 2014 survey, Verdantix found that the Big Four accounting firms dominated both the sustainability consulting and sustainability assurance services markets. 12 Thus, students who wish to enter the accounting profession should be aware of these reporting developments.

10KPMG, 2015 Survey of Corporate Responsibility Reporting. 11Governance and Accountability Institute, http://www .ga-institute.com/nc/issue-master-system/news-deta ils/ article/flash-repo rt-seventy-five-percent- 7 5-of-the-sp-index-pu blished-corporate-sustaina bility-rep .html. 12http://research.verdantix.com/index .cfm/papers/Press.Details/press_id/105/verdantix-global-survey-finds-the-big-four- accounting-firms-continue-to-dominate-the-sustainability-brands-landscape/

Building Blocks of Managerial Accounting 71

What Other Cost Terms Are Used by Managers? So far in this chapter, we have discussed direct versus indirect costs and product costs versus period costs. Now let's turn our attention to other cost terms that managers and accountants use when planning and making decisions.

Controllable Versus Uncontrollable Costs When deciding to make business changes, management needs to distinguish controllable costs from uncontrollable costs. In the long run, most costs are controllable, meaning management is able to influence or change them. However, in the short run, companies are often locked in to certain costs arising from previous decisions. These are called uncon- trollable costs. For example, Toyota has little or no control over the property tax and insurance costs of its existing plants. These costs were locked in when Toyota built its plants. Toyota could replace existing production facilities with different-sized plants in different areas of the world that might cost less to operate, but that would take time. To see immediate benefits, management must change those costs that are controllable at the present time. For example, management can control costs of research and development, design, and advertising. Sometimes Toyota's management chose to increase rather than decrease these costs in order to successfully gain market share. However, Toyota was also able to decrease other controllable costs, such as the price paid for raw materials, by working with its suppliers.

Relevant and Irrelevant Costs Decision making involves identifying various courses of action and then choosing among them. When managers make decisions, they focus on only those costs and revenues that are relevant to the decision.

Say you want to buy a new car and you have narrowed your decision to two choices: the Nissan Sentra or the Toyota Corolla. As shown in Exhibit 2-20, say the Sentra you like costs $18,480, whereas the Corolla costs $19,385. Because sales tax is based on the sales price, the Corolla's sales tax is higher. However, your insurance agent quotes you a higher price to insure the Sentra ($195 per month versus $149 per month for the Corolla). All of these costs are relevant to your decision because they differ between the two cars. The differential cost, is the difference in cost between two alternative courses of action.

EXHIBIT 2-20 Comparison of Relevant Information

~- A B -- C D 1 Relevant Costs Sentra Corolla Differential Cost 2 Car's orice s 18 480 S 19 385 s (905) 3 Sales tax (8%) (rounded) 1478 1551 (73) 4 Insurance* 11 700 8 940 2 760 5 Total relevant costs 31,658 $ 29,876 $ 1,782 6

*Over the five years (60 months) you plan to keep the car.

Other costs are not relevant to your decision. For example, both cars run on regular unleaded gasoline and have about the same fuel economy ratings, so the cost of operat- ing the vehicles is about the same. Likewise, you don't expect cost differences in servic- ing the vehicles because they both carry the same warranty and have received excellent quality ratings. Because you project operating and maintenance costs to be the same for both cars, these costs are irrelevant to your decision. In other words, they won't influ- ence your decision either way. Based on your analysis, the differential cost is $1,782 in favor of the Corolla. Does this mean that you will choose the Corolla? Not necessarily.

6 Describe costs that ~re relevant and irrelevarit for decision making

72 CHAPTER 2

7 .Classify costs as -: .:fixed or variable and

calculate total and average costs at different volumes

The Sentra may have some characteristics you like better, such as a particular paint color, more comfortable seating, or more trunk space. When making decisions, management must also consider qualitative factors, such as effect on employee morale, in addition to differential costs.

Another cost that is irrelevant to your decision is the price you paid for the vehicle you currently own. Say you just bought a Ford F-150 pickup truck two months ago, but you've decided you need a small sedan rather than a pickup truck. The cost of the truck is a sunk cost. Sunk costs are costs that have already been incurred. Nothing you do now can change the fact that you already bought the truck. Thus, the cost of the truck is not relevant to your decision of whether to choose between the Sentra and the Corolla. The only thing you can do now is (1) keep your truck or (2) sell it for the best price you can get.

Managers often have trouble ignoring sunk costs when making decisions, even though they should. Perhaps they invested in a factory or a computer system that no longer serves the company's needs. Many times, new technology makes managers' past investments in older technology look like bad decisions, even though they weren't at the time. Managers should ignore sunk costs because their decisions about the future cannot alter decisions made in the past.

Fixed and Variable Costs Managers cannot make good plans and decisions without first knowing how their costs behave. Costs generally behave as fixed costs or variable costs. We will spend all of Chap- ter 6 discussing cost behavior. For now, let's look just at the basics. Fixed costs stay con- stant in total over a wide range of activity levels. For example, let's say you decide to buy the Corolla, so your insurance cost for the year is $1,788 ($149 per month X 12 months). As shown in Exhibit 2-21, your total insurance cost stays fixed whether you drive your car 0 miles, 1,000 miles, or 10,000 miles during the year.

EXHIBIT 2-21 Fixed Cost Behavior

~ : >,

i $1,788 +- ---------------~ 'In Q ... B = ~ ill .5

0 1,000 10,000

Miles driven

II Why is this important? "Most business decisions depend on how costs are

expected to change at different volumes of activity. Managers can't make good decisions without first

understanding how their costs behave."

However, the total cost of gasoline to operate your car varies depending on whether you drive 0 miles, 1,000 miles, or 10,000 miles. The more miles you drive, the higher your total gasoline cost for the year. If you don't drive your car at all, you won't incur any costs for gasoline. As shown in Exhibit 2-22, variable costs, such as your gasoline cost, change in total in direct proportion to changes in volume. To accurately forecast the total cost of operat- ing your car during the year, you need to know which costs are fixed and which are variable.

Building Blocks of Managerial Accounting 73

EXHIBIT 2-22 Variable Cost Behavior

0 1,000 10,000

Miles driven J

How Manufacturing Costs Behave Most companies have both fixed and variable costs. At a manufacturer, materials are con- sidered to be variable costs. The more cars Toyota makes, the higher its total cost for tires, steel, and parts. The behavior of direct labor is harder to characterize. Salaried employees are paid a fixed amount per year. Hourly wage earners are paid only when they work. The more hours they work, the more they are paid. Nonetheless, direct labor is generally treated as a variable cost because the more cars Toyota produces, the more assembly-line workers and machine operators it must employ. Manufacturing overhead includes both variable and fixed costs. For example, the cost of indirect materials is variable, while the cost of property tax, insurance, and straight-line depreciation on the plant and equipment is fixed. The cost of utilities is partially fixed and partially variable. Factories incur acer- tain level of utility costs just to keep the lights on. However, when more cars are produced, more electricity is used to run the production equipment. Exhibit 2-23 summarizes the behavior of manufacturing costs.

EXHIBIT 2-23 The Behavior of Manufacturing Costs

1@§1§1 .. A variable cost +

.. Generally treated as a variable cost

+

w .. A mixture of fixed and variable costs Mi@MM .. A mixture of fixed and variable costs

Calculating Total and Average Costs Why is cost behavior important? Managers need to understand how costs behave to pre- dict total costs and calculate average costs. In our example, we'll look at Toyota's total and average production costs, but the same principles apply to period costs.

Let's say Toyota wants to estimate the total cost of manufacturing 10,000 vehi- cles at one of its plants next year. To do so, Toyota must estimate (1) the total fixed

74 CHAPTER 2

manufacturing costs at the plant, and (2) the variable cost of manufacturing each vehicle. Let's say Toyota expects to spend $20 million on fixed manufacturing costs at the plant. In addition, it expects to spend $5,000 of variable costs producing each vehicle. 13 How much total product cost should Toyota budget at this plant for the year? Toyota would calculate it as follows:

Total fixed cost+ (Variable cost per unit X Number of units)= Total product cost

$20,000,000 + ($5,000 per vehicle X 10,000 vehicles) = $70,000,000

What is the average cost of manufacturing each vehicle at this plant next year? It's the total cost divided by the number of units produced at the plant:

Total cost Number of units

Average product cost per unit

$70,000,000 $? 000 h. l 10,000 vehicles = ' per ve IC e

If Toyota's managers decide they need to produce 12,000 vehicles at this plant instead, can they simply predict total product cost as follows?

Average cost per unit X Number of units = Total product cost???

$7,000 X 12,000 = $84,000,000???

No! They cannot! Why? Because the average product cost per unit is NOT appro- priate for predicting total costs at different levels of output. Toyota's managers should forecast total product costs based on cost behavior:

Total fixed cost+ (Variable cost per unit X Number of units) = Total product cost

$20,000,000 + ($5,000 per vehicle X 12,000 vehicles) = $80,000,000

Why is the correct forecasted cost of $80 million less than the faulty prediction of $84 million? The difference stems from fixed costs. Remember, Toyota incurs $20 million of fixed manufacturing costs whether it makes 10,000 vehicles or 12,000 vehicles. As Toy- ota makes more vehicles, the fixed manufacturing costs are spread over more vehicles, so the average product cost per vehicle declines. If Toyota ends up making 12,000 vehicles, the new average product cost per vehicle decreases as follows:

Total cost Number of units

$80,000,000 12,000 vehicles

Average product cost per unit

$6,667 per vehicle (rounded)

The average product cost per unit is lower when Toyota produces more vehicles because the company is using the fixed manufacturing costs more efficiently-taking the same $20 million of resources and making more vehicles with it.

13 All references to Toyota in this hypothetica l example were created by the author solely for academic purposes and are not intended in any way to represent the actual business practices of, or costs incurred by, Toyota-Motor Corporation.

Building Blocks of Managerial Accounting 7 5

Keep the following two important rules of thumb in mind:

• Managers like to operate near 100% capacity in order to spread fixed costs over more units. By doing so, they are able to reduce the average cost per unit.

• The average cost per unit is valid only at ONE level of output-the level used to compute the average cost per unit. NEVER use average costs to forecast costs at different output levels; if you do, you will miss the mark.

Finally, a marginal cost is the cost of making one more unit. Fixed costs will not change when Toyota makes one more vehicle unless the plant is operating at 100% capac- ity and simply cannot make one more unit. If that's the case, Toyota will need to incur additional costs to expand the plant. So, unless the plant is operating at 100% capacity, the marginal cost of a unit is simply its variable cost.

As you have seen, management accountants and managers use specialized terms for discussing costs. They use different costs for different purposes. To be able to communi- cate effectively with other people in the organization and get the correct cost information for different business decisions, managers and accountants need a solid understanding of these terms.

76 CHAPTER 2

Building Blocks of Managerial Accounting Toyota also needs to know many characteristics about its costs in order to plan and make deci- sions . It also needs to know how to differentiate between product costs and period costs for external reporting . The following guidelines help managers with these types of decisions .

Decision

How do you compute cost of goods sold?

How do you compute the cost of goods manufactured?

How do managers decide which costs are relevant to their decisions?

How should managers forecast total costs for different production volumes?

Guidelines

Service companies: No cost of goods sold because they don't sell tangible goods

• Merchandising companies:

Beginning inventory

+ Purchases plus freight-in and import duties, if any = Cost of goods available for sale

- Ending inventory

= Cost of goods sold

• Manufacturing companies:

Beginning finished goods inventory

+ Cost of goods manufactured = Cost of goods available for sale

- Ending finished goods inventory

= Cost of goods sold

Beginning work in process inventory

+ Total manufacturing costs incurred during year (direct materials used+ direct labor+ manufacturing overhead)

= Total manufacturing costs to account for

- Ending work in process inventory

= Cost of goods manufactured

Costs are relevant to a decision when they differ between alternatives and affect the future . Thus, differential costs are relevant, whereas sunk costs and costs that don't differ are not relevant .

Total cost= Total fixed costs + (Variable cost per unit X Number of units)

Managers should not use a product's average cost to forecast total costs because it will change as production volume changes. As production increases, the average cost per unit declines (because fixed costs are spread over more units) .

Building Blocks of Managerial Accounting 77 - SUMMARY PROBLEM 2 . • _.

Requirements

1. Show how to compute cost of goods manufactured. Use the following amounts : direct materials used ($24,000}, direct labor ($9,000}, manufacturing overhead ($17,000}, beginning work in process inventory ($5,000), and ending work in process inventory ($4,000) .

2. Auto-USA spent $300 million in total to produce 50,000 cars this year . The $300 mil- lion breaks down as follows: The company spent $50 million on fixed costs to run its manufacturing plants and $5,000 of variable costs to produce each car. Next year, it plans to produce 60,000 cars using the existing production facilities.

a. What is the current average product cost per car this year? b. Assuming there is no change in fixed costs or variable costs per unit, what is the

total forecasted cost to produce 60,000 cars next year? c. What is the forecasted average product cost per car next year?

d. Why does the average product cost per car vary between years?

• SOLUTIONS Requirement 1 Cost of goods manufactured :

_J A B C D 1 Calculation of Cost of Good Manufactured 2 Beginning Work in Process lnventorv $ 5,000 3 Plus manufacturing costs incurred: 4 Direct materials used 24000 5 Direct labor 9,000 6 Manufacturing overhead 17 000 7 Total manufacturing costs to account for $ 55,000 8 Less: Ending Work in Process Inventory 4,000 9 Cost of goods manufactured (CGM) $ 51,000 10

Requirement 2 a.

b.

c.

Total cost -;-Number of units = Current average product cost

$300 million -;-50,000 cars = $6,000 per car

Total fixed costs + Total variable costs = Total projected product cost $50 million + (60,000 cars X $5,000 per car) = $350 million

Total cost-;- Number of units = Projected average product cost

$350 million -i- 60,000 cars = $5,833 per car

d. The average product cost per car decreases because Auto-USA will use the same fixed costs ($50 million) to produce more cars next year. Auto-USA will be using its resources more efficiently, so the average cost per unit will decrease .

Learning Objectives • 1 Distinguish among service, merchandising, and manufacturing companies

• 2 Describe the value chain and its elements

• 3 Distinguish between direct and indirect costs

• 4 Identify product costs and period costs

• 5 Prepare the financial statements for service, merchandising, and manufacturing companies

• 6 Describe costs that are relevant and irrelevant for decision making

• 7 Classify costs as fixed or variable and calculate total and average costs at different volumes

Accounting Vocabulary Allocate. (p. 56) To assign an indirect cost to a cost object.

Assign. (p. 55) To attach a cost to a cost object.

Average Cost. (p. 74) The total cost divided by the number of units.

Biomimicry. (p. 53) A means of product design in which a company tries to mimic, or copy, the natural biological process in which dead organisms (plants and animals) become the input for another organism or process.

Controllable Costs. (p. 71) Costs that can be influenced or changed by management.

Conversion Costs. (p. 61) The combination of direct labor and manufacturing overhead costs.

Cost Object. (p. 55) Anything for which managers want to know the cost.

Cost of Goods Manufactured. (p. 67) The cost of manufac- turing the goods that were finished during the period.

Customer Service. (p. 52) Support provided for customers after the sale.

Design. (p. 52) Detailed engineering of products and ser- vices and the processes for producing them.

Differential Cost. (p. 71) The difference in cost between two alternative courses of action.

Direct Cost. (p. 55) A cost that can be traced to a cost object; a cost that is readily identifiable or associated with the cost object.

Direct Labor. (p. 60) The cost of compensating employ- ees who physically convert raw materials into the company's products; labor costs that are directly traceable to the finished product.

Direct Materials. (p. 60) Primary raw materials that become a physical part of a finished product and whose costs are traceable to the finished product.

Distribution. (p. 52) Delivery of products or services to customers.

Finished Goods Inventory. (p. 50) Completed goods that have not yet been sold.

78

Fixed Costs. (p. 72) Costs that stay constant in total despite wide changes in volume.

Greenwashing. (p. 54) The unfortunate practice of overstat- ing a company's commitment to sustainability.

Indirect Cost. (p. 55) A cost that relates to the cost object but cannot be traced specifically to it; a cost that is jointly used or shared by more than one cost object.

Indirect Labor. (p. 60) Labor costs that are difficult to trace to specific products.

Indirect Materials. (p. 60) Materials whose costs are difficult to trace to specific products.

Life-Cycle Assessment. (p. 53) A method of product design in which the company analyzes the environmental impact of a product, from cradle to grave, in an attempt to minimize nega- tive environmental consequences throughout the entire lifespan of the product.

Manufacturing Company. (p. 50) A company that uses labor, plant, and equipment to convert raw materials into new finished products.

Manufacturing Overhead. (p. 60) All manufacturing costs other than direct materials and direct labor; also called factory overhead and indirect manufacturing cost.

Marginal Cost. (p. 75) The cost of producing one more unit.

Marketing. (p. 52) Promotion and advertising of products or services.

Merchandising Company. (p. 49) A company that resells tangible products previously bought from suppliers.

Operating Income. (p. 65) Earnings generated from the company's primary ongoing operations; the company's earn- ings before interest and taxes.

Other Indirect Manufacturing Costs. (p. 61) All manufactur- ing overhead costs aside from indirect materials and indirect labor.

Period Costs. (p. 57) The costs incurred by the company to operate the business that do not get treated as inventory, but rather are expensed immediately in the period in which they are incurred. These costs do not relate to manufactur- ing or purchasing product. Period costs are often called

operating expenses or selling, general, and administrative expenses.

Periodic Inventory. (p. 66) An inventory system in which Cost of Goods Sold is calculated at the end of the period rather than every time a sale is made.

Perpetual Inventory. (p. 66) An inventory system in which both Cost of Goods Sold and Inventory are updated every time a sale is made.

Prime Costs. (p. 61) The combination of direct material and direct labor costs.

Product Costs. (p. 57) The costs incurred by manufacturers to produce their products or incurred by merchandisers to purchase their products. For externa l financial reporting, GMP requires that these costs be assigned to inventory until the products are sold, at which point, they are expensed as Cost of Goods Sold.

Production or Purchases. (p. 52) Resources used to pro- duce a product or service or to purchase finished merchandise intended for resale.

Raw Materials Inventory. (p. 50) All raw materials (direct materials and indirect materials) not yet used in manufacturing.

Research and Development (R&D). (p. 52) Researching and developing new or improved products or services or the pro- cesses for producing them .

Retailer. (p. 49) Merchandising company that se lls to consumers.

Building Blocks of Managerial Accounting 79

Service Company. (p. 49) A company that sells intangible services rather than tangible products.

Sunk Cost. (p. 72) A cost that has a lready been incurred.

Total Cost. (p. 57) The cost of all resources used throughout the value chain.

Trace. (p. 56) To assign a direct cost to a cost object.

Triple Bottom Line. (p. 49) Evaluating a company's perfor - mance not only by its abi lity to generate economic profits, but also by its impact on people and the planet.

Uncontrollable Costs. (p. 71) Costs that cannot be changed or influenced in the short run by management.

Value Chain. (p. 51) The activities that add value to a firm's products and services; includes R&D, design, production or purchases, marketing, distribution, and customer service.

Variable Costs. (p. 72) Costs that change in total in direct proportion to changes in volume.

Wholesaler. (p. 49) Merchandising companies that buy in bulk from manufacturers, mark up the prices, and then se ll those products to retai lers.

Work in Process Inventory. (p. 50) Goods that are partway through the manufacturing process but not yet comp lete.

MyAccounting lab Go to http://myaccountinglab.com/ for the following Quick Check, Short Exercises, Exer- cises, and Problems. They are available with immediate grading, explanations of correct and incorrect answers, and interactive media that acts as your own online tutor.

Quick Check

1. (Learning Objective 7) Which of the following types of companies would have work in process inventory?

a. Service

b. Merchandising

c. Manufacturing

d. All of the above

2. (Learning Objective 2) Which of the following is not an activity in the value chain?

a. Marketing

b. Customer Service

c. Design

d. Administration

3. (Learning Objective 3) A cost that can be traced to a cost object is known as a

a. period cost .

b. product cost .

c. direct cost .

d. indirect cost .

4. (Learning Objective 4) Period costs are often referred to as

a. manufacturing expenses.

b. operating expenses.

c. direct costs.

d. product costs .

5. (Learning Objective 4) Conversion costs consist of

a. direct materials and manufacturing overhead .

b. direct labor and manufacturing overhead .

c. direct materials and direct labor .

d. direct materials, direct labor, and manufacturing overhead .

6. (Learning Objective 4) Which of the following is not part of manufacturing overhead?

a. Period costs, such as depreciation on office computers

b. Indirect materials, such as machine lubricants

c. Indirect labor, such as plant forklift operators' wages

d. Other indirect manufacturing costs, such as plant utilities

80 CHAPTER 2

7 . (Learning Objective 5) Which of the following is a calcu- lated amount, rather than a general ledger account?

9 . (Learning Objective 6) Which of the following is false?

a. Uncontrollable costs are costs over which the a. Finished goods inventory company has little or no control in the short run .

b. Cost of goods manufactured b. Sunk costs are costs that have already been incurred .

c. Sales revenue c. Sunk costs are generally relevant to decisions .

d. Cost of goods sold

8. (Learning Objective 5) Which of the following types

d. The difference in cost between two alternatives is known as a differential cost .

of companies will always have the Cost of Goods Sold account on their income statements?

10. (Learning Objective 7) Which ofthe following is true?

a. The average cost per unit can be used for predicting total costs at many different output levels . a. Service and merchandising companies

b. Merchandising and manufacturing companies b. Manufacturing overhead is composed of only variable costs . c. Service and manufacturing companies

d. Service, merchandising, and manufacturing companies

c. Fixed costs stay constant in total over a wide range of activity levels .

Madison Company

Cash

Accounts receivable

Raw materials inventory

Work in process inventory

Finished goods inventory

Total

d. Direct materials are considered to be fixed costs .

Quick Check Answers

:, ·o L :, • 6 q ·g q . L e ·9 q ·s q ·17 :, "£ P ·1: :, . L

Short Exercises

52-1 Identify types of companies and their inventories (Learning Objective 1) Complete the following statements with one of the terms listed here . You may use a term more than once, and some terms may not be used at all.

Finished goods inventory Inventory (merchandise) Service companies

Manufacturing companies Merchandising companies Work in process inventory

Raw materials inventory Wholesalers

a. ___ report three types of inventory on the balance sheet .

b. ___ fora company such as Best Buy (consume r electronics) includes all of the costs necessary to purchase products and get them onto the store shelves.

c. Most for-profit organizations can be described as being in one (or more) of three categories:---~---~ and __ _

d. ___ is composed of goods partially through the manufacturing process (not finished yet).

e. Forever 21, Target, and Kohl's are all examples of __ _

f. ___ typically do not have an inventory account .

g. Johnson & Johnson, a personal care products manufacturer, converts ___ into finished products .

h. A law office, an advertising agency, and a hospital are all examples of __ _

i. ___ buy products in bulk from p roducers, mark them up, and resell to retailers .

52 -2 Identify type of company from balance sheets (Learning Objective 1) The current asset sections of the balance sheets of three companies follow . Which company is a service company? Which is a merchandiser? Which is a manufacturer? How can you tell?

Dean Company Anderson Company

$3,000 Cash $2,400 Cash $3,000

4,000 Accounts receivable 6,500 Accounts receivable 5,000

2,000 Inventory 8,000 Prepaid expenses 600 ---

900 Prepaid expenses 300 Total $8,600 ---

4,000 Total $17,200

$13,900

Building Blocks of Managerial Accounting 81

52-3 Classify costs by value chain function (Learning Objective 2) Classify each of The J . M . Smucker Company's costs as one of the six business functions in the value chain .

a. Cost of a prime-time lV ad featuring Smucker's ® Fruit & Honey™ Fruit Spreads

b. Salary of engineers who are designing the new plant's layout

c. Depreciation on Orrville, Ohio, plant

d. Depreciation on delivery vehicles

e. Transportation costs to deliver Folgers Coffee ® to retailers such as Kroger, Wal mart, and Save-A-Lot

f. Costs of a customer support center website

g. Plant manager's salary

h. Purchase of strawberries used in Smucker's ® Strawberry Preserves

i. Depreciation on food research lab

52-4 Classify costs as direct or indirect (Learning Objective 3)

52-5

Classify each of the following costs as a direct cost or an indirect cost, assuming that the cost object is the Juniors Department (clothing and accessories for teenage and young women) in the Stow Kohl's department store . (Kohl's is a chain of department stores and has stores located across the United States .)

a.

b.

C.

d.

e.

f.

g.

h.

i.

j.

k.

I.

Juniors Department sales clerks

Cost of Juniors clothing

Cost of hangers used to display the clothing in the store

Electricity for the building

Cost of radio advertising for the store

Juniors clothing buyers' salaries (these buyers buy for all the Juniors Departments of Kohl's stores)

Depreciation of the building

Cost of costume jewelry on the mannequins in the Juniors Department

Cost of bags used to package customer purchases at the main registers for the store

The Stow Kohl's store manager's salary

Cost of the security staff at the Stow store

Manager of Juniors Department

Define cost terms (Learning Objectives 3 & 4) Complete the following statements with one of the terms listed here . You may use a term more than once, and some terms may not be used at all.

Prime costs Cost objects Product costs

Assigned Direct costs Fringe benefits

Period costs Assets Cost of goods sold

Indirect costs Conversion costs Total costs

a. ____ are the costs of transforming direct materials into finished goods .

b. ____ include R&D, marketing, distribution, and customer service costs .

c. Direct material plus direct labor equals ___ _

d. Steel, tires, engines, upholstery, carpet, and dashboard instruments are used in the assembly of a car. Since the manufacturer can trace the cost of these materials (includ- ing freight-in and import duties) to specific units or batches of vehicles, they are con- sidered ____ of the vehicles .

e. Costs that can be traced directly to a(n) ____ are called ___ _

f. ____ are initially treated as ____ on the balance sheet .

g. The allocation process results in a less precise cost figure being ____ to the

h. ____ cannot be directly traced to a(n) ___ _

i. ____ include the costs of all resources used throughout the value chain .

82 CHAPTER 2

j. U.S. GAAP requires companies to use only _______ for inventory reported on external financial statements .

k. Company-paid ___ may include health insurance, retirement plan contributions, payroll taxes, and paid vacations .

I. When manufacturing companies sell their finished products, the costs of those fin- ished products are removed from inventory and expensed as ______ _

52-6 Identify product costs and period costs (Learning Objective 4) PEZ Candy Inc. produces the popular small candy that is dispensed in collectible flip-top dispensers . In the United States, PEZ candies are produced in a factory in Connecticut . The Connecticut location also houses PEZ's U.S. headquarters and a PEZ Visitors Center. PEZ candy is made from sugar, fruit flavoring, coloring, and corn syrup; the ingredients are put under pressure to form the hard tablets . About 95% of a PEZ tablet is sugar . The PEZ dispensers are popular with collectors; there are several PEZ collector conventions throughout the world .

In 2011, PEZ Candy Inc. opened a 6,000-square-foot Visitors Center in Connecticut . The Visitors Center houses the world's largest collection of PEZ memorabilia on public display . Visitors can also view the factory through special viewing windows. The center also has a touch-screen PEZ trivia game and interactive reviews of PEZ history . Birthday party packages are also offered in the Visitors Center; partygoers receive goodie bags that include a blank customizable PEZ dispenser, PEZ candy, a PEZ lanyard, and discount coupons .

52-7

Requirements

1.

2.

3.

4.

5.

6.

Is the cost of sugar in PEZ candies a product or a period cost? What about the wrap- pers that the candy is packaged in?

Is the cost of quality control testing in the manufacturing process for PEZ candies a product or a period cost?

Is the cost of the labor to make PEZ candy in the factory a product or a period cost? What about the cost of the benefits (i.e ., health care, payroll taxes, vacation pay) for those workers?

Is the cost of staffing the PEZ Visitors Center a product or a period cost? What about the cost of the benefits (i.e., health care, payroll taxes, vacation pay) for those workers who work in the Visitors Center?

Assume that PEZ purchased the touch-screen PEZ trivia game from a custom video game developer . Is the cost of that game a product or a period cost? What about the costs of maintaining and updating the software and hardware for the game?

Is food cost for a birthday party in the PEZ Visitors Center a product or a period cost? What about the cost of the items included in the goodie bags?

Classify product costs and period costs (Learning Objective 4) Classify each of Ford Motor Company's costs as either product costs or period costs. Ford Motor Company is an automobile manufacturer headquartered in Detroit, Michigan .

a. Cost of chemical included in paint to inhibit rust

b. Life insurance for the CEO

c. Cost of electricity at the Lima Engine Plant in Ohio

d. Depreciation on the buildings at the Flat Rock Assembly Plant in Michigan

e. Cost of ad campaign and slogan called "By Design" to highlight the designs of Ford's cars

f. Purchase of aluminum to be used in car wheels

g. Salaries of Ford engineers researching ways to reduce CO 2 emissions

h. Cost of new software to schedule production

i. Salaries of Ford Motor Company's top executives

Building Blocks of Managerial Accounting 83

52-8 Classify a manufacturer's costs (Learning Objective 4) Classify each of the following costs as a period cost or a product cost . If you classify the cost as a product cost, further classify it as direct material (DM), direct labor (DL}, or man- ufacturing overhead (MOH) .

a. Property taxes-30% of building is used for sales, marketing, and administrative offices; 70% of building is used for manufacturing

b. Wages and benefits paid to assembly-line workers in the manufacturing plant

c. Depreciation on automated production equipment

d. Salaries paid to quality control inspectors in the plant

e. Repairs and maintenance on factory equipment

f. Standard packaging materials used to package individual units of product for sale (for example, cereal boxes in which cereal is packaged)

g. Lease payment on administrative headquarters

h. Telecommunications costs for the customer service call cente r

52-9 Classify costs incurred by a dairy processing company (Learning Objective 4)

Each of the following costs pertains to Bailey Dairy Products Company, a dairy processing company . Classify each of the company's costs as a period cost or a product cost . Further classify product costs as direct material (DM}, direct labor (DL}, or manufacturing over- head (MOH).

Cost

1. Television advertisements for Bailey's products

2 . Lubricants used in running bottling machines

3 . Research and development related to elimination of antibi- otic residues in milk

4 . Gasoline used to operate refrigerated trucks delivering fin- ished dairy products to grocery stores

5 . Company president's annual bonus

6 . Depreciation on refrigerated trucks used to collect raw milk from local dairy farmers

7 . Plastic gallon containers in which milk is packaged

8 . Property insurance on dairy processing plant

9 . Cost of milk purchased from local dairy farmers

10 . Depreciation on tablets used by sales staff

11 . Wages and salaries paid to machine operators at dairy pro- cessing plant

Period Cost or Product Cost?

52-10 Determine total manufacturing overhead (Learning Objective 4)

DM, DL, or MOH?

McKay Frames manufactures picture frames . Suppose the company's January records include the items described be- low. What is McKay Frames' total manufacturing overhead cost in January?

Oil for manufacturing equipment .................................................................. . $ 250

Wood for frames ............................................................................................ . $46,000

Company p resident's salary ........................................................................... . $26 ,500

Interest expense ............................................................................................. . $ 1,500

Plant supervisor's salary ................................................................................. . $ 3,100

Depreciation expense on company cars used by sales force ........................ . $ 2,100

Plant janitor's salary .... .......... .......... .......... .......... .................... .......... .......... .... . $ 1,800

Plant depreciation expense ............................................................................ . $ 6,000

Glue for picture frames .................................................................................. . $ 400

84 CHAPTER 2

52-11 Prepare a retailer's income statement (Learning Objective 5) Salon Hair is a retail chain specializing in salon-quality hair-care products . During the year, Salon Hair had sales of $38,850,000 . The company began the year with $3,500,000 of merchandise inventory and ended the year with $4,445,000 of inventory . During the year, Salon Hair purchased $23,975,000 of merchandise inventory . The company's selling, gen- eral, and administrative expenses totaled $7,100,000 for the year . Prepare Salon Hair's income statement for the year .

52-12 Compute Cost of Goods Sold for a merchandiser (Learning Objective 5) Given the following information for a retailer, compute the cost of goods sold .

Ending inventory ............... ........................................ ..................................... .

Website maintenance ..................................................................................... .

Revenues ........................................................................................................ .

Freight-in ................ .... ...... .... ....... ...... .......... ............. .... ...... ................. ........... .

Import duties ............... .......... ....... .......... ............. .......... .......... ....... .......... ...... .

Marketing expenses ....................................................................................... .

Delivery expenses ...... ...... .... ....... ...... .......... ............. .... ...... ................. ........... .

Purchases ................ .... ...... ........... ...... .................. ..... .......... ................. ........... .

Beginning inventory ............ ................. ............. .......... ...... ........................ ..... .

52-13 Calculate direct materials used (Learning Objective 5)

$ 5,900

$ 7,700

$67,000

$ 3,700

$ 1,300

$12,000

$ 1,500

$40,000

$ 3,800

You are a new accounting intern at Mason Bikes. Your boss gives you the following infor- mation and asks you to compute the cost of direct materials used (assume that the com- pany's raw materials inventory contains only direct materials) .

Import duties ............. .......... ................. ............. .......... .......... .................... ..... . $ 1,300

Beginning raw materials inventory ................................................................. . $ 4,700

Ending raw materials inventory ................................................. ..................... . $ 1,200

Freight-in ........... .......... .......... ....... .......... ............ ........... .......... ....... ............ .... . $ 400

Freight-out ..................................................................................................... . $ 600

Purchases of direct materials ............ ....................... ................. ..................... . $16,000

52-14 Compute Cost of Goods Manufactured (Learning Objective 5) Robinson Manufacturing found the following information in its accounting records : $519,800 of direct materials used, $223,500 of direct labor, and $775,115 of manufacturing overhead . The Work in Process Inventory account had a beginning balance of $72,400 and an ending balance of $87,600 . Compute the company's Cost of Goods Manufactured .

52-15 Describe other cost terms (Learning Objectives 6 & 7) Complete the following statements with one of the terms listed here . You may use a term more than once, and some terms may not be used at all.

Differential costs

Marginal cost

Uncontrollable costs

Variable costs

Fixed costs

Sunk costs

a. A(n) ___ is the cost of making one more unit .

Controllable costs

Average cost

b. Gasoline is one of many ___ in the operation of a motor vehicle .

c. A product's ___ and---~ not the product's---~ should be used to forecast total costs at different production volumes .

d. Within the relevant range, ___ do not change in total with changes in production volume .

e. The ____ per unit declines as a production facility produces more units .

f. Costs that differ between alternatives are called ___ _

g. In the long run, most costs are---~ meaning that management is able to influ- ence or change the amount of the cost .

h. ___ are costs that have already been incurred .

Building Blocks of Managerial Accounting 85

52 -16 Classify costs as fixed or variable (Learning Objective 7) Classify each of the following costs as fixed or variable :

a. Cost of French fries used at a McDonald 's restaurant

b. Hourly wages paid to cashiers at The Home Depot

c. Monthly sugar costs for The Hershey Company

d. Cost of fuel used by Old Dominion Freight Line, a national trucking company

e. Shipping costs at Amazon .com

f. Monthly rent for Onyx Nail Bar, a nail salon in Dallas, Texas

g. Sales commissions at Tampa Honda in Florida

h. Monthly insurance costs for the building housing the administrative offices of Panera Bread in St . Louis, Missouri

i. Monthly depreciation of equipment used in the customer service department at Kla- ben Ford Lincoln, a car dealership in Kent, Ohio

j. Cost of rubber used to manufacture LL.Bean boots

k. Cost of oranges sold at a Kroge r's grocery store

I. Monthly office lease costs for the Portland office of E & Y, a global audit firm m. Monthly cost of coffee at a Dunkin' Donuts store

n. Property taxes for an Applebee's Neighborhood Grill & Bar

o. Depreciation of exercise equipment at an LA Fitness club

52-17 Identify ethical standards violated (Learning Objectives 1, 2, 3, 4, 5, 6, & 7) For each of the situations listed, identify the primary standard from the IMA Statement of Ethical Professional Practice that is violated (competence, confidentiality, integrity, or credibility) . Refer to Exhibit 1-7 for the complete standard .

1. To reduce the company's tax bill, Jack uses total cost to value inventory instead of us- ing product cost as required by law.

2. Since Emilie works in the accounting department , she is aware that profits are going to fall short of analysts' projections . She tells her aunt to sell stock in the company be- fore the earnings release date .

3. Veronica pays a Mexican official a bribe of $50,000 to allow the company to locate a factory in that jurisdiction so that the company can take advantage of the cheaper labor costs . Without the bribe, the factory cannot be located in that location .

4. There is a failure in the company's backup system after a system crash . Month-end reports will be delayed . Kayla, the manager of the division experiencing the system failure, does not report this upcoming delay to anyone since she does not want to be the bearer of bad news .

5. Taylor overhears a subordinate at a mutual friend's party tell others about a confiden- tial deal with a supplier to get raw materials for a price lower than market price . Taylor does not do anything about the subordinate's indiscreet conversation.

EXERCISES Group A E2-18A Classify costs along the value chain for a retailer (Learning Objective 2)

Suppose Motor Shack incurred the following costs at its Ann Arbor, Michigan, store :

Newspaper advertisements ...... .......... .......... .................... .......... .......... ......... . $ 5,100

Payment to consultant for advice on location of new store ............ .......... .... . $ 2,700

Purchases of merc handise .............................................................................. . $37 ,000

Freight-in ..... .................... .......... .......... .......... .................... .......... .......... ......... . $ 3,700

Salespeople's salaries ..................................................................................... . $ 4 ,600

Depreciation expense on delivery trucks ....................................................... . $ 1,500

Research on whether store should sell satellite radio service ........................ . $ 250

Customer Complaint Department ................................................................. . $ 550

Rearranging store layout ................................................................................ . $ 650

86 CHAPTER 2

SUSTAINABILITY

Requirements

1. Classify each cost as to which category of the value chain it belongs (R&D, Design, Purchases, Marketing, Distribution, or Customer Service) .

2. Compute the total costs for each value chain category .

3. How much are the total product costs?

E2-19A Classify costs along the value chain for a manufacturer (Learning Objectives 2 & 4)

Suppose the smartphone manufacturer Kobo Electronics provides the following information for its costs last month (in millions):

Delivery expense to customers via UPS.................................................................. $ 9

Salaries of salespeople ............................................................................................ $ 4

Chipset (the set of chips used on a phone's motherboard) .................................... $56

Exterior case for phone ....... ................. ............. .......... .......... ....... ............. .......... .... $ 6

Assembly-line workers' wages ................................................................................ $ 8

Technical customer support hotline .......................... .............................. .......... ...... $ 5

Depreciation on plant and equipment .............. .......... .......... ....... ............. .......... .... $60

Rearrangement of production process to accommodate new robot ......... ..... ....... $ 3

1-800 (toll-free) line for customer orders .... ............. .... ...... ........... ...... ............. ....... $ 1

Salaries of scientists who developed new model ................................................... $10

Requirements

1. Classify each of these costs according to its place in the value chain (R&D, Design, Production, Marketing, Distribution, or Customer Service) . (Hint: You should have at least one cost in each value chain function .)

2. Within the production category, break the costs down further into three subcatego- ries : Direct Materials, Direct Labor, and Manufacturing Overhead .

3. Compute the total costs for each value chain category .

4. How much are the total product costs?

5. How much are the total prime costs?

6. How much are the total conversion costs?

E2-20A Value chain and sustainability efforts (Learning Objective 2) Each of the following scenarios describes some cost item for organizations in recent years . For each scenario, identify which function of the value chain that cost would repre- sent (R&D, Design, Purchasing/Producing, Marketing, Distributing, or Customer Service) . Note: The companies and products used in this exercise are real companies with a strong sustainable practices commitment.

a. In recent years, the U.S. National Park Service approved the use of an erosion control system from GeoHay ® for a roadway construction project in the Great Smoky Moun- tains National Park . GeoHay ® erosion and sediment control products are produced from recycled carpet fibers . The cost of these erosion and sediment control products would fall into which function in the value chain?

b. Ford Motor Company's Rouge Center in Dearborn, Michigan, has a "living roof" on the Dearborn Truck Plant final assembly building . It is the largest living roof in the world, encompassing 10.4 acres . The living roof is made from living grass, and its primary purpose is to collect and filter rainfall as part of a natural stormwater manage- ment system . It also provides cooler surroundings and offers a longer roof life than a traditional roof . The cost of promoting the company's products and its sustainability efforts would fall into which function in the value chain?

c. Nike Products, an athletic apparel and shoe manufacturer, developed the Envi- ronmental Apparel Design Tool over a period of seven yea rs . The Environmental Apparel Design Tool helps apparel and shoe designers to make real-time choices that decrease the environmental impact of their work . With the tool, the designers can see the potential waste resulting from their designs and the amount of environ- mentally preferred materials used by their designs . When designers make changes to

Building Blocks of Managerial Accounting 87

the preliminary product design, they can see instantly the effect of those changes on waste and input usage . The $6 million investment used to develop the Environmental Apparel Design Tool would fall into which function in the value chain?

d. GreenShipping™ is a service that companies can use to purchase carbon offsets for the carbon generated by shipments to customers . Any shipments made with UPS, FedEx, or USPS can be tracked . The GreenShipping™ calculator uses weight, distance traveled, and mode of transport to calculate the carbon generated by that shipment . A carbon offset is then purchased so that the shipment becomes carbon neutral. The carbon offset helps to fund the development of renewable energy sources . The cost of these carbon offsets to the company making the shipment to the customer would fall into which function in the value chain?

e. The Red Wing Shoe Company manufactures work boots . The company has a philoso- phy that products should be repaired, not thrown away . After the 12-month warranty has expired on Red Wing boots, the company offers free oiling, free laces, low-cost replacement insoles, and low-cost hardware repairs . The cost of operating this shoe repair service would fall into which function in the value chain?

f. Nyloboard ® produces decking materials made from recycled carpet . The cost of the research into how to create Nyloboard ® from recycled carpet would fall into which function in the value chain?

E2-21A Classify and calculate a manufacturer's costs (Learning Objectives 2 & 4)

An airline manufacturer incur red the following costs last month (in thousands of dollars) :

a. Airplane seats ............................................................................................... . $ 240

b. Production supervisors' salaries ................................................................... . $ 100

c. Depreciation on forklifts in factory ................ ........................................ ...... . $ 40

d. Machine lubricants ....................................................................................... . $ 35

e. Factory janitors' wages ................................................................................ . $ 15

f. Assembly workers' wages ......... .......... .......... .......... ....... ............. .......... ....... . $ 620

g. Property tax on corporate marketing office ................................................ . $ 30

h. Plant utilities ................................................................................................. . $ 120

i. Cost of warranty repairs ......... ............. .......... ................. ............. .......... ....... . $ 260

j. Machine operators' health insurance ........................................................... . $ 10

k. Depreciation on administrative offices ........................................................ . $ 60

I. Cost of designing new plant layout ............................................................. . $ 170

m. Jet engines ................................................................................................... . $1,400

Requirements

1. Assuming the cost object is an airplane, classify each cost as one of the following : direct material (DM), direct labor (DL}, indirect labor (IL}, indirect materials (IM}, other manufacturing overhead (other MOH}, or period cost . (Hint: Set up a column for each type of cost .) What is the total for each type of cost?

2. Calculate total manufacturing overhead costs .

3. Calculate total product costs .

4. Calculate total prime costs .

5 . Calculate total conversion costs .

6 . Calculate total pe riod costs .

E2-22A Construct an income statement using product and period costs (Learning Objectives 4 & 5)

Outdoor Amenities is a manufacturer of backyard and deck furniture . Its products are in high demand, and it carries no inventory . Following is a list of selected account balances from its trial balance for the most recent year ended December 31 (in no particular order .)

88 CHAPTER 2

Salaries and wages (for administrative and sales staff) .......................... .......... ...... . $ 37,400

Stain (used in manufacturing furniture) .................................................................. . $ 12,700

Indirect labor costs (wages of maintenance workers in factory) ............................ . $ 21,300

Other manufacturing overhead (includes factory insurance and property taxes) .. $ 9,800

Rent and utilities (for administrative offices) .......................................................... . $ 12,000

Utility costs (related to factory) .............................................................................. . $ 11,200

Labor costs (wages of carpenters who build furniture) .......................................... . $ 36,900

Accounts receivable ............................................................................................... . $ 27,100

Marketing costs ...................................................................................................... . $ 17,300

Wood (used in manufacturing furniture) ................................................................ . $ 57,800

Sales revenues ........................................................................................................ . $255,000

Accounts payable ................................................................................................... . $ 7,100

Requirements Using the income statement accounts in the table, calculate:

1. Cost of goods sold . Hint: Cost of goods sold can be calculated by summing the total product costs since there is no inventory .

2. Operating expenses . Hint: Operating expenses are the company's period costs .

3. Gross profit

4. Operating income

E2-23A Work backward to find missing amounts (Learning Objective 5) Gamma Electronics manufactures and sells a line of smartphones . Unfortunately, Gamma Electronics suffered serious fire damage at its home office . As a result, the accounting records for October were partially destroyed-and completely jumbled . Gamma Electron- ics has hired you to help figure out the missing pieces of the accounting puzzle . Assume that the Raw Materials Inventory contains only direct materials .

Revenues in October ...... .......... .............................. .......... .......... ............................ . $27,600

Work in process inventory, October 31 ................................................................. . $ 1,700

Raw materials inventory, October 31 ..................................................................... . $ 3,200

Direct labor in October ............ ........................................ .......... ............................ . $ 3,400

Manufacturing overhead in October ..................................................................... . $ 6,300

Work in process inventory, October 1 ................................................................... . 0

Finished goods inventory, October 1 .................................................................... . $ 4,900

Direct materials used in October ........................................................................... . $ 8,600

Gross profit in October .......... ................. ....... ...... .......... .............................. ......... . . $12,800

Purchases of direct materials in October ............................................................... . $ 9,200

Requirement Find the following amounts :

a. Cost of Goods Sold in October

b. Beginning Raw Materials Inventory

c. Ending Finished Goods Inventory

E2-24A Prepare a retailer's income statement (Learning Objective 5)

Neil Webster is the sole proprietor of Prestigious Pugs, a business specializing in the sale of high-end pet gifts and accessories . Prestigious Pugs' sales totaled $1,105,000 during the most recent year. During the year, the company spent $55,000 on expenses relating to website maintenance, $30,500 on marketing, and $29,500 on wrapping, boxing, and shipping the goods to customers . Prestigious Pugs also spent $638,000 on inventory purchases and an additional $19,500 on freight-in charges . The company started the year with $16,250 of inventory on hand and ended the year with $16,000 of inventory. Prepare Prestigious Pugs' income statement for the most recent year .

Building Blocks of Managerial Accounting 89

E2-25A Compute direct materials used and Cost of Goods Manufactured (Learning Objective 5)

Just ine Industries is calculating its Cost of Goods Manufactured at yea r-end . The company 's accounting records show the following : The Raw Materials Inventory account had a begin- ning balance of $17,000 and an ending balance of $12,000 . During the year, the company purchased $55,000 of direct materials. Direct labor for the year totaled $121,000, while manufacturing overhead amounted to $151,000 . The Work Process Inventory account had a beginning balance of $22,000 and an ending balance of $21,000 . Assume that Raw Materials Inventory contains only direct materials . Compute the Cost of Goods Manufactured for the year. (Hint : The first step is to calculate the direct materials used during the year .)

E2-26A Compute Cost of Goods Manufactured and Cost of Goods Sold (Learning Objective 5)

Compute the Cost of Goods Manufactured and Cost of Goods Sold for West Nautical Company for the most recent year using the amounts described next . Assume that the Raw Materials Inventory contains only direct materials .

Beginning of Year

End of Year

End of Year

Raw materials inventory ..... ....... $23,000

Work in process inventory ......... $35,000

Finished goods inventory .......... $20,000

Purchases of direct materials ... .

Direct labor .............................. .

$25,000

$31,000

$22,000

$74,000

$86,000

$42,000

Insurance on plant ....................... .......... .......... .. $ 11,500

Depreciation-plant building and equipment. . $ 13,400

Repairs and maintenance-plant. ......... .......... .. $ 3,700

Marketing expenses .......................................... $ 77,000

General and administrative expenses ............... $ 28,500

Indirect labor ............................ .

E2-27 A Continues E2-26A: Prepare income statement (Learning Objective 5) Prepare the income statement for West Nautical Company in E2-26A for the most recent year . Assume that the company sold 34,000 units of its product at a price of $12 each during the year .

E2-28A Determine whether information is relevant (Learning Objective 6) Classify each of the following costs as relevant or irrelevant to the decision at hand and briefly explain your reason .

a. The fair market value of old manufacturing equipment when deciding whether to re- place it with new equipment (old equipment will be sold if new equipment is purchased)

b. Cost of purchasing packaging materials from an outside vendor when deciding whether to continue manufacturing the packaging materials in-house

c. Depreciation expense on old manufacturing equipment when deciding whether to replace it with newer equipment

d. The total amount of the restaurant's fixed costs when deciding whether to add addi- tional items to the menu

e. The cost of land purchased three years ago when deciding whether to build on the land now or wait two more years before building

f. The interest rate received on invested funds when deciding how much inventory to keep on hand

g. Cost of computers purchased six months ago when deciding whether to upgrade to computers with a faster processing speed

h. The property tax rates in different locales when deciding where to locate the com- pany's headquarters

i. The type of fuel (gas or diesel) used by delivery vans when deciding which make and model of van to purchase for the company's delivery van fleet

j. Cost of operating automated production machinery versus the cost of direct labor when deciding whether to automate production

90 CHAPTER 2

E2-29A Compute total and average costs (Learning Objective 7) Bubbly Soda spends $2 on direct materials, direct labor, and variable manufacturing overhead for every unit (12-pack of soda) it produces . Fixed manufacturing overhead costs $7 million per year . The plant, which is currently operating at only 75% of capacity, produced 25 million units this year. Management plans to operate closer to full capacity next year, producing 35 million units. Management doesn't anticipate any changes in the prices it pays for materials, labor, and manufacturing overhead .

Requirements

1. What is the current total product cost (for the 25 million units}, including fixed and variable costs?

2. What is the current average product cost per unit?

3. What is the current fixed cost per unit?

4. What is the forecasted total product cost next year (for the 35 million units}, including fixed and variable costs?

5 . What is the forecasted average product cost next year?

6. What is the forecasted fixed cost per unit?

7. Why does the average product cost decrease as production increases?

EXERCISES Group B E2-30B Classify costs along the value chain for a retailer (Learning Objective 2)

Suppose Electronics Shack incurred the following costs at its Forest Lake, Minnesota, store.

Newspaper advertisements ................. ............. .......... .......... ....... ............. ........ . $ 5,700

Payment to consultant for advice on location of new store ............................. . $ 2,100

Purchases of merchandise ................. .......... ............. .......... ....... .......... ............. . . $36,000

Freight-in ........................................................................................................... . $ 3,500

Salespeople's salaries ........................................................................................ . $ 4,100

Depreciation expense on delivery trucks ............ .......... .......... ....... .......... ......... . $ 1,100

Research on whether store should sell satellite radio service ........................... . $ 500

Customer Complaint Department .................. .......... .............................. .......... . $ 550

Rearrangement of store layout ......................................................................... . $ 900

Requirements

1. Classify each cost as to which category of the value chain it belongs (R&D, Design, Purchases, Marketing, Distribution, Customer Service).

2. Compute the total costs for each value chain category .

3. How much are the total product costs?

E2-31 B Classify costs along the value chain for a manufacturer (Learning Objectives 2 & 4)

Suppose the smartphone manufacturer Sabre Electronics provides the following informa- tion for its costs last month (in millions):

Delivery expense to customers via UPS........................................................................... $10

Salaries of salespeople. ............ ................. .......... ............. .......... ....... .......... .......... ........... $ 6

Chipset (the set of chips used on a phone's motherboard) ........................................... .. $60

Exterior case for phone .................................................................................................... $ 4

Assembly-line workers' wages ......................................................................................... $12

Technical customer-support hotline ................................................................................. $ 5

Depreciation on plant and equipment ...... .......... ............. .......... ....... .......... .......... ........... $65

Rearrange production process to accommodate new robot ........................................... $ 1

1-800 (toll-free) line for customer orders ....... .......... ............. .......... ....... .......... ............. ... $ 3

Salaries of scientists who developed new model ........ .......... .............................. .......... .. $11

Building Blocks of Managerial Accounting 91

Requirements

1. Classify each of these costs according to its place in the value chain (R&D, Design, Production, Marketing, Distribution, or Customer Service) .

2. Within the production category, break the costs down further into three subcatego- ries : Direct Materials, Direct Labor, and Manufacturing Overhead .

3. Compute the total costs for each value chain category .

4. How much are the total product costs?

5. How much are the total prime costs?

6. How much are the total conversion costs?

E2-32B Value chain and sustainability efforts (Learning Objective 2) Each of the scenarios to follow describes some cost item for organizations in the recycled carpet industry . For each scenario, identify which function of the value chain that cost would represent (R&D, Design, Purchasing/Producing, Marketing, Distributing, or Customer Service) . Note: The companies and products used in this exercise are real com- panies with a strong sustainable practices commitment .

a. Flor®, a company that produces residential carpet tiles made from recycled carpet, has an R&R (return and recycle) Program . Homeowners can arrange to have old tiles picked up and shipped back to the plant for recycling . The cost of operating this R&R program would fall into which function in the value chain?

b. Los Angeles Fiber Company (LAFC) received the EPA/CARE award to recognize Los Angeles Fiber Company's sustainability efforts . Since 2000, LAFC has recycled more than 464 million pounds of post-consumer carpet. Its carpet brand, Reliance Carpet, is made entirely from post-consumer carpet fiber. The cost of promoting the company's products and its sustainability efforts would fall into which function in the value chain?

c. Ford Motor Company purchases cylinder head covers made from a nylon resin con- taining 100% recycled carpet in its Mustangs . The cost of the cylinder head covers would fall into which function in the value chain?

d. Axminster Carpets offsets the carbon emissions from its carpet distribution process by investing in renewable energy projects such as wind, power, and hydropower plants . This carbon offset is verified independently by the Voluntary Carbon Standard . The cost of these carbon offsets would fall into which function in the value chain?

e. Shaw Industries is a flooring manufacturer . It has created Cradle to Cradle Silver Cer- tified carpet, which is carpet that can be recycled back into new carpet again and again at the end of its useful life, or it can go back into the soil. The costs to develop the production process for the Cradle to Cradle Silver Certified carpet would fall into which function in the value chain?

f. Fibre(B)lock® Flooring is manufactured using the waste generated from the manufac- ture of commercial nylon carpet . The cost of the research into how to create Fibre (B)lock® Flooring would fall into which function in the value chain?

E2-33B Classify and calculate a manufacturer's costs (Learning Objectives 2 & 4) An airline manufacturer incurred the following costs last month (in thousands of dollars) .

a. Airplane seats ............................................................................................... . $ 300

b. Production supervisors' salaries ................................................................... . $ 110

c. Depreciation on forklifts in factory ............................................................... . $ 90

d. Machine lubricants ....................................................................................... . $ 30

e. Factory janitors' wages ................................................................................ . $ 50

f. Assembly workers' wages ............................................................................ . $ 630

g. Property tax on corporate marketing offices ............................................... . $ 20

h. Plant utilities ...... ........................................................................................... . $ 140

i. Cost of warranty repairs ............................................................................... . $ 230

j. Machine operators' health insurance ........................................................... . $ 40

k. Depreciation on administrative offices ........................................................ . $ 100

I. Cost of designing new plant layout ............................................................. . $ 160

m. Jet engines ................................................................................................... . $1,400

SUSTAINABILITY

92 CHAPTER 2

Requirements

1. Assuming the cost object is an airplane, classify eac h cost as one of the following : direct material (DM}, direct labor (DL}, indirect labor (IL}, indirect materials (IM}, other manu- facturing overhead (other MOH}, or period cost . What is the total for each type of cost?

2. Calculate total manufacturing overhead costs .

3. Calculate total product costs .

4. Calculate total prime costs .

5. Calculate total conversion costs .

6. Calculate total period costs .

E2-34B Construct an income statement using product and period costs (Learning Objectives 4 & 5)

Backyard Amenities is a manufacturer of backyard and deck furniture . Its products are in high demand, and it carries no inventory . To follow is a list of selected account balances from its trial balance for the most recent year ended December 31 (in no particular order) .

Salaries and wages (for administrative and sales staff} .......................................... . $ 38,100

Stain (used in manufacturing furniture) .................................................................. . $ 14,500

Indirect labor costs (wages of maintenance workers in factory) ............................ . $ 23,700

Other manufactu ring overhead (includes factory insurance and property taxes) .. $ 11,300

Rent and utilities (for administrative offices) .......................................................... . $ 13,200

Utility costs (related to factory) .............................................................................. . $ 12,100

Labor costs (wages of carpenters who build furniture) .......................................... . $ 33,700

Accounts receivable ............................................................................................... . $ 31,200

Marketing costs ...................................................................................................... . $ 15,200

Wood (used in manufacturing furniture) ................................................................ . $ 59,100

Sales revenues ........................................................................................................ . $ 267,000

Accounts payable ................................................................................................... . $ 8,200

Requirements Using the income statement accounts in the table, calculate :

1. Cost of goods sold . Hint: Cost of goods sold can be calculated by summing the total product costs since there is no inventory .

2. Operating expenses . Hint: Operating expenses are the company's period costs . 3. Gross profit

4. Operating income

E2-35B Work backward to find missing amounts (Learning Objective 5) Swift Electronics manufactures and sells smartphones . Unfortunately, the company recently suffered serious fire damage at its home office . As a result, the accounting records for October were partially destroyed and completely jumbled . Swift has hired you to help figure out the missing pieces of the accounting puzzle . Assume that Swift Elec- tronics' Raw Materials Inventory contains only direct materials .

Work in process inventory, October 31 .................................................................... .. $ 1,900

Finished goods inventory, October 1 ........................................................................ . $ 4,300

Direct labor in October .............................................................................................. . $ 3,300

Purchases of direct materials in October .................................................................. .. $ 9,700

Work in process inventory, October 1 ...................................................................... .. 0

Revenues in October .................................................................................................. . $27,500

Gross profit in October .............................................................................................. . $12,700

Direct materials used in October .............................................................................. .. $ 8,800

Raw materials inventory, October 31 .................... .......... .......... .............................. .. .. $ 3,200

Manufacturing overhead in October ......................................................................... . $ 6,300

Building Blocks of Managerial Accounting 93

Requirement Find the following amounts :

a. Cost of Goods Sold in October

b. Beginning Raw Materials Inventory

c. Ending Finished Goods Inventory

E2-36B Prepare a retailer's income statement (Learning Objective 5) Sam Peters is the sole proprietor of Charismatic Cats, a business specializing in the sale of high-end pet gifts and accessories . Charismatic Cats' sales totaled $1,060,000 during the most recent year . During the year, the company spent $53,000 on expenses relating to website maintenance, $33,200 on marketing, and $28,500 on wrapping, boxing, and shipping the goods to customers. Charismatic Cats also spent $636,000 on inventory purchases and an additional $19,500 on freight-in charges. The company started the year with $19,800 of inventory on hand and ended the year with $13,100 of inventory . Prepare Charismatic Cats' income statement for the most recent year.

E2-37B Compute direct materials used and Cost of Goods Manufactured (Learning Objective 5)

Laurel Industries is calculating its Cost of Goods Manufactured at year-end. The company's accounting records show the following: The Raw Materials Inventory account had a begin- ning balance of $14,000 and an ending balance of $19,000 . During the year, the company purchased $63,000 of direct materials . Direct labor for the year totaled $133,000 while man- ufacturing overhead amounted to $162,000 . The Work in Process Inventory account had a beginning balance of $25,000 and an ending balance of $24,000 . Assume that Raw Materials Inventory contains only direct materials . Compute the Cost of Goods Manufactured for the year. (Hint: The first step is to calculate the direct materials used during the year.)

E2-38B Compute Cost of Goods Manufactured and Cost of Goods Sold (Learning Objective 5)

Compute the Cost of Goods Manufactured and Cost of Goods Sold for Golden Bay Com- pany for the most recent year using the amounts described next . Assume that Raw Mate- rials Inventory contains only direct materials .

Beginning End of Year of Year

Raw materials inventory ..... ..... . $25,000 $33,000 Insurance on plant ...... .................... .......... .......... .

Work in process inventory ....... . $42,000 $36,000 Depreciation-plant building and equipment ... .

Finished goods inventory ........ . $21,000 $28,000 Repairs and maintenance-plant ....................... .

Purchases of direct materials .. . $79,000 Marketing expenses ........................................... .

Direct labor ............................. . $84,000 General and administrative expenses ................ .

Indirect labor ....... .......... .......... . $46,000

E2-39B Continues E2-38B: Prepare income statement (Learning Objective 5) Prepare the income statement for Golden Bay Company using the data in E2-38B for the most recent year . Assume that the company sold 39,000 units of its product at a price of $15 each during the year .

E2-40B Determine whether information is relevant (Learning Objective 6) Classify each of the following costs as relevant or irrelevant to the decision at hand and briefly explain your reason .

a. The cost of production when determining whether to continue to manufacture the screen for a smartphone or to purchase it from an outside supplier (old equipment will be sold if new equipment is purchased)

b. The cost of land when determining where to build a new call center

c. The average cost of vehicle operation when purchasing a new delivery van

d. Real estate property tax rates when selecting the location for a new order processing center

e. The purchase price of the old computer when replacing it with a new computer with improved features

End of Year

$ 7,500

$13,100

$ 4,400

$76,000

$26,500

94 CHAPTER 2

f. The cost of renovations when deciding whether to build a new office building or to renovate the existing office building

g. The original cost of the current stove when selecting a new, more efficient stove for a restaurant

h. Local tax incentives when selecting the location of a new office complex for a com- pany 's headquarters

i. The fair market value (trade-in value) of the existing forklift when deciding whether to replace it with a new, more efficient model

j. Fuel economy when purchasing new trucks for the delivery fleet

E2-41 B Compute total and average costs (Learning Objective 7) Crackling Soda spends $1 on direct materials, direct labor, and variable manufacturing overhead for every unit (12-pack of soda) it produces . Fixed manufacturing overhead costs $3 million per year . The plant, which is currently operating at only 85% of capacity, produced 20 million units this year. Management plans to operate closer to full capacity next year, producing 30 million units . Management doesn't anticipate any changes in the prices it pays for materials, labo r, or manufacturing overhead .

Requirements

1. What is the current total product cost (for the 20 million units}, including fixed and variable costs?

2. What is the current average product cost per unit?

3. What is the current fixed cost per unit?

4. What is the forecasted total product cost next yea r (for the 30 million units}, including fixed and variable costs?

5. What is the forecasted average product cost next year?

6. What is the forecasted fixed cost per unit?

7. Why does the average product cost decrease as production increases?

PROBLEMS Group A P2-42A Classify costs along the value chain (Learning Objective s 2 & 4)

Ravenna Cola produces a lemon-lime soda . The production process starts with workers mixing the lemon syrup and lime flavors in a secret recipe . The company enhances the combined syrup with caffeine . Finally, the company dilutes the mixture with carbonated water . Ravenna Cola incurs the following costs (in thousands) :

Plant janitors' wages ................................................................................................. . $ 1,100

Delivery truck drivers' wages .................................................................................... . $ 305

Payment for new recipe ............................................................................................ . $ 1,260

Depreciation on delivery trucks ................................................................................ . $ 250

Plant utilities .............................................................................................................. . $ 450

Lime flavoring .... .......... ............. ................. .......... ............. .......... ....... .......... .......... .... . $ 820

Rearrangement of plant layout ................................................................................. . $ 1,600

Bottles .......... .......... .......... ............. ....... .......... .......... ............. .......... ....... .......... ......... . $ 1,040

Salt ... .......................................................................................................................... . $ 50

Sales commissions ..................................................................................................... . $ 425

Production costs of "cents-off" store coupons for customers ........ ....... .......... ......... . $ 800

Lemon syrup .............................................................................................................. . $18,000

Replacement of products with expired dates upon customer complaint ................. . $ 30

Depreciation on plant and equipment ...................................................................... . $ 3,400

Wages of workers who mix syrup ......... .......... ............. .......... .......... ....... .................. . $ 8,300

Customer hotline ......... .......... .................... .......... .......... ............. ....... .......... .......... .... . $ 210

Freight-in on materials .............................................................................................. . $ 1,100

Building Blocks of Managerial Accounting 95

Requirements

1. Classify each of the listed costs according to its category in the value chain (R&D, Design, Production, Marketing, Distribution, or Customer Service) .

2. Further break down production costs into three subcategories : Direct Materials (DM), Direct Labor (DL}, or Manufacturing Overhead (MOH).

3. Compute the total costs for each value chain category .

4. How much are the total product costs?

5. Suppose the managers of the R&D and design functions receive year-end bonuses based on meeting their unit's target cost reductions . What are they likely to do? How might this affect costs incurred in other elements of the value chain?

P2-43A Determine ending inventory balances (Learning Objectives 5) Unique Displays designs and manufactures displays used in mobile devices . Serious flooding throughout the region affected Unique Displays' facilities . Inventory was com- pletely ruined, and the company's computer system, including all accounting records, was destroyed .

Before the disaster recovery specialists clean the buildings, Louise Ditchey, the company controller, is anxious to salvage whatever records she can to support an insurance claim for the destroyed inventory . She is standing in what is left of the Accounting Department with Trent Parker, the cost accountant .

"I didn't know mud could smell so bad," Trent says . "What should I be looking for?" "Don't worry about beginning inventory numbers," responds Louise . "We'll get them

from last year's annual report . We need first-quarter cost data ." "I was working on the first-quarter results just before the storm hit," Trent says . "Look,

my report's still in my desk drawer . But all I can make out is that for the first quarter, direct material purchases were $533,000 and that direct labor, manufacturing overhead (other than indirect materials}, and total manufacturing costs to account for were $551,000; $218,000; and $1,491,000, respectively . Wait, and cost of goods available for sale was $1,615,000 ."

"Great," says Louise . "I remember that sales for the period were approximately $1.8 million. Given our gross profit of 30%, that's all you should need ."

Trent is not sure about that but decides to see what he can do with this information . The beginning inventory numbers are as follows :

• Raw materials, $75,000

• Work in process, $226,000

• Finished goods, $213,000

He remembers several schedules he learned in college that may help him get started .

Requirement Use exhibits in the chapter to determine the ending inventories of raw materials, work in process, and finished goods . Assume that Raw Materials Inventory contains only direct materials .

P2-44A Prepare income statements (Learning Objective 5) Part One: In 2015, Patsy Jackson opened Patsy's Posies, a small retail shop selling floral arrangements . On December 31, 2016, her accounting records show the following :

Sales revenue ..................................................................................................... $53,000

Utilities for shop ................................................................................................. $ 1,100

Inventory on December 31, 2016 ...................................................................... $ 9,100

Inventory on January 1, 2016 ............................................................................. $12,000

Rent for shop ...................................................................................................... $ 4,600

Sales commissions .............................................................................................. $ 4,000

Purchases of merchandise .................................................................................. $36,000

Requirement Prepare an income statement for Patsy's Posies, a merchandiser, for the year ended December 31, 2016 .

96 CHAPTER 2

Part Two: Patsy's Posies was so successful that Patsy decided to manufacture her own brand of floral supplies : Floral City Manufacturing . At the end of December 2017, her accounting records show the following:

Utilities for plant .............................................................................................. . $ 4,900

Delivery expense ............................................................................................. . $ 1,500

Sales salaries expense ..................................................................................... . $ 4,300

Plant janitorial services .................................................................................... . $ 1,350

Work in process inventory, December 31, 2017 ............................................. . $ 5,000

Finished goods inventory, December 31, 2016 .............................................. . 0

Finished goods inventory, December 31, 2017 .............................................. . $ 2,500

Sales revenue .................................................................................................. . $104,000

Customer service hotline expense .................................................................. . $ 1,400

Direct labor ..................................................................................................... . $ 23,000

Direct material purchases ................................................................................ . $ 30,000

Rent on manufacturing plant .......................................................................... . $ 9,600

Raw materials inventory, December 31, 2016 ................................................ . $ 14,000

Raw materials inventory, December 31, 2017 ......... ....................................... . $ 8,000

Work in process inventory, December 31, 2016 ............................................. . 0

Requirements

1. Calculate the Cost of Goods Manufactured for Floral City Manufacturing for the year ended December 31, 2017 .

2. Prepare an income statement for Floral City Manufacturing for the year ended December 31, 2017 .

3. How does the format of the income statement for Floral City Manufacturing differ from the income statement of Patsy's Posies?

Part Three: Show the ending inventories that would appear on these balance sheets:

1. Patsy's Posies at December 31, 2016

2. Floral City Manufacturing at December 31, 2017

P2-45A Identify relevant information (Learning Objective 6) You receive two job offers in the same big city. The first job is close to your parents' house, and they have offered to let you live at home for a year so you won't have to incur expenses for housing, food, or cable and Internet . This job pays $49,000 per year . The second job is far from your parents' house, so you'll have to rent an apartment with park- ing ($8,500 per year), buy your own food ($3,250 per year), and pay for your own cable and Internet ($650 per year). This job pays $54,000 per year . You still plan to do laundry at your parents' house once a week if you live in the city, and you plan to go into the city once a week to visit with friends if you live at home . Thus, the cost of operating your car will be about the same either way . In addition, your parents refuse to pay for your cell phone service ($670 per year) .

Requirements

1. Based on this information alone, what is the net difference between the two alterna- tives (salary, net of relevant costs)?

2. What information is irrelevant? Why?

3. What qualitative information is relevant to your decision?

4. Assume that you really want to take Job #2, but you also want to live at home to cut costs . What new quantitative and qualitative information will you need to incorporate into your decision?

P2-46A Calculate the total and average costs (Learning Objective 7) The owner of Marshall Restaurant is disappointed because the restaurant has been aver- aging 7,500 pizza sales per month, but the restaurant and wait staff can make and serve 10,000 pizzas per month . The variable cost (for example, ingredients) of each pizza is

Building Blocks of Managerial Accounting 97

$1.55. Monthly fixed costs (for example, depreciation, property taxes, business license, and manager's salary) are $12,000 per month. The owner wants cost information about different volumes so that some operating decisions can be made .

Requirements

1. Fill in the following chart to provide the owner with the cost information . Then use the completed chart to help you answer the remaining questions.

Monthly pizza volume ........................................................... 6,000

Total fixed costs ..................................................................... $

Total variable costs ............................................................... .

Total costs ............................................................................. .

Fixed cost per pizza .............................................................. $

Variable cost per pizza .............. .......... .......... ............ ........ ... .

Average cost per pizza ......................................................... .

Selling price per pizza ........................................................... $ 6 .25

Average profit per pizza ............ .......... .......... ............ ........... .

7,500

$

$

$ 6.25

10,000

$

$

$ 6 .25

2. From a cost standpoint, why do companies such as Marshall Restaurant want to oper- ate near or at full capacity?

3. The owner has been considering ways to increase the sales volume . The owner thinks that 10,000 pizzas could be sold per month by cutting the selling price per pizza from $6 .25 to $5.75 . How much extra profit (above the current level) would be generated if the selling price were to be decreased? (Hint: Find the restaurant's current monthly profit and compare it to the restaurant's projected monthly profit at the new sales price and volume .)

PROBLEMS Group B P2-47B Classify costs along the value chain (Learning Objectives 2 & 4)

Crystal Cola produces a lemon-lime soda . The production process starts with workers mixing the lemon syrup and lime flavors in a sec ret recipe . The company enhances the combined syrup with caffeine . Finally, the company dilutes the mixture with carbonated water. Crystal Cola incurs the following costs (in thousands):

Delivery truck drivers' wages ......................................................................... . $ 285

Lemon syrup ................................................................................................... . $16,000

Depreciation on delivery trucks ..................................................................... . $ 175

Lime flavoring ................................................................................................. . $ 1,020

Payment for new recipe ....... .......... .......... .......... .......... .......... .......... .......... .... . $ 1,090

Customer hotline ............................................................................................ . $ 220

Sales commissions ........ ............. .......... .......... .................... .......... .......... ......... . $ 450

Production costs of "cents-off" store coupons for customers ....................... . $ 630

Rearrangement of plant layout ...................................................................... . $ 1,200

Freight-in on materials .............. .......... .......... .................... .......... .......... ......... . $ 1,300

Depreciation on plant and equipment ........................................................... . $ 2,900

Bottles ............................................................................................................ . $ 1,490

Salt .................................................................................................................. . $ 15

Plant utilities ................................................................................................... . $ 1,250

Wages of workers who mix syrup ............ .......... .......... .......... .......... .......... .... . $ 7,900

Plant janitors' wages ...................................................................................... . $ 1,000

Replacement of products with expired dates upon customer complaint ...... . $ 40

98 CHAPTER 2

Requirements

1. Classify each of the listed costs according to its category in the value chain (R&D, De- sign, Production, Marketing, Distribution, or Customer Service) .

2. Further break down production costs into three subcategories : Direct Materials (DM), Direct Labor (DL}, or Manufacturing Overhead (MOH).

3. Compute the total costs for each value chain category .

4. How much are the total product costs?

5. Suppose the managers of the R&D and design functions receive year-end bonuses based on meeting their unit's target cost reductions . What are they likely to do? How might this affect costs incurred in other elements of the value chain?

P2-48B Determine ending inventory balances (Learning Objective 5) Finney Displays designs and manufactures displays used in mobile devices. Serious flood- ing throughout the region affected Finney Displays' facilities . Inventory was completely ruined, and the company's computer system, including all accounting records, was destroyed .

Before the disaster recovery specialists clean the buildings, Heather Bailey, the company controller, is anxious to salvage whatever records she can to support an insur- ance claim for the destroyed inventory. She is standing in what is left of the Accounting Department with Tad Myers, the cost accountant.

"I didn't know mud could smell so bad," Tad says . "What should I be looking for?" "Don't worry about beginning inventory numbers," responds Heather . "We'll get

them from last year's annual report . We need first-quarter cost data ." "I was working on the first-quarter results just before the storm hit," Tad says . "Look,

my report's still in my desk drawer. But all I can make out is that for the first quarter, direct material purchases were $524,000 and that direct labor, manufacturing overhead (other than indirect materials}, and total manufacturing costs to account for were $545,000; $218,000; and $1,508,000, respectively . Wait, and cost of goods available for sale was $1,615,000 ."

"Great," says Heather . "I remember that sales for the period were approximately $1 .6 million. Given our gross profit of 15%, that's all you should need ."

Tad is not sure about that but decides to see what he can do with this information. The beginning inventory numbers are as follows:

• Raw materials, $85,000

• Work in process, $187,000

• Finished goods, $209,000

He remembers several schedules he learned in college that may help him get started .

Requirement Use exhibits in the chapter to determine the ending inventories of raw materials, work in process, and finished goods. Assume that the Raw Materials Inventory contains only direct materials .

P2-49B Prepare income statements (Learning Objective 5) Part One: In 2015, Fran Lexa opened Fran's Flowers, a small shop selling floral arrange- ments. On December 31, 2016, her accounting records show the following:

Sales revenue ......... .......... ................. .......... ............. .......... ....... .......... ............. .. $53,000

Utilities for shop ................................................................................................. $ 1,000

Inventory on December 31, 2016 ...................................................................... $ 9,200

Inventory on January 1, 2016 ............................................................................. $12,600

Rent for shop ...................................................................................................... $ 4,400

Sales commissions .............................................................................................. $ 4,100

Purchases of merchandise. ................................................................................. $38,000

Requirement Prepare an income statement for Fran's Flowers, a merchandiser, for the year ended December 31, 2016 .

Building Blocks of Managerial Accounting 99

Part Two: Fran 's Flowers succeeded so well that Fran decided to manufacture her own brand of floral supplies : Floral Place Manufacturing . At the end of December 2017, her accounting records show the following :

Utilities for plant ............................................................................................ . $ 4,300

Delivery expense ........................................................................................... . $ 3,800

Sales salaries expense ..... .......... .......... .......... ............ ........ ..... ..... ..... ..... ........ . $ 4,800

Plant janitorial services .................................................................................. . $ 1,250

Work in process inventory, December 31, 2017 ........................................... . $ 4,000

Finished goods inventory, December 31, 2016 .... ............. ......... ..... ..... ........ . 0

Finished goods inventory, December 31, 2017 ......... .......... .......... ............. .. . $ 4,500

Sales revenue ............... ............. .......... .......... .................... .......... .......... ........ . $109,000

Customer service hotline expense .................... ................. .......... ............. .... . $ 1,700

Direct labor ................................................................................................... . $ 22,000

Direct material purchases ..... ..... .......... ........ ................. ..... .......... .......... ........ . $ 31,000

Rent on manufacturing plant ..... ........................................ ........................... . $ 9,400

Raw materials inventory, December 31, 2016 .............................................. . $ 18,000

Raw materials inventory, December 31, 2017 .............................................. . $ 7,500

Work in process inventory, December 31, 2016 ............... .... ...... .... ...... ........ . 0

Requirements

1. Calculate the cost of goods manufactured fo r Floral Place Manufacturing for the year ended December 31, 2017 .

2. Prepare an income statement for Floral Place Manufacturing for the year ended De- cember 31, 2017 .

3. How does the format of the income statement for Floral Place Manufacturing differ from the income statement of Fran's Flowers?

Part Three: Show the ending inventories that would appear on these balance sheets :

1. Fran's Flowers at December 31, 2016 .

2. Floral Place Manufacturing at December 31, 2017 .

P2-50B Identify relevant information (Learning Objective 6) You receive two job offers in the same big city . The first job is close to your parents' house, and they have offered to let you live at home for a year so you won't have to incur expenses for housing, food, or cable and Internet . This job pays $42,000 per year . The second job is far away from your parents' house, so you'll have to rent an apartment with parking ($12,000 per year}, buy your own food ($3,000 per year}, and pay for your own cable and Internet ($800 per year) . This job pays $47,000 per year . You still plan to do laundry at your parents' house once a week if you live in the city and plan to go into the city once a week to visit with friends if you live at home . Thus, the cost of operating your car will be about the same either way . Additionally, your parents refuse to pay for your cell phone service ($740 per year) .

Requirements

1. Based on this information alone, what is the net difference between the two alterna- tives (salary, net of relevant costs)?

2. What information is irrelevant? Why?

3. What qualitative information is relevant to your decision?

4. Assume you really want to take Job #2, but you also want to live at home to cut costs . What new quantitative and qualitative information will you need to incorporate in your decision?

100 CHAPTER 2

P2-51 B Calculate the total and average costs (Learning Objective 7) The owner of Yoders Restaurant is disappointed because the restaurant has been aver- aging 8,000 pizza sales per month but the restaurant and wait staff can make and serve 10,000 pizzas per month . The variable cost (for example, ingredients) of each pizza is $1 .45 . Monthly fixed costs (for example, depreciation, property taxes, business license, manager's salary) are $10,000 per month . The owner wants cost information about differ- ent volumes so that some operating decisions can be made .

Requirements

1. Fill in the chart to provide the owner with the cost information . Then use the com- pleted chart to help you answer the remaining questions .

Monthly pizza volume.. ...................................... ..... $5,000 $8,000 $10,000

Total fixed costs ............. ................. ............. .......... . .

Total variable costs ................................................. .

Total costs ............................................................... .

Fixed cost per pizza ...... ................. ............. .......... .. $ $ $

Variable cost per pizza ................ .......... ............. .... .

Average cost per pizza ........................................... .

Selling price per pizza ............................................. $ 6 .25 $ 6 .25 $ 6 .25

Average profit per pizza ......................................... .

2. From a cost standpoint, why do companies such as Yoders Restaurant want to operate near or at full capacity?

3. The owner has been considering ways to increase the sales volume. The owner thinks that 10,000 pizzas could be sold per month by cutting the selling price from $6.25 per pizza to $5.75. How much extra profit (above the current level) would be generated if the selling price were to be decreased? (Hint: Find the restaurant's current monthly profit and com- pare it to the restaurant's projected monthly profit at the new sales price and volume.)

Serial Case C2-52 Calculate operating income (Learning Objective 5)

This case is a continuation of the Caesars Entertainment Corporation serial case that began in Chapter 1. Refer to the introductory story in Chapter 1 (see page 43) for additional back- ground. (The components of the Caesars serial case can be completed in any order.)

What follows is a table listing condensed revenue and expense figures for Caesars Enter- tainment Corporation for the years ending December 31, 2012 through 2014 .

2014 2013 2012 Food and beverage expenses $ 694 $ 639 $ 634

Other revenues 369 73 (315)

Casino expenses 3,253 3,112 3,368

Food and beverage revenue 1,522 1,451 1,438

Rooms expenses 315 296 289

Miscellaneous expenses 4,706 6,199 3,761

Casino revenue 5,418 5,529 5,916

Rooms revenue 1,207 1,167 1,147

Requirements

1. Using the data provided, construct income statements for each of the three years; in- clude the proper headings .

2. Did Caesars's operating income increase or decrease over the three-year period presented?

3. Which division, Food and Beverage, Casino, Rooms, or Other generated the most reve- nue for Caesars in 2014? Which division generated the most operating income in 2014?

CRITICAL THINKING Discussion & Analysis A2-53 Discussion Questions

Building Blocks of Managerial Accounting 101

1. Briefly describe a service company, a merchandising company, and a manufacturing com- pany . Give an example of each type of company, but do not use the same examples as given in the chapter .

2. How do service, merchandising, and manufacturing companies differ from each other? How are service, merchandising, and manufacturing companies similar to each other? List as many similarities and differences as you can identify .

3. What is the value chain? What are the six types of business activities found in the value chain? Which type(s) of business activities in the value chain generate costs that go directly to the income statement once incurred? What type(s) of business activities in the value chain generate costs that flow into inventory on the balance sheet?

4. Compare direct costs to indirect costs . Give an example of a cost at a company that could be a direct cost at one level of the organization but would be considered an indirect cost at a different level of that organization . Explain why this same cost could be both direct and indirect (at different levels) .

5. What is meant by the term product costs? What is meant by the term period costs? Why does it matter whether a cost is a product cost or a period cost?

6. Compare product costs to period costs . Using a product of your choice, give examples of product costs and period costs . Explain why you categorized your costs as you did .

7. Describe how the income statement of a merchandising company differs from the income statement of a manufacturing company . Also comment on how the income statement from a merchandising company is similar to the income statement of a manufacturing company .

8. How are the cost of goods manufactured, the cost of goods sold, the income statement, and the balance sheet related for a manufacturing company? What specific items flow from one statement or schedule to the next? Describe the flow of costs between the cost of goods manufactured, the cost of goods sold, the income statement, and the balance sheet for a manufacturing company .

9. What makes a cost relevant or irrelevant when making a decision? Suppose a company is evaluating whether to use its warehouse for storage of its own inventory or whether to rent it out to a local theater group for housing props . Describe what information might be relevant when making that decision .

10. Explain why" differential cost" and "variable cost" do not have the same meaning . Give an example of a situation in which there is a cost that is a differential cost but not a vari- able cost .

11. Greenwashing, the practice of overstating a company's commitment to sustainability, has been in the news over the past few years . Perform an on line search of the term green- washing . What examples of greenwashing can you find?

12. Ricoh is a company that has designed its copiers so that at the end of the copier's life, Ricoh will collect and dismantle the product for usable parts, shred the metal casing, and use the parts and shredded material to build new copiers . This product design can be called "cradle-to-cradle" design . Are there any other products you are aware of that have such a design? Perform an online search for "cradle-to-cradle design" or a related term if you need ideas .

1 02 CHAPTER 2

Application & Analysis Mini Cases

A2-54 Costs in the value chain at a real company and cost objects Choose a company with which you are familiar that manufactures a product . In this activity, you will be making reasonable assumptions about the activities involved in the value chain for this product; companies do not typically publish information about their value chains .

Basic Discussion Questions

1. Describe the product that is being produced and the company that produces it.

2. Describe the six value chain business activities that this product would pass through from its inception to its ultimate delivery to the customer .

3. List at least three costs that would be incurred in each of the six business activities in the value chain .

4. Classify each cost you identified in the value chain as being either a product cost or a period cost . Explain your justification .

5. A cost object can be anything for which managers want a separate measurement of cost . List three different potential cost objects other than the product itself for the company you have selected .

6. List a direct cost and an indirect cost for each of the three different cost objects in ques- tion 5 . Explain why each cost would be direct or indirect .

A2-55 Ethics involved with assigning costs to inventory (Learning Objectives 4 & 5) Brandon is the production manager of a large manufacturing firm. He is worried about the prospect of bonuses for the upcoming year . The company has paid out bonuses for the past ten years, so Brandon has been counting on the bonus to help pay some debts he has accumulated over the year . In addition, Brandon and his wife are expecting their first baby in two months . Due to the unexpected downturn in sales, bonuses appear to be unlikely this year.

Ryan is the accounting manager for the company . He and Brandon are good friends . Over lunch one day, Brandon confides in Ryan about his financial difficulties . He is stressed out over the bills and the baby on the way . He really needs that bonus .

Ryan wants to help Brandon . Ryan has been with the company for many years and knows that fundamentally the company is strong . This year is just an unusual year . He thinks about ways that he can help Brandon . Brandon is a good employee, and the company does not want to lose him if he were to go to work for a competitor .

Ryan thinks about how he can best help Brandon . He thinks about a few different options, including the following:

Option #1: Ryan could increase income for the year by adding sales commission costs and advertising costs to the products . If he does this, the product cost will be higher . However, there is still a large inventory of units on hand . The units that are still in ending inventory will shield these costs from decreasing net income until the units are sold in a future year. Option #2: Ryan could quietly make Brandon a loan from the company to help him get back on his feet. The company does not have a policy prohibiting loans to employees, but neither does it have a policy of allowing such loans to employees .

Ryan does not know what to do.

Requirements Using the IMA Statement of Ethical Professional Practice as an ethical framework, answer the following questions :

a. If Ryan were to increase income by adding sales commission costs and advertising costs to product costs as described in Option #1, what ethical principles would be violated?

b. If Ryan were to make a company loan to Brandon (Option #2), what, if any, ethical principles would be violated?

c. What do you think Ryan should do in this situation?

Building Blocks of Managerial Accounting 103

A2-56 Cost definitions (Learning Objectives 1, 2, 3, & 4) During 2015, the price that Starbucks paid its suppliers for its coffee decreased . Despite the decrease in coffee costs, Starbucks raised the prices of its brewed coffee across the United States by an average of about 1 % in 2015 .14 Starbucks did not raise prices for its bagged coffee sold at grocery stores and at Starbucks stores.

In many of the regions in which Starbucks operates, laws have been passed to raise the minimum wage . In addition, the real estate market has recovered in several cities, causing the cost of retail space to increase . Starbucks also started an initiative in 2015 to cover the full cost of an on line degree for its U.S. employees who work at least 20 hours per week .

Requirements

1. Would you consider Starbucks to be a service company, a merchandiser, a manufac- turer, or some combination thereof? Support your answer with specific examples .

2. Describe the value chain for a cup of coffee at Starbucks . Use your imagination and brainstorm possible costs at each phase of the value chain . Where are the cost increases occurring in that value chain? Where are the cost decreases occurring in the value chain?

3. Think about a Starbucks cafe in Bellevue, Tennessee, and a cup of coffee served and consumed in that cafe .

a. What costs would be included in the cost of a cup of coffee served in the cafe? Separate these costs into direct materials, direct labor, and overhead costs. Which type(s) of costs (direct materials, direct labor, or overhead costs) would have increased in 2015 for Starbucks? Which type(s) would have decreased in 2015?

b. What are the direct costs of a cup of coffee, assuming that the cost object is the Bellevue location? What are the indirect costs of that same cup of coffee for the Bellevue location?

c. Assume now that the cost object is the Starbucks corporation itself . What costs of that cup of coffee will now be reclassified as direct (as compared to using the Bellevue location as the cost object)?

4. Now think about a Starbucks cafe in Bellevue, Tennessee, and a pound of bagged ground coffee sold in that cafe (assume that the beans are ground in the store at the time of sale).

a. What costs are included in the cost of a pound of bagged ground coffee sold at the Bellevue location? Separate these costs into direct materials, direct labor, and overhead costs.

b. What are the direct costs of a pound of bagged ground coffee (to be sold to consumers), assuming that the cost object is the Bellevue location? What are the in- direct costs of that same pound of bagged ground coffee for the Bellevue location?

c. Assume now that the cost object is the Starbucks corporation itself . What costs of that bagged ground coffee will now be reclassified as direct (as compared to using the Bellevue location as the cost object)?

Try It Solutions page 57:

Only those costs that can be traced directly to the Pro- duce Department would be considered direct costs: 2, 3, 5, 6 and 8 . All other costs (1, 4, and 7) would be consid- ered indirect costs because they are part of the cost of selling produce at the store, yet cannot be traced directly to the Produce Department .

page 59:

The only costs that become inventoriable costs of the product are numbers 3, 5, and 8. All other costs are classified as period costs, which are shown as "operating expenses" on the income statement.

page 67:

Beginning inventory

Plus: Purchases of merchandise

Freight-in and import duties

Cost of goods available for sale

Less: Ending inventory

Cost of goods sold

14Source: "Starbucks Raises Prices Despite Declining Coffee Costs," The Wall Street Journal, July 6, 2015.

REAL LIFE

$ 35,000

400,000

20,000

455,000

38,000

$417,000

Job Costing

Learning Objectives

• 1 Distinguish between job costing and process costing

• 2 Understand the flow of production and how direct materials and direct labor are traced to jobs

• 3 Compute a predetermined manufacturing overhead rate and use it to allocate MOH to jobs

Nithid Memanee / Shutterstock

Sources: Brunswick Corp. 2015 10(k) filing; http:// lifefitness.com

• 4 Determine the cost of a job and use it to make business decisions

• 5 Compute and dispose of overallocated or underallocated manufacturing overhead

• 6 Prepare journal entries for a manufacturer's job costing system

• 7 (Appendix) Use job costing at a service firm as a basis for billing clients

With annual sales of over $794 million, Life Fitness, a division of the Brunswick Corporation, is the world's largest manufacturer of commercial fitness equipment

and a global leader in consumer fitness equipment . The company began in the 1970s by intro-

ducing the world's first-ever computerized stationary exercise bicycle . Since then, the company

has grown to design and manufacture hundreds of different products, including treadmills, ellip-

tical cross-trainers, stair climbers, strength equipment, and, of course, exercise bikes . While the

company's growth has been propelled in part by consumers' ever-increasing zeal for personal

fitness, the company has also grown through carefully analyzing the profit margins on each of its

products and adjusting its operations accordingly .

How do managers determine the profit margins on each ofthe company's different models of-fitness

equipment? Managers first determine how much it costs to manufacture a batch of each model. Each

batch of units produced is called a "job ." The company's job costing system traces the cost of direct ma-

terials and direct labor used to each job . It also allocates some manufacturing overhead to each job . By

adding up the direct materials, direct labor, and manufacturing overhead assigned to each job, the com-

pany can determine the cost of the job, as well as the average cost of each unit in the job. The company

then uses this information to prepare the company's financial reports and make vital business decisions.

Whether you plan a career in marketing, engineering, production, general management, or accounting, you'll need to understand how much each of the company's products cost to produce. This chapter will show you the way companies determine their product costs when they make unique products or products made in relatively small batches.

What Methods Are Used to Determine the Cost of Manufacturing a Product? Most manufacturers use one of two product costing systems in order to find the cost of producing their products:

• Process costing

• Job costing

The end goal of both product costing systems is the same: to find the cost of manu- facturing one unit of the product. However, the manner in which this goal is achieved differs. Management chooses the product costing system that works best for its particular manufacturing environment. Let's go over the basics of each system and identify the types of companies that would be most likely to use them.

Process Costing Process costing is used by companies that produce extremely large numbers of identical units through a series of uniform production steps or processes. Because each unit is identi- cal, in theory, each unit should cost the same to make. In essence, process costing averages manufacturing costs across all units produced so that each identical unit bears the same cost.

For example, let's assume Pace Foods uses two processes to make picante sauce: (1) cleaning and chopping vegetables and (2) mixing and bottling the sauce. First, Pace accumulates all manufacturing costs incurred in the cleaning and chopping process over a period of time, such as a month. The costs incurred in this process include the cost of the vegetables themselves, as well as the cost of cleaning and chopping the vegetables. Next, the company averages the total costs of this process over all units passing through the process during the same period of time.

For example, let's say Pace spends $500,000 on purchasing, cleaning, and chopping the vegetables to make 1 million jars of picante sauce during the month. The average cost per jar of the cleaning and chopping process is as follows:

A . f h 1 . d h . $500,000 $0 50 . verage cost per 1ar o t e c eanmg an c oppmg process = l,000,000 jars = . per Jar

Now the cleaned and chopped vegetables go through the second production process, mixing and bottling, where a similar calculation is performed to find the average cost of that process. The cost of the second process would include any direct materials used, such as the cost of the glass jars, as well as the cost of mixing the sauce and filling the jars with the sauce. Let's say the average cost to mix and bottle each jar of sauce is $0.25.

Now Pace can determine the total cost to manufacture each jar of picante sauce:

' ~· .. -::.-. -' • \\iio;;,'Q.; ---:-• - -~f{f

+

Mixing and Bottling:

Manufacturing Cost

I ANl\ E $0.75 par jar

Job Costing 105

1 Dist inguish between ··. job costing and · process costing

1 06 CHAPTER 3

Each jar of picante sauce is identical to every other jar, so each bears the same aver- age cost: $0.75. Once managers know the cost of manufacturing each jar of sauce, they can use that information to help set sales prices and make other business decisions. To generate a profit, the sales price will have to be high enough to cover the $0.75 per jar product cost as well as the company's operating costs incurred in other areas of the value chain, including research and development (R&D), design, marketing, distribution, and customer service. We'll delve more deeply into process costing in Chapter 5. For now, just remember that any company that mass-produces identical units of product will most likely use process costing to determine the cost of making each unit.

II Why is this important? Job Costing Whereas process costing is used by companies that mass-manu- facture identical units, job costing (also called job order costing) is used by companies that produce unique, custom-ordered prod- ucts, or relatively small batches of different products. Each unique product or batch of units is considered a separate "job." Different jobs can vary considerably in direct materials, direct labor, and manufacturing overhead costs, so job costing tracks these costs separately for each individual job. For example, Life Fitness pro- duces hundreds of different models of fitness equipment, includ- ing cross-trainers, bikes, stairclimbers, and strength equipment. Each model is produced in relatively small, separate batches. Each batch is considered a separate job. Job costing would also be used by Boeing (airplanes), custom-home builders (unique houses),

"Managers need the most accurate

cost information they can get in order to make good business decisions . They will choose a costing system (usually job costing or process costing ) based on which system best fits their

operations." high-end jewelers (unique jewelry), furniture manufacturers (so- fas and chairs with different fabrics), and any other manufactur- ers that build relatively unique products in small batches.

Job costing is not limited to manufacturers. Professional service providers such as law firms, accounting firms, consulting firms, and marketing firms use job costing to determine the cost of serving each client. People working in trades, such as mechanics, plumbers, and electricians, also use job costing to determine the cost of performing separate jobs for clients. In both cases, the job cost is used as a basis for billing the client. The appendix to this chapter illustrates a complete example of how a law firm would use job costing to bill its clients.

In summary, companies use job costing when their products or services vary in terms of materials needed, time required to complete the job, and/or the complexity of the pro- duction process. Because the jobs are so different, it would not be reasonable to assign them equal costs. Therefore, the cost of each job is compiled separately. We'll spend the rest of this chapter looking at how companies compile, record, and use job costs to make important business decisions. Before moving on, take a look at Exhibit 3-1, which sum- marizes the key differences between job and process costing.

EXHIBIT 3-1 Differences Between Job and Process Costing

Cost object:

Outputs:

Extent of averaging:

Job Costing

Job

Single units or small batches with

large differences between jobs

Less averaging--costs are

averaged over the small

number of units in a job

(often one unit in a job)

Process Costing

Process

Large quantities of identical units

More averaging--costs are

averaged over the thousands or

millions of identical units

that pass through each process

Do all manufacturers use job costing or process costing systems?

Answer: Some manufacturers use a hybrid of these two costing systems if neither "pure" system reflects their production environment very well. For example, clothing manufacturers often mass-produce the same product over and over (dress shirts) but use different materi- als on different batches (cotton fabric on one batch and silk fabric on another) . Apple allows consumers to custom order computers with different choices on memory, storage, screen size, and so forth . Mass customization is large-scale production that allows manufacturers to meet a variety of consumer desires, while at the same time achieving the efficiencies of mass production (economies of scale) that drive down unit costs . A hybrid costing system suitable to mass customization would include some elements of a process costing system (averaging labor and manufacturing overhead costs across all units) and some elements of a job costing system (tracing different fabric costs to different batches; tracing different components to different build-to-order computers).

How Do Manufacturers Determine a Job's Cost? As we've just seen, manufacturers use job costing if they produce unique products or relatively small batches of different products. Life Fitness produces hundreds of different models in relatively small batches, so it considers each batch a separate job. In this sec- tion, we will show you how Life Fitness would determine the cost of producing Job 603, a batch of 50 identical X4 Elliptical Cross-Trainers. 1 The company's market for these cross-trainers includes health and fitness clubs, student fitness centers on college cam- puses, professional athletic teams, hotels, city recreation departments, and direct sales to customers for home fitness gyms. As we walk through the process, keep in mind that most companies maintain the illustrated documents in electronic, rather than hard copy , form. Even so, the basic information stored in the documents and the purpose for the documents remain the same.

Overview: Flow of Inventory Through a Manufacturing System Before we delve into Life Fitness's job costing system, let's take a quick look at how the physical products, as well as costs, flow through the company. As you learned in Chapter 2, manufacturers such as Life Fitness maintain three separate types of inventory: raw materi- als, work in process, and finished goods. The cost of each of these inventories is reflected on the company's balance sheet.

As shown in Exhibit 3-2, the raw materials (RM) inventory is maintained in a store- room in or near the factory until the materials are needed in production. As soon as these materials are transferred to the factory floor, they are no longer considered raw materials because they have become part of the work in process in the factory. The work in process (WIP) inventory consists of all products that are partway through the production process. As soon as the manufacturing process is complete, the products are moved out of the factory and into a finished goods (FG) inventory storage area, or warehouse, where they will await sale and shipment to a customer. Finally, when the products are shipped to cus- tomers, the cost of manufacturing those products becomes the Cost of Goods Sold (CGS) shown on the company's income statement.

1 All references to Life Fitness in this hypothetical example were created by the author solely for academic pu r- poses and are not intended, in any way, to represent the actual business practices of, or costs incurred by, Life Fitness, Inc.

Job Costing 107

2 Understand the flov-i·. of production and how direct materia ls and · direct labor are traced to jobs

1 08 CHAPTER 3

EXHIBIT 3-2 Flow of Inventory Through a Manufacturing System

RM ____ _ - Inv.

FACTORY

WIP Inventory ______ FG Cost of

Inv. ----- Goods Sold

(materials kept in storeroom

until needed)

(all products currently being worked on

in the factory)

(all finished, unsold products)

(when products are sold)

Keep the basic flow of inventory shown in Exhibit 3-2 in mind as we delve into Life Fitness's job costing system.

Scheduling Production Job costing begins with management's decision to produce a batch of units. Sometimes companies produce a batch of units just to meet a particular customer order. For example, the Chicago Bears may custom order treadmills that have characteristics not found on other models. This batch of unique treadmills would become its own job. On the other hand, most companies also produce stock inventory for products they sell on a regular basis. They want to have stock available to quickly fill customer orders. By forecasting demand for the product, the manufacturer is able to estimate the number of units that should be produced during a given time period. As shown in Exhibit 3-3, the production schedule indicates the quantity and types of inventory that are scheduled to be manufac- tured during the period. Depending on the company, the types of products it offers, and the production time required, production schedules may cover periods of time as short as one day (Dell, producing customized laptops), several months (Boeing, manufacturing 737 airplanes), or several years (bridges, roads, large commercial buildings and stadiums).

EXHIBIT 3-3 Month ly Production Schedu le

Production Schedule For the Month of December

Job Model Number Stock or

Quantity Customer

603 X4 Cross-Trainer For stock 50

604 TS Treadmill For stock 60

605 Custom T6-C Treadmill Chicago Bears 15

606 Custom S3-C Stair-Climber Chicago Bears 12

FACTORY CLOSED FOR

HOLIDAYS and ANNUAL

MAINTENANCE

Scheduled Scheduled Start Date End Date

12/2 12/6

12/7 12/17

12/18 12/21

12/22 12/24

12/25 12/31

The production schedule is very important in helping management determine the direct labor and direct materials needed during the period. To complete production on time, managers must ensure they have the right amounts and types of raw materials and skilled labor available to meet production requirements.The next section shows how this is accomplished.

Purchasing Raw Materials Production engineers prepare a bill of materials for each job. The bill of materials is like a recipe card: It simply lists all of the raw materials needed to manufacture the job. Exhibit 3-4 illustrates a partial bill of materials for Job 603:

EXHIBIT 3-4 Bil l of Materia ls (Partial Listing)

Bill of Materials Job:603

Model: X4 Elliptical Cross-Trainer Quantity: 50 units

Part Description

Quantity Number Needed

HRM50812 Heart rate monitor 50

LCD620 LCD enterta inment screen 50

B4906 Front and rear roller base 100

HG2567 Hand grips 100

FP689 Foot platform 100

Etc . .____ ________ ~

After the bill of materials has been prepared, the purchasing department checks the raw materials inventory to determine which raw materials needed for the job are currently in stock and which raw materials must be purchased. As shown in Exhibit 3-5, a raw materials record shows detailed information about each item in stock, including the number of units received, the number of units used, and the running balance of units currently in stock. Additionally, the raw materials record shows the cost of each unit purchased, the cost of each unit used, and the cost of the units currently in the raw materials inventory.

EXHIBIT 3-5 Raw Materials Record

Raw Materials Record

Item No.: HRM50812 Description: Heart rate mon itor

Received Used Balance

Date Units Cost Total Requisition

Units Cost Total Units Cost Total Number

11-25 100 $60 $6,000 100 $60 $6,000

11-30 #7235 70 $60 $4,200 30 $60 $1,800

According to the raw materials record pictured in Exhibit 3-5, only 30 heart rate moni- tors are currently in stock. However, the bill of materials shown in Exhibit 3-4 indicates that 50 heart rate monitors are needed for Job 603. Therefore, the purchasing department will need to buy 20 more monitors. The purchasing department must also consider other jobs that will be using heart rate monitors in the near future, as well as the time it takes to obtain the monitors from the company's suppliers. According to the production schedule, Job 603

Job Costing 109

11 0 CHAPTER 3

is scheduled to begin production on December 2; therefore, the purchasing department must make sure all necessary raw materials are on hand by that date.

Life Fitness's purchasing department will issue a purchase order to its suppliers for any needed parts. Incoming shipments of raw materials are counted and then recorded on a receiving report, as well as on the individual raw materials records. The receiving report is typically a duplicate of the purchase order, except it does not pre-list the quantity of parts ordered. The quantity ordered is intentionally left blank to ensure the receiving dock personnel will actually count and record the quantity of materials received. Progressive companies use bar-coding systems to electronically update the raw materials records as soon as incoming shipments are received.

Life Fitness's accounting department will not pay the invoice (bill from the supplier) unless the amount billed agrees with the quantity of parts both ordered and received. By matching the purchase order, receiving report, and invoice, Life Fitness ensures that it pays for only those parts that were ordered and received, and nothing more. This is an impor- tant control that helps companies avoid scams in which businesses are sent and billed for inventory that was not ordered.

In addition to tracking the current level of individual inventory items, the raw materials records also form the basis for valuing the Raw Materials Inventory account found on the balance sheet. On a given date, by adding together the balances in the individual raw materi- als records, the company is able to substantiate the total Raw Materials Inventory shown on the ba lance sheet. For example, as shown in Exhibit 3-6, on November 30, Life Fitness had $1,800 of heart rate monitors in stock, $24,000 of LCD entertainment screens, $1,200 of roller bases, and so forth. When added together, these individual balances sum to the Raw Materials Inventory balance shown on Life Fitness's November 30 balance sheet.

EXHIBIT 3-6 Individua l Raw Materials Records Sum to the Raw Materia ls Inventory Ba lance

Heart Rate Monitors

Date Received Used Balance

11-30 $1 ,800

LCD Entertainment Screen

Date I Received I Used I Balance 11-30 I I I $24 ,000

Roller Base

Date I Received I Used I Balance 11-30 I I I $1 ,200

Hand Grips

Date I Received I Used I Balance 11-30 I I I $500

Wheels

Date I Received I Used I Balance 11-30 I I I $3 ,000

Foot Platform

Life Fitness Balance Sheet November 30

Assets:

Cash

Accounts Receivable

- Ra w M at erials Invent ory

Work in Process Inventory

Finished Goods Inventory

Total Current Assets

Property and Equipment

Total Assets

Liabilities and Owners' Equity:

Accounts Payable

Wages and Salaries Payable

Other Liabilities

Total Liabilities

Common Stock

Retained Earnings

Total Owners' Equity

Total Liabilities and Owners' Equity

Date Received Used Balance

11-30 $1 ,000

Using a Job Cost Record to Keep Track of Job Costs Job 603 will be started when the scheduled production date arrives. A job cost record, as pictured in Exhibit 3-7, will be used to keep track of all the direct materials and direct labor used on the job, as well as the manufacturing overhead allocated to the job.

Match the following concepts to their descriptions :

1. Document specifying when jobs will be manufactured

2. Product costing system used by mass manufacturers

3. Bill from supplier

4. Document specifying parts needed to produce a job

5. Product costing system used by manufacturers of unique products

6. Document containing the details and balance of each part in stock

7. Document for recording incoming shipments

8. Products normally kept on hand in order to fill orders quickly

Please see page 174 for solutions .

EXHIBIT 3-7 Job Cost Record

Job Cost Record

Job Number: 603

Customer : For stock

Job Description: 50 units of X4 Ellipt ical Cross-Trainers

a. Process costing

b. Stock inventory

c. Raw materials records

d. Production schedule

e. Receiving report

f. Invoice

g. Bill of materials

h. Job costing

Date Started: Dec. 2 Date Completed: ___ _

Manufacturing Cost Information: Cost Summary

Direct Materials

$ Direct Labor

$ Manufacturing Overhead

$ Total Job Cost $ Number of Units 50 un its

Cost per Unit $

Shipping Information:

Date Quantity Shipped Units Remaining Cost Balance

Job Costing 111

11 2 CHAPTER 3

II Why is this important? "Job cost records keep track of all manufacturing costs assigned to individual jobs so

Each job will have its own job cost record. Note that the job cost record is merely a form (electronic or hard copy) for keeping track of the three manufacturing costs associated with each job:

• direct materials,

• direct labor, and

• manufacturing overhead.

that managers know the cost of The job cost records also show the number of units produced on the job, as well as the cost per unit.

making each product." As we saw in the last section, the individual raw materials re- cords add up to the total Raw Materials Inventory account shown on the balance sheet. Likewise, as shown in Exhibit 3-8, the job

cost records on incomplete jobs provide the supporting detail for the total Work in Process Inventory account shown on the balance sheet.

EXHIBIT 3-8 Job Cost Records on Incomplete Jobs Sum to the WIP Inventory Balance

JOB560-

Direct Materia ls

Direct Labor

MOH

Total Job Cost

JOB561-

Direct Materials

Direct Labor

MOH

Total Job Cost

JOB562- > Direct Materia ls

Direct Labor

MOH

Total Job Cost

JOB563-

Direct Materials

Direct Labor

MOH

Total Job Cost

Life Fitness Balance Sheet November 30

Assets:

Cash

Accounts Receivable

Raw Materials Inventory

- Work in Process Inventory

Finished Goods Inventory

Total Current Assets

Property and Equipment

Total Assets

Liabilities and Owners ' Equity:

Accounts Payable

Wages and Salaries Payable

Other Liabilities

Total Liabilit ies

Common Stock

Retained Earnings

Total Owners' Equity

Total Liabilities and Owners' Equity

Once jobs are completed, the job cost records serve as a basis for valuing the Finished Goods Inventory account. As shown near the bottom of Exhibit 3-7, job cost records typi- cally list the date and quantity of units shipped to customers, the number of units remain- ing in finished goods inventory, and the cost of those units. The balance of unsold units from completed job cost records add up to the total Finished Goods Inventory account shown on the balance sheet.

As you can see, the job cost records serve a vital role in a job costing system. Now let's take a look at how Life Fitness accumulates manufacturing costs on the job cost re- cord. We'll begin by looking at how direct materials costs are traced to individual jobs.

Tracing Direct Materials Cost to a Job Production will eventually need all of the parts shown on the bill of materials for Job 603 (Exhibit 3-4). However, according to the production schedule (Exhibit 3-3), this job is

scheduled to take five days to complete, so the production crew may not want all of the raw materials at once. Each time materials are needed, production personnel will fill out a materials requisition. As shown in Exhibit 3-9, the materials requisition is a document itemizing the materials currently needed from the storeroom. Notice that the root word of requisition is request. In essence, production personnel use this document to request that certain materials be sent from the storeroom into the factory. Most progressive companies use electronic forms, but we show a hard copy here.

EXHIBIT 3-9 Materials Requisition

Materials Requisition

Date: 12/2 Number: #7568 --- -- Job: 603 ---

Part Description Quantity Unit Cost Amount

Number

HRM50812 Heart rate monitor 50 $60 $3,000 LCD620 LCD entertainment screen 50 $100 5,000 B4906 Front and rear roller base 100 $5 500

Job Costing 113

Total $8,500 .. . .. . .......... ..... ................... ··>-

As soon as the materials requisition is received by the raw materials storeroom, work- ers pick the appropriate materials and send them to the factory floor. Picking is just what it sounds like: storeroom workers pick the needed materials off of the storeroom shelves. The unit cost and total cost of all materials picked are posted to the materials requisition based on the cost information found in the individual raw materials records. The indi- vidual raw materials records are also updated as soon as the materials are picked, often using bar-coding systems to simplify the process and provide real-time information. For example, in Exhibit 3-10, we show how the raw material record for heart rate monitors is updated after requisition #7568 (Exhibit 3-9) has been picked.

EXHIBIT 3-10 Raw Materials Record Updated for Materials Received and Used

Raw Materials Record

Item No.: HRM50812 Description: Heart rate monitor

Received Used Balance

Date Units Cost Total Requisition

Units Cost Total Units Cost Total Number

11-25 100 $60 $6,000 100 $60 $6,000 11-30 #7235 70 $60 $4,200 30 $60 $1,800 12-1 75 $60 $4,500 105 $60 $6,300 12-2 #7568 50 $60 $3,000 55 $60 $3,300

Finally, the raw materials requisitioned for the job are posted to the job cost record. As shown in Exhibit 3-11, each time raw materials are requisitioned for Job 603, they are

11 4 CHAPTER 3

posted to the direct materials section of the job cost record. Again, bar-coding systems allow this process to be completed with more efficiency. These materials are considered direct materials (rather than indirect materials), because they can be traced specifically to Job 603. By using this system to trace direct materials to specific jobs, managers know exactly how much direct materials cost is incurred by each job.

EXHIBIT 3-11 Posting Direct Materials Used to the Job Cost Record

Job Cost Record

Job Number: 603

Customer: For stock ---------------------------

Job Description: 50 units of X4 Elliptical Cross-Trainers

Date Started: Dec. 2 Date Completed: ___ _

Manufacturing Cost Information: Cost Summary

Direct Materials

· ·· · · ·> Req. #7568 : $ 8,500 (shown in Exhibit 3-9) Req. #7580: $14,000

Req. #7595: $13,500

Req. #7601: $ 4,000 $ 40,000

Direct Labor

$

Manufacturing Overhead

$

Total Job Cost $

Number of Units 50 units

Cost per Unit $

Tracing Direct Labor Cost to a Job Now let's look at how direct labor costs are traced to individual jobs. All direct laborers in the factory fill out labor time records. As shown in Exhibit 3-12, a labor time record simply records the time spent by each employee on each job he or she worked on throughout the day. Often, these records are kept electronically. Rather than using old-fashioned time tick- ets and punch clocks, factory workers now "swipe" their bar-coded employee identification cards on a computer terminal and enter the appropriate job number. Based on each employ- ee's unique hourly wage rate, the computer calculates the direct labor cost to be charged to the job. Companies that are even more progressive use biometric scanning devices to quickly capture information about how long individual employees work on each job.

For example, in Exhibit 3-12, we see that Hannah Smith, who is paid a wage rate of $20 per hour, worked on both Jobs 602 and 603 during the week. Hannah spent five hours working on Job 603 on December 2. Therefore, $100 of direct labor cost ($20 X 5) will be charged to Job 603 for Hannah's work on that date. On December 3, Hannah's eight hours of work on Job 603 resulted in another $160 ($20 X 8) of direct labor being charged to the job. The cost of each direct laborer's time will be computed using each employee's unique wage rate, just as was done with Hannah Smith's time. Then, as shown in Exhibit 3-13, the information from the individual labor time records is posted to the direct labor section of the job cost record. Again, this posting is normally done automatically, and often in real time, by the company's computer system.

As you can see, by tracing direct labor cost in this fashion, individual jobs are charged only for the exact amount of direct labor actually used in their production.

Job Costing 115

EXHIBIT 3-12 Labor Time Record

Labor Time Record

Employee: Hannah Smith Week: 12/2 - 12/9

Hourly Wage Rate: $20 Record #: 324 --

Date Job

Start Time End Time Hours Cost Number

12/2 602 8:00 11:00 3 $60

12/2 603 12:00 5:00 5 $100 J-12/3 603 8:00 4:00 8 $160 12/4 etc.

'------- ~

EXHIBIT 3-13 Posting Direct Labor Used to the Job Cost Record

Job Cost Record

Job Number: 603 --- Customer: For stock

Job Description: 50 units of X4 Elliptical Cross-Trainers

Date Started: Dec. 2 Date Completed:

Manufacturing Cost Information: Cost Summary

Direct Materials

Req. #7568: $ 8,500

Req. #7580: $14 ,000

Req. #7595: $13 ,500

Req. #7601: $ 4,000 $ 40,000

Direct Labor

No. #324 (30 DL hours): $100, $160 , etc . (shown in Exhibit 3-12) -

No. #327 (40 DL hours): $240, $210, etc.

No. #333 (36 DL hours): $80, $120, etc.

Etc.

(a total of 500 DL hours) $ 10,000

Manufacturing Overhead

$

Total Job Cost $

Number of Units 50 units

Cost per Unit $

What about employee benefits, such as employee-sponsored retirement plans, health insurance, payroll taxes, and other benefits? As discussed in Chapter 2, these payroll- related benefits often add another 30% or more to the cost of gross wages and salaries. Some companies factor, or load, these costs into the hourly wage rate charged to the jobs. For example, if a factory worker earns a wage rate of $10 per hour, the job cost records would show a loaded hourly rate of about $13 per hour, which would include all benefits

11 6 CHAPTER 3

3 _Compute a --:.: predetermined

manufacturing overhead rate and use it to allocate MOH to jobs

associated with employing the worker. However, because coming up with an accurate loaded hourly rate such as this is difficult, many companies treat these extra payroll- related costs as part of manufacturing overhead, rather than loading these costs into the direct labor wage rates. Either method is acceptable. We'll next discuss how manufactur- ing overhead costs are handled.

Allocating Manufacturing Overhead to a Job So far we have traced the direct materials and direct labor costs to Job 603. Recall, how- ever, that Life Fitness incurs many other manufacturing costs that cannot be directly traced to specific jobs. These indirect manufacturing costs, otherwise known as manufacturing overhead (MOH), include depreciation on the factory plant and equipment, utilities to run the plant, property taxes and insurance on plant, equipment maintenance, the salaries of plant janitors and supervisors, machine lubricants, and so forth. Because of the nature of these costs, we cannot tell exactly how much of these costs are attributable to producing a specific job. Therefore, we cannot trace these costs to specific jobs, as we did with direct materials and direct labor. Rather, we will have to allocate some reasonable amount of these costs to each job. Why bother? Generally Accepted Accounting Principles (GAAP) requires that manufacturing overhead must be treated as a product cost for external finan- cial reporting purposes. The rationale is that these costs are a necessary part of the pro- duction process: Jobs could not be produced without incurring these costs, so they must become part of each job's stated product cost. Let's now look at how companies allocate manufacturing overhead costs to jobs.

What Does Allocating Mean? Allocating manufacturing overhead 2 to jobs simply means that we will be "splitting up" or "dividing" the total manufacturing overhead costs among the jobs we produced during the year. There are many different ways we could split up the total manufacturing over- head costs among jobs. For example, there are a number of different ways you could split up a pizza pie among friends: You could give equal portions to each friend, you could give larger portions to the largest friends, or you could give larger portions to the hungriest

friends. All in all, you have a set amount of pizza, but you could

II Why is this important? come up with several different reasonable bases for splitting it among your friends (based on number of friends, size of friends, or hunger level of friends).

"Managers use the

predetermined MOH rate Likewise, a manufacturer has a total amount of manufactur-

ing overhead that must be split among all of the jobs produced during the year. Because each job is unique in size and resource requirements, it wouldn't be fair to allocate an equal amount of manufacturing overhead to each job. Rather, management needs some other reasonable basis for splitting up the total manufactur- ing overhead costs among jobs. In this chapter, we'll discuss the most basic method of allocating manufacturing overhead to jobs. This method has traditionally been used by most manufacturers, but more progressive companies are learning to use better, more

I d' as a way to sprea (allocate) indirect manufacturing costs, such as factory utilities, among all jobs produced in the factory during the year."

accurate allocation systems, which we will discuss in Chapter 4. However, for now, we'll start with a basic allocation system.

Steps to Allocating Manufacturing Overhead Manufacturers follow four steps to implement this basic allocation system. The first three steps are taken before the year begins:

STEP 1: The company estimates its total manufacturing overhead costs for the coming year.

This is the total "pie" to be allocated. For Life Fitness, let's assume manage- ment estimates total manufacturing overhead costs for the year to be $1 million.

2 The term applying manufacturing overhead is often used synonymously with "allocating" manufacturing overhead.

STEP 2: The company selects an allocation base and estimates the total amount that will be used during the year.

This is the basis management has chosen for "dividing up the pie." For Life Fitness, let's assume management has selected direct labor hours as the alloca- tion base. Furthermore, management estimates that 62,500 of direct labor hours will be used during the year.

Ideally, the allocation base should be the cost driver of the manufacturing overhead costs. As the term implies, a cost driver is the primary factor that causes, or drives, a cost. For example, in many companies, manufacturing overhead costs rise and fall with the amount of work performed in the factory. Because of this, most companies traditionally use either direct labor hours or direct labor cost as their allocation base. This informa- tion is also easy to gather from the labor time records or job cost records. However, for manufacturers that have automated much of their production process, machine hours is a more appropriate allocation base because the amount of time spent running the machines drives the utility, maintenance, and equipment depreciation costs in the factory. As you'll learn in Chapter 4, some companies use multiple allocation bases to more accurately al- locate manufacturing overhead costs to individual jobs. The important point is that the allocation base selected should bear a strong, positive relationship to the manufacturing overhead costs.

STEP 3: The company calculates its predetermined manufacturing overhead (MOH) rate using the information estimated in Steps 1 and 2:

p d . d MOH Total estimated manufacturing overhead costs re etermme rate= Total estimated amount of the allocation base

For example, Life Fitness calculates its predetermined MOH rate as follows:

Predetermined MOH rate= 62

,~~i~ti~urs = $16 per direct labor hour

This rate will be used throughout the coming year. It is not revised unless the com- pany finds that either the manufacturing overhead costs or the total amount of the alloca- tion base being used in the factory (direct labor hours in our example) has substantially shifted away from the estimated amounts. If this is the case, management might find it necessary to revise the rate part way through the year.

Why does the company use a predetermined MOH rate, based on estimated or bud- geted data, rather than an actual MOH rate based on actual data for the year? In order to get actual data, the company would have to wait until the end of the year to set its MOH rate. By then, the information is too late to be useful for making pricing and other deci- sions related to individual jobs. Managers are willing to sacrifice some accuracy in order to get timely information on how much each job costs to produce.

Once the company has established its predetermined MOH rate, it uses that rate throughout the year to calculate the amount of manufacturing overhead to allocate to each job produced, as shown in Step 4.

STEP 4: The company allocates some manufacturing overhead to each individual job as follows:

Job Costing 117

MOH allocated to a job= Predetermined MOH rate X Actual amount of allocation base used by the job

Let's see how this works for Life Fitness's Job 603. Because the predetermined MOH rate is based on direct labor (DL) hours ($16 per DL hour), we'll need to know how many direct labor hours were used on Job 603. From Exhibit 3-13, we see that Job 603 required a total of 500 DL hours. This information was collected from the individual labor time

11 8 CHAPTER 3

records and summarized on the job cost record. Therefore, we calculate the amount of manufacturing overhead to be allocated to Job 603 as follows:

MOH to be allocated to Job 603 = $16 per direct labor hour X 500 direct labor hours

= $8,000

The $8,000 of manufacturing overhead allocated to Job 603 is now posted to the job cost record, as shown in Exhibit 3-14.

EXHIBIT 3-14 Posting Manufacturing Overhead and Completing the Job Cost Record

Job Cost Record

Job Number: 603

Customer: For stock

Job Description: 50 units of X4 Elliptical Cross-Trainers

Date Started: Dec. 2 Date Completed: Dec. 6

Manufacturing Cost Information: Cost Summary

Direct Materials

Req. #7568: $ 8,500

Req. #7580: $14,000

Req. #7595: $13,500

Req. #7601: $ 4,000 $ 40,000

Direct Labor

No. #324 (30 DL hours): $100, $160, etc.

No. #327 (40 DL hours): $240, $210, etc.

No. #333 (36 DL hours): $80, $120, etc.

Etc.

(a total of 500 DL hours) $ 10,000

Manufacturing Overhead

$16/DL hour x 500 DL hours= $8,000 $ 8,000

Total Job Cost $ 58,000

Number of Units 50 units

Cost per Unit ~ 1160

When Is Manufacturing Overhead Allocated to Jobs? The point in time at which manufacturing overhead is allocated to a job depends on the sophistication of the company's computer system. In most sophisticated systems, some manufacturing overhead is allocated to a job each time some of the allocation base is posted to the job cost record. In our Life Fitness example, every time an hour of direct labor is posted to a job, $16 of manufacturing overhead would also be posted to the same job. In less sophisticated systems, manufacturing overhead is allocated only once: as soon as the job is complete and the total amount of allocation base used by the job is known (as shown in Exhibit 3-14). However, if the balance sheet date (for example, December 31) arrives before the job is complete, Life Fitness would need to allocate some manufacturing overhead to the job based on the number of direct labor hours used on the job thus far. Only by updating the job cost records will the company have the most accurate Work in Process Inventory on its balance sheet.

Assume Life Fitness's managers had chosen direct labor cost as the MOH allocation base, rather than direct labor hours. Furthermore, assume management estimates $1,200,000 of direct labor cost for the year.

1. Calculate the company's predetermined MOH rate based on direct labor cost.

2. How much MOH would have been allocated to Job 603?

Answer:

1 p d · d MOH $1,000,000 .8333 or 83.33% · re etermme rate = $1,200,000 of DL cost of direct labor cost

2. MOH allocated to Job 603 = 83.33% X $10,000 direct labor cost (from Exhibit 3-14)

= $8,333

Note that this allocation differs from that shown in Exhibit 3-14 ($8,000) . That's because the amount of MOH allocated to an individual job is highly dependent on the allocation base cho- sen by management as well as the amount of the allocation base used by the job . Although there is no one "correct" allocation, the most accurate allocation occurs when the company uses the MOH cost driver as its allocation base .

Completing the Job Cost Record and Using It to Make Business Decisions As shown in Exhibit 3-14, now that all three manufacturing costs have been posted to the job cost record, Life Fitness can determine the total cost of manufacturing Job 603 ($58,000) as well as the cost of producing each of the 50 identical units in the job ($1,160 each). Let's look at a few ways management uses this information.

REDUCING FUTURE JOB COSTS Management will use the job cost information to control costs. By examining the exact costs traced to the job, management might be able to determine ways of reducing the cost of similar jobs produced in the future. For example, are the heart rate monitors costing more than they did on previous jobs? Perhaps management can renegotiate the contracts with its primary suppliers, or identify different suppliers that are willing to sell the parts more cheaply, without sacrificing quality.

What about direct labor costs? By examining the time spent by various workers on the job, management may be able to improve the efficiency of the process so that less production time is required. Management will also examine the hourly wage rates paid to the individuals who worked on the job to determine if less skilled and therefore less costly workers could accomplish the same production tasks, freeing up the more highly skilled employees for more challenging work.

ASSESSING AND COMPARING THE PROFITABILITY OF EACH MODEL Management will also use job cost information to determine the profitability of the various models. Assume the X4 Elliptical Cross-Trainer is listed on the company's website at a sales price of $1,900. That means the company can expect the following gross profit on each unit sold:

Sales price per unit ................................................................................... .

Cost of goods sold per unit (computed on job cost record in Exhibit 3-14)

Gross profit per unit ................................................................................. .

$1,900

1,160

$ 740

This profit analysis shows that the company would generate a gross profit of $740 on each unit sold from this job. Although this may seem fairly high, keep in mind that

Job Costing 119

4 Determine the cost ~fa job and use it to make business decisions ·.

1 20 CHAPTER 3

companies incur many operating costs, outside of manufacturing costs, that must be cov- ered by the gross profit earned by product sales. For example, in 2014, Life Fitness spent over $23 million on research and development in the fitness segment. 3 Managers will compare the gross profit on this model to the gross profit of other models to determine which products should be emphasized in sales effort. Obviously, management will want to concentrate on marketing those models that yield the higher profit margins.

DEALING WITH PRICING PRESSURE FROM COMPETITORS Management can also use job cost information to determine how it will deal with pricing pressure. Say a competitor drops the price of its similar elliptical cross-trainer to $1,500. The profit analysis shows that Life Fitness could drop its sales price to $1,500 and still generate $340 of gross profit on the sale ($1,500 - $1,160). In fact, Life Fitness could use a sales promotion to undercut competitors' prices. As long as Life Fitness charges at least $1,161 for each unit in this job, the company will be earning a positive gross profit on the sale.

ALLOWING DISCOUNTS ON HIGH-VOLUME SALES Customers will often expect discounts for high-volume sales. For example, say the City of Westlake wants to order 40 of these cross-trainers for the city's recreation center and has asked for a 25% volume discount off of the regular sales price. If Life Fitness won't agree to the discount, the city will take its business to the competitor. Can Life Fitness agree to this discount and still earn a profit on the sale? Let's see:

Discounted sales price per unit .................................................................. $ 1,425

Cost of goods sold per unit....................................................................... 1,160

Gross profit per unit .................................................................................. $ 265

Multiplied by: Number of units................................................................. X 40

Total gross profit on sale ........................................................................... $ 10,600

II Why is this important? These calculations show that the discounted sales price will

still provide a gross profit. We'll talk more about special orders like this in Chapter 8.

"Once managers know how much

it costs to complete a job , they use that information to do the following:

• Find cheaper ways of completing similar jobs in the future,

• Determine which products are

most profitable, and • Establish prices for custom-

ordered jobs."

BIDDING FOR CUSTOM ORDERS Management also uses product cost information to bid for custom orders. Let's say that the Atlanta Falcons training facility would like to order 15 custom treadmills and is accepting bids from various fitness equipment manufacturers. Management can use the job cost records from past treadmill jobs to get a good idea of how much it will cost to complete the custom order. For example, the custom treadmills may require additional components not found on the standard models. Life Fitness will factor in these additional costs to get an estimate of the total job cost before it is produced. Life Fitness will most likely use cost-plus pricing to determine a bid price for the custom job. When companies use cost-plus pricing, they take the cost of the job (from the estimated or actual job cost record) and add a markup to help cover operating expenses and generate a profit:

Cost plus price = Cost + Markup on cost

Usually, the markup percentage or final bid price is agreed upon in a written contract before the company goes ahead with production. For example, let's say that Life Fitness typically adds a 40% markup on cost to help cover operating costs and generate a reason- able profit. If the estimated total job cost for the 15 treadmills is $25,000, then the bid price would be calculated as follows:

3 Brunswick Corp., 2014 10-K filing. Life Fitness is a division of Brunswick Corporation.

Cost-plus price = $25,000 + (40% X $25,000) = $35,000

Once the management team of the Atlanta Falcons has received Life Fitness's bid as well as bids from other companies, the team will decide which bid to accept based on price, quality, reputation for service, and so forth.

PREPARING THE FINANCIAL STATEMENTS Finally, the job cost information is critical to preparing the company's financial statements. Why? Because the information is used to determine the total Cost of Goods Sold shown on the income statement, as well as the Work in Process and Finished Goods Inventory accounts shown on the balance sheet. Every time a cross-trainer from Job 603 is sold, its cost ($1,160) becomes part of the Cost of Goods Sold during the period. Likewise, every time a cross-trainer from the job is sold, the balance in Finished Goods Inventory is reduced by $1,160. As shown earlier (Exhibit 3-8), the cost-to-date of unfinished jobs remains in the company's Work in Process Inventory.

How Can Job Costing Information Be Enhanced for Decision Making? We have just finished developing a traditional job cost record and have seen how managers use the information to make vital business decisions. With the help of today's advanced in- formation systems, the job cost information can be further enhanced to help managers make even more informed decisions. This section describes just a few of these enhancements.

Non-Manufacturing Costs

Job Costing 121

Job costing has traditionally focused on assigning only manufac- turing-related costs to jobs. The focus on manufacturing costs arises because GAAP requires that only direct materials, direct labor, and manufacturing overhead be assigned to units of inven- tory for external financial reporting purposes. Costs incurred by other activities in the value chain are not assigned to products for external financial reporting but instead are treated as operating expenses (period costs).

II Why is this important?

However, for setting long-term average sales prices and making other critical decisions, manufacturers must take into account the total costs of researching and developing, designing, producing, marketing, distributing, and providing customer service for new or existing prod- ucts. In other words, they want to know the total cost of the product across the entire value chain. But how do managers figure this out?

The same principles of tracing direct costs and allocating in-

"Job cost records can provide managers with the detailed

environmental and social impact information needed to develop more sustainable

products and manufacturing processes."

direct costs apply to all costs incurred in other activities of the value chain. Managers add these non-manufacturing costs to the production-related job costs to build the total cost of the product across the entire value chain. For example, say Life Fitness spent $2 million de- signing and marketing the X4 Elliptical Cross-Trainer. These costs are direct costs of the X4 Elliptical product line. On the other hand, the company may have spent $3 million research- ing basic technology for the video screen that is used on all of its products, making it an indirect cost of the X4 Elliptical, shared with other products that use the same video screen. Life Fitness may choose to add an additional cost section to the job cost record, indicating specific operating expenses associated with each job. By adding this information to the job cost record, managers have a more complete understanding of the total job costs, not just the job's manufacturing costs.

Keep in mind that these non-manufacturing costs are assigned to products only for internal decision making, never for external financial reporting, because GAAP does not allow it. For financial reporting, non-manufacturing costs must always be expensed on the income statement as operating expenses in the period in which they are incurred.

1 2 2 CHAPTER 3

See Exercises E3-22A and E3-36B

Job cost records serve a vital role for manufacturers who embrace sustainability. Because job cost records contain information about the direct materials, direct la- bor, and manufacturing overhead assigned to each job, they capture the essential resources required to manufacture a product. The summary information on the job cost records can be enhanced to provide management with further information about how the product or production process may affect the environment, employees in- volved in the manufacturing process, future consumers of the product, and future disposal of the packaging materials and product itself.

For example, the direct materials section of the job cost record can be broken down into subcategories that provide management with useful environmental infor- mation. Categories might include:

• percentage of material and packaging inputs that are post-consumer-use or re- cycled materials,

• percentage of materials sourced from local suppliers versus those sourced from geo- graphically distant suppliers (thereby increasing the company's carbon footprint),

• amount of materials that will become waste as a result of the production process,

• percentage of the end-of-life product and packaging that can be recycled by the consumer.

Likewise, the job cost record can help management track the extent of the com- pany's fair-labor practices related to each job, such as:

• the percentage of labor paid at a rate greater than minimum wage as defined by law,

• the percentage of labor force receiving health-care benefits, and

• the diversity of labor force used on the job.

Finally, although MOH resources cannot be traced to specific jobs, the company can provide its potential customers with general information such as:

• percentage of factory utilities generated from renewable sources (wind, solar) ver- sus fossil fuels, and

• percentage reclaimed and recycled water, versus potable water, used in the factory.

We'll discuss MOH and sustainability more in Chapter 4, but this should give you a basic idea of the types of sustainability-related data that can be measured and reported.

Once the company has tracked this information on job cost records, how is it used? First, it can be used by management to identify areas of weakness so that the company can move toward a more sustainable business model. Second, it can be used to provide information to potential customers, as part of their supply chain assessment.

Sustainability-related information is becoming increasingly important in sup- ply chain management. Many of the world's largest companies, such as Walmart and Costco, are now assessing the environmental and social impact of the suppliers with whom they choose to do business. In fact, supply chain pressure has become a major driving force in corporate adoption of greener and more socially responsible practices.

Third, this information is useful for marketing and labeling. The Sustainability Con- sortium, a multi-stakeholder group of companies and organizations, is working on devel- oping a standardized system for measuring and reporting the environmental and social impact of consumer products across their entire life cycles. The Consortium is in the pro- cess of developing a "sustainability profile" that would be shown on consumer products, somewhat akin to the nutrition labels currently found on food products. By accurately labeling consumer products with environmental and social impact information, consum- ers will be in a better position to make informed purchasing decisions.

Fourth, this information can be used to assess the risk of future environmental costs associated with each job. For example, Extended Producer Responsibility (EPR)

laws, more commonly known as "take-back" laws, create future costs associ- ated with the production of electronic devices and other problem waste, such as mattresses, paint, and batteries. EPR laws, which have been passed in over 25 states as well as several European countries, require manufacturers of electronic devices and other problem waste to take back a large percentage of their prod- ucts at the end of the products' useful lives. For example, the Wisconsin £-waste Law requires electronics manufacturers to take back 80% of the products they have produced (by weight) in the previous three years; manufacturers that vio- late this law are subject to a fine.

The goal of EPR laws is to reduce the amount of potentially dangerous waste in landfills by shifting the end-of-life disposal cost back to the manufac- turer. By bearing the disposal cost, manufacturers should be motivated to design products and components that are more easily repairable, reusable, and recy- clable, and have a longer life cycle.

How doe-waste EPR laws work? Major electronics retailers, such as Best Buy and Staples, collect unused electronics from consumers free of charge, and then partner with responsible recyclers to ensure that the e-waste is dismantled and recycled rather than dumped in landfills or exported to developing nations. Electronics manufacturers partner with these retailers and recyclers by subsidiz- ing their costs.

To put the size of e-waste into perspective, consider the following. In the first quarter of 2016, Apple sold over 74 million iPhones, 16 million iPads, and 5 million Macs. 4 And that's just for three months of sales! When you consider all of the other computer, TV, and smartphone producers, you begin to understand the size of the potential e-waste issue. In fact, a study funded by the EPA and carried out by MIT and others indicated that in 2010, approximately 258 million units of used electronics such as cell phones, TVs, and computers (equating to 1.6 mil- lion tons) were generated in the United States, but only 66% were collected. 5 As a result, many electronics producers, such as Apple, HP, and Dell, are supporting take-back policies and providing recycling options for their old products.

In addition to state EPR laws, the federal government is also considering a bill (the Responsible Electronics Recycling Act) that will restrict the export of toxic e-waste, which historically has been shipped to developing countries. This bill, if passed, will not only help with environmental and public health issues caused by e-waste but will also create even more incentive for manufacturers and recyclers to find alternative uses for outdated electronic equipment.

Direct or Variable Costing Even though the job cost records contain information about all three manufacturing costs, managers base certain decisions on just the direct costs (direct materials and labor) or vari- able costs found on a job cost record. Why? For two reasons: (1) The simple allocation of MOH that we have described in this chapter results in a fairly arbitrary amount of MOH being allocated to jobs, and (2) because many MOH costs are fixed and will not be affected as a result of producing a job. Later in the book, we'll see how management accountants have addressed these issues. In Chapter 4, we'll show how managers can improve the al- location system so that the amount of manufacturing overhead assigned to the job is much more accurate. In Chapters 6 and 8, we'll discuss how direct costing or variable costing can be used to improve the decision-making process.

4 www.apple.com; http://electronicstakeback.com/promote-good-laws/state-legislation 5 December 2013, "Quantitative Character ization of Domestic and Transboundary Flows of Used Electron- ics: Analysis of Generation, Collection, Export in the United States. " www.epa.gov/international-cooperation/ cleaning-electronic-waste-e-waste

Job Costing 123

124 CHAPTER 3

• Decision Guidelines

Job Costing Life Fitness uses a job costing system that assigns manufacturing costs to each batch of exer- cise machines that it makes . These guidelines explain some of the decisions Life Fitness made in designing its costing system .

Decision

Should we use job costing or process costing?

How do we determine the cost of manufacturing each job?

Should we use a predetermined manufacturing overhead rate or the actual manufacturing overhead rate?

How do we calculate the predetermined MOH rate?

What allocation base should we use for allocating manufacturing overhead?

How should we allocate manufacturing overhead to individual jobs?

Can job cost records help companies in their journey toward sustainability?

Can manufacturers also assign operating expenses to jobs?

Guidelines

Managers use the costing system that best fits their production environment . Job costing is best suited to manufacturers that produce unique, custom-built products or relatively small batches of different products . Process costing is best suited to manufacturers that mass-produce identical units in a series of uniform production processes .

The exact amount of direct materials and direct labor can be traced to individual jobs using materials requisitions and labor time records . However, the exact amount of manufacturing overhead attributable to each job is unknown and there- fore cannot be traced to individual jobs. To deal with this issue, companies allocate some manufacturing overhead to each job .

Although it would be more accurate to use the actual manufacturing overhead rate, companies would have to wait until the end of the year to have that informa- tion. Most companies are willing to sacrifice some accuracy for the sake of having timely information that will help them make decisions throughout the year . There- fore, most companies use a predetermined overhead rate to allocate manufactur- ing overhead to jobs as they are produced throughout the year .

p d . d MOH Total estimated manufacturing overhead cost re etermme rate = Total estimated amount of the allocation base

If possible, companies should use the cost driver of manufacturing overhead as the allocation base . The most common allocation bases are direct labor hours, direct labor cost, and machine hours . Some companies use multiple bases in order to more accurately allocate MOH . This topic will be covered in Chapter 4 .

The MOH allocated to a job is calculated as follows:

= Predetermined MOH rate X Actual amount of allocation base used by the job

Job cost records can be enhanced to provide more detail about the environmental and social impact of the resources used on the job . In addition to satisfying supply chain assessment, managers can use this information to determine how a product, or production process, can become more sustainable .

Operating expenses can also be assigned to jobs, but only for internal decision- making purposes . Operating expenses are never assigned to jobs for external fi- nancial reporting purposes . Direct operating costs would be traced to jobs (such as the sales commission on a particular job or the design costs related to a particular job) whereas indirect operating costs (such as the R&D costs associated with sev- e ral product lines) would be allocated to jobs.

Job Costing 125 - SUMMARY PROBLEM 1 . • _.

E-Z-Boy Furniture makes sofas, loveseats, and recliners. The company allocates manufacturing overhead based on direct labor hours . E-Z-Boy estimated a total of $2 million of manufacturing overhead and 40,000 direct labor hours for the year .

Job 310 consists of a batch of 10 recliners. The company's records show that the follow- ing direct materials were requisitioned for Job 310:

Lumber : 10 units at $30 per unit

Padding: 20 yards at $20 per yard

Upholstery fabric: 60 yards at $25 per yard, sourced from a local manufacturer

Labor time records show the following employees (direct labor) worked on Job 310:

Jesse Slothower: 10 hours at $12 per hour

Becky Wilken : 15 hours at $18 per hour

Chip Lathrop: 12 hours at $15 per hour

Requirements

1. Compute the company's predetermined manufacturing overhead rate.

2. Compute the total amount of direct materials, direct labor, and manufacturing over- head that should be shown on Job 31 O's job cost record .

3. Compute the total cost of Job 310, as well as the cost of each recliner produced in Job 310 .

4. The company's customers are concerned about environmental responsibility and so- cial justice and require additional sustainability-related information prior to making their purchasing decisions . To meet customer concerns, determine (a) which materials used for the product are sourced locally, and (b) the percentage of labor paid at a rate greater than minimum wage . Currently, the federal minimum wage is $7 .25 per hour.

• SOLUTIONS 1. The predetermined MOH rate is calculated as follows:

p d . d MOH Total estimated manufacturing overhead cost re etermme rate= Total estimated amount of the allocation base

For E-Z-Boy:

P d . d MOH $2,000,000 re etermme rate = 40 OOO d. I b h , uect a or ours $50 per direct labor hour

2. The total amount of direct materials ($2,200) and direct labor ($570) incurred on Job 310 is determined from the materials requisitions and labor time records, as shown on the following job cost record. Because the job required 37 direct labor hours, we de- termine the amount of manufacturing overhead to allocate to the job is as follows:

= Predetermined MOH rate X Actual amount of allocation base used by the job

= $50 per direct labor hour X 37 direct labor hours used on Job 310

= $1,850

1 26 CHAPTER 3

These costs are summarized on the following job cost record :

Job Cost Record

Job Number: 310

Job Description:_1_0_re_c_li_ne_r_s _____________________ _

Manufacturing Cost Information: Cost Summary

Direct Materials

Lumber: 1 0 units x $30 = $300 Padding: 20 yards x $20 = $400 Fabric: 60 yards x $25 = $1 ,500 $ 2,200

Direct Labor

Slothower: 10 hours x $12 = $120 Wilken: 15 hours x $18 = $270 Lathrop: 12 hours x $15 = $180

Total hours: 37 hours $ 570

Manufacturing Overhead

37 direct labor hours x $50 = $1,850 $ 1,850 Total Job Cost $ 4,620

Number of Units 10 units

Cost per Unit i 462

3. The direct materials ($2,200), direct labor ($570), and manufacturing overhead ($1,850) sum to a total job cost of $4,620 . When the total job cost is averaged over the 10 recliners in the job, the cost pe r recliner is $462 .

4. Supplemental sustainability information for Job 310 :

a. All fabric contained in the product was sourced locally. b. All labor used in the manufacturing was paid at a rate higher than minimum wage .

How Do Managers Deal with Underallocated or Overallocated Manufacturing Overhead?

Job Costing 127

In the first half of the chapter, we showed how managers find the cost of completing a job. Direct materials and direct labor are traced to each job using materials requisitions and labor time records, and manufacturing overhead is allocated to each job us- ing a predetermined overhead rate. At the end of the period, all manufacturers will have a problem to deal with: Invariably, they will have either underallocated manufacturing overhead or over- allocated manufacturing overhead to the jobs worked on during the period.

II "Why is this important?" Because managers allocate MOH to jobs using a predetermined rate that is based on estimates, the amount of MOH allocated to

Recall that manufacturing overhead is allocated to jobs us- ing a predetermined rate that is calculated using estimates of the company's total annual manufacturing overhead costs and estimates of the total annual allocation base (such as direct labor hours). By the end of the period, the actual manufacturing overhead costs in- curred by the company will be known, and they will likely differ from the total amount allocated to jobs during the period.

jobs during the year will not be quite

right. At the end of the period ,

For example, suppose Life Fitness incurred the follow- ing actual manufacturing overhead costs during the month of December:

managers find out whether the jobs

have been allocated too much or too little MOH and then fix the error in the financial records.

Manufacturing Overhead Incurred Actual MOH Costs

Indirect materials used (janitorial supplies, machine lubricants, etc.) ......... $ 2,000

Indirect labor (janitors ' and supervisors' wages, etc.) .......................... 13,000

Other indirect manufacturing costs

(Plant utilities, depreciation, property taxes, insurance, etc.)........... 10,000

Total actual manufacturing overhead costs incurred ........................... $25,000

Now let's look at the total amount of manufacturing overhead that was allocated to indi- vidual jobs during the month using the predetermined manufacturing overhead rate of $16 per direct labor hour. For simplicity, we'll assume only two jobs were worked on during December.

Amount of MOH Jobs Allocated to Job

603 (from Exhibit 3-14) ($16 per DL hour X 500 DL hours) ............. $ 8,000

604 (not shown) ($16 per DL hour X 1,000 DL hours)....................... 16,000

Total MOH allocated to jobs ($16 per DL hour X 1,500 DL hours) ......... $24,000

Notice that we don't need to have the individual job cost records available to figure out the total amount of MOH allocated to jobs during the period. Rather, we can calculate the total amount of MOH allocated to jobs as follows:

5 Compute and dispo ~e - of overal located ·

or undera llocated manufacturing overhead

Total MOH allocated= Predetermined MOH rate X Actual total amount of allocation base used on all jobs

= $16 per DL hour X 1,500 direct labor hours

= $24,000 total MOH allocated to jobs during the period

1 2 8 CHAPTER 3

To determine whether manufacturing overhead had been overallocated or underal- located, we simply compare the amount of MOH actually incurred during the period with the amount of MOH that was allocated to jobs during the same period. The difference be- tween the actual manufacturing overhead costs incurred by the company and the amount of manufacturing overhead allocated to jobs shows that Life Fitness underallocated manu- facturing overhead by $1,000 during December:

Actual manufacturing overhead costs incurred ....................................... .

Manufacturing overhead allocated to jobs ............................................. .

Underallocated manufacturing overhead ................................................ .

$25,000

24,000

$ 1,000

By underallocating manufacturing overhead, Life Fitness did not allocate enough manufacturing overhead cost to the jobs worked on during the period. In other words, the jobs worked on during the period should have had a total of $1,000 more manufacturing overhead cost allocated to them than the job cost records indicated. These jobs have been undercosted, as shown in Exhibit 3-15. If, on the other hand, a manufacturer finds that the amount of manufacturing overhead allocated to jobs is greater than the actual amount of manufacturing overhead incurred by the company, we would say that manufacturing overhead had been overallocated, resulting in overcosting these jobs.

EXHIBIT 3-15 Undera llocated Versus Overa llocated Manufacturing Overhead

If MOH allocated< actual MOH incurred, then ...

If MOH allocated> actual MOH incurred, then ...

MOH has been underallocated, so ...

MOH has been overallocated, so ...

J What do manufacturers do about this problem? Assuming that the amount of un-

derallocation or overallocation is immaterial, or that most of the inventory produced during the period has been sold, manufacturers typically adjust Cost of Goods Sold for the total amount of the under- or overallocation. Why? Because (1) as a result of using a predetermined MOH rate, too much or too little MOH was originally recorded on the job cost records and (2) when the jobs were sold, the job cost records were used as a basis for recording Cost of Goods Sold. Hence, the Cost of Goods Sold account will be wrong unless it is corrected. As shown in Exhibit 3-16, by increasing Cost of Goods Sold when manufacturing overhead has been underallocated, or by decreasing Cost of Goods Sold when manufacturing overhead has been overallocated, the company actually corrects the error that exists in Cost of Goods Sold.

EXHIBIT 3-16 Correcting Cost of Goods So ld for Underal located or Overa llocated MOH

If jobs have been undercosted due to under allocation of MOH, then

Cost of Goods Sold is too low, so ...

If jobs have been overcosted due to over allocation of MOH, then

Cost of Goods Sold is too high, so ...

Increase Cost of Goods Sold for the amount of the underallocation

Decrease Cost of Goods Sold for the amount of the overallocation

What if the amount of under- or overallocation is large, and the company has not sold almost all of the units produced during the period? Then the company will prorate the total amount of under- or overallocation among Work in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold based on the current status of the jobs worked on during the period. For example, if 30% of the jobs are still in Work in Process, 20% are still in Finished Goods, and 50% were sold, then the total amount of underallocation ($1,000 in the case of Life Fitness) would be roughly allocated as follows: 30% ($300) to Work in Process Inventory, 20% ($200) to Finished Goods Inventory, and 50% ($500) to Cost of Goods Sold. The exact procedure for prorating is covered in more advanced accounting textbooks.

Recall that Life Fitness had estimated $1,000,000 of MOH for the year and 62,500 DL hours, resulting in a predetermined MOH rate of $16/DL hour. By the end of the year, the com- pany had actually incurred $975,000 of MOH costs and used a total of 60,000 DL hours on jobs. By how much had Life Fitness overallocated or underallocated MOH for the year?

Please see page 174 for solutions .

What Journal Entries Are Needed in a Manufacturer's Job Costing System? Now that you know how manufacturers determine job costs and how those costs are used to make business decisions, let's look at how these costs are entered into the company's general ledger accounting system. We'll consider the journal entries needed to record the flow of costs through Life Fitness's accounts during the month of December. We'll use the same examples used earlier in the chapter. For the sake of simplicity, we'll continue to as- sume that Life Fitness only worked on two jobs during the month:

• Job 603: 50 units of the X4 Elliptical Cross-Trainers

• Job 604: 60 units of the TS Treadmill

You may wish to review the basic mechanics of journal entries, shown in Exhibit 3-17, before we begin our discussion.

EXHIBIT 3-17 Review of Journal Entry and T-account Mechanics

Accounts Increased Through Debits.

• Assets (e.g., inventory) • Expenses (e.g., rent expense)

WIP Inventory

D:bit I Credit

Accounts Increased Through Credits.

• Liabilities (e.g., wages payable) • Revenue (e.g., sales revenue) • Owners' Equity (e.g., retained earnings)

Wages Payable

Debit I Cr:dit

Additionally, keep in mind the flow of inventory that was first described in Exhibit 3-2. You may find this visual reminder helpful as we describe how the journal entries reflect the flow of inventory through the manufacturing system. In Exhibit 3-18, each arrow represents a journal entry that must be made to reflect activities that occur along the

Job Costing 129

6 Prepare journa l entr ies - for a manufacturer's ·

job costing system

1 3 0 CHAPTER 3

process: purchasing raw materials, using direct materials, using direct labor, recording actual MOH costs, allocating MOH to jobs, moving the jobs out of the factory after completion, and, finally, selling the units from a job. We'll now walk through journal entries associated with each of these activities.

EXHIBIT 3-18 Flow of Costs through a Manufacturing Plant

Purchasing raw

materials

Using direct labor

Purchase of Raw Materials

Cost of Goods Sold

Indirect Indirect Other indirect materials labor mfg. costs

MOH

Assume that Life Fitness ordered and received $90,000 of raw materials during December. Once the materials are received and verified against the purchase order and the invoice received from the supplier, the purchase is recorded as follows:

(1) Raw Materials Inventory 90,000

Accounts Payable 90,000

(to record purchases of raw materials on account) I

These materials will remain in the raw materials storeroom until they are needed for production. The liability in Accounts Payable will be removed when the supplier is paid.

Use of Direct Materials

Recall that direct materials are the primary physical components of the product. Each time production managers need particular direct materials for Jobs 603 and 604, they fill out a materials requisition informing the storeroom to pick the materials and send them into the manufacturing facility. Once these materials are sent into production, they become part of the work in process on Jobs 603 and 604, so their cost is added to the job cost records, as follows:

Job Cost Record

Job Number: 603 (50 Cross-trainers)

Job Cost Record

Job Number: 604 (60 Treadmills)

Manufacturing Cost Information: Cost Summary Manufacturing Cost Information: Cost Summary

Direct Materials $40,000 Direct Materials $72,000 Direct Labor Direct Labor Manufacturing Overhead Manufacturing Overhead

Total Job Cost Total Job Cost

~---- :J ~---- ~

From an accounting perspective, the cost of these materials must also be moved into Work in Process Inventory (through a debit) and out of Raw Materials Inventory (through a credit). The following journal entry is made:

(2) Work in Process Inventory ($40,000 + $72,000) 112,000

Raw Materials Inventory 112,000 I (to record the use of direct materials on jobs) I

Recall from the first half of the chapter that the individual job cost records form the underlying support for Work in Process Inventory shown on the balance sheet.6 Therefore, the amount posted to the general ledger account ($112,000) must be identical to the sum of the amounts posted to the individual job cost records ($40,000 + $72,000 = $112,000). Keep this important rule of thumb in mind:

Whenever a cost is added to a job cost record, a corresponding journal entry is made to increase WIP Inventory.

Use of Indirect Materials

Indirect materials are materials used in the manufacturing plant that cannot be traced to individual jobs and therefore are not recorded on any job cost record. Examples include janitorial supplies used in the factory and machine lubricants for the factory machines. Once again, materials requisitions inform the raw materials storeroom to release these materials. However, instead of becoming part of the Work in Process account for a par- ticular job, the indirect materials used in the factory (let's say $2,000) become part of the Manufacturing Overhead account. Therefore, the Manufacturing Overhead account is debited (to increase the account) and Raw Materials Inventory is credited (to decrease the account) as follows:

(3) Manufacturing Overhead 2,000

Raw Materials Inventory 2,000

(to record the use of indirect materials in the factory)

All indirect manufacturing costs, including indirect materials, indirect labor, and other indirect manufacturing costs (such as plant insurance and depreciation), are accu- mulated, or gathered together, in the Manufacturing Overhead account. The Manufactur- ing Overhead account is a temporary account used to "pool" (gather together) indirect manufacturing costs until those costs can be allocated to individual jobs. In fact, the MOH account is sometimes referred to as the "MOH cost pool."

6 The job cost records of unfinished jobs form the subsidiary ledger for the Work in Process Inventory account. Recall that a subsidiary ledger is simply the supporting detail for a general ledger account. Many other general ledger accounts (such as Accounts Receivable, Accounts Payable, and Plant & Equipment) also have subsidiary ledgers. The raw material inventory records form the subsidiary ledger for the Raw Materials Inventory account, whereas the job cost records on completed, unsold jobs form the subsidiary ledger for the Finished Goods Inventory account.

Job Costing 131

1 3 2 CHAPTER 3

Raw materials

purchased

We can summarize the flow of materials costs through the T-accounts as follows:

Raw Materials Inventory Work in Process Inventory l Direct

Beg Bal XXX 112,000 materials Beg Bal XXX - 90,000 2,000 used on jobs - 112,000

Indirect Manufacturing Overhead

materials o 2,000 I

used in factory

Use of Direct Labor The labor time records of individual factory workers are used to determine exactly how much time was spent directly working on Jobs 603 and 604. The cost of this direct labor is entered on the job cost records, as shown:

Job Cost Record

Job Number: 603 (50 Cross-trainers)

Job Cost Record

Job Number: 604 (60 Treadmills)

Manufacturing Cost Information: Cost Summary Manufacturing Cost Information: Cost Summary

Direct Materials $40,000 Direct Materials $72,000 Direct Labor $10,000 Direct Labor $20,000 Manufacturing Overhead Manufacturing Overhead

Total Job Cost Total Job Cost

'-------- :J Again, because the job cost records form the underlying support for Work in Process

Inventory, an identical amount ($10,000 + $20,000 = $30,000) must be debited to the Work in Process Inventory account. Wages Payable is credited to show that the company has a liability to pay its factory workers:

(4) Work in Process Inventory ($10,000 + $20,000 ) 30,000

Wages Payable 30,000 [

(to record the use of direct labor on jobs) I

The Wages Payable liability will be removed on payday when the workers receive their pay.

Use of Indirect Labor Recall that indirect labor consists of the salary, wages, and benefits of all factory work- ers who are not directly working on individual jobs. Examples include factory janitors, supervisors, and forklift operators. Because their time cannot be traced to particular jobs, the cost of employing these factory workers during the month (let's say $13,000) cannot be posted to individual job cost records. Thus, we record the cost of indirect labor as part of Manufacturing Overhead, not Work in Process Inventory:

(5) Manufacturing Overhead 13,000

Wages Payable 13,ooo I (to record the use of indirect labor in the factory)

Again, the Wages Payable liability will be removed on payday when the workers receive their pay.

We can summarize the flow of manufacturing labor costs through the T-accounts as follows:

Wages Payable Work in Process Inventory

XXX Beg Bal Direct BegBal XXX 30,000 labor 112,000 13,000 used on jobs 30,000

Manufacturing Overhead

Indirect 2.000 I labor - 13,000

used in factory

Incurring Other Manufacturing Overhead Costs

We have already recorded the indirect materials and indirect labor used in the factory during December by debiting the Manufacturing Overhead account. However, Life Fit- ness incurs other indirect manufacturing costs during the period, such as plant utilities ($3,000), plant and equipment depreciation ($4,000), plant insurance ($1,000), and plant property taxes ($2,000). All of these other costs of running the manufacturing plant dur- ing the month are also added to the Manufacturing Overhead account until they can be allocated to specific jobs:

(6) Manufacturing Overhead 10,000

Accounts Payable (for electric bill) 3,000

Accumulated Depreciation-Plant and Equipment 4,000

Prepaid Plant Insurance (for expiration of prepaid insurance) 1,000

Plant Property Taxes Payable (for taxes to be paid) 2,000

(to record other indirect manufacturing costs incurred

during the month) I

After recording all other indirect manufacturing costs, the Manufacturing Overhead account appears as follows:

Manufacturing Overhead

Other 2,000 13,000

indirect mfg. ----~ 10,000 costs

Job Costing 133

I

1 3 4 CHAPTER 3

Since all MOH costs are combined, or "pooled together" into one account, the MOH account is sometimes referred to as a "cost pool." As shown in Exhibit 3-19, you might find it helpful to visualize a pool being filled with the actual MOH costs incurred during the year. In the next section, we'll see how the costs are removed from the pool and as- signed to specific jobs.

EXHIBIT 3-19 Pooling Actua l MOH Costs

Indirect Materials ($2,000)

Indirect Labor Other MOH Costs ($13,000) ($10,000)

$25,000 of Actual MOH

MOH

Allocating Manufacturing Overhead to Jobs Life Fitness allocates some manufacturing overhead to each job using its predetermined MOH rate, calculated in the first half of the chapter to be $16 per direct labor hour. The total of direct labor hours used on each job is found on the labor time records and is summarized on the job cost records. Assume Job 603 used 500 DL hours and Job 604 used 1,000 DL hours. Then the amount of manufacturing overhead allocated to each job is determined as follows:

Job 603: $16 per DL hour X 500 DL hours = $8,000 Job 604: $16 per DL hour X 1,000 DL hours = $16,000

Job Cost Record

Job Number: 603 (50 Cross-trainers)

Job Cost Record

Job Number: 604 (60 Treadmills)

Manufacturing Cost Information: Cost Summary Manufacturing Cost Information: Cost Summary

Direct Materials $40,000 Direct Materials $72,000 Direct Labor (500 DL hrs) $10,000 Direct Labor (1,000 DL hrs) $20,000 Manufacturing Overhead $ 8,000 Manufacturing Overhead $16,000

Total Job Cost Total Job Cost

Again, because the job cost records form the underlying support for Work in Process Inventory, an identical amount ($8,000 + $16,000 = $24,000) must be debited to the Work in Process Inventory account. Because we accumulated all actual manufacturing overhead costs into an account called Manufacturing Overhead (through debiting the ac- count), we now allocate manufacturing overhead costs out of the account by crediting it.

(7) Work in Process Inventory ($8,000 + $16,000) 24,000

Manufacturing Overhead 24,000 l (to allocate manufacturing overhead to specific jobs) I

As shown in Exhibit 3-20, you might find it helpful to visualize the allocation process as removing, or ladling out, some of the MOH cost in the pool and allocating it to individual jobs worked on in the factory. In our example, we assumed only two jobs were worked on during the month (Jobs 603 and 604). However, if more jobs were worked on, the same allocation process would take place for each and every job. To recap, the MOH cost pool is increased through the addition of actual MOH costs as they are incurred, and decreased through the allocation of MOH to individual jobs. In the general ledger, the MOH cost pool is represented by the MOH account. Thus, the account is increased (debited) whenever an actual MOH cost is incurred, and it is credited whenever MOH costs are allocated to jobs.

EXHIBIT 3-20 Allocating MOH Costs to Individua l Jobs

MOH Job 603 $8,000

Job 604 $16,000

By looking at the Manufacturing Overhead T-account, you can see how actual manu- facturing overhead costs are accumulated in the account through debits, and the amount of manufacturing overhead allocated to specific jobs is credited to the account:

Manufacturing Overhead

(ACTUAL) (ALLOCATED to Jobs) 2,000 24,000 --------, MOH

13,000 allocated 10,000 to jobs

Completion of Jobs

Work in Process Inventory

BegBal XXX 112,000 30,000

-----~ .. 24,000

Once the job has been completed, the three manufacturing costs shown on the job cost record are summed to find the total job cost. If the job consists of more than one unit, the total job cost is divided by the number of units to find the cost of each unit:

Job Cost Record

Job Number: 603 (50 Cross-trainers)

Manufacturing Cost Information: Cost Summary

Direct Materials $40,000 Direct Labor $10,000 Manufacturing Overhead $ 8,000

Total Job Cost $58,000 Number of Units +50 Cost per Unit $ 1,160

'-------- ~

Job Cost Record

Job Number: 604 (60 Treadmills)

Manufacturing Cost Information:

Direct Materials Direct Labor Manufacturing Overhead

Total Job Cost Number of Units Cost per Unit

Job Costing 135

Cost Summary

$ 72,000 $ 20,000 $ 16,000 $108,000

+60 $ 1,800

1 3 6 CHAPTER 3

The units produced in the jobs are physically moved off of the plant floor and into the fin- ished goods warehouse. Likewise, in the accounting records, the jobs are moved out of Work in Process Inventory (through a credit) and into Finished Goods Inventory (through a debit):

(8) Finished Goods Inventory ($58,000 + $108,000) 166,000

Work in Process Inventory 166,000

(to move the completed jobs out of the factory and into

Finished Goods) I

The T-accounts show the movement of completed jobs off of the factory floor:

Work in Process Inventory

166,000

Finished Goods Inventory Move

completed Beg Bal XXX BegBal XXX ~ .----... 112,000 ~ ~ 30,000 ~ ~ 24,000

MOH allocated

Sale of Units

XXX

jobs 1------ 166,000

For simplicity, let's assume that Life Fitness only had one sale during the month: It sold 40 cross-trainers from Job 603 and all 60 treadmills from Job 604 to the City of Westlake for its recreation centers. The sales price was $1,425 for each cross-trainer and $2,500 for each treadmill. Like most companies, Life Fitness uses a perpetual inventory system so that its in- ventory records are always up to date. Two journal entries are needed. The first journal entry records the revenue generated from the sale and shows the amount due from the customer:

(9) Accounts Receivable (40 X $1,425) + (60 X $2,500) 207,000

Sales Revenue 20?,000 I (to record the sale of 40 cross-trainers and 60 treadmills)

The second journal entry reduces the company's Finished Goods Inventory and re- cords the Cost of Goods Sold. From the job cost record, we know that each cross-trainer produced in Job 603 cost $1,160 to make, and each treadmill from Job 604 cost $1,800 to make. Therefore, the following entry is recorded:

(10) Cost of Goods Sold (40 X $1,160) + (60 X $1,800) 154,400 Finished Goods Inventory 154,400 [

(to reduce Finished Goods Inventory and record Cost of Goods Sold)

The following T-accounts show the movement of the units out of Finished Goods Inventory and into Cost of Goods Sold:

Finished Goods Inventory

BegBal XXX 166,000 154,400

End Bal XXX

Cost of Goods Sold

Sale of cross-trainers ---- 154,400 I and treadmills

Operating Expenses Let's assume Life Fitness also incurred $32,700 of operating expenses during the month to run its business. For example, Life Fitness incurred salaries and commissions ($20,000) for its salespeople, office administrators, research and design staff, and customer service representatives. It also needs to pay rent ($3,300) for its office headquarters. The company also received a bill from its advertising agency for marketing expenses incurred during the month ($9,400). All costs incurred outside of the manufacturing function of the value chain would be expensed in the current month as shown in the following journal entry:

(11) Salaries and Commission Expense 20,000

Rent Expense 3,300 I Marketing Expenses 9,400

Salaries and Commissions Payable 20,000

Rent Payable 3,300

Accounts Payable 9,400

(to record all non-manufacturing costs incurred during the month)

All non-manufacturing expenses (period costs) will be shown as "operating expenses" on the company's income statement, as shown in Exhibit 3-21 on the next page.

Closing Manufacturing Overhead As a final step, Life Fitness must deal with the balance in the manufacturing overhead account. Because the company uses a predetermined manufacturing overhead rate to al- locate manufacturing overhead to individual jobs, the total amount allocated to jobs will most likely differ from the amount of manufacturing overhead actually incurred.

Let's see how this plays out in the Manufacturing Overhead T-account:

1. All manufacturing overhead costs incurred by Life Fitness were recorded as debits to the Manufacturing Overhead account. These debits total $25,000 of actual manufac- turing overhead incurred.

2. On the other hand, all manufacturing overhead allocated to specific jobs ($8,000 + $16,000) was recorded as credits to the Manufacturing Overhead account:

Manufacturing Overhead

I Indirect material (ACTUAL) (ALLOCATED to Jobs) $8,000 allocated b· ====:;-_ i-------t•~ 2,000 24,000 ~---r--i to Job 603 I Indirect labor >-1 -------•~ 13,000

__,,--_ 1_0~ 00~0'-+------ $16,000 allocated Other indirect 1,000 to Job 604

manufacturing costs

This leaves a debit balance of $1,000 in the Manufacturing Overhead account, which means that manufacturing overhead has been underallocated during the month. More manufacturing overhead costs were incurred than were allocated to jobs. Because Manu- facturing Overhead is a temporary account not shown on any of the company's financial statements, it must be closed out (zeroed out) at the end of the period. Because most of the inventory produced during the period has been sold, Life Fitness will close the balance in Manufacturing Overhead to Cost of Goods Sold as follows:

(12) Cost of Goods Sold 1,000

Manufacturing Overhead 1,000 I (to close the Manufacturing Overhead account) I

Job Costing 137

1 3 8 CHAPTER 3

As a result of this entry, (1) the Manufacturing Overhead account now has a zero balance, and (2) the balance in Cost of Goods Sold has increased to correct for the fact that the jobs had been undercosted during the period.

Manufacturing Overhead Cost of Goods Sold

2,000 24,000 154,400

l3,000 Adjustment for 10 000 1 000 ------ --1 Underallocation >---_-:_-:_-:_-:_-:::'._~_1_0_0_0--+-_____ _

0 155,400

If, in some period, Life Fitness were to overallocate its overhead, the journal entry to close Manufacturing Overhead would be the opposite of that shown: Manufacturing Overhead would be debited to zero it out; Cost of Goods Sold would be credited to reduce it as a result of having overcosted jobs during the period.

Now you have seen how all of the costs flow through Life Fitness's accounts during December. Exhibit 3-21 shows the company's income statement that resulted from all of the previously shown journal entries.

EXHIBIT 3-21 Income Statement After Adjusting for Underallocated Manufacturing Overhead

-- -_J A B C D 1 Life Fitness 2 Income Statement 3 For the Month Ended December 31 4 5 Sales Revenue $ 207,000 6 Less: Cost of Goods Sold 155,400 7 Gross Profit 51,600 8 Less: Operating Expenses 32,700 9 Operating Income $ 18,900 10

Job Costing 139

Decision Guidelines •

Job Costing ·-..... .. . The following decision guidelines describe the implications of over- or underallocating manufacturing overhead, as well as other decisions that need to be made in a job costing environment .

Decision

How does overallocating or underallocat- ing MOH affect the cost of jobs manufac- tured during the period?

What do we do about overallocated or underallocated manufacturing overhead?

How do we know whether to increase or decrease Cost of Goods Sold (CGS)?

How do we record the use of direct materials on a job?

How do we record the use of direct labor on a job?

How do we record actual MOH cost incurred in the factory?

How do we record the allocation of MOH costs to jobs?

How do we record the completion of the job?

How does job costing work at a service firm (Appendix)?

Guidelines

If manufacturing overhead has been underallocated, it means that not enough MOH was allocated to the jobs . The jobs have been undercosted as a result .

On the other hand, if manufacturing overhead has been overa//ocated, it means that too much MOH was allocated to jobs . The jobs have been overcosted as a result .

Assuming most of the inventory produced during the period has been sold, manufacturers generally adjust the Cost of Goods Sold for the total amount of the under- or overallocation . If a significant portion of the inventory is still on hand, then the adjustment will be prorated between WIP Inventory, Finished Goods Inventory, and Cost of Goods Sold .

If manufacturing overhead has been overallocated, then Cost of Goods Sold (CGS) is too high and must be decreased through a credit to the CGS account .

If manufacturing overhead has been underallocated, then Cost of Goods Sold is too low and must be increased through a debit to the CGS account .

Work in Process Inventory X

Raw Materials Inventory X

Work in Process Invento ry X

Wages Payable X

Manufacturing Overhead X

Raw Materials Inventory (for indirect materials) x i Wages pa yable (for ind irect labor) x i Accounts payable, etc. (for other MOH) X

Work in Process Inventory X

Manufacturin g Overhead X

Finished Goods Inventory X

Work in Process Inventory X

Job costing at a service firm is very similar to job costing at a manufacturer . The main difference is that the company is allocating operating expenses, rather than manufacturing costs, to each client job . In addition, because there are no Inventory or Cost of Goods Sold accounts, no journal entries are needed to move inventory through the system . All costs are simply expensed as period costs, but separate job cost records are maintained to keep track of the costs of serving each client.

140 CHAPTER 3 - •. _ . . SUMMARY PROBLEM 2

Fashion Fabrics makes custom handbags and accessories for high-end clothing boutiques. Re- cord summary journal entries for each of the following transactions that took place during the month of January, the first month of the fiscal year.

Requirements

1. During January, $150,000 of raw materials was purchased on account.

2. During the month, $140,000 of raw materials was requisitioned. Of this amount, $135,000 was traced to specific jobs, while the remaining materials were for general factory use.

3. Manufacturing labor (both direct and indirect) for the month totaled $80,000. It has not yet been paid. Of this amount, $60,000 was traced to specific jobs.

4. The company recorded $9,000 of depreciation on the plant building and machinery . In addition, $3,000 of prepaid property tax expired during the month . The company also received the plant utility bill for $6,000 which will be paid at a later date.

5. Manufacturing overhead was allocated to jobs using a predetermined manufactur- ing overhead rate of 75% of direct labor cost. (Hint: Total direct labor cost is found in Requirement 3.)

6. Several jobs were completed during the month. According to the job cost records, these jobs cost $255,000 to manufacture.

7. Sales (all on credit) for the month totaled $340,000. According to the job cost records, the units sold cost $250,000 to manufacture. Assume the company uses a perpetual inventory system.

8. The company incurred operating expenses of $60,000 during the month. Assume that 80% of these were for marketing and administrative salaries and the other 20% were lease and utility bills related to the corporate headquarters. The expenses will be paid later.

9. In order to prepare its January financial statements, the company had to close its Manufacturing Overhead account.

10. Prepare the January income statement for Fashion Fabrics based on the transactions recorded in Requirements 1 through 9.

• SOLUTIONS 1. During January, $150,000 of raw materials was purchased on account.

Raw Materials Inventory 150,000 I Accounts Payable 1so,ooo I

(to record purchases of raw materials) I

2. During the month, $140,000 of raw materials was requisitioned . Of this amount, $135,000 was traced to specific jobs, while the remaining materials were for general factory use.

Work in Process Inventory 135,000

Manufacturing Overhead 5,000

Raw Materials Inventory 140,000

(to record the use of direct materials and indirect materials)

3. Manufacturing labor (both direct and indirect) for the month totaled $80,000 . It has not yet been paid . Of this amount, $60,000 was traced to specific jobs.

Work in Process Inventory (for direct labor) 60,000

Manufacturing Overhead (for indirect labor) 20,000

Wages Payable 80,000

(to record the use of direct labor and indirect labor)

4. The company recorded $9,000 of depreciation on the plant building and machinery . In addition, $3,000 of prepaid property tax expired during the month . The company also received the plant utility bill for $6,000 which will be paid at a later date .

Manufacturing Overhead 18,000

Accumulated Depreciation - Plant and Equipment 9,000

Prepaid Plant Property Tax (for expiration of property tax) 3,000

Accounts Payable (for electric bill) 6,000

(to record other indirect manufacturing costs incurred

during the month)

5. Manufacturing overhead was allocated to jobs using a predetermined manufacturing overhead rate of 75% of direct labor cost. (Hint: Total direct labor cost is found in Re- quirement 3.)

Work in Process Inventory (75% X $60,000 of direct labor) 45,000 I Manufacturing Overhead 4s,ooo I

(to allocate manufacturing overhead to jobs) I

6. Several jobs were completed during the month . According to the job cost records, these jobs cost $255,000 to manufacture .

Finished Goods Inventory 255,000

Work in Process Inventory 255,000

(to move the completed jobs out of the factory and into

Finished Goods)

7. Sales (all on credit) for the month totaled $340,000. According to the job cost records, the units sold cost $250,000 to manufacture . Assume the company uses a perpetual inventory system .

Accounts Receivable 340,000 I Sales Revenue 340,000 I

(to record the sales and receivables) I

Cost of Goods Sold 250,000 I Finished Goods Inventory 2so,ooo I

(to reduce Finished Goods Inventory and record Cost of Goods Sold) I

Job Costing 141

142 CHAPTER 3

_J

1 2 3 4 5 6 7 8 9 10 11

8. The company incurred operating expenses of $60,000 during the month . Assume that 80% of these were for marketing and administrative salaries and the other 20% were lease and utility bills related to the corporate headquarters. The expenses will be paid later.

Salaries Expense ($60,000 X 80%) 48,000

Lease and Utilities Expense ($60,000 X 20%) 12,000

Salaries and Wages Payable 48,000

Accounts Payable 12,000

(to record all non-manufacturing costs incurred during the month)

9. In order to prepare its January financial statements, the company had to close its Manufacturing Overhead account .

An analysis of the manufacturing overhead account prior to closing shows the following:

Manufacturing Overhead

Cost of Goods Sold

Manufacturing Overhead

(ACTUAL) 5,000

20,000 18,000

(ALLOCATED) 45,000

2,000

(to close the Manufacturing Overhead account to CGS)

2,000 I 2,000 I

I

10. Prepare the January income statement for Fashion Fabrics based on the transactions recorded in Requirements 1 through 9 .

A B C D Fashion Fabrics

Income Statement For Month Endin" lanuarv 31

Sales Revenue $ 340,000 Less: Cost of Goods Sold** 248,000 Gross Profit 92,000 Less: Operating Expenses 60,000 Operating Income $ 32,000

(** $250,000 - $2,000 closing adjustment)

Job Costing 143

• Appendix 3A • •

How Do Service Firms Use Job Costing to Determine the Amount to Bill Clients? So far in this chapter we have illustrated job costing in a manufacturing environment. However, job costing is also used by service firms (such as law firms, accounting firms, marketing firms, and consulting firms) and by tradespeople (such as plumbers, electri- cians, and auto mechanics). At these types of companies, the work performed for each individual client is considered a separate job. Service firms need to keep track of job costs so that they have a basis for billing their clients. As shown in Exhibit 3-22, the direct costs of serving the client are traced to the job, whereas the indirect costs of serving the client are allocated to the job.

EXHIBIT 3-22 Assigning Costs to Client Jobs

The amount billed to the client is determined by adding a profit markup to the total job cost. The main difference between job costing at a manufacturer and job costing at a service firm is that the indirect costs of serving the client are all operating expenses (period costs) rather than manufacturing (product) costs. In the next section, we will illustrate how job costing is used at the Bucaro & Associates law firm to determine how much to bill Client 367.

What Costs Are Considered Direct Costs of Serving a Client? Professional labor is often the most significant direct cost at a service firm. It is con- sidered a direct cost because professionals can use labor time records to keep track of the amount of time they spend performing work for individual clients. Because most professionals are paid an annual salary rather than an hourly wage rate, firms estimate the hourly professional labor cost based on the number of hours the professionals are expected to work during the year. For example, say Attorney Taylor Sweeney is paid a salary of $100,000 per year. The law firm she works for, Bucaro & Associates, expects her to spend 2,000 hours a year performing legal work for clients (50 weeks x 40 hours per week). Therefore, for job costing purposes, the law firm converts her annual salary to an hourly professional labor cost as follows:

$100,000 annual salary $ 50

h = per our

2,000 hours per year

7 Use job costing at a : __ service firm as a basi~-- for billing clients

1 44 CHAPTER 3

If the labor time record indicates that Sweeney has spent 14 hours on Client 367, then the direct professional labor cost traced to the client is calculated as follows:

14 hours X $50 per hour = $700 of direct professional labor

In addition to professional labor, any other costs that are readily identifiable with specific clients would be considered direct costs. For example, the law firm would be able to trace court filing fees to specific clients. Marketing firms would be able to trace the cost of placing print, billboard, and TV advertisements to specific clients. Plumbers, electri- cians, and auto mechanics would be able to trace materials (such as garbage disposals, lighting, and new tires) to specific clients. In summary, any cost that is traceable to a client would be considered a direct cost of serving the client.

What Costs Are Considered Indirect Costs of Serving a Client? Service firms also incur general operating expenses, such as office rent, office supplies, and advertising. These costs are considered indirect because they can not be traced to in- dividual clients. Rather, they are a joint cost of serving all clients. Since these costs cannot be traced to specific clients, they will be allocated among all clients using a predetermined indirect cost allocation rate. Service firms use the same four basic steps to allocate indirect costs as manufacturers use. The only real difference is that they are allocating indirect operating expenses, rather than indirect manufacturing costs (MOH).

STEP 1: Estimate the total indirect costs for the coming year. Before the fiscal year begins, the law firm estimates the total indirect costs

for the coming year:

Office rent ............................................................................................ .

Office supplies, telephone, internet access, and copier lease .................. .

Office support staff ............................................................................... .

Maintaining and updating law library for case research ....................... .

Advertising ........................................................................................... .

Total indirect costs ............................................................................... .

$190,000

10,000

70,000

25,000

5,000

$300,000

STEP 2: Choose an allocation base and estimate the total amount that will be used dur- ing the year.

Next, the law firm chooses a cost allocation base. Service firms typically use professional labor hours as the cost allocation base. For example, Bucaro & Associates estimates that attorneys will spend a total of 10,000 professional labor hours working on client jobs throughout the coming year.

STEP 3: Compute the predetermined indirect cost allocation rate. The predetermined indirect cost allocation rate is found as follows:

. . . . Total estimated indirect costs Predetermined md1rect cost allocat10n rate = T

1 . d f h

11 · b

ota estimate amount o t e a ocat10n ase $300,000 total indirect costs

10,000 professional labor hours = $30 per professional labor hour

STEP 4: Allocate indirect costs to client jobs using the predetermined rate. Throughout the year, indirect costs are allocated to individual client jobs

using the predetermined indirect cost allocation rate. For example, assume Taylor Sweeney spent 14 hours working on Client 367 and she was the only attorney who worked on this job. The amount of indirect cost allocated to the job is computed as follows:

= Predetermined indirect cost allocation rate X Actual amount of allocation base used by the job

= $30 per professional labor hour X 14 professional labor hours

= $420

Finding the Total Cost of the Job and Adding a Profit Markup Bucaro & Associates can now determine the total cost of serving Client 367:

Direct costs traced to Client 367 ($50 per hour X 14 hours)..................... $ 700

Indirect costs allocated to Client 367 ($30 per hour X 14 hours).............. 420

Total cost of serving Client 367 ................................................................ $1,120

Once the total job cost is known, Bucaro & Associates can determine the amount to bill the client. Let's assume that Bucaro & Associates bills clients at 25% over its costs. Bucaro & Associates would bill Client 367 as follows:

Job cost + Markup for profit = Amount to bill the client $1,120 + (25% X $1,120) = $1,400

Job Costing 145

Invoicing Clients Using a Professional Billing Rate When service firms and tradespeople bill their clients, they don't show the actual direct costs of providing the service, the alloca- tion of indirect costs, or the profit they earned on the job. Rather, these individual figures are hidden from the client's view. How is this done? By incorporating these costs and profit components in the labor rate, often known as the billing rate, charged to the customer. Consider the last time you had your vehicle repaired. A typical mechanic billing rate exceeds $48 per hour, yet the me- chanic employed by the auto repair shop does not actually earn a $48-per-hour wage rate.

II Why is this important? "Service companies (such as law firms ) and tradespeople (such as auto mechanics and plumbers) use

job costing to determine how much to bill their clients."

Let's look at the calculations a service firm performs "be- hind the scenes" to determine its hourly billing rates. Bucaro & Associates determines Taylor Sweeney's billing rate as follows:

Professional labor cost per hour ................................................................ .

Plus: Indirect cost allocation rate per hour ................................................ .

Total hourly cost ....................................................................................... .

Plus profit markup: (25 % X $80 hourly cost) ........................................... .

Hourly billing rate for Taylor Sweeney ..................................................... .

$ 50

30

$ 80

+ 20 $100

1 46 CHAPTER 3

Whenever Taylor Sweeney performs legal work for a client, her time will be billed at $100 per hour. Remember, this is the price Bucaro & Associates charges its clients for any work performed by Taylor Sweeney. The actual invoice to Client 367 would look similar to Exhibit 3-23.

EXHIBIT 3-23 Invo ice to Client

'---

Bucaro & Associates Law Firm Invoice: Client 367

Work performed the week of July 23: Researching and filing patent applicat ion

Attorney Taylor Sweeney: 14 hours x $100 hourly billing rate .......................................... $1 ,400

What Journal Entries Are Needed in a Service Firm's Job Costing System? The journal entries required for job costing at a service firm are much simpler than those used at a manufacturing company. That's because service firms typically have no inven- tory; hence, there is no need to record the movement of inventory through the system. Rather, all costs at a service company are treated as period costs, meaning they are imme- diately recorded as operating expenses in the period when they are incurred (for example, salary expense, rent expense, telephone expense, and advertising expense). The tracing of direct costs and the allocation of indirect costs is performed only on the client's job cost record, not through journal entries to the company's general ledger.

Sarah Haymeyer, CPA, pays her new staff accountant, Hannah, a salary equivalent to $25

per hour, while Sarah receives a salary equivalent to $40 per hour . The firm's predetermined

indirect cost allocation rate for the year is $12 per hour . Haymeyer bills for the firm's ser-

vices at 30% over cost. Assume Sarah works 5 hours and Hannah works 10 hours preparing

a tax return for Michele Meckfessel.

1. What is the total cost of preparing Meckfessel's tax return?

2. How much will Sarah bill Meckfessel for the tax work?

Please see page 174 for solutions .

Learning Objectives • 1 Distinguish between job costing and process costing

• 2 Understand the flow of production and how direct materials and direct labor are traced to jobs

• 3 Compute a predetermined manufacturing overhead rate and use it to allocate MOH to jobs

• 4 Determine the cost of a job and use it to make business decisions

• 5 Compute and dispose of overallocated or underallocated manufacturing overhead

• 6 Prepare journal entries for a manufacturer's job costing system

• 7 (Appendix) Use job costing at a service firm as a basis for billing clients

Accounting Vocabulary Bill of Materials. (p. 109) A list of all of the raw materia ls needed to manufacture a job.

Billing Rate. (p. 145) The labor rate charged to the cus- tomer, which includes both cost and prof it components.

Cost Driver. (p. 117) The primary facto r that causes a cost.

Cost-Plus Pricing. (p. 120) A pricing approach in wh ich the company adds a desired leve l of profit to the product's cost.

Extended Producer Responsibility (EPR). (p. 122) Laws that require product manufacturers to "take back" a large percent- age of the products they manufacture at the end of the prod- uct's life in order to reduce the amount of waste ending up in landf ills and the env ironment.

Invoice. (p. 110) Bill from a supp lier.

Job Cost Record. (p. 110) A written or electronic document that lists the d irect mater ia ls, direct labor, and manufactur ing overhead costs assigned to each individua l job.

Job Costing. (p. 106) A system for assigning costs to prod- ucts or services that differ in the amount of mater ials, labor, and overhead requ ired. Typically used by manufacturers that produce un ique, or custom-ordered products in sma ll batches; also used by professional serv ice firms.

Labor Time Record. (p. 114) A written or e lectron ic docu- ment that identifies the emp loyee, the amount of time spent on a particular job, and the labor cost charged to a job.

Mass Customization. (p. 107) Large-scale production of cus- tom ized product that a llows manufacturers to meet a variety of consumer desires, wh ile at the same time achieving the ef- ficienc ies of mass production that dr ive down unit costs.

Materials Requisition. (p. 113) A written or e lectron ic docu- ment request ing that spec ific materia ls be transferred from the raw mater ia ls inventory storeroom to the production floor.

Overallocated Manufacturing Overhead. (p. 127) The amount of manufacturing overhead allocated to jobs is more

than the amount of manufacturing overhead costs actua lly in- curred; resu lts in jobs being overcosted.

Pick. (p. 113) Storeroom workers remove items from raw ma- terials inventory that are needed by product ion.

Predetermined Manufacturing Overhead Rate. (p. 117) The rate used to a llocate manufactur ing overhead to ind ividua l jobs; calcu lated before the year begins as fo llows: tota l estimated manufacturing overhead costs d ivided by total estimated amount of a llocation base.

Process Costing. (p. 105) A system for assigning costs to a large number of identica l un its that typ ical ly pass through a se- ries of uniform production steps. Costs are averaged over the units produced such that each unit bears the same unit cost.

Production Schedule. (p. 108) A written or electronic docu- ment indicating the quant ity and types of inventory that will be manufactured during a specified t ime frame.

Purchase Order. (p. 110) A written or electronic document author izing the purchase of specific raw mater ials from a spe- cific supp lier.

Raw Materials Record. (p. 109) A written or e lectron ic document listing the number and cost of all units used and re- ceived, and the balance current ly in stock; a separate record is maintained for each type of raw material kept in stock.

Receiving Report. (p. 110) A written or e lectronic document listing the quant ity and type of raw materia ls received in an incom ing shipment; the report is typically a dup licate of the purchase order without the quant ity pre-listed on the form.

Stock Inventory. (p. 108) Products normally kept on hand in order to quick ly fill customer orders.

Subsidiary Ledger. (p. 131) Support ing deta il for a genera l ledger account.

Underallocated Manufacturing Overhead. (p. 127) The amount of manufactur ing overhead allocated to jobs is less than the amount of manufacturing overhead costs actua lly in- curred; this resu lts in jobs be ing undercosted.

147

148 CHAPTER 3

MyAccounting lab Go to http://myaccountinglab.com/ for the following Quick Check, Short Exercises, Exercises, and Problems. They are available with immediate grading, explanations of correct and incorrect answers, and interactive media that acts as your own online tutor.

Quick Check 1. (Learning Objective 1) For which of the following

would job costing not be appropriate? a. Electrician

b. Manufacturer of mass-produced carbonated beverages

c. Law firm

d. Manufacturer of custom-ordered production equipment

2. (Learning Objective 2) Which of the following docu- ments specifies the materials needed to produce a job?

a. Bill of materials

b. Raw materials records

c. Receiving report

d. Production schedule

3. (Learning Objective 2) Which of the following docu- ments is used to accumulate all of the manufacturing costs assigned to a job?

a. Labor time record

b. Materials requisition

c. Purchase order

d. Job cost record

4 . (Learning Objective 3) The amount of manufacturing overhead recorded on a job cost record for a particular job is found by

a. tracing manufacturing overhead to the job .

b. either tracing or allocating manufacturing overhead costs (management's choice) .

c. allocating manufacturing overhead to the job .

d. None of the answers listed is correct .

5 . (Learning Objective 4) Which of the following is false? a. Direct costing focuses on only the direct costs found

on the job cost record .

b. Job cost information is not useful for assessing the profitability of different products .

c. A cost-plus price is determined by adding a markup to the cost .

d. Non-manufacturing costs can be assigned to jobs only for internal decision making, never for external financial reporting .

6. (Learning Objective 5) Which of the following is true? a. If manufacturing overhead is underallocated, then

jobs will be overcosted .

b. If manufacturing overhead is overallocated, then jobs will be undercosted .

c. Both of the statements are true .

d. None of the statements is true .

7. (Learning Objective 5) Assuming the amount of manu- facturing overhead overallocation or underallocation is not material, which account is adjusted at the end of the period?

a. Sales Revenue

b. Work in Process Inventory

c. Raw Materials Inventory

d. Cost of Goods Sold

8. (Learning Objective 6) Whenever direct material, di- rect labor, and manufacturing overhead are recorded on a job cost record, an associated journal entry is made to debit which of the following accounts?

a. Sales Revenue

b. Work in Process Inventory

c. Cost of Goods Sold

d. Finished Goods Inventory

9. (Learning Objective 6) When a job is completed, the total cost of manufacturing the job should be moved to which of the following general ledger accounts?

a. Finished Goods Inventory

b. Sales Revenue

c. Cost of Goods Sold

d. Work in Process Inventory

10. (Learning Objective 7, Appendix) Which of the fol- lowing is true when using job costing at a service firm? a. Professional labor cost would be considered an indi-

rect cost of serving the client .

b. Office rent would be considered a direct cost of serving the client .

c. Both direct and indirect costs are assigned to client jobs .

d. The professional billing rate consists solely of the professionals' labor cost .

Quick Check Answers

:, ·o L e . 6 q ·g P . L P ·9 q ·s :, ·17 P "£ e ·z q . L

Short Exercises

53-1 Identify product costs, period costs, and product costing system (Learning Objective 1)

Smarties, the sugar candy that is packaged in rolls of 15 small candies, come in six flavors : white (orange creme}, yellow (pineapple}, pink (cherry}, green (strawberry}, purple (grape}, and orange (orange) . Smarties are gluten free and vegan and have 25 calories per roll of 15 candies . The main ingredient in Smarties is dextrose, a form of sugar .

The Smarties Candy Company, founded in 1949, makes its Smarties candy in a New Jersey plant . Its founder bought gunpowder pellet machines after World War I and re- purposed them to make the tablet-shaped candies . Smarties are made by color in large batches and then dumped together to be sorted by machines into rolls and packs.

Three granddaughters of the original founder of Smarties now run the company and have been working to improve efficiency . Their chief mechanic designed a faster candy press and a new wrapper machine . Previously, 125 Smarties rolls could be wrapped per minute; now 200 rolls can be wrapped per minute . Smarties are produced 24 hours a day in continuous batches .

The Smarties Candy Company has its one main product that is likely to account for most of its sales, but recently it introduced Smarties ' n creme, whic h are tablets that are about the size of a quarter and have a flavor burst that is half fruit (strawberry, blueberry, raspberry, peach, or orange) and half cream (dairy-free) .

Requirements

1. Give an example of each of the following types of costs at the Smarties Candy Company :

a. Direct material

b. Direct labor

c. Manufacturing overhead

d. Selling and administrative expense

2. Assume that only Smarties candies are made in the New Jersey plant . Do you think the Smarties Candy Company is likely to use job order costing or process costing? Explain .

3. If the New Jersey plant begins to produce Smarties 'n creme in addition to Smarties candy rolls, would this change be likely to impact whether the company uses job or- der costing or process costing? Why or why not?

53-2 Decide on product costing system (Learning Objective 1) Would the following companies use job costing or process costing?

a. A legal firm

b. An oil refinery

c. A commercial plumbing contractor

d. A cereal manufacturer e. A custom-home builder

53-3 Determine the flow of costs between inventory accounts (Learning Objective 2)

Kirkland Furniture is a manufacturing plant that makes a variety of tables, benches, and other furniture . Indicate which inventory account(s) would be affected by the following actions that occur at Kirkland's in the process of manufacturing its standard picnic tables . Also indicate whether the inventory account would increase or decrease as a result of the action .

a. Lumber is delivered by the supplier to the plant, where it is stored in a materials store- room until needed .

b. Lumber is requisitioned from the storeroom to be used for tops and seats for the tables .

c. Factory workers cut the lumber for the tables .

d. Five tables are completed and moved to the inventory storage area to await sale .

e. A customer purchases a table and takes it home .

Job Costing 149

150 CHAPTER 3

53-4 Understanding key document terms in a job cost shop (Learning Objective 2)

Listed below are several document terms . Match each term with the corresponding statement in the list provided . Some terms may be used more than once and other terms may not be used at all.

a . Bill of materials

d . Purchase orders

g . Receiving report

Terms

b. Job cost record

e . Raw materials record

h. Materials requisition

c. Production schedule

f. Labor time record

i. Invoice

1. A(n) ___ is used to accumulate all of the costs affiliated with each job.

2. All direct laborers in the factory fill out a(n) __ .

3. The accounting department will not pay a(n) __ unless it agrees with the quantity of parts both ordered and received .

4. Each item in the raw materials storeroom has its own

5. The __ is a control for the materials stored in the storeroom . In order to get direct materials, a(n) __ must be presented .

6. Before production begins, a manufacturer's purchasing department issues __ to its supplier for needed direct materials .

7. A(n) __ is typically a duplicate of the purchase order but without the quantity pre- listed on the form .

8. The __ is like a list of ingredients in a recipe, stating the materials needed to pro- duce a product.

53-5 Compute a professional billing rate (Learning Objective 7) Nicole Grandstone is a new staff accountant at James & Associates . She is paid a salary of $67,600 per year and is expected to work 2,600 hours per year on client jobs. The firm's indirect cost allocation rate is $25 per hour . The firm would like to achieve a profit equal to 20% of cost .

1. Convert Nicole's salary to an hourly wage rate for billing purposes .

2. Calculate the professional billing rate James & Associates would use for billing out Nicole's services .

53-6 Compute various manufacturing overhead rates (Learning Objective 3) Edmonton Pools manufactures swimming pool equipment. Edmonton estimates total manufacturing overhead costs next year to be $1,400,000 . Edmonton also estimates it will use 50,000 direct labor hours and incur $1,000,000 of direct labor cost next year . In addition, the machines are expected to be run for 40,000 hours . Compute the prede- termined manufacturing overhead rate for next year under the following independent situations :

1. Assume that the company uses direct labor hours as its manufacturing overhead allocation base.

2. Assume that the company uses direct labor cost as its manufacturing overhead allocation base .

3. Assume that the company uses machine hours as its manufacturing overhead allocation base.

53-7 Continuation of 53-6: compute total allocated overhead (Learning Objective 3)

Use your answers from 53-6 to determine the total manufacturing overhead allocated to Edmonton's manufacturing jobs in the following independent situations :

1. Assume that the company actually used 51,700 direct labor hours .

2. Assume that the company actually incurred $1,020,000 of direct labor cost .

3. Assume that the company actually ran the machines 39,500 hours .

4. Briefly explain what you have learned about the total manufacturing overhead allo- cated to production .

53-8 Continuation of 53-7: determine over- or underallocation (Learning Objectives 3 & 5)

Use your answers from 53-7 to determine the total overallocation or underallocation of manufacturing overhead during the year . Actual manufacturing costs for the year for Edmonton Pools totaled $1,425,000 .

1. Assume that the company used direct labor hours as the allocation base .

2. Assume that the company used the direct labor cost as the allocation base .

3. Assume that the company used machine hours as the allocation base .

4. Were there any situations in which jobs were costed correctly? If not, when were they overcosted? When were they undercosted?

53-9 Calculate rate and analyze year-end results (Learning Objectives 3 & 5) Adam Industries manufactures wooden backyard playground equipment . Adam esti- mated $1,800,000 of manufacturing overhead and $2,000,000 of direct labor cost for the year . After the year was over, the accounting records indicated that the company had ac- tually incurred $1,660,000 of manufacturing overhead and $2,650,000 of direct labor cost .

1. Calculate Adam's predetermined manufacturing overhead rate, assuming that the company uses direct labor cost as an allocation base.

2. How much manufacturing overhead would have been allocated to manufacturing jobs during the year?

3. At year-end, was manufacturing overhead overallocated or underallocated? By how much?

53-10 Calculate job cost and billing at appliance repair service (Learning Objectives 2, 4, & 7 (Appendix))

Selle Appliance provides repair services for all makes and models of home appliances . Selle Appliance charges customers for labor on each job at a rate of $89 per hour . The labor rate is high enough to cover actual technician wages of $27 per hour, to cover shop overhead (allocated at a cost of $14 per hour}, and to provide a profit . The company charges the customer "at cost" for parts and materials . A recent customer job consisted of $45 in parts and materials and 8 hours of technician time.

1. What was Selle Appliance's cost for this job? Include shop overhead in the cost calculation .

2. How much was charged to the customer for this repair job?

53-11 Calculating overallocated or underallocated overhead (Learning Objective 5)

Well-Flow Company had estimated $1,053,000 of manufacturing overhead (MOH) for the year and 58,500 direct labor (DL) hours, resulting in a predetermined MOH rate of $18 per DL hour . By the end of that year, the company had actually incurred $1,005,000 of MOH costs and had used a total of 57,000 DL hours on various jobs.

1. By how much did the company overallocate or underallocate MOH for the year?

2. Was MOH overallocated or underallocated for the year? How do you know?

53-12 Record purchase and use of materials (Learning Objective 6) RitePacks manufactures backpacks . Its plant records include the following materials- related transactions :

Purchases of canvas (on account) ........................................................... .

Purchases of thread (on account) ............................................................ .

Material requisitions :

Canvas .... .......... ....... ............. .......... .......... ................. ............. .......... ... .

Thread ................................................................................................. .

$70,000

$ 700

$60,000

$ 500

Make the journal entries to record these transactions . Post these transactions to the Raw Materials Inventory account . lfthe company had $37,000 of Raw Materials Inventory at the beginning of the period, what is the ending balance of Raw Materials Inventory?

Job Costing 151

1 5 2 CHAPTER 3

53-13 Record manufacturing labor costs (Learning Objective 6) Bentley Glass reports the following labor-related transactions at its plant in Bryan, Ohio .

Plant janitor's wages ................................................................................. .

Plant supervisor's wages ......... ................. .......... .......... .................... ......... .

Glassblowers' wages ................................................................ ................. .

Record the journal entries for the incurrence of these wages .

$ 610

$ 900

$77,000

53-14 Recompute job cost at a legal firm (Learning Objectives 3, 4, & 7) Irvin Associates, a law firm, hires Attorney Amanda Hiller at an annual salary of $207,000 . The law firm expects her to spend 2,300 hours per year performing legal work for clients . Indirect costs are assigned to clients based on attorney billing hours . Firm attorneys are expected to work a total of 22,000 direct labor hours this year . Before the fiscal year be- gins, Irvin estimates that the total indirect costs for the upcoming year will be $660,000 .

1. What would be the hourly (cost) rate to Irvin Associates of employing Hiller?

2. If Hiller works on Client 367 for 16 hours, what direct labor cost would be traced to Client 367?

3. What is the indirect cost allocation rate?

4. What indirect costs will be allocated to Client 367?

5. What is the total job cost for Client 367?

53-15 Identify ethical standards violated (Learning Objectives 1, 2, 3, 4, 5, & 6) For each of the situations listed, identify the primary standard from the IMA Statement of Ethical Professional Practice that is violated (competence, confidentiality, integrity, or credibility) . Refer to Exhibit 1-7 for the complete standard .

1. Joe added in sales commissions to product costs on the financial statements because it seemed reasonable to include those costs .

2. At a neighborhood party, Megan talks about the upcoming bid her company is mak- ing for a city project . She shares specific cost estimates that are included in the bid .

3. Justin changed the way that manufacturing overhead is allocated to divisions on the monthly internal reports to better reflect resource usage . However, he did not note the change on any of the reports, nor did he inform any managers of the change .

4. Raquel does not disclose to her employer, Alpha Company, that her brother is the owner of a company that is bidding on a major contract with Alpha Company. Raquel is on the committee that evaluates the bids and makes a recommendation for which bid to select .

5. Anthony is asked to do an inventory count of a wide assortment of parts . Anthony does not know how to distinguish the various parts. He guesses when he enters the quantity. He does not ask for help because he does not want to look stupid.

53-16 Understanding key terms (Learning Objectives 1, 2, 3, & 4) Listed next are several terms . Complete the following statements with one of these terms . You may use a term more than once, and some terms may not be used at all.

Cost allocation

Cost tracing

Cost driver

Job cost record

Job costing

Materials requisition

Process costing

a. __ is used by companies that produce unique services and products .

b. Raw materials are stored in a storeroom until a __ is received requesting the trans- fer of materials to the production area.

c. __ is the assignment of direct costs to specific jobs .

d. Indirect costs cannot be traced to specific products, so they are divided up using a process called __ .

e. A custom-home builder would use a __ system to determine product cost . f. A __ is any activity that causes a cost to be incurred . g. __ is used by companies that produce large numbers of identical units through a

series of uniform production steps or processes .

h. The __ is used to track and accumulate all of the costs for an individual job .

i. PepsiCo produces Ruffles potato chips; it would use a __ system to determine product cost .

EXERCISES Group A E3-17 A Identify type of costing system (Learning Objective 1)

For each of the following companies, specify whether each company would be more likely to use job costing or process costing .

a. Janitorial services company

b. Soup manufacturer

c. Commercial plumbing contractor

d. Toothpaste manufacturer

e. Catering service

f. Shipbuilder

g. Company providing Web design services

h. Medical practice of six doctors and four physician assistants

i. Soft drink bottler

j. Movie studio

k. Plastic bottle manufacturer

I. Architect

m. Temporary staffing agency

n. Oil refinery

E3-18A Understand the flow of costs in a job cost shop (Learning Objective 2) Gerbig Lighting manufactures a variety of lamps for lighting specialty stores . In Septem- ber, Gerbig Lighting received an order from Zucca Decor for 32 mission-style table lamps (Model SA). The order from Zucca Decor became Job Number 804 at Gerbig Lighting .

Materials requisition #1247 for Job 804 shows that a total of $147 of direct materi- als were used in manufacturing the job . In addition to the materials requisition, the labor time records show that a total of $68 of direct labor costs was incurred in producing these lamps; a total of 8 direct labor hours were worked on this job .

Job Cost Record

Job Number: 804 --- Customer: Zucca Decor

Job Description: 32 Model 5A - Mission-style table lamps

Date Started: Sep. 14 Date Completed:

Manufacturing Cost Information: Cost Summary

Direct Materials

Req.# : Direct Labor

Manufacturing Overhead

8 hours x $2 per direct labor hour $ 16 Total Job Cost

Number of Units

Cost per Unit

Requirement Add direct materials and direct labor to the Job Cost Record for Job 804 . Manufacturing overhead has already been added to the Job Cost Record for this job . Assume that the job was completed on September 19 . Complete the Job Cost Record by calculating the total job cost and the cost per unit . Remember that this job consisted of 32 lamps (units).

Job Costing 153

1 54 CHAPTER 3

E3-19A Determine the cost of a job and use it for pricing (Learning Objectives 2, 3, & 4)

Playtime Industries manufactures custom-designed playground equipment for schools and city parks . Playtime expected to incur $586,600 of manufacturing overhead cost, 41,900 of direct labor hours, and $1,592,200 of direct labor cost during the year (the cost of direct labor is $38 per hour) . The company allocates manufacturing overhead on the basis of direct labor hours . During May, Playtime completed Job 304 . The job used 190 direct labor hours and required $14,800 of direct materials . The City of Jonestown has contracted to purchase the playground equipment at a price of 28% over manufacturing cost .

Requirements

1. Calculate the manufacturing cost of Job 304 .

2. How much will the City of Jonestown pay for this playground equipment?

E3-20A Compute a predetermined overhead rate and calculate cost of jobs based on direct labor hours (Learning Objectives 3 & 4)

Elkland Heating & Cooling installs and services commercial heating and cooling systems . Elkland uses job costing to calculate the cost of its jobs . Overhead is allocated to each job based on the number of direct labor hours spent on that job . At the beginning of the current year, Elkland estimated that its overhead for the coming year would be $61,500 . It also anticipated using 4,100 direct labor hours for the year. In November, Elkland started and completed the following two jobs :

Job 101

Direct materials used ................................. $15,000

Direct labor hours used ............................. . 155

Job 102

$10,000

72

Elkland paid a $24-per-hour wage rate to the employees who worked on these two jobs.

Requirements

1. What is Elkland's predetermined overhead rate based on direct labor hours?

2. Calculate the overhead to be allocated to each of the two jobs based on direct labor hours .

3. What is the total cost of Job 101? What is the total cost of Job 102?

E3-21A Compute a predetermined overhead rate and calculate cost of job based on direct labor costs (Learning Objectives 3 & 4) Raymond Industries uses job costing to calculate the costs of its jobs with direct labor cost as its manufacturing overhead allocation base . The company manufactures a variety of engines for use in farm equipment . At the beginning of the current year, Raymond esti- mated that its overhead for the coming year would be $371,800 . It also anticipated using 26,000 direct labor hours for the year . Raymond pays its employees an average of $22 per direct labor hour . Raymond just finished Job 371, which consisted of two engines for a farm equipment manufacturer. The costs and hours for this job consisted of $13,500 in direct materials used and 180 direct labor hours .

Requirements

1. What is Raymond's predetermined manufacturing overhead rate based on direct labor cost?

2. Calculate the manufacturing overhead to be allocated based on direct labor cost to Job 371.

3. What is the total cost of Job 371?

E3-22A Sustainability and job costing (Learning Objectives 2, 3, & 4) Lawrence Plastics manufactures custom park furniture and signage from recycled plastics (primarily shredded milk jugs) . Many of the company's customers are mu- nicipalities that are required by law to purchase goods that meet certain recycled- content guidelines . (Recycled-content can include post-consumer waste materials, pre-consumer waste materials, and recovered materials) . As a result, Lawrence includes two types of direct material charges in its job cost for each job : (1) virgin materials (non-recycled}, and (2) recycled-content materials . Lawrence also keeps track of the pounds of each type of direct material so that the final recycled-content percentage for the job can be reported to the customer . Lawrence also reports on the percentage of recycled content as a total of total plastic used each month in its own internal reporting system to help encourage managers to use recycled content whenever possible.

Lawrence Plastics uses a predetermined manufacturing overhead rate of $14 per direct labor hour . Here is a summary of the materials and labor used on a recent job for Summit County :

Description

Virgin materials

Recycled-content materials

Direct labor

Requirements

Quantity

30 pounds

70 pounds

18 hours

1. Calculate the total cost of the Summit County job .

Cost

$ 3 .80 per pound

$ 3 .50 per pound

$19 .00 per hour

2. Calculate the percentage of recycled content used in the Summit County job (using pounds) . If items purchased by Summit County are required by county charter to con- tain at least 40% recycled content, does this job meet that requirement?

E3-23A Determine the cost of a job (Learning Objectives 2, 3, & 4) Fontaine Furniture started and finished Job 310 during April. The company's records show that the following direct materials were requisitioned for Job 310 :

Lumber : 45 units at $4 per unit

Padding : 13 yards at $14 per yard

Upholstery fabric : 25 yards at $30 per yard

Labor time records show the following employees (direct labor) worked on Job 310 :

Penny Rawls: 12 hours at $13 per hour

Mark Frizzell: 16 hours at $22 per hour

Fontaine allocates manufacturing overhead at a rate of $12 per direct labor hour .

Requirements

1. Compute the total amount of direct materials, direct labor, and manufacturing over- head that should be shown on Job 31 O's job cost record .

2. Job 310 consists oftwelve recliners . If each recliner sells for $750, what is the gross profit per recliner?

Job Costing 155

SUSTAINABILITY

156 CHAPTER 3

E3-24A Compare bid prices under two different allocation bases (Learning Objectives 3 & 4)

Olney Recycling recycles newsprint, cardboard, and so forth, into recycled packaging materi- als. For the coming year, Olney estimates total manufacturing overhead to be $370,000 . The company's managers are not sure if direct labor hours (estimated to be 10,000) or machine hours (estimated to be 14,800 hours) is the best allocation base to use for allocating manufac- turing overhead . Olney bids for jobs using a 31 % markup over total manufacturing cost .

After the new fiscal year began, Leftwich Paper Supply asked Olney Recycling to bid for a job that will take 2,020 machine hours and 1,650 direct labor hours to produce . The direct labor cost for this job will be $11 per hour, and the direct materials will total $25,400 .

Requirements

1. Compute the total job cost and bid price if Olney Recycling decided to use direct la- bor hours as the manufacturing overhead allocation base for the year .

2. Compute the total job cost and bid price if Olney Recycling decided to use machine hours as the manufacturing overhead allocation base for the year.

3. In addition to the bid from Olney Recycling, Leftwich Paper Supply received a bid of $126,000 for this job from Drund Recycling. What are the ramifications for Olney Recycling?

E3-25A Analyze manufacturing overhead (Learning Objectives 3 & 5) Smith Foundry in Columbus, Ohio, uses a predetermined manufacturing overhead rate to allocate overhead to individual jobs based on the machine hours required . At the begin- ning of the year, the company expected to incur the following:

Manufacturing overhead costs ........ ............. .......... .......... .......... .......... .. $ 630,000 Direct labor cost ....... ............. ....... .......... .......... ............. .......... ....... ........ $1,650,000 Machine hours ........................................................................................ 90,000

At the end of the year, the company had actually incurred the following :

Direct labor cost ................................................................................. . Depreciation on manufacturing plant and equipment .................... ... . Property taxes on plant ........................................................... ........... . Sales salaries ...................................................................................... . Delivery drivers' wages ............................. ....................... ................. . . Plant janitors' wages .......................................................................... . Machine hours .................................................................................... .

Requirements

1. Compute Smith's predetermined manufacturing overhead rate.

$1,230,000 $ 480,000 $ 19,500 $ 26,500 $ 17,000 $ 8,500

56,500 hours

2. How much manufacturing overhead was allocated to jobs during the year?

3. How much manufacturing overhead was incurred during the year? Is manufacturing overhead underallocated or overallocated at the end of the year? By how much?

4. Were the jobs overcosted or undercosted? By how much?

E3-26A Record manufacturing overhead (Learning Objectives 5 & 6) Refer to the data in Exercise 3-25A. Smith's accountant found an error in the expense records from the year reported . Depreciation on manufacturing plant and equipment was actually $364,000, not the $480,000 that had originally been reported. The unadjusted Cost of Goods Sold balance at year-end was $610,000.

Requirements

1. Prepare the journal entry (entries) to record manufacturing overhead costs incurred .

2. Prepare the journal entry to record the manufacturing overhead allocated to jobs in production.

3. Use a T-account to determine whether manufacturing overhead is underallocated or overallocated and by how much.

4. Record the entry to close out the underallocated or overallocated manufacturing overhead .

5. What is the adjusted ending balance of Cost of Goods Sold?

E3-27 A Record journal entries (Learning Objectives 2, 3, 5, & 6) The following transactions were incurred by Howe Fabricators during January, the first month of its fiscal year .

Requirements

1. Record the proper journal entry for each transaction.

a. $215,000 of materials was purchased on account . b. $190,000 of materials was used in production; of this amount, $164,000 was used

on specific jobs.

c. Manufacturing labor and salaries for the month totaled $210,000. A total of $180,000 of manufacturing labor and salaries was traced to specific jobs, and the remainder was indirect labor used in the factory .

d. The company recorded $15,000 of depreciation on the plant and plant equip- ment . The company also received a plant utility bill for $8,000 which will be paid at a later date .

e. $70,000 of manufacturing overhead was allocated to specific jobs.

f. The company received a bill for CAD design services for $9,000.

2. By the end of January, was manufacturing overhead overallocated or underallocated? By how much?

E3-28A Analyze T-accounts (Learning Objectives 2, 3, 5, & 6)

Crystale Displays produces screens for use in various smartphones . The company reports the following information at December 31 . Crystale Displays began operations on January 31 earlier that same year .

Work in Process Wages Manufacturing Finished Goods Inventory Payable Overhead Inventory

27,500 127,000 75,000 75,000 9,000 44,000 127,000 114,000 64,000 11,000 44,000 Balance 0 42,500

Requirements

1. What is the cost of direct materials used?

2. What is the cost of indirect materials used?

3. What is the cost of direct labor?

4. What is the cost of indirect labor?

5. What is the cost of goods manufactured?

6. What is the cost of goods sold (before adjusting for any under- or overallocated manufacturing overhead)?

7. What is the actual manufacturing overhead?

8. How much manufacturing overhead was allocated to jobs?

9. What is the predetermined manufacturing overhead rate as a percentage of direct labor cost?

10. Is manufacturing overhead underallocated or overallocated? By how much?

Job Costing 157

Raw Materials Inventory

55,500 36,500

1 5 8 CHAPTER 3

E3-29A Job cost and bid price at a consulting firm (Learning Objective 7) Robert Consulting, a real estate consulting firm, specializes in advising companies on po- tential new plant sites . The firm uses a job cost system with a predetermined indirect cost allocation rate computed as a percentage of expected direct labor costs .

At the beginning of the year, managing partner DeeAnn Robert prepared the follow- ing plan, or budget, for the year:

Direct labor hours (professionals) .......... ............. .......... .......... ....... .......... .... 14,000 hours

Direct labor costs (professionals) ................................................................. $2,150,000

Office rent .................................................................................................... $ 240,000

Support staff salaries ............................................................... .................... $ 930,000

Utilities .............. ........................................ ............. ........................... ........... $ 290,000

Chase Resources is inviting several consulting firms to bid for work . Robert estimates that this job will require about 210 direct labor hours .

Requirements

1. Compute Robert Consulting's (a) hourly direct labor cost rate and (b) indirect cost allocation rate.

2. Compute the predicted cost of the Chase Resources job .

3. If Robert Consulting wants to earn a profit that equals 25% of the job's cost, how much should the company bid for the Chase Resources job?

E3-30A Record journal entries (Learning Objectives 2, 3, 5, & 6) The following transactions were incurred by Augustine Fabricators during January, the first month of its fiscal year.

Requirements

1. Record the proper journal entry for each transaction .

a. $205,000 of materials was purchased on account.

b. $158,000 of materials was used in production; of this amount, $155,000 was used on specific jobs.

c. Manufacturing labor and salaries for the month totaled $250,000 . $215,000 of the total manufacturing labor and salaries was traced to specific jobs, and the remain- der was indirect labor used in the factory .

d. The company recorded $19,000 of depreciation on the plant and plant equipment. The company also received a plant utility bill for $10,000 which will be paid at a later date .

e. $62,000 of manufacturing overhead was allocated to specific jobs .

2. By the end of January, was manufacturing overhead overallocated or underallocated? By how much?

EXERCISES Group B E3-31 B Identify type of costing system (Learning Objective 1)

For each of the following companies, specify whether the company would be more likely to use job costing or process costing .

a. Yacht builder h. Cement plant

b. Cereal manufacturer i. Dentist

C. Landscaper j. Advertising agency

d. Pet food processor k. Custom-home builder

e. Wallpaper installation service I. Oil refinery

f. Aircraft builder m. House painter

g. Hospital n. Computer chip manufacturer

E3-32B Understand the flow of costs in a job cost shop (Learning Objective 2)

Hamilton Lighting manufactures a variety of lamps for lighting specialty stores . In September, Hamilton Lighting received an order from Rose Decor for 34 mission-style table lamps (Model SA.) The order from Rose Decor became Job Number 951 at Hamilton Lighting .

Materials requisition #1298 for Job 951 shows that a total of $196 of direct materi- als were used in manufacturing the job . In addition to the materials requisition, the labor time records show that a total of $79 of direct labor costs was incurred in producing these lamps; a total of 8 direct labor hours were worked on this job .

Job Cost Record

Job Number: 951 --- Customer: Rose Decor

Job Description: 34 Model SA Miss ion-style table lamps

Date Started: Sep. 14 Date Completed:

Manufacturing Cost Information: Cost Summary

Direct Materials

Req.# : Direct Labor

Manufacturing Overhead

8 hours x $3 per direct labor hour $ 24 Total Job Cost

Number of Units

Cost per Unit

Requirement Add direct materials and direct labor to the Job Cost Record for Job 951 . Manufacturing overhead has already been added to the Job Cost Record for this job . Assume that the job was completed on September 19. Complete the Job Cost Record by calculating the total job cost and the cost per unit. Remember that this job consisted of 34 lamps (units).

E3-33B Determine the cost of a job and use it for pricing (Learning Objectives 2, 3, & 4)

Alltime Industries manufactures custom-designed playground equipment for schools and city parks . Alltime expected to incur $664,000 of manufacturing overhead cost, 41,500 of direct labor hours, and $1,577,000 of direct labor cost during the year (the cost of di- rect labor is $38 per hour) . The company allocates manufacturing overhead on the basis of direct labor hours . During February, Alltime completed Job 302 . The job used 160 direct labor hours and required $13,900 of direct materials . The City of Cooperstown has contracted to purchase the playground equipment at a price of 25% over manufacturing cost .

Requirements

1. Calculate the manufacturing cost of Job 302 .

2. How much will the City of Cooperstown pay for this playground equipment?

Job Costing 159

160 CHAPTER 3

SUSTAINABILITY

E3-34B Compute a predetermined overhead rate and calculate cost of jobs (Learning Objectives 3 & 4)

Peterson Heating & Cooling installs and services commercial heating and cooling sys- tems . Peterson uses job costing to calculate the cost of its jobs . Overhead is allocated to each job based on the number of direct labor hours spent on that job . At the beginning of the current year, Peterson estimated that its overhead for the coming year would be $63,750 . It also anticipated using 4,250 direct labor hours for the year . In October, Peterson started and completed the following two jobs :

Job 101

Direct materials used ........ ....... .......... ............. .......... .......... $17,500

Direct labor hours used ......... ....... .......... .......... .......... ......... 195

Job 102

$13,000

76

Peterson paid a $24-per-hour wage rate to the employees who worked on these two jobs .

Requirements

1. What is Peterson's predetermined overhead rate based on direct labor hours?

2. Calculate the overhead to be allocated to each of the two jobs based on direct labor hours.

3. What is the total cost of Job 101? What is the total cost of Job 102?

E3-35B Compute a predetermined overhead rate and calculate cost of job (Learning Objectives 3 & 4)

Miskimen Industries uses job costing to calculate the costs of its jobs with direct labor cost as its manufacturing ove rhead allocation base . The company manufactures a variety of engines for use in farm equipment . At the beginning of the current year, Miskimen es- timated that its overhead for the coming year will be $364,000 . It also anticipated using 28,000 direct labor hours for the year . Miskimen pays its employees an average of $26 per direct labor hour . Miskimen just finished Job 371, which consisted of two engines for a farm equipment manufacturer . The costs and hours for this job consisted of $15,500 in direct materials used and 110 direct labor hours .

Requirements

1. What is Miskimen's predetermined manufacturing overhead rate based on direct labor cost?

2. Calculate the manufacturing overhead to be allocated based on direct labor costs to Job 371 .

3. What is the total cost of Job 371?

E3-36B Sustainability and job costing (Learning Objectives 2, 3, & 4) Lancaster Plastics manufactures custom park furniture and signage from recycled plastics (primarily shredded milk jugs). Many of the company's customers are munici- palities that are required by law to purchase goods that meet certain recycled-content guidelines . (Recycled content can include post-consumer waste materials, pre-consumer waste materials, and recovered materials) . As a result, Lancaster Plastics includes two types of direct material charges in its job cost for each job : (1) virgin materials (non- recycled}, and (2) recycled-content materials . Lancaster Plastics also keeps track of the pounds of each type of direct material so that the final recycled-content percentage fo r the job can be reported to the customer . The company also reports on the percentage of recycled-content as a total of plastics used each month on its own internal reporting system to help encourage managers to use recycled content whenever possible .

Lancaster Plastics uses a predetermined manufacturing overhead rate of $8 per direct labor hour . Here is a summary of the materials and labor used on a recent job for Lyon County :

Description Quantity Cost

Virgin materials 80 pounds $ 3 .80 per pound

Recycled-content materials 120 pounds $ 2 .60 per pound

Direct labor 12 hours $ 16 .00 per hour

Requirements

1. Calculate the total cost of the Lyon County job .

2. Calculate the percentage of recycled-content used in the Lyon County job (using pounds .) If items purc hased by Lyon County are required by county charter to contain at least 40% recycled-content, does the job meet that requirement?

E3-37B Determine the cost of a job (Learning Objectives 2, 3, & 4) Stonecreek Furniture started and finished Job 310 during November . The company's re- cords show that the following direct materials were requisitioned for Job 310:

Lumber : 45 units at $6 per unit

Padding: 14 yards at $21 per ya rd

Upholstery fabric : 32 yards at $27 per yard .

Labor time records show the following employees (direct labor) worked on Job 310 :

Holly Powers : 14 hours at $16 per hour

Patrick Aaronson : 13 hou rs at $22 per hour .

Stonecreek Furniture allocates manufacturing overhead at a rate of $9 per direct labor hour .

Requirements

1. Compute the total amount of direct materials, direct labor, and manufacturing over- head that should be shown on Job 31 O's job cost record .

2. Job 310 consists of eight recliners . If each recliner sells for $725, what is the gross profit per recliner?

E3-38B Compare bid prices under two different allocation bases (Learning Objectives 3 & 4)

Nestor Recycling recycles newsprint, cardboard, and so forth, into recycled packaging materials. For the coming year, Nestor Recycling estimates total manufacturing overhead to be $369,260 . The company's manage rs are not sure if direct labor hours (estimated to be 9,980) or machine hours (estimated to be 18,463 hours) is the best allocation base to use for allocating manufac- turing overhead . Nestor bids for jobs using a 29% markup over total manufacturing cost.

After the new fiscal year began, Elliott Paper Supply asked Nestor Recycling to bid for a job that will take 1,975 machine hours and 1,600 direct labor hours to produce . The di- rect labor cost for this job will be $12 per hour, and the direct materials will total $25,600 .

Requirements

1. Compute the total job cost and bid price if Nestor Recycling decided to use direct labor hours as the manufacturing overhead allocation base for the year .

2. Compute the total job cost and bid price if Nestor Recycling decided to use machine hours as the manufacturing overhead allocation base for the year .

3. In addition to the bid from Nestor Recycling, Elliott Paper Supply received a bid of $125,500 for this job from Kitson Recycling. What are the ramifications for Nestor Recycling?

E3-39B Analyze manufacturing overhead (Learning Objectives 3 & 5) Benson Foundry in Charleston, South Carolina, uses a predetermined manufacturing overhead rate to allocate overhead to individual jobs based on the machine hours required . At the beginning of the year, the company expected to incur the following:

Manufacturing overhead costs ......... ............. .......... ....... .......... ....... .

Direct labor cost ............................................................................... . Machine hours .................................................................................. .

$ 610,000 $1,500,000

76,250

At the end of the year, the company had actually incurred the following :

Direct labor cost .... ....... .......... ............. .......... .......... ....... ............. .. . Dep reciation on manufacturing plant and equipment ............. ..... .

Property taxes on plant ................................................................. . Sales salaries .................................................................................. . Delivery drivers' wages .................................................................. . Plant janitors' wages ...................................................................... .

Machine hours ................................................................................ .

$1,220,000

$ 470,000

$ 19,000 $ 25,500

$ 14,500 $ 8,000

55,500 hours

Job Costing 161

1 6 2 CHAPTER 3

Work in Process Inventory

30,500 123,500 64,000 43,000

Requirements

1. Compute Benson Foundry's predetermined manufacturing overhead rate.

2. How much manufacturing overhead was allocated to jobs during the year?

3. How much manufacturing overhead was incurred during the year? Is manufacturing overhead underallocated or overallocated at the end of the year? By how much?

4. Were the jobs overcosted or undercosted? By how much?

E3-40B Record manufacturing overhead (Learning Objectives 5 & 6) Refer to the data in Exercise E3-39B. Benson Foundry's accountant found an error in the expense records from the year reported . Depreciation on manufacturing plant and equip- ment was actually $415,000, not the $470,000 it had originally reported . The unadjusted Cost of Goods Sold balance at year-end was $560,000 .

Requirements

1. Prepare the journal entry (entries) to record manufacturing overhead costs incurred .

2. Prepare the journal entry to record the manufacturing overhead allocated to jobs in production .

3. Use a T-account to determine whether manufacturing overhead is underallocated or overallocated, and by how much .

4. Record the entry to close out the underallocated or overallocated manufacturing overhead.

5. What is the adjusted ending balance of Cost of Goods Sold?

E3-41 B Record journal entries (Learning Objectives 2, 3, 5, & 6) The following transactions were incurred by Gregor Fabricators during January, the first month of its fiscal year.

Requirements

1. Record the proper journal entry for each transaction .

a. $205,000 of materials was purchased on account.

b. $170,000 of materials was used in production; of this amount, $152,000 was used on specific jobs .

c. Manufacturing labor and salaries for the month totaled $255,000 . $215,000 of the total manufacturing labor and salaries was traced to specific jobs, and the remain- der was indirect labor used in the factory .

d. The company recorded $25,000 of depreciation on the plant and plant equip- ment . The company also received a plant utility bill for $12,000 which will be paid at a later date .

e. $79,000 of manufacturing overhead was allocated to specific jobs .

f. The company received a bill for CAD design services for $1,000.

2. By the end of January, was manufacturing overhead overallocated or underallocated? By how much?

E3-42B Analyze T-accounts (Learning Objectives 2, 3, 5, & 6) ClearDay Displays produces screens for use in various smartphones. The company reports the following information at December 31 . ClearDay Displays began operations on January 31 earlier that same year.

Wages Manufacturing Finished Goods Raw Materials Payable Overhead Inventory Inventory

77,000 77,000 4,000 43,000 123,500 115,500 57,500 34,500 13,000

Balance 0 40,500

Requirements

1. What is the cost of direct materials used?

2. The cost of indirect materials used?

3. What is the cost of direct labor?

4. The cost of indirect labor?

5. What is the cost of goods manufactured?

6. What is the cost of goods sold (before adjusting for any under- or overallocated man- ufacturing overhead)?

7. What is the actual manufacturing overhead?

8. How much manufacturing overhead was allocated to jobs?

9. What is the predetermined manufacturing overhead rate as a percentage of direct labor cost?

10. ls manufacturing overhead underallocated or overallocated? By how much?

E3-43B Job cost and bid price at a consulting firm (Learning Objective 7) Sayres Consulting, a real estate consulting firm, specializes in advising companies on potential new plant sites. The firm uses a job costing system with a predetermined indirect cost allocation rate computed as a percentage of direct labor costs . At the beginning of the year, managing partner Dana Sayres prepared the following plan, or budget, for the year :

Direct labor hours (professionals) .......................................................... . 15,000 hours

Direct labor costs (professionals) ........................................................... . $ 2,250,000

Office rent .............................................................................................. . $ 250,000

Support staff salaries ............................................................................. . $ 940,000

Utilities ................................................................................................... . $ 310,000

Granite Resources is inviting several consultants to bid for work . Sayres estimates that this job will require about 250 direct labor hours .

Requirements

1. Compute Sayres Consulting's (a) hourly direct labor cost rate and (b) indirect cost allocation rate .

2. Compute the predicted cost of the Granite Resources job .

3. If Sayres Consulting wants to earn a profit that equals 30% of the job's cost, how much should the company bid for the Granite Resources job?

E3-44B Record journal entries (Learning Objectives 2, 3, 5, & 6)

The following transactions were incurred by Mooney Fabricators during January, the first month of its fiscal year .

Requirements

1. Record the proper journal entry for each transaction .

a. $210,000 of materials were purchased on account .

b. $178,000 of materials were used in production; ofthis amount, $143,000 was used on specific jobs.

c. Manufacturing labor and salaries for the month totaled $245,000 . A total of $220,000 of manufacturing labor and salaries was traced to specific jobs, while the remainder was indirect labor used in the factory .

d. The company recorded $16,000 of depreciation on the plant and plant equip- ment . The company also received a plant utility bill for $8,000 which will be paid at a later date .

e. $74,000 of manufacturing overhead was allocated to specific jobs .

2. By the end of January, was manufacturing overhead overallocated or underallocated? By how much?

Job Costing 163

1 64 CHAPTER 3

PROBLEMS Group A P3-45A Analyze Manufacturing Overhead (Learning Objectives 3 & 5)

Hartley Uniforms produces uniforms . The company allocates manufacturing overhead based on the machine hours each job uses . Hartley Uniforms reports the following cost data for the past year :

Direct labor hours .......... .......... .......... .......... .......... .. .

Machine hours ....... ............. ....... .......... .......... .......... . Depreciation on salespeople's autos ...................... .

Indirect materials ............ .......... .......... .......... .......... . .

Depreciation on trucks used to deliver uniforms to customers ......................................... .

Depreciation on plant and equipment .................... . Indirect manufacturing labor ................................... .

Customer service hotline ........ ................................. .

Plant utilities ............. ............. ................. .......... ....... .

Direct labor cost ...................................................... .

Requirements

Budget

7,600 hours

7,200 hours

$23,000

$48,500

$13,000

$70,000 $40,000

$19,000

$35,900

$72,500

1. Compute the predetermined manufacturing overhead rate.

2. Calculate the allocated manufacturing overhead for the past year .

Actual

6,100 hours

6,300 hours

$23,000

$50,500

$11,000

$72,500 $42,000

$21,000

$38,400

$85,500

3. Compute the underallocated or overallocated manufacturing overhead . How will this underallocated or overallocated manufacturing overhead be disposed of?

4. How can managers use accounting information to help control manufacturing over- head costs?

P3-46A Use job costing at an advertising agency (Learning Objectives 3, 4, & 7)

Anderson & Little is an advertising agency . The firm uses a job cost system in which each client is a different "job ." Anderson & Little traces direct labor, software licensing costs, and travel costs directly to each job (client). The company allocates indirect costs to jobs based on a predetermined indirect cost allocation rate based on direct labor hours .

At the beginning of the current year, managing partner Trang Anderson prepared a budget :

Direct labor hours (professional) ............................................................... .

Direct labor costs (professional) .............. ....................... ................. ........... .

Support staff salaries ..... .......... .......... .......... .......... ............. ..... ............ ....... .

Rent and utilities ......................................................................................... . Supplies ...................................................................................................... .

Lease payments on computer hardware .................................................... .

17,100 hours

$2,052,000

$ 160,000

$ 48,000 $ 461,300

$ 66,000

During January of the current year, Anderson & Little served several clients . Records for two clients appear here :

DreamVacation.com Port Armour Golf Resort

Direct labor hours ............................ . Software licensing costs .................. .

Travel costs ..................................... .

Requirements

750 hours $2,500

$8,000

30 hours $150

$ 0

1. Compute Anderson & Little's predetermined indirect cost allocation rate for the current year based on direct labor hours .

2. Compute the total cost of each job .

3. If Anderson & Little wants to earn profits equal to 20% of sales revenue, how much (what total fee) should it charge each of these two clients?

4. Why does Anderson & Little assign costs to jobs?

P3-47 A Use job costing at a consulting firm (Learning Objectives 3, 4, & 7) Sierra Design is an interior design firm . The firm uses a job cost system in which each cli- ent is a different "job ." Sierra Design traces direct labor, licensing costs, and travel costs directly to each job (client). It allocates indirect costs to jobs based on a predetermined indirect cost allocation rate computed as a percentage of direct labor costs .

At the beginning of the current year, managing partner Laurie Walker prepared the following budget:

Direct labor hours (professional) ............ .............. ................. ............. .... . 10,000 hours

Direct labor costs (professional) ........ ...... ..................... ............. .......... .. . $ 1,100,000

Support staff salaries .... ................................. .......... ....... ....................... . $ 140,000

Computer lease payments ........ .......... ............. .... ....... ...... .... ...... .......... . . $ 46,000

Office supplies ....................................................................................... . $ 26,000

Office rent .............................................................................................. . $ 63,000

Later that same year in November, Sierra Design served several clients. Records for two clients appear here :

Direct labor hours ....................................... .

Licensing costs ........... ...... ............. .......... .... .

Travel costs .... .............................. .......... ..... .

Requirements

Delightful Dining

710 hours

$ 2,300

$ 10,000

Dine Now.com

40 hours

$300

$ 0

1. Compute Sierra Design's predetermined indirect cost allocation rate for the current year .

2. Compute the total cost of each of the two jobs listed .

3. If Sierra Design wants to earn profits equal to 20% of sales revenue, how much (what total fee) should the company charge each of these two clients?

4. Why does Sierra Design assign costs to jobs?

P3-48A Prepare job cost record (Learning Objectives 2, 3, & 4) Chattanooga Tire manufactures tires for all-terrain vehicles . Chattanooga uses job costing and has a perpetual inventory system .

On June 22, Chattanooga received an order for 110 TX tires from ATV Corporation at a price of $90 each . The job, assigned number 298, was promised for July 10 . After purchasing the materials, Chattanooga began production on June 30 and incurred the following direct labor and direct materials costs in completing the order :

Labor Time Date Record No. Description Amount

6/30 1896 12 hours at $20 $240

7/3 1904 30 hours at $16 $480

Materials Date Requisition No. Description Amount

6/30 437 60 pounds rubber at $10 $ 600

7/2 439 40 meters polyester fabric at $12 $ 480

7/3 501 100 meters steel cord at $14 $1,400

Chattanooga allocates manufacturing overhead to jobs on the basis of the relation be- tween expected overhead costs ($490,000) and expected direct labor hours (17,500) . Job 298 was completed on July 3 and shipped to ATV on July 5 .

Requirements

1. Prepare a job cost record for Job 298 .

2. Calculate the total profit and the per-unit profit for Job 298 .

Job Costing 165

166 CHAPTER 3

P3-49A Determine and record job costs (Learning Objectives 2, 3, 4, & 6) Veon Homes manufactures prefabricated chalets in Colorado . The company uses a per- petual inventory system and a job cost system in which each chalet is a job . The following events occurred during May:

a. Purchased materials on account, $490,000 .

b. Incurred total manufacturing wages of $115,000, which included both direct labor and indirect labor . Used direct labor in manufacturing as follows :

Chalet 13 .................................................................................... . Chalet 14 .................................................................................... .

Chalet 15 .................................................................................... . Chalet 16 ................................................. ....................... ............ .

c. Requisitioned direct materials in manufacturing as follows :

Chalet 13 .................................................................................... . Chalet 14 .................................................................................... . Chalet 15 ............ .......... .......... ....... .......... ............. .......... ............ .

Chalet 16 .................................................................................... .

Direct Labor

$14,200 $28,500

$19,900 $21,900

Direct Materials

$41,400 $56,700 $62,400

$66,500

d. Depreciation of manufacturing equipment used on different chalets, $6,300 .

e. Other overhead costs incurred on Chalets 13-16:

Equipment rentals paid in cash ........... .... ...... ............. .......... ...... .

Prepaid plant insurance expired ................................................. .

$10,600 $8,000

f. Allocated overhead to jobs at the predetermined rate of 60% of direct labor cost .

g. Chalets completed: 13, 15, and 16. h. Chalets sold on account : 13 for $92,000 and 16 for $141,000 .

Requirements

1. Record the preceding events in the general journal.

2. Open T-accounts for Work in Process Inventory and Finished Goods Inventory . Post the appropriate entries to these accounts, identifying each entry by letter . Determine the ending account balances, assuming that the beginning balances were zero .

3. Summarize the job cost of the unfinished chalet and show that this equals the ending balance in Work in Process Inventory .

4. Summarize the job cost of the completed chalet that has not yet been sold and show that this equals the ending balance in Finished Goods Inventory .

5. Compute the gross profit on each chalet that was sold . What costs must the gross profit cover for Veon Homes?

P3-S0A Determine flow of costs through accounts (Learning Objectives 2 & 6) Stewart Engine reconditions engines. Its job cost records yield the following information. Stewart Engine uses a perpetual inventory system .

Date

Job No. Started Finished

1 5/26 6/7

2 5/3 6/12

3 6/29 6/30

4 6/30 7 /1 5 7/8 7/12

6 7/23 8/6

Sold

6/9

6/13

7/3

7 /1 7/14

8/9

Total Cost of Job at June 30

$1,600

$1,500

$1,300

$ 900

Total Manufacturing

Cost Added in July

$ 300

$ 500

$1,400

Requirements

1. Compute Stewart Engine's cost of (a) Work in Process Inventory at June 30 and July 31, (b) Finished Goods Inventory at June 30 and July 31, and (c) Cost of Goods Sold for June and July .

2. Make summary journal entries to record the transfer of completed jobs from Work in Process Inventory to Finished Goods Inventory for June and July .

3. Record the sale of Job 5 on account for $1,900 .

4. Compute the gross profit for Job 5 . What costs must the gross profit cover?

PROBLEMS Group B P3-51 B Analyze Manufacturing Overhead (Learning Objectives 3 & 5)

Sloan Company produces uniforms. The company allocates manufacturing overhead based on the machine hours each job uses . Sloan Company reports the following cost data for the past year :

Direct labor hours ..................................................... .

Machine hours ........................................................... .

Depreciation on salespeople's autos ...... .......... ........ .

Indirect materials ............... ............. .... ...... .... ...... ....... .

Depreciation on trucks used to deliver uniforms to customers ............ ............. ..... . .

Depreciation on plant and equipment ........ .... ...... ... .

Indirect manufacturing labor ..................................... .

Customer service hotline .......................................... .

Plant utilities ................... .......... ............. .......... .......... .

Direct labor cost .................... .......... .......... ............. ... .

Requirements

Budget

7,600 hours

7,000 hours

$23,000

$50,500

$16,000

$68,000

$39,500

$21,500

$38,000

$72,500

1. Compute the predetermined manufacturing overhead rate .

2. Calculate the allocated manufacturing overhead for the past year .

Actual

6,100 hours

6,500 hours

$23,000

$54,000

$15,000

$69,000

$42,500

$22,500

$40,500

$86,500

3. Compute the underallocated or overallocated manufacturing overhead . How will this underallocated or overallocated manufacturing overhead be disposed of?

4. How can managers use accounting information to help control manufacturing over- head costs?

P3-52B Use job costing at an advertising agency (Learning Objectives 3, 4, & 7) Unch ii & Doshak is an advertising agency . The firm uses a job cost system in which each client is a different "job ." Unch ii & Doshak traces direct labor, software licensing costs, and travel costs directly to each job (client). The company allocates indirect costs to jobs based on a predetermined indirect cost allocation rate based on direct labor hours .

At the beginning of the current year, managing partner Anoop Unch ii prepared a budget:

Direct labor hours (professional) .............................. ......................... .

Direct labor costs (professional) ........................................................ .

Support staff salaries ......................................................................... .

Rent and utilities ............. ............. .......... .......... .......... ....... ............. ... .

Supplies ............................................................................................. .

Lease payments on computer hardware ......... .......... ....... ............. .... .

17,100 hours

$2,052,000

$ 305,000

$ 46,000

$ 319,300

$ 65,000

Job Costing 167

1 6 8 CHAPTER 3

During January of the current year, Unch ii & Doshak served several clients . Records for two clients appear here:

Direct labor hours ....... .......... ....... .......... .......... .

Software licensing costs .................................. .

Travel costs ........ .......... .......... ....... .......... ......... .

Requirements

Go Trip.com

770 hours

$2,100

$7,000

Port South Golf Resort

65 hours

$400

$0

1. Compute Unch ii & Doshak's predetermined indirect cost allocation rate for the cur- rent year based on direct labor hours .

2. Compute the total cost of each job .

3. If Unch ii & Doshak wants to earn profits equal to 20% of sales revenue, how much (what total fee) should it charge each of these two clients?

4. Why does Unch ii & Doshak assign costs to jobs?

P3-53B Use job costing at a consulting firm (Learning Objectives 3, 4, & 7)

Thomas Design is an interior design firm . The firm uses a job cost system, in which each client is a different job. Thomas Design traces direct labor, licensing costs, and travel costs directly to each job (client). It allocates indirect costs to jobs based on a predeter- mined indirect cost allocation rate computed as a percentage of direct labor costs .

At the beginning of the current year, managing partner Sarah Miracle prepared the following budget :

Direct labor hours (professional) ...................................................... .

Direct labor costs (professional) .............................................. ........ .

Support staff salaries ........................................................................ .

Computer leases ..................... .......................................................... .

Office supplies .................................................................................. .

Office rent ........................................................................ ................. .

10,000 hours

$1,400,000

$ 170,000

$ 49,000

$ 29,000

$ 60,000

Later that same year in November, Thomas Design served several clients . Records for two clients appear here:

Direct labor hours .................................................. .

Software licensing costs ........................................ .

Travel costs ............................................................ .

Requirements

Organic Foods

730 hours

$2,700

$7,000

All News.com

25 hours

$400

$ 0

1. Compute Thomas Design's predetermined indirect cost allocation rate for the current year .

2. Compute the total cost of each of the two jobs listed .

3. If Thomas Design wants to earn profits equal to 30% of sales revenue, how much (what total fee) should the company charge each of these two clients?

4. Why does Thomas Design assign costs to jobs?

P3-54B Prepare job cost record (Learning Objectives 2, 3, & 4)

Durable Tire manufactures tires for all-terrain vehicles . Durable Tire uses job costing and has a perpetual inventory system . On November 22, Durable Tire received an order for 100 TX tires from ATV Corporation at a price of $60 each . The job, assigned number 298, was promised for December 10 . After purchasing the materials, Durable Tire began production on November 30 and incurred the following direct labor and direct materials costs in completing the order:

Labor Time Date Record No. Description Amount

11/30 1896 12 hours at $16 $192

12/3 1904 30 hours at $18 $540

Materials Date Requisition No. Description Amount

11/30 437 60 pounds rubber at $14 $ 840

12/2 439 40 meters polyester fabric at $12 $480

12/3 501 100 meters steel cord at $8 $ 800

Durable Tire allocates manufacturing overhead to jobs on the basis of the relationship between expected overhead costs ($529,000) and expected direct labor hours (23,000) . Job 298 was completed on December 3 and shipped to ATV on December 5.

Requirements

1. Prepare a job cost record for Job 298 .

2. Calculate the total profit and the per-unit profit for Job 298 .

P3-55B Determine and record job costs (Learning Objectives 2, 3, 4, & 6)

Red Canyon Homes manufactures prefabricated chalets in Colorado . The company uses a perpetual inventory system and a job cost system in which each chalet is a job . The fol- lowing events occurred during May:

a. Purchased materials on account, $470,000.

b. Incurred total manufacturing wages of $115,000, which included both direct labor and indirect labor . Used direct labor in manufacturing as follows:

Chalet 13 .......................................................................................... .

Chalet 14 .......................................................................................... .

Chalet 15 ................. ......................................................................... .

Chalet 16 .......................................................................................... .

c. Requisitioned direct materials in manufacturing as follows :

Chalet 13 ................. ......................................................................... .

Chalet 14 .............. ................. .......... .......... ............. ....... .......... ......... .

Chalet 15 .......................................................................................... .

Chalet 16 ................. ......................................................................... .

Direct Labor

$14,600

$28,000

$19,300

$21,400

Direct Materials

$41,500

$56,700

$62,700

$66,000

d. Depreciation of manufacturing equipment used on different chalets, $6,500 .

e. Other overhead costs incurred on Chalets 13-16 :

Equipment rentals paid in cash ................................................................. .

Prepaid plant insurance expired ............................................................... .

$10,000

$6,000

f. Allocated overhead to jobs at the predetermined rate of 60% of direct labor cost .

g. Chalets completed: 13, 15, and 16. h. Chalets sold on account : 13 for $93,000; 16 for $144,000 .

Requirements

1. Record the events in the general journal.

2. Open T-accounts for Work in Process Inventory and Finished Goods Inventory . Post the appropriate entries to the T-accounts, identifying each entry by letter . Determine the ending account balances, assuming that the beginning balances were zero .

Job Costing 169

1 7 0 CHAPTER 3

3. Summarize the job cost of the unfinished chalet, and show that this total amount equals the ending balance in the Work in Process Inventory account .

4. Summarize the job cost of the completed chalet that has not yet been sold and show that this equals the ending balance in Finished Goods Inventory .

5. Compute gross profit on each chalet that was sold . What costs must gross profit cover for Red Canyon Homes?

P3-56B Determine flow of costs through accounts (Learning Objectives 2 & 6)

Engine Pro reconditions engines . Its job costing records yield the following information . Engine Pro uses a perpetual inventory system .

Date

Job No. Started Finished

3/26 4/7

2 4/3 4/12

3 4/29 4/30

4 4/30 5/1

5 5/8 5/12

6 5/23 6/6

Requirements

Sold

4/9

4/13

5/3

5/1

5/14

6/9

Total Cost of Job at April 30

$1,800

$1,300

$1,500

$ 300

Total Manufacturing Cost Added in

May

$ 800

$ 500

$1,900

1. Compute Engine Pro's cost of (a) Work in Process Inventory at April 30 and May 31, (b) Finished Goods Inventory at April 30 and May 31, and (c) Cost of Goods Sold for April and May.

2. Make summary journal entries to record the transfer of completed jobs from Work in Process to Finished Goods for April and May.

3. Record the sale of Job 5 on account for $2,300 .

4. Compute the gross profit for Job 5 . What costs must the gross profit cover?

Serial Case C3-57 Calculate operating income (Learning Objectives 1, 2, 3, 4, & 7)

This case is a continuation of the Caesars Entertainment Corporation serial case that began in chapter 1. Refer to the introductory story in Chapter 1 (see page 43) for ad- ditional background . (The components of the Caesars serial case can be completed in any order.)

Caesars Palace ® Las Vegas offers several wedding packages for on-site wedding ceremonies and/or receptions . Packages can include limousines, flowers, photographers, pianist/organist, and other services . Caesars charges a flat fee for the basic wedding package plus additional charges for a la carte or individually added-on items and services . Each wedding is facilitated by a Caesars wedding coordinator; assume that the planning services of a wedding coordina- tor are paid on an hourly basis .

1. Would Caesars be likely to use a job costing system or a process costing system for de- termining the costs and profit for each wedding? Explain .

2. If Caesars uses a job costing system for a wedding, describe what cost items might be included in each of the following categories:

a. Direct material

b. Direct labor

c. Overhead

CRITICAL THINKING Discussion & Analysis A3-58 Discussion Questions

1. Why would it be inappropriate for a custom-home builder to use process costing?

2. For what types of products is job costing appropriate? Why? For what types of products is process costing appropriate? Why?

3. What product costs must be allocated to jobs? Why must these costs be allocated rather than assigned?

4. When the predetermined manufacturing overhead rate is calculated, why are estimated costs and cost driver levels used instead of actual dollars and amounts?

5. Why should manufacturing overhead be allocated to a job even though the costs cannot be directly traced to a job? Give at least two reasons .

6. Why does management need to know the cost of a job? Discuss at least five reasons.

7. Why is it acceptable to close overallocated or underallocated manufacturing overhead to Cost of Goods Sold rather than allocating it proportionately to Work in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold? Under what circumstances would it be advisable to allocate the overallocated or underallocated manufacturing overhead to Work in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold?

8. Desc ribe a situation that may cause manufacturing overhead to be overallocated in a given year . Also, describe a situation that may cause manufacturing overhead to be un- derallocated in a given year .

9. Explain why the cost of goods sold should be lower if manufacturing overhead is over- allocated . Should operating income be higher or lower if manufacturing overhead is over- allocated? Why?

10. What account is credited when manufacturing overhead is allocated to jobs during the period? What account is debited when manufacturing overhead costs are incurred during the period? Would you expect these two amounts (allocated and incurred manufacturing overhead) to be the same? Why or why not?

11. How can job cost records help to promote sustainability efforts within a company?

12. Why should companies estimate the environmental costs of a given job? Why have EPR (extended producer responsibility) laws come into existence?

Application & Analysis Mini Cases

A3-59 Unwrapped or How It's Made

Product Costs and Job Costing Versus Process Costing Go to www.YouTube.com and search for clips from the show Unwrapped on the Food Network or How It's Made on the Discovery Channel. Watch a clip for a product you find interesting .

Basic Discussion Questions 1. Describe the product that is being produced and the company that makes it.

2. Summarize the production process that is used in making this product .

3. What raw materials are used to make this product?

4. What indirect materials are used to make this product?

5. Describe the jobs of the workers who would be considered "direct labor" in the making ofthis product .

6. Describe the jobs of the workers who would be considered "indirect labor" in the making ofthis product .

Job Costing 171

172 CHAPTER 3

REAL LIFE

7. Define manufacturing overhead. In addition to the indirect materials and indirect labor previously described, what other manufacturing overhead costs would be incurred in this production process? Be specific and thorough . Make reasonable "guesses" if you do not know for sure .

8. Would a job-order costing system or a process costing system be used for this production process? Give specific reasons for your choice of which costing system would be most ap- propriate for this manufacturer .

A3-60 Ethics involved with choice of cost driver (Learning Objectives 2, 3, & 4) Vicki Thornton is the controller for Jackson Manufacturing. It is a small company that manufac- tures plastic lumber and is run by the owner and CEO, Franklin Jackson . At the end of the year, Jackson is reviewing the projected operating income for the company for the year. He tells Thornton that the projected operating income is too low; if operating income is not at least $250,000, no holiday bonuses will be paid to employees, including Thornton .

Hoping to find an error, Thornton first rechecks the projected financial statements; she finds no errors . Since cost of goods sold is a large portion of Jackson's expenses, she next ana- lyzes the components of cost of goods sold . The amount of direct material used ties directly to the physical inventory count, so there are no errors there. The direct labor dollars also tie directly to the payroll reports, eliminating another potential source of errors . She then looks at the way manufacturing overhead has been allocated to products .

Traditionally, manufacturing overhead has been allocated to products based on direct labor hours because the manufacturing process for plastic lumber is labor intensive . Thornton calculates manufacturing overhead based on machine hours used and finds that cost of goods sold will be $55,000 lower if manufacturing overhead is allocated based on machine hours rather than direct labor hours. The $55,000 d ifference, if booked, would cause net income to be $262,000, which means that bonuses would be paid to all employees . Thornton knows that several factory employees are struggling and the holiday bonus would be much appreciated . In addition, Thornton herself feels that she has earned the bonus over the past year because she has helped to implement several cost savings programs and has worked many long days without overtime pay.

Requirements

1. Using the IMA Statement of Ethical Professional Practice as an ethical framework, answer the following questions :

a. What is(are) the ethical issue(s) in this situation?

b. What are Thornton's responsibilities as a management accountant?

2. Discuss the specific steps Thornton should take to resolve the situation . Refer to the IMA Statement of Ethical Professional Practice in your response .

A3-61 Costs included in product cost (Learning Objectives 1, 2, 3, & 4) A research firm, IHS (formerly known as iSuppli}, did a teardown of the iPad Air 2 shortly after Apple refreshed the iPad in late 2014 .7 IHS estimated that the costs of the components in the 64-gigabyte (GB) model of the iPad Air 2 (Wi-Fi-only) add up to $295 .25 . See data table that follows .

Questions

1. Do you think that Apple uses a process costing system or a job costing system? Give reasons for your answer .

2. The iPad Air 2 is assigned a cost of $5 for "manufacturing cost ." What specific costs do you think are included in that "manufacturing cost"?

3. In accounting terminology, what would Bill of Materials (BOM) be when discussing product cost?

4. The gross profit per iPad Air 2 is approximately $303.75, which is the difference between the retail price of $599 and its estimated cost (BOM + Manufacturing) of $295.25. Is Apple really making $303.75 for each iPad Air 2 sold? If not, what other types of costs would that gross profit have to go toward covering?

75ource: "Still Air: Apple iPad Air 2 Largely Holds the Line on Features and Costs, IHS Teardown Reveals " (Re- tr ieved from https://technology.ihs .com/514553/stil l-air-app le-ipad-air-2-largely-holds-the- line-on-features-and- costs-ihs-teardown-reveals, on December 28, 2015.)

5. The BOM costs for the units sold would appear on Apple's income statement . In which income statement component would these BOM costs appear?

6. Apple has announced that it is going to start manufacturing some products in the United States rather than in China. If the iPad Air 2 were to be manufactured in the United States, which cost components would you expect to increase? Which cost components might you expect to decrease? What other factors would Apple consider when deciding where to manufacture its products?

Preliminary Bill of Materials (BOM) and Manufacturing Costs for the iPad Air 2 with 64GBytes of NAND Flash and Wi-Fi Only (Pricing in U.S. Dollars)

Components/Hardware Elements

Retail Pricing (as of October 2014) ....... ..... ..... .......... .......... .......... ..... ..... .... .

Total BOM Cost .......................................................................................... .

Manufacturing Cost .................................................................................... .

BOM + Manufacturing ............................................................................... . Major Cost Drivers

Memory : 2GB LPDDR3 DRAM + 64GB NAND Flash ................................ . Display & Touchscreen : 9 .7" 2048 X 1536 IPS Mode LCD/GF2 ................. .

Processors : 64-Bit ABX Processor + MB Co-Processor .............................. . Camera(s): 8MP + 1.2 MP .......................................................................... . User Interface & Sensors & WLAN/BT/FM/GPS ....... .......... .......... .......... .... .

Power Management ................................................................................... .

Battery : 27 .6Wh Pack ................................................................................. .

Mechanical/Electro-Mechanical/Other ....................................................... .

Box Contents .............................. .......... ........................................ .......... .... .

Source : IHS iSuppli Research, October 2014 .

A3-62 Issues with cost of job (Learning Objectives 2, 3, & 4)

Price

$599.00

$290.25

$ 5.00

$295.25

$ 45 .00

$115 .00

$ 22 .00

$ 11.00

$ 26.50

$ 8 .25

$ 15.00

$ 42.50

$ 5 .00

Custom Cookies produces gourmet cookies with company logos for special promotions . The cookies are customized with the customer's choice of shape, color, flavor, and decorations . Custom Cookies uses a job cost system and allocates manufacturing overhead based on direct labor cost . At the beginning of the most recent year, Custom Cookies calculated the cost per batch of dozen cookies as :

Direct materials (flour, sugar, butter, eggs, baking soda, vanilla) $1 .50

Direct labor (shape and decorate cookies) .............................................................. 0 .50

Manufacturing overhead ................................................... ....................................... 0 .90

Total manufacturing cost per dozen cookies ........................................................... $2 .90

In September, Chesrown Motor Group ordered 400 dozen cookies to present to its clients as holiday gifts. Delivery of the cookies to Chesrown would occur in early December . At the time of Chesrown Motor Group's order, the selling price per dozen cookies was $7 .25 .

Chesrown Motor Group placed an order for an additional 100 dozen cookies in November, to be delivered with the original order of 400 dozen . However, since that original order, two events occurred that increased the cost of the cookies . First, the price of sugar skyrocketed due to bad weather in Brazil and India, two of the largest sugar suppliers in the world . Second, a new local cookie bakery is about to open in time for the holiday season and is aggressively trying to hire the cookie decorators from Custom Cookies . In response, Custom Cookies in- creased the hourly rate of the employees who decorate the cookies to keep those workers from going to work for the competition . All other costs at Custom Cookies have remained the same.

Job Costing 173

1 7 4 CHAPTER 3

Because of these two events, Custom Cookies recalculated the cost of a dozen cookies as follows:

Direct materials (flour, sugar, butter, eggs, baking soda, vanilla) .......... .......... .... .

Direct labor (shape and decorate cookies) .......................................................... .

Manufacturing overhead ...................................................................................... .

Total manufacturing cost per dozen cookies .................. ..................................... .

Requirements

$1 .60

0 .65

__Lll_

$3.42

1. Do you agree with the cost analysis for the second order? Explain your answer.

2. Should the two orders be accounted for as one job or as two jobs in Custom Cookies' system?

3. What sales price per box should Custom Cookies set for the second order? Explain why you have selected this per-box price. What are the advantages and disadvan- tages of this price?

Try It Solutions page 111: 1. d 2. a 3. f 4. g 5. h 6. c 7. e 8. b

page 129:

Actual MOH incurred during the year ........... ............ .......... .......... ................. .

MOH allocated to jobs during the year ($16/DL hour X 60,000 DL hours) ... .

Difference: Underallocated MOH .................................................................. .

$975,000

960 000

$ 15 000

Since the company allocated less MOH to jobs than was actually incurred during the year, it has underallocated MOH. Notice that the $1 million of estimated MOH at the beginning of the year is only used to calculate the predetermined MOH rate.

page 146:

1.

Direct cost: Sarah's time (5 hr X $40/hr) + Hannah's time (10 hr X $25/hr) ... .

Indirect cost: (15 hr X $12/hr) ........................................................................ .

Total cost of preparing tax return .................... .......... .......... .......... ................. .

2.

Total cost of preparing tax return ................................................................... .

Plus profit markup ($630 X 30%) ................................................................... .

Amount to bill Meckfessel ............ ................. ....................... .......... ....... ........ .

$450

180

$630

$630

189

_$_fil_2

Ando r Bujdo so/ Alamy

Source: http: // lifefitnes s.com

Activity-Based Costing, Lean Operations, and the Costs of Quality

Learning Objectives

• 1 Develop and use departmental overhead rates to allocate indirect costs

• 2 Develop and use activity-based costing (ABC) to allocate indirect costs

• 3 Understand the benefits and limitations of ABC/ABM systems

• 4 Describe lean operations

• 5 Describe and use the costs of quality framework

When Life Fitness began, it only had one product : the ufecyc1e exercise bike . With time, Life Fitness expanded its product lines to include treadmills, elliptical cross-trainers, stair

climbers, and strength-training equipment . As a result of increased product diversity and competi-

tion, managers often found they needed better, more accurate product cost information to help

guide their business decisions. While a traditional job costing system ensures that the direct materi-

als and direct labor traced to each job is correct, it doesn 't always do an adequate job of allocat-

ing manufacturing overhead, especially when a company produces multiple product lines that use

different amounts of indirect manufacturing resources . In such cases, managers benefit from using

a refined cost allocation system : one that isn't based on a single, predetermined manufacturing

overhead rate . Refined costing systems not only help managers more accurately determine the cost

of individual jobs but also highlight the cost of wasteful activities in the production process . Armed

with this knowledge, managers are able to make more profitable business decisions .

1 7 6 CHAPTER 4

A s the chapter-opening story illustrates, successful companies experience increased competition over time. In addition, companies often seek to expand their customer base by offering a more diversified line of products. Both of these factors are good for con- sumers, who now enjoy more product options at very competitive prices. However, these factors also present unique challenges to business managers and the accounting systems that support them. To thrive in a globally competitive market, companies must provide value to the customer by delivering a high-quality product at an attractive price, while managing costs so that the company still earns a profit. This chapter will introduce several tools that today's managers use to make their companies as competitive as possible:

• Refined costing systems

• Lean operations

• Total quality management and the costs of quality

Why and How Do Companies Refine Their Cost Allocation Systems? The traditional overhead cost allocation system we described in Chapter 3 may not be accurate enough for some compaies. Why? Because under certain conditions, the simple system doesn't do a good job of matching the cost of overhead resources with the products that consume those resources. The following example illustrates why simple systems can lead to less-than-acceptable results.

Simple Cost Allocation Systems Can Lead to Cost Distortion David, Matt, and Marc are three college friends who share an apartment. They agree to split the following monthly costs equally:

Rent, Internet, and utilities......................................................................................... $570

Cable TV.................................................................................................................... 50

Covered parking fee .. ... .. ... .. .. ... .. .. ... .. ... .. .. ... .. .. ... .. ... .. .. ... .. .. ... .. .. ... .. ... .. .. ... .. .. ... .. ... .. .. .. 40

Groceries.................................................................................................................... 240

Total monthly costs.................................................................................................... !2QQ

Each roommate's share is $300 (=$900/3). Things go smoothly for the first few months. But then David calls a meeting: "Because

I started having dinner at Amy's each night, I shouldn't have to chip in for the groceries." Matt then pipes in: "I'm so busy studying and using the Internet that I never have time to watch TV. I don't want to pay for the cable TV anymore. And Marc, because your friend Jennifer eats here most evenings, you should pay a double share of the grocery bill." Marc replies, "If that's the way you feel, Matt, then you should pay for the covered parking since you're the only one around here who uses it!"

What happened? The friends originally agreed to share the costs equally. But they are not participating equally in watching cable TV, using the covered parking, and eating the groceries. Splitting these costs equally is not equitable.

The roommates could use a cost allocation approach that better matches costs with the people who participate in the activities that cause those costs. This means splitting the cable TV costs between David and Marc, assigning the covered parking cost to Matt, and allocating the grocery bill one-third to Matt and two-thirds to Marc. Exhibit 4-1 compares the results of this refined cost allocation system with the original cost allocation system.

No wonder David called a meeting! The original cost allocation system charged him $300 a month, but the refined system shows that a more equitable share would be only $215. The new system allocates Marc $375 a month instead of $300. David was paying for resources he did not use (covered parking and groceries), while Marc was not paying for all of the resources (groceries) he and his guest consumed. The simple cost allocation

Activity-Based Costing, Lean Operations, and the Costs of Quality 177

EXHIBIT 4-1 More Refined Versus Less Refined Cost Allocation System

_j A B C D E 1 Allocation of Exoenses David Matt Marc Total 2 More-refined cost allocation svstem: 3 Rent, internet, and utilities $190 $190 $190 $570 4 Cable TV 25 0 25 50 5 Covered parking 0 40 0 40 6 Groceries 0 80 160 240 7 Total cost allocated $215 $310 $375 $900 8 9 OriE!inal cost allocation svstem: 10 Equal allocation of expenses $300 $300 $300 $900 11 12 Difference ($85) $ 10 $ 75 $ 0 13

system the roommates initially devised had ended up distorting the cost that should be charged to each roommate: David was overcharged by $85 while Matt and Marc were undercharged by an equal, but offsetting, amount ($10 + $75 = $85). Notice that the total "pool" of monthly costs ($900) is the same under both allocation systems. The only difference is how the pool of costs is allocated among the three roommates.

Just as the simple allocation system had resulted in overcharg- ing David, yet undercharging Matt and Marc, many companies find that the simple overhead cost allocation system described in the last chapter results in "overcosting" some of their jobs or products while "undercosting" others. Cost distortion occurs when some products are overcosted while other products are undercosted by the cost allo- cation system. As we'll see in the following sections, companies often refine their cost allocation systems to minimize the amount of cost distortion caused by the simpler cost allocation systems. By refining their costing systems, companies can more equitably assign indirect costs (such as manufacturing overhead) to their individual jobs, prod- ucts, or services. As a result, less cost distortion occurs and managers have more accurate information for making vital business decisions.

In the following section, we will describe how refined cost allo- cation systems can be used to better allocate manufacturing overhead to specific products to reduce cost distortion. However, keep in mind that the same principles apply to allocating any indirect costs to any cost objects. Thus, even merchandising and service companies, as well as governmental agencies, can use these refined cost allocation systems to provide their managers with better cost information.

Review: Using a Plantwide Overhead Rate to Allocate Indirect Costs

II Why is this important? "With better cost information , managers are able to make more

profitable decisions. One company reported triple sales and

a five-fold increase in profits after it implemented a refined costing system . By using better cost information for quoting

jobs, management was able to generate a more profitable mix of job contracts." 1

In the last chapter, we assumed that Life Fitness allocated its manufacturing overhead (MOH) costs using one predetermined MOH rate ($16 per DL hour). This rate was based on management's estimate of the total manufacturing overhead costs for the year ($1 million) and its estimate of the total amount of the allocation base (62,500 DL hours) for the year.2

The rate was calculated as follows:

P d . d MOH $1,000,000 re etermme rate = 62 ,500 DL hours $16 per direct labor hour

1Douglas Hicks, "Yes, ABC Is for Small Business, Too," Journal of Accountancy, August 1999, p. 41. 2All references to Life Fitness in this hypothetical example were created by the authors solely for academic purposes and are not intended, in any way, to represent the actual business practices of, or costs incurred by, Life Fitness, Inc.

1 7 8 CHAPTER 4

This rate is also known as a plantwide overhead rate because any job produced in the plant, whether it be treadmills, elliptical cross-trainers, or stair climbers, would be allo- cated manufacturing overhead using this single rate. It wouldn't matter whether the job was worked on in one department or many departments during the production process: The same rate would be used throughout the plant.

Let's see how this works for Life Fitness. Keep in mind that the company produces many different products and completes thousands of different jobs throughout the year. For simplicity of illustration, we will be following just two of those jobs:

• Job 101: One elliptical

• Job 102: One treadmill

In Chapter 3, we followed a job in which each elliptical cross-trainer required about 10 direct labor hours to make. 3 We'll continue to assume that each elliptical made by the company requires 10 direct labor hours to complete. Let's also assume that each treadmill requires 10 direct labor hours to complete. Exhibit 4-2 shows how manufacturing over- head would be allocated to a job in which one elliptical was made, and another job in which one treadmill was made, using the plantwide overhead rate.

EXHIBIT 4-2 A llocating Manufacturing Overhead Using a Plantwide Overhead Rate

A B I C D E I F G H

1 Job Plantwide

Overhead Rate Actual Use of

Allocation Base MOH Allocated

to Job 2 Job 101: One elliptical $ 16 lper DL hour x 10 IDL hours = $ 3 lob 102: One treadmill $ 16 loer DL hour x 10 IDL hours = S 4

NOTE: Arithmetic signs are only shown for illustrative teaching purposes. They are not typically displayed in spreadsheets.

The plantwide allocation system is illustrated in Exhibit 4-3.

EXHIBIT 4-3 Plantwide A llocation System

Indirect costs -----t- Plantwide overhead rate

160 160

Indirect cost allocated to cost objects

Job 101: One Elliptical

$160

Job 102: One Treadmill

$160

Job 103, etc. (all other jobs)

3 Job 603, a batch of 50 elliptical cross-trainers, required 500 DL hours to complete. Thus, the average time spent on each unit was 10 DL hours .

Activity-Based Costing, Lean Operations, and the Costs of Quality 179

Using Departmental Overhead Rates to Allocate Indirect Costs The plantwide allocation system previously described works well for some companies but may end up distorting costs if the following conditions exist:

1. Different departments incur different amounts and types of manufacturing overhead.

2. Different jobs or products use the departments to a different extent.

If these circumstances exist, the company should strongly consider refining its cost allocation system. Let's see if these conditions exist at Life Fitness.

CONDITION 1: DO DIFFERENT DEPARTMENTS HAVE DIFFERENT AMOUNTS AND TYPES OF MOH COSTS? As shown in Exhibit 4-4, let's assume Life Fitness has two primary production departments: Machining and Assembly. The Machining Department has a lot of machinery, which drives manufacturing overhead costs such as machine depreciation, utilities, machine lubricants, and repairs and maintenance. Let's say these overhead costs are estimated to be $400,000 for the year. On the other hand, the Assembly Department does not incur as many of these types of overhead costs. Rather, the Assembly Department's manufacturing overhead costs include more indirect labor for supervision, quality inspection, and so forth. These manufacturing overhead costs are expected to total $600,000 for the year.

Exhibit 4-4 shows that the first condition is present: Each department incurs different types and amounts of MOH. Life Fitness expects to incur a total of $1 million of manufac- turing overhead: $400,000 relates to the Machining Department, while $600,000 relates to the Assembly Department.

EXHIBIT 4-4 Machining and Assemb ly Departments' Manufacturing Overhead

Total Plantwide MOH $1 Million

~ Machining Deparbnent

($400.000 of MOH)

Elliptical: 1 DL hr __ + ___

+ Treadmill: 4 DL hr -----

I

I Assembly Deparbnent (-.000 of MOH) Total '

Elliptical: 9 DL hr = 10 DL hrs

Treadmill: 6 DL hr = 10 DL hrs

L

CONDITION 2: DO DIFFERENT PRODUCTS USE THE DEPARTMENTS TO A DIFFERENT EXTENT? Although both ellipticals and treadmills take 10 direct labor hours in total to make, Exhibit 4-4 also shows that ellipticals and treadmills spend different amounts of time in each production department. Each elliptical only requires 1 DL hour in the Machining Department but requires 9 DL hours in the Assembly Department. Contrast that with a treadmill, which spends more time in Machining to fabricate some of its components (4 DL hours) but less time in Assembly (6 DL hours). As a result of these

1 Develop and use . - departmental overhead

rates to allocate · indirect costs

1 80 CHAPTER 4

differences, the second condition is also present. The company's cost allocation system would be much more accurate if it took these differences into account when determining how much manufacturing overhead to allocate to each product.

Since both conditions are present, the company should consider "fine-tuning" its cost allocation systems by establishing separate manufacturing overhead rates, known as departmental overhead rates, for each department. That means that Life Fitness will establish one manufacturing overhead rate for the Machining Department and another overhead rate for the Assembly Department. These rates will then be used to allocate manufacturing overhead to jobs or products based on the extent to which each product uses the different manufacturing departments.

Exhibit 4-5 shows the circumstances favoring the use of departmental overhead rates rather than a single, plantwide overhead rate.

EXHIBIT 4-5 Circumstances Favoring Use of Departmental Overhead Rates

Departmental overhead rates increase the accuracy of job costs when ...

• Each department incurs different types and amounts of manufacturing overhead.

• Each product, or job, uses the departments to a different extent.

Four Basic Steps to Computing and Using Departmental Overhead Rates In Chapter 3, we used four steps for allocating manufacturing overhead. These steps are summarized in Exhibit 4-6.

EXHIBIT 4-6 Four Basic Steps for Allocating Manufacturing Overhead

1. Estimate the total manufacturing overhead costs (MOH) for the coming year.

2. Select an allocation base and estimate the total amount that will be used during the year.

3. Calculate the predetermined overhead rate by dividing the total estimated MOH costs by

the total estimated amount of the allocation base.

4. Allocate some MOH cost to each job worked on during the year by multiplying the

predetermined MOH rate by the actual amount of the allocation base used by the job. J The same four basic steps are used to allocate manufacturing overhead using depart-

mental overhead rates. The only real difference is that we will be calculating separate rates for each department. Let's see how this is done.

STEP 1: The company estimates the total manufacturing overhead costs that will be incurred in each department in the coming year. These estimates are known as departmental overhead cost pools.

Some MOH costs are easy to identify and trace to different departments. For example, management can trace the cost of lease payments and repairs to the machines used in the Machining Department. Management can also trace the cost of employing supervisors and quality control inspectors to the Assem- bly Department. However, other overhead costs are more difficult to identify with specific departments. For example, the depreciation, property taxes, and insurance on the entire plant would have to be split, or allocated, between the individual departments, most likely based on the square footage occupied by each department in the plant.

As shown in Exhibit 4-4, Life Fitness has determined that $400,000 of its total estimated MOH relates to its Machining Department, while the remaining $600,000 relates to its Assembly Department.

Activity-Based Costing, Lean Operations, and the Costs of Quality 181

Department Total Departmental Overhead Cost Pool

Machining Department............................................................................. $ 400,000 Assembly Department............................................................................... $ 600,000

TOTAL MOH.......................................................................................... $1,000,000

STEP 2: The company selects an allocation base for each department and estimates the total amount that will be used during the year.

The allocation base selected for each department should be the cost driver of the costs in the departmental overhead pool. Often, manufacturers will use different allocation bases for the different departments. For example, machine hours might be the best allocation base for a very automated Machining Depart- ment that uses machine robotics extensively. However, direct labor hours might be the best allocation base for an Assembly Department.

Let's assume that Life Fitness's Machining Department uses a lot of human- operated machinery; therefore, the number of direct labor hours used in the department is identical to the number of hours the machines are run. While the number of machine hours is the real cost driver, direct labor hours will make an adequate surrogate. As a result, management has selected direct labor hours as the allocation base for both departments. Recall that Life Fitness estimates using a total of 62,500 direct labor hours during the year. Of this amount, manage- ment expects to use 12,500 in the Machining Department and 50,000 in the Assembly Department.

Total Amount of Departmental

Department Allocation Base

Machining Department........................................................................... 12,500 DL hours

Assembly Department............................................................................. 50,000 DL hours

STEP 3: The company calculates departmental overhead rates using the information es- timated in Steps 1 and 2:

D I h d Total estimated departmental overhead cost pool

epartmenta over ea rate = . . Total estimated amount of the departmental allocation base

Therefore, Life Fitness calculates its departmental overhead rates as follows:

M h . . D h d $400,000 ac mmg epartment over ea rate = 12,500 DL hours

$600,000 Assembly Department overhead rate = SO,OOO DL hours

$32 per DL hour

$12 per DL hour

These first three steps are performed before the year begins, using estimated data for the year. Thus, departmental overhead rates are also "predetermined," just like the plant- wide predetermined manufacturing overhead rate discussed in Chapter 3. The first three steps, performed before the year begins, are summarized in Exhibit 4-7.

1 8 2 CHAPTER 4

EXHIBIT 4-7 Steps to Calculating the Departmental Overhead Rates

~ A B

Step 1: Total

Departmental 1 Department Overhead Cost Pool 2 Machining $ 400000 3 Assemblv s 600 000 4

C D I E Step 2:

Total Amount of Departmental Allocation Base 12 500 I DL hours 50 000 I DL hours

I

G I H

Step 3: Departmental

Overhead Rate

$ 32 l oer DL hou1 S 12 l oer DL hou1

I

NOTE: Arithmetic signs are only shown for illustrative teaching purposes . They are not typically displayed in spreadsheets.

Once these rates have been established, the company uses them throughout the year to allocate manufacturing overhead to each job as it is produced, as shown in Step 4.

STEP 4: The company allocates some manufacturing overhead from each department to the individual jobs that use those departments.

The amount of MOH allocated from each department is calculated as follows:

MOH allocated to job = Departmental overhead rate X Actual amount of departmental allocation base used by job

Exhibit 4-8 shows how these departmental overhead rates would be used to allocate manufacturing overhead to a job in which one elliptical is produced.

EXHIBIT 4-8 Allocating MOH to One Elliptical Using Departmental Overhead Rates

A B C D E I F G H

Actual Use of Departmental Departmental MOH Allocated Overhead Rate Allocation Base to Job 101:

1 Department (from Exhibit 4-7) (from Exhibit 4-4) One Elliptical 2 Machining S 32 loer DL hou1 x 1 I DL hours = S 32 3 Assembly $ 12 loer DL hou1 x 9 I DL hours = $ 108 4 .,To! a,.1._ _______ 1 _________ 1 _______ _,.;, _____ 1_, 4,Q.,., __

NOTE: Arithmetic signs are only shown for illustrative teaching purposes. They are not typically displayed in spreadsheets.

Exhibit 4-9 shows how the same rates would be used to allocate manufacturing overhead to another job in which one treadmill is produced. Because the treadmill spends more time in the Machining Department, but less time in the Assembly Department, the amount of MOH allocated to the treadmill differs from the amount allocated to the elliptical in Exhibit 4-8.

EXHIBIT 4-9 Al locating MOH to One Treadmi ll Using Departmenta l Overhead Rates

A

1 Department 2 Machining 3 Assembly 4 Total 5

B C

Departmental Overhead Rate

(from Exhibit 4-7)

D

$ 32 1oer DL hoUJ x $ 12 IPer DL hoUI x

E I F

Actual Use of Departmental

Allocation Base (from Exhibit 4-4)

4 DL hours 6 DL hours

G H

MOH Allocated to Job 102:

One Treadmill $ 128 $ 72 $ 200

NOTE: Arithmetic signs are only shown for illustrative teaching purposes. They are not typically displayed in spreadsheets.

Exhibit 4-10 illustrates the company's departmental cost allocation system.

Activity-Based Costing, Lean Operations, and the Costs of Quality 183

EXHIBIT 4-10 Departmental Cost Allocation System

Indirect Costs:

Departmental Cost Pools:

Departmental Overhead Rates:

Indirect Cost Allocated to Cost Objects:

Total Plantwide MOH $1 million

Machining Dept. $400,000

Job 101: One Elliptical

$32 + $108 = $140

Job 102: One Treadmill

$128 + $72 = $200 Job 103, etc.

(all other jobs)

Had the Plantwide Overhead Rate Been Distorting Product Costs?

We have just seen that Life Fitness's refined cost allocation system allocates $140 of MOH to each elliptical and $200 of MOH to each treadmill (Exhibits 4-8 and 4-9). Does this differ from the amount that would have been allocated to each unit using Life Fitness's original plantwide rate? Yes. Recall from Exhibit 4-2 that if Life Fitness uses a plant- wide overhead rate, $160 of manufacturing overhead would be allocated to both types of equipment, simply because both types of equipment require the same total number of direct labor hours (10 DL hours) to produce.

The plantwide allocation system does not pick up on the nuances of how many direct labor hours are used by the products in each department. Therefore, it was not able to do a very good job of matching manufacturing overhead costs to the products that use those costs. As a result, the plantwide rate would have overcosted each elliptical but under- costed each treadmill, as shown in Exhibit 4-11.

EXHIBIT 4-11 Cost Distort ion Caused by Plantwide Overhead Rate

Plantwide Overhead Rate MOH Allocation

(from Exhibit 4-2)

Job 101: One Elliptical $160

Job 102: One Treadmill $160

Departmental Overhead Rates MOH Allocation

(from Exhibits 4-8 and 4-9)

$140

$200

Amount of Cost Distortion

$20 overcosted

$40 undercosted

On the other hand, the refined cost allocation system recognizes the cost differences between departments and the usage difference between jobs. Therefore, the refined cost- ing system does a better job of matching each department's overhead costs to the products that use the department's resources. This is the same thing we saw with the three room- mates: The refined costing system did a better job of matching the cost of resources (cable, covered parking, groceries) to the roommates who used those resources. Because of this better matching, we believe that the departmental overhead rates more accurately allocate MOH costs than does a single plantwide overhead rate.

1 84 CHAPTER 4

2 .Develop and use activity-based costing (ABC) to a llocate indirect costs

Assume a job with one stair climber requires 5 direct labor (DL) hours to produce: 3 DL hours in the Machining Department and 2 DL hours in the Assembly Department . Use the plantwide overhead rate and departmental allocation rates computed in the chapter example to answer the following:

1. How much MOH would be allocated to the job using the plantwide overhead rate?

2. How much MOH would be allocated to the job using the departmental overhead rates?

3. Does the plantwide overhead rate overcost or undercost the job? By how much?

Please see page 244 for solutions .

Do companies always have separate production departments, such as Machining and Assembly, for each step of the production process?

Answer: No. Rather than basing production departments on separate processing steps, some companies have separate production departments for each of their products . For example, Life Fitness could have one department for producing treadmills, another department for producing ellipticals, and yet another department for producing stair climbers. Each depart- ment would have all of the machinery and equipment necessary for producing its unique product . Departmental overhead rates would be formulated using the same four basic steps just discussed to determine a unique departmental overhead rate for each department . The only difference is that each product (for example, a treadmill) would travel through only one department (the Treadmill Department) rather than traveling through separate production de- partments (Machining and Assembly). Always keep in mind that the accounting system should reflect the actual production environment .

Using Activity-Based Costing to Allocate Indirect Costs We just saw how companies can refine their cost allocation systems by using departmental overhead rates. If a company wants an even more refined system, one that reduces cost distortion to a minimum, it will use activity-based costing (ABC). Activity-based costing (ABC} focuses on activities, rather than departments, as the fundamental cost objects. ABC recognizes that activities are costly to perform, and each product manufactured may require different types and amounts of activities. Thus, activities become the building blocks for compiling the indirect costs of products, services, and customers. Companies can use ABC to more accurately estimate the cost of resources required to produce differ- ent products, to render different services, and to serve different customers.

Think about the three roommates for a moment. The most equitable and accurate cost allocation system for the roommates was one in which the roommates were charged only for the activities in which they participated, and the extent to which they participated in those activities. Likewise, activity-based costing generally causes the least amount of cost distortion among products because indirect costs are allocated to the products based on the (1) types of activities used by the product and (2) the extent to which the activities are used.

Four Basic Steps to Computing and Using Activity Cost Allocation Rates ABC requires the same four basic steps listed in Exhibit 4-6. The main difference between an ABC system and a plantwide or departmental cost allocation system is that ABC sys- tems have separate cost allocation rates for each activity identified by the company.

Activity-Based Costing, Lean Operations, and the Costs of Quality 185

STEP 1: The company first identifies its primary activities and then estimates the total manufacturing overhead costs associated with each activity. These are known as activity cost pools.

Let's assume Life Fitness has determined that the following activities occur in its plant: First, the machines must be set up to meet the particular specifica- tions of the production run. Next, raw materials must be moved out of the storeroom and into the Machining Department, where some of the parts for the units are fabricated. Once the parts have been fabricated, they are moved into the Assembly Department, along with additional raw materials that are needed from the storeroom. The units are then assembled by direct laborers, while pro- duction engineers supervise the process. All units are inspected after assembly. Upon passing inspection, each unit is packaged so that it is not damaged during shipment. Finally, the units are moved to the finished goods warehouse where they await shipment to customers. These activities are pictured in Exhibit 4-12.

EXHIBIT 4-12 Primary Activities Identified in the Manufacturing Plant

Manufacturing Activities

As part of this step, management must determine how much of the total estimated $1 million of MOH relates to each activity. Exhibit 4-13 shows some of the specific MOH costs that management has identified with each activity, along with the total estimated amount of each activity cost pool.

EXHIBIT 4-13 Activity Cost Pools

Activity MOH Costs Related to the Activity Total Activity

Cost Pool

Machine Setup......................... Indirect labor used to set up machines............... $ 80,000 Materials Handling ................. . Forklifts, gas, operators' wages ........................ . Fabricating Parts ..................... . Machine lease payments, electricity, repairs ..... .

Supervising Assembly .............. . Production engineers' labor .............................. . Inspecting ................................ . Testing equipment, inspection labor ................. . Packaging ................................ . Packaging equipment ....................................... .

TOTAL MOH ..................... .

200,000

300,000

150,000

170,000

100,000

$1,000,000

Keep in mind that all of the costs in the activity costs pools are MOH costs; direct labor costs and direct materials costs are not included because they will be directly traced to specific jobs and therefore do not need to be allocated. That is why we only include supervisory labor in the overhead cost pool for the assembly activity. The machine opera- tors and assembly-line workers are considered direct labor, so their cost will be traced to individual jobs, not allocated as part of MOH.

1 86 CHAPTER 4

STEP 2: The company selects an allocation base for each activity and estimates the total amount that will be used during the year.

When selecting an allocation base for each activity, the company should keep the following in mind:

• The allocation base selected for each activity should be the cost driver of the costs in that particular activity cost pool.

• The company will need to keep track of how much of the allocation base each job or product uses. Therefore, the company must have the means to collect usage information about each allocation base. Thankfully, bar coding and other technological advances have helped make data collection easier and less costly in recent years.

Let's assume that Life Fitness has identified a cost driver for each activity and has plans for how it will collect usage data. Exhibit 4-14 shows the selected allocation bases along with the total estimated amounts for the year.

EXHIBIT 4-14 Activity Al location Bases and Total Estimated Amount of Each

Activity Activity Allocation Base

Machine Setup ........................ . Numbe r of setups ........................... .

Mate rials Handling ................. . Number of parts moved ................. .

Fabricating Parts ..................... . Machine hours ............................... .

Supervising Assembly .............. . Direct labor hours .......................... .

Inspecting ................................ . Numbe r of inspections ................... .

Packaging ................................ . Cubic feet packaged ....................... .

Total Estimated Amount of

Allocation Base

8,000 setups

400,000 parts

12,500 machine hours

50,000 DL hours

34,000 inspections

400,000 cubic feet

STEP 3: The company calculates its activity cost allocation rates using the information estimated in Steps 1 and 2.

The formula for calculating the activity cost allocation rates is as follows:

A . . 11

. Total estimated activity cost pool ct1V1ty coSt a ocation rate = Total estimated activity allocation base

Exhibit 4-15 shows how this formula is used to compute a unique cost allocation rate for each of the company's production activities.

EXHIBIT 4-15 Computing Activity Cost Al location Rates

A

1 Activity 2 Machine Setup 3 Materials Handling 4 Fabricatim:i: Parts 5 Suoervisine: Assemblv 6 Inspecting 7 Packaging 8 Total MOH 9

B

Step 1: Total

Activity Cost Pool (from

Exhibit 4-13) $ 80 000

200 000 300 000 150 000 170 000 100 000

$ 1,000,000

C D G H

Step 2: Step 3: Total Amount of Activity

Activity Allocation Cost Allocation Base (from Exhibit 4-14) Rate

8,000 setups = $ 10.00 per setup 400 000 parts = 0.50 per part

12 500 machine hours = 24.00 per machine hour 50 000 DL hours = 3.00 per DL hour 34,000 inspections = 5.00 per inspection

400,000 cubic feet = 0.25 per cubic foot

NOTE: Arithmetic signs are only shown for illustrative teaching purposes. They are not typically displayed in spreadsheets.

Activity-Based Costing, Lean Operations, and the Costs of Quality 187

Once again, these rates are calculated based on estimated, or budgeted, costs for the year. Hence, they too are "predetermined" before the year begins. Then, during the year, the company uses them to allocate manufacturing overhead to specific jobs, as shown in Step 4.

STEP 4: The company allocates some manufacturing overhead from each activity to the individual jobs that use the activities.

The formula is as follows:

MOH allocated to job = Activity cost allocation rate X Actual amount of activity allocation base used by job

Exhibit 4-16 shows how these activity cost allocation rates would be used to allocate manufacturing overhead to Job 101, in which one elliptical was produced.

EXHIBIT 4-16 Allocating MOH to Job 101 (One Elliptical) Using ABC

A

1 Activity 2 Machine Setup 3 Materials Handling 4 Fabricatine-Parts 5 Supervising Assembly 6 Inspecting 7 Packaging 8 Total 9

B C D E

Activity Cost Allocation Rate (from

Exhibit 4-15)

Actual Use of Activity Allocation Base (information collected on job

cost record) 10.00 per setup x 2 setups 0 .50 per part x 20 parts

24.00 oer machine hour x 1 machine hours 3.00 per DL hour x 9 DL hours 5.00 per inspection x 3 inspections 0 .25 per cubic foot x 52 cubic feet

G H

MOH Allocated

to Job 101: One Elliptical

= s 20 10 24 27 15 13

$ 109

NOTE : Arithmetic signs are only shown for illustrative teaching purposes. They are not typically displayed in spreadsheets.

Exhibit 4-17 shows how the same activity cost allocation rates are used to allocate MOH to Job 102, in which one treadmill was produced.

EXHIBIT 4-17 Al locating MOH to Job 102 (One Treadmill) Using ABC

..:'..I A B l C DE F

Actual Use of Activity Cost Activity Allocation

Allocation Base (information Rate (from collected on job

1 Activity Exhibit 4-15) cost record) 2 Machine Setup $10.00 oer setuo x 4 setuos 3 Materials Handling S 0.50 oer oart x 26 parts 4 Fabricating Parts $24.00 oer machine hour x 4 machine hours 5 Suoervising Assembly S 3.00 oer DL hour x 6 DL hours 6 Inspecting 5 5.00 per inspection x 6 inspections 7 Packaging 5 0.25 per cubic foot x 60 cubic feet 8 Total 9

G H

MOH Allocated

to Job 102: One Treadmill

= S 40 = 13 = 96 = 18 = 30 = 15

$ 212

NOTE: Arithmetic signs are only shown for illustrative teaching purposes. They are not typically displayed in spreadsheets.

Exhibit 4-18 illustrates the company's ABC system.

1 8 8 CHAPTER 4

EXHIBIT 4-18 Illustration ofthe Company's ABC System

Indirect Costs:

Activity Cost Pools:

Activity Cost Allocation Rates:

Indirect Cost Allocated to Cost Objects:

Job 101:

$0.50 per part

One Elliptical $20 + $10 + $24 + $27 + $15 + $13

= $109

Total Plantwide MOH $1 million

$24 per machine

hour

Job 102: One Treadmill

$40 + $13 + $96 + $18 + $30 + $15 =$212

Job 103, etc. (all other jobs)

One Last Look at Cost Distortion: Comparing the Three Allocation Systems Exhibit 4-19 compares the amount of manufacturing overhead that would have been al- located to each elliptical and each treadmill using the three cost allocation systems that we have discussed: (1) a single plantwide overhead rate, (2) departmental overhead rates, and (3) ABC.

EXHIBIT 4-19 Comparing the Three Cost Allocation Systems

Plantwide Overhead Rate

(Exhibit 4-2)

Job 101: One Elliptical $160

Job 102: One Treadmill $160

Departmental Overhead Rates

(Exhibit 4-8 & 4-9)

$140

$200

Activity-Based Costing

(Exhibit 4-16 & 4-17)

$109

$212

As you can see, each allocation system renders different answers for the amount of MOH that should be allocated to each elliptical and treadmill. Which is correct? Keep the following important rule of thumb in mind:

ABC costs are generally thought to be the most accurate because ABC takes into account (1) the specific resources each product uses (for example, inspecting resources) and (2) the extent to which they use these resources (for example, each elliptical required three inspections, while each treadmill required six inspections.

Exhibit 4-19 shows that the plantwide rate had been severely distorting costs: The elliptical had been overcosted by $51 ($160 - $109), and the treadmill had been

Activity-Based Costing, Lean Operations, and the Costs of Quality 189

undercosted by $52 ($160 - $212). Here, we have only looked at two jobs produced dur- ing the year. However, the following rule of thumb holds true:

If we consider all of the jobs and products the company produced during the year, we will see that the total amount by which some products have been overcosted will equal the total amount by which other products have been undercosted.

Why? Because $1 million of MOH is being allocated: If some products are allocated too much MOH, then other products are allocated too little MOH.

Keep in mind that cost distortion is solely a result of the way indirect costs (manufac- turing overhead) are allocated. The direct costs of each product (direct materials and direct labor) are known with certainty because of the precise way in which they are traced to jobs.

lii•UW:£ If a company refines its costing system using departmental overhead rates or ABC, will manu- facturing overhead still be overallocated or underallocated by the end of the year (as we saw in Chapter 3 when the company used a plantwide overhead rate)?

Answer: Yes. The use of any predetermined allocation rate will result in the over- or under-al- location of manufacturing overhead . That's because predetermined rates are developed using estimated data before the actual manufacturing overhead costs and actual cost driver activity for the year are known. Refined costing systems decrease cost distortion between products but do not eliminate the issue of over- or underallocating total manufacturing overhead .4 As described in Chapter 3, the Cost of Goods Sold account will need to be adjusted at year-end for the total amount by which manufacturing overhead has been over- or underallocated .

Sustainability and Refined Costing SY.stems

Refined costing systems are almost always a necessity for companies that wish to move toward environmental sustainability. Why? Because jobs and product lines do not drive environmental overhead costs equally. Even a smaller manu- facturing company with only two or three product lines will often find that environmental-related overhead costs, such as:

• solid waste disposal

• water use

• energy consumption

• hazardous materials handling and training

• air emissions

are not driven equally between each product line. If a company uses a single plantwide overhead rate, environmental and nonenvironmental overhead costs will be combined within one cost pool, where they will be allocated to each of the company's product lines using the same rate.

However, refined costing systems allow companies to identify the activities driving environmental costs and separately pool and allocate these costs to the appropriate products. As a result, management will have a clearer picture of the envirommental impact of its products and can use that information to work on reducing the company's environmental footprint. This information can also be used if the company is required to report environmental impact information to its customers upstream in the supply chain (for example, Walmart and Costco assess the environmental and social impact of their suppliers).

4 In some cases, ABC may reduce the total amount of over- or underallocation of manufacturing overhead costs. How? Some activity cost pools may be overallocated, while others are underallocated, resulting in an offsetting total effect.

See Exercises E4-21A and E4-32B

190 CHAPTER 4

The Cost Hierarchy: A Useful Guide for Setting Up Activity Cost Pools Some companies use a classification system, called the cost hierarchy, to establish activity cost pools. Companies often have hundreds of different activities. However, to keep the ABC system manageable, companies need to keep the system as simple as possible, yet refined enough to accurately determine product costs. 5 The cost hierarchy, pictured in Exhibit 4-20, helps managers understand the nature of each activity cost pool and what drives it.

EXHIBIT 4-20 The Cost Hierarchy

There are four categories of activity costs in this hierarchy, each determined by the underlying factor that drives its costs:

1. Unit-level activities-activities and costs incurred for every unit. Examples include inspecting and packaging each unit the company produces.

2. Batch-level activities-activities and costs incurred for every batch, regardless of the number of units in the batch. One example would be machine setup. Once the ma- chines are set up for the specifications of the production run, the company could pro- duce a batch of 1, 10, or 100 units, yet the company only incurs the machine setup cost once for the entire batch.

3. Product-level activities-activities and costs incurred for a particular product, re- gardless of the number of units or batches of the product produced. One example would be the lease payments on equipment used solely for manufacturing a particular product.

4. Facility-level activities-activities and costs incurred no matter how many units, batches, or products are produced in the plant. An example is facility upkeep: the cost of depreciation, insurance, property tax, and maintenance on the entire produc- tion plant.

By considering how the costs of different activities are consumed (at the unit, batch, product, or facility level), managers are often able to maintain a relatively simple, yet relatively accurate, ABC system. After initially identifying perhaps 100 different activi- ties, managers may be able to settle on 5-15 cost pools by combining those activities that behave the same way into the same cost pools. For example, all batch-level costs might be combined into one cost pool that is allocated based on number of batches produced. Since facility-level costs do not have any particular cost driver, they are sometimes combined together in their own cost pool where they are allocated using a simple volume-based allo- cation base such as direct labor or machine hours, much like we saw in Chapter 3. Keep in mind that the cost hierarchy is simply a tool for helping managers think about costs and what drives them.

5 When ABC system implementations fail, it is often due to managers' development of an overly complex system with too many cost pools and too many different cost drivers. After several redesigns of their ABC systems, Coca-Cola and Allied Signal both found that the simpler designs resulted in just as much accuracy. G. Cokins, "Learning to Love ABC," Journal of Accountancy, August 1999, pp. 37-39.

Activity-Based Costing, Lean Operations, and the Costs of Quality 191

Do the journal entries used to record job costing differ if a manufacturer uses a refined cost allocation system (departmental overhead rates or ABC) rather than a single, plantwide over- head rate?

Answer: The journal entries used for a refined costing system are essentially the same as those described in Chapter 3 for a traditional job costing system . The only difference is that the company will typically use several MOH accounts (one for each department or activity cost pool) rather than one MOH account . By using several MOH accounts, the manufacturer obtains more detailed information on each cost pool. This information may help managers make better estimates when calculating allocation rates the next year.

How Do Managers Use the Refined Cost Information to Improve Operations? We've just seen how companies can increase the accuracy of their product costing systems by using departmental overhead rates or ABC. Now let's consider how managers use this improved cost information to run their companies more effectively and efficiently.

Activity-Based Management (ABM) Activity-based management (ABM) refers to using activity-based cost information to make decisions that increase profits while satisfying customers' needs. Companies can use ABC information for pricing and product mix decisions, for identifying opportunities to cut costs, and for routine planning and control decisions.

Pricing and Product Mix Decisions Earlier in the chapter, our ABC example showed managers that ellipticals cost less to make and treadmills cost more to make than indicated by the original plantwide cost al- location system. As a result, managers may decide to change pricing on these products. For example, the company may be able to reduce its price on ellipticals to become more price-competitive. Or the company may decide to capitalize on the extra profitability of the product by leaving the price where it is but increasing demand by placing more ad- vertisements for ellipticals. On the other hand, managers will want to reevaluate the price charged for treadmills. The price must be high enough to cover the cost of producing and selling the treadmills while still being low enough to compete with other companies and earn Life Fitness a reasonable profit.

After implementing ABC, companies often realize they are overcosting their high- volume products and undercosting their low-volume products. Plantwide overhead rates based on volume-sensitive allocation bases (such as direct labor hours) end up allocating more cost to high-volume products and less cost to low-volume products. However, ABC recognizes that not all indirect costs are driven by the number of units produced. That is to say, not all costs are unit-level costs. Rather, many costs are incurred at the batch level or product level, where they can be spread over the number of batches or product lines. As shown in Exhibit 4-21, ABC tends to increase the unit cost of low-volume products (that have fewer units over which to spread batch-level and product-level costs), and decrease the unit cost of high-volume products.

As a result of using ABC, some companies have found that they were actually losing money on some of their products while earning much more profit than they had realized on other products! By shifting the mix of products offered away from the less profitable and toward the more profitable, companies are able to generate a higher operating income.

Cutting Costs Most companies adopt ABC to get more accurate product costs for pricing and product mix decisions, but they often reap even greater benefits by using ABM to pinpoint op- portunities to cut costs. For example, the ABC data calculated in Exhibit 4-15 showed

3 Understand the benefits and limitati~Ms of ABC/ ABM systems ·

1 9 2 CHAPTER 4

EXHIBIT 4-21 Typical Result of ABC Costing

Type of product

Low-volume products

High-volume products

Plantwide allocation systems tend to:

undercost

overcast

ABC systems tend to:

t unitcost

' unitcost

managers that each inspection costs $5, each machine setup costs $10, each part costs $0.50 to move, and so forth. This information gives production managers a starting place for cutting costs.

Once managers identify the company's activities and their related costs, managers can analyze whether all of the activities are really necessary. As the term suggests, value- added activities are activities for which the customer is willing to pay because these activi- ties add value to the final product or service. In other words, these activities help satisfy the customer's expectations of the product or service. For example, fabricating component parts and assembling the units are value-added activities because they are necessary for changing raw materials into high-quality ellipticals and treadmills.

On the other hand, non-value-added activities (also referred to as waste activities), neither enhance the customer's image of the product or service nor provide a competitive advantage. These types of activities could be reduced or removed from the process with no ill effect on the end product or service. The primary goal of lean thinking, which is described in the second half of the chapter, is to make the company's processes as efficient as possible by eliminating all wasteful activities.

One way of determining whether an activity adds value is to ask if it could be elimi- nated or reduced by improving another part of the process. For example, could the move- ment of parts be eliminated or reduced by changing the factory layout? Could inventory storage be eliminated if the company only purchased the raw materials that were needed for each day's production run? Could inspection be reduced if more emphasis was placed on improving the production process, training employees, or using better-quality inputs? In the second half of the chapter we'll discuss tools that many companies have adopted to identify and eliminate these costly non-value-added activities.

Routine Planning and Control Decisions In addition to pricing, product mix, and cost-cutting decisions, companies can use ABC in routine planning and control. Activity-based budgeting uses the costs of activities to create budgets. Managers can compare actual activity costs to budgeted activity costs to determine how well they are achieving their goals.

Using ABC Across the Value Chain and in Service and Merchandising Companies Our chapter example revolved around using refined costing systems at a manufacturer to more accurately allocate manufacturing overhead costs. However, ABC can be used to identify the cost of all activities across the value chain associated with particular jobs, products, and services. For example, using ABC, a company can better determine the costs of designing or marketing new or existing products and services. It can also calculate the cost of providing customer service to different clients. The 80%/20% rule generally holds: 20% of clients often provide 80% of the company's profits once all the activities incurred on behalf of "needy" clients is taken into consideration. By more accurately allocating the

Activity-Based Costing, Lean Operations, and the Costs of Quality 193

cost of all activities across the value chain, businesses can focus on their most profitable products, services, and customers.

Merchandising and service companies also find ABC useful. For example, Walmart may use ABC to allocate the cost of store operating activities such as ordering, stocking, and customer service among its Housewares, Clothing, and Electronics Departments. An accounting firm may use ABC to allocate secretarial support, software costs, and travel costs between its tax, audit, and consulting clients. To implement ABC, these companies use the same four basic steps discussed earlier but apply them to indirect operating costs rather than indirect manufacturing costs (MOH). Once again, managers can use the data generated by ABC to determine which products or services to emphasize, to set prices, to cut costs, and to make other routine planning and control decisions.

lii•U•~£ Can governmental agencies use ABC/ABM to run their operations more efficiently?

Answer: Yes. ABC/ABM is not just for private-sector companies .The City of Indianapolis was able to save its taxpayers millions of dollars after using ABC to study the cost of providing city services (activities) to local citizens . Once the city determined the cost of its activities, it was able to obtain competitive bids for those same services from private businesses . As a result, the city outsourced many activities to private-sector firms for a lower cost. 6

Passing the Cost-Benefit Test Like all other management tools, managers must determine whether the cost of design- ing and implementing an ABC/ABM system is worth the benefits of having more precise information. The system should be refined enough to provide accurate product costs but simple enough for managers to understand. In our chapter example, ABC increased the number of allocation rates from the single plantwide allocation rate in the original system to six activity cost allocation rates. ABC systems are even more complex in real-world companies that have many more activities and cost drivers.

Circumstances Favoring ABC/ ABM Systems ABC and ABM pass the cost-benefit test when the benefits of adopting ABC/ABM exceed the costs.

The benefits of adopting ABC/ABM are higher for companies in competitive markets because

• accurate product cost information is essential for setting competitive sales prices that still allow the company to earn a profit.

• ABM can pinpoint opportunities for cost savings, which increase the company's profit or are passed on to customers through lower prices.

The benefits of adopting ABC/ABM are higher when the risk of cost distortion is high, for example, when

• the company produces many different products that use different types and amounts of resources. (If all products use similar types and amounts of resources, a simple plantwide allocation system works fine.)

• the company has high indirect costs. (If the company has relatively few indirect costs, it matters less how they are allocated.)

• the company produces high volumes of some products and low volumes of other prod- ucts. (Plantwide allocation systems based on a volume-related driver, such as direct labor hours, tend to overcost high-volume products and undercost low-volume products.)

6H. Meyer, "Indianapolis Speeds Away, " The Journal of Business Strategy, May/June 1998, pp. 41-46.

194 CHAPTER 4

We have seen that ABC offers many benefits. However, the cost and time required to implement and maintain an ABC system are often quite high. Some companies report spending up to two to four years to design and implement their ABC systems. The larger the company, the longer it usually takes. Top management support is crucial for the suc- cess of such an expensive and time-consuming initiative. Without such support, ABC implementations might easily be abandoned for an easier, less costly accounting system. Because we know ABC systems are costly to implement, how can a company judge the costs involved with setting one up?

The costs of adopting ABC/ABM are generally lower when the company has

• accounting and information system expertise to develop the system. However, even "off-the-shelf" commercial accounting packages offer ABC modules. Small compa- nies often find that Excel spreadsheets can be used to implement ABC, rather than integrating ABC into their general ledger software.

• information technology such as bar coding, optical scanning, Web-based data collec- tion, or data warehouse systems to record and compile cost driver data.

Signs That the Old System May Be Distorting Costs Broken cars or computers simply stop running. But unlike cars and computers, even broken or outdated costing systems continue to report product costs. How can you tell whether a costing system is broken and needs repair? In other words, how can you tell whether an existing costing system is distorting costs and needs to be refined by way of departmental rates or ABC?

A company's product costing system may need repair in the following situations:

Managers don't understand costs and profits:

• In bidding for jobs, managers lose bids they expected to win and win bids they ex- pected to lose.

• Competitors with similar high-volume products price their products below the com- pany's costs but still earn good profits.

• Employees do not believe the cost numbers reported by the accounting system.

The cost system is outdated:

• The company has diversified its product offerings since the allocation system was first developed.

• The company has reengineered its production process but has not changed its ac- counting system to reflect the new production environment.

Activity-Based Costing, Lean Operations, and the Costs of Quality 195

Refined Costing Systems ·-..... .. . Several years ago , Dell decided that it needed to refine its costing system . Starting with an Excel spreadsheet, Dell devel- oped a simple ABC system that focused on the 10 most critical activities . Here are some of the decisions Dell faced as it began refining its costing system .

Decision

How do we develop an ABC system?

How do we compute an activity cost allocation rate?

How do we allocate an activity's cost to a job?

How can a refined costing system support environmental sustainability?

What types of decisions would benefit from the use of ABC?

What are the main benefits of ABC?

When is ABC most likely to pass the cost- benefit test?

How do we tell when a cost system needs to be refined?

Guidelines

1. Identify the activities and estimate the total MOH associated with each activity. These are known as the activity cost pools .

2 . Select a cost allocation base for each activity and estimate the total amount that will be used during the year .

3. Calculate an activity cost allocation rate for each activity .

4. Allocate some MOH from each activity to the individual jobs that use the activities .

Tot al estimat ed activity cost pool Tot al estim ated activity allocation base

Actu al amount of Activity cost

allocation rat e x activity allocation base used by job

By creating separate cost pools for environmental related costs, manag- ers are better able to identify those activities and products with larger environmental footprints .

Managers use ABC data in ABM to make the following decisions :

• Pricing and product mix

• Cost cutting

• Routine planning and control

• More accurate product cost information .

• More detailed information on costs of activities and associated cost drivers help managers control costs and eliminate non-value-added activities .

• The company is in a competitive environment and needs accurate prod- uct costs .

• The company makes different products that use different amounts of resources .

• The company has high indirect costs .

• The company produces high volumes of some products and lower vol- umes of other products .

• The company has accounting and information technology expertise to implement the system .

• Managers lose bids they expected to win and win bids they expected to lose .

• Competitors earn profits despite pricing high-volume products below the company's costs .

• Employees do not believe cost numbers .

• The company has diversified the products it manufactures .

• The company has reengineered the production process but not the ac- counting system .

196 CHAPTER 4 - •. _ . . SUMMARY PROBLEM 1

Indianapolis Auto Parts (IAP) has a Seat Manufacturing Department that uses ABC. IAP's activ- ity cost allocation rates include the following:

Activity

Machining

Assembling

Packaging

Allocation Base

Number of machine hours

Number of parts

Number of finished seats

Activity Cost Allocation Rate

$30.00 per machine hour

0.50 per part

0.90 per finished seat

Suppose Ford has asked for a bid on 50,000 built-in baby seats that would be installed as an option on some Ford SUVs. Each seat has 20 parts, and the direct materials cost per seat is $11 . The job would require 10,000 direct labor hours at a labor wage rate of $25 per hour . In addition, IAP will use a total of 400 machine hours to fabricate some of the parts required for the seats .

Requirements

1. Compute the total cost of producing and packaging 50,000 baby seats . Also compute the average cost per seat .

2. For bidding, IAP adds a 30% markup to total cost . What price will the company bid for the Ford order?

3. Suppose that instead of an ABC system, IAP has a traditional product costing system that allocates manufacturing overhead at a plantwide overhead rate of $65 per direct labor hour . The baby seat order will require 10,000 direct labor hours . Compute the total cost of producing the baby seats and the average cost per seat . What price will IAP bid using this system's total cost?

4. Use your answers to Requirements 2 and 3 to explain how ABC can help IAP make a better decision about the bid price it will offer Ford .

Activity-Based Costing, Lean Operations, and the Costs of Quality 197

• SOLUTIONS Requirements 1 and 2 Total Cost of Order, Average Cost per Seat, and Bid Price:

_J A B C D E F G H 1 Manufacturine Costs Usaee of Activity Cost Rate Total 2 Direct Material 50,000 seats x $ 11.00 per seat = $ 550000 3 Direct Labor 10 000 DL hours x $ 25.00 oer DL hour 250000 4 MOH: 5 Machinine 400 machine hours x $ 30.00 oer machine hour = 12 000 6 Assembline 1 000 000* oarts x $ 0.50 oer oart = 500 000 7 Packaeine 50,000 seats x $ 0.90 oer seat = 45 000 8 Total Cost S 1357 000 9 Divide bv: Number of units 50000 10 Average cost per unit S 27.14 11 12 Ca1cu1at1on ot DID price: 13 Total job cost $ 1 357,000 14 Multip ly by: 100% + Markup 130% 15 Bid price $ 1,764,100 16

*1,000,000 = 50,000 seats X 20 parts per seat. NOTE : Arithmetic signs are only shown for illustrative teaching purposes. They are not typically displayed in spreadsheets .

Requirement 3 Bid Price (Traditional System):

_J A B I C 1 Manufacturine Costs Usaee of Activity 2 Direct Material 50,000 seats 3 Direct Labor 10 000 DL hours 4 MOH: 10 000 DL hours 5 Total Cost 6 Divide bv: Number of units 7 Average cost per unit 8 9 Calculation of bid price: 10 Total job cost 11 Multiply by: 100% + Markup 12 Bid price 13

D E I F Cost Rate

x $ 11.00 per seat x $ 25.00 oer DL hour x $ 65.00 oer DL hour

G H Total

= $ 550000 250 000 650 000

$ 1450 000 50000

s 29.00

S 1450 000 130%

$ 1885000

NOTE : Arithmetic signs are only shown for illustrative teaching purposes. They are not typically displayed in spreadsheets.

Requirement 4 IAP's bid would be $120,900 higher using the plantwide overhead rate than using ABC ($1,885,000 versus $1,764,100) . Assuming that the ABC system more accurately captures the costs caused by the order, the traditional plantwide overhead system overcosts the order . This leads to a higher bid price that reduces IAP's chance of winning the bid . The ABC system shows that IAP can increase its chance of winning the bid by bidding a lower price and still make a profit .

1 9 8 CHAPTER 4

4 .Describe lean ~ -: operations

What Is Lean Thinking? Lean thinking is a management philosophy and strategy focused on creating value for the customer by eliminating waste. Lean is often described by the Japanese word Kaizen, meaning "change for the better." Lean thinking is quickly becoming the dominant business paradigm; without it, a company has little chance of long-term survival in the highly com- petitive global marketplace. Since management accounting systems should be designed to reflect the company's operations, it's important for you to understand the key elements of lean operations and the costs that can be reduced by eliminating waste.

One key element of creating customer value is to emphasize a short customer response time: the time that elapses between receipt of a customer order and delivery of the product or service. To shorten this time, companies need to reduce their own internal processing time. Although lean thinking developed in the manufacturing industry (at Toyota, in par- ticular), the concepts and tools are being applied with great success to all types of com- panies. For example, service companies, such as hospitals, car repair shops, and fast-food restaurants, must also focus on eliminating the waste in their operations. No matter the industry, the bottom line is clear: By eliminating wasteful activities, companies can reduce their costs and improve their customer response time.

The Eight Wastes of Traditional Operations Advocates of lean thinking often talk about eight wastes that comprise much of the waste found in traditional organizations, including service and merchandising compa- nies. As shown in Exhibit 4-22, these wastes are easy to remember using the acronym DOWNTIME. 7

EXHIBIT 4-22 The Eight Wastes

D • Defects Q • Overproduction W •Waiting N • Not utilizing people to their full potential T • Transportation I • Inventory

M •Movement E • Excess processing

1. Defects: Producing defective products or services costs time and money. The prod- uct will either need to be repaired, at additional cost, or disposed of. In either case, resources are wasted. The final section of this chapter is devoted to discussing the various costs associated with poor quality of product or service.

2. Overproduction: Overproduction means that the company is making more product than needed or making product sooner than it is needed. Traditional manufacturers often make products in large batches because of long and costly machine setup times and to protect themselves against higher than expected demand for the product. Also, traditional manufacturers often make extra work in process inventory so that each department will have something to continue working on in the event production stops or slows in earlier departments. For example, in Exhibit 4-23, we see the series of production steps required to produce drill bits from bar stock. If the company keeps

7 MAGNET (Manufacturing Advocacy and Growth Network), Cleveland, Ohio.

Activity-Based Costing, Lean Operations, and the Costs of Quality 199

some work in process inventory between the grinding and smoothing operations, the smoothing operation can continue even if the shaping or grinding operations slow or come to a halt as a result of machine breakdown, absence of sick workers, or other production problems.

EXHIBIT 4-23 Sequence of Operations for Drill Bit Production

- - - ·-~ Finished goods As you'll see next, overproduction can snowball into many problems, including

extra wait time, extra transportation, and excess inventory build-up.

3. Waiting: Employees must often wait for parts, materials, information, or machine repairs before they can proceed with their tasks. In addition, because of overproduc- tion and large batches, work in process inventory often waits in a queue for the next production process to begin. Whether it refers to people or product, wait time is wasted time. The company's customer response time could be much shorter if wait time were eliminated.

4. Not utilizing people to their full potential: By assuming that managers always know best, traditional companies have often underutilized their employees. In contrast, one of the key mantras of lean thinking is employee empowerment at all levels of the organization. Employees usually have excellent ideas on how their jobs could be done more efficiently and with less frustration.

5. Transportation: While movement of parts, inventory, and paperwork is necessary to some extent, any excess transportation is simply wasteful because of the equipment, manpower, energy, and time it requires. Excess transportation is often caused by poor plant layout, large centralized storage cribs, large batches, and long lead times that re- quire product to be moved elsewhere until the next production process is ready to begin.

6. Inventory: Typically, traditional manufacturers buy more raw materials than they need "just in case" any of the materials are defective or the supplier is late with the next delivery. As noted earlier, they produce extra work in process inventory "just in case" something goes wrong in the production process. Also, they produce extra fin- ished goods inventory "just in case" demand is higher than expected. In other words, large inventories are essentially a response to uncertainty. Uncertainty is a valid rea- son for keeping large inventories. So why are large inventories considered wasteful?

• Inventories use cash. Companies incur interest expense from borrowing cash to finance their inventories or forgo income that could be earned from investing their cash elsewhere.

• Large inventories hide quality problems, production bottlenecks, and obsoles- cence. Inventory may spoil, be broken or stolen, or become obsolete as it sits in storage and waits to be used or sold. Companies in high-tech and fashion indus- tries are particularly susceptible to inventory obsolescence.

• Storing and unstoring inventory is very expensive. Building space, shelving, ware- house equipment, security, computer systems, and labor are all needed to manage inventories.

7. Movement: In contrast to the waste of transportation, which refers to moving prod- ucts and materials, the waste of movement refers to excess human motion, such as excess bending, reaching, turning, and walking. This waste is often caused by clut- tered or unorganized work areas (where employees must search for the needed tools and supplies), poorly designed facilities (where employees must walk from one area of the building to another), and poorly designed workstations and work methods

200 CHAPTER 4

(where employees must continually crouch, stretch, bend, and turn to do their tasks). Not only does excess movement take time, but also it can signal unsafe work condi- tions that can decrease employee morale and increase the company's exposure to workers' compensation claims.

8. Excess processing: This waste refers to performing additional production steps or adding features the customer doesn't care about. Often, this waste is caused when customer requirements are not clearly defined, when engineering changes are made without simultaneous process changes, or when additional steps are performed to make up for shortfalls in earlier production steps. For example, to keep its price point relatively low, IKEA flat packs all of its furniture and lets the customer perform the final assembly. By eliminating the final assembly process, IKEA gives customers what they want at a price that is affordable. Also, IKEA saves on related transportation and warehousing costs that would be incurred on bulkier, fully assembled furniture.

Characteristics of Lean Operations One primary goal of a lean organization is to eliminate the waste of time and money that accompanies large inventories. Therefore, lean companies often adopt a "just-in-time" illTI inventory philosophy. As the name suggests, JIT inventory focuses on purchasing raw materials just in time for production and then completing finished goods just in time for delivery to customers. By doing so, companies eliminate the waste of storing and unstoring raw materials and finished goods, as pictured in Exhibit 4-24.

EXHIBIT 4-24 Traditional System Versus JIT System

Traditional System

Materials from Suppliers

Raw materials warehouse (handling to store and unstore)

Production

Finished goods warehouse (handling to store and unstore)

Customer

Just-in-Time (Jm Syslam

Materials from Suppliers

Production

Customer

Most companies that adopt lean thinking have several common characteristics that help minimize the amount of inventory that is kept on hand, yet enable the company to quickly satisfy customer demand. These characteristics are described next.

Activity-Based Costing, Lean Operations, and the Costs of Quality 201

Value Stream Mapping

Companies need to understand their current state of operations before they can attempt to remove waste and improve operations. Each family of products or services the company of- fers is known as a value stream. Value stream maps (VSM) are used to identify and visually illustrate the flow of materials and information for each separate value stream, all the way from order receipt to final delivery. A current state VSM is used to illustrate the sequence of activities, communication of information, time elapsing, and build-up of inventories that is currently occurring. After identifying waste within the current state VSM, companies pre- pare a future state VSM, with waste removed, and use it as a goal for process improvement.

Production Occurs in Self-Contained Production Cells One of the first wastes many companies identify on the current state VSM is the waste of time, transportation, and movement that occurs as a result of poor plant or office layout. On one hand, a traditional drill bit manufacturer would group all cutting machines in one area, all shaping machines in another area, all grinding machines in a third area, and all smooth- ing machines in a fourth area, as illustrated in Panel A of Exhibit 4-25. On the other hand, lean companies would group the machines in self-contained production cells as shown in Panel B of Exhibit 4-25. These self-contained production cells minimize the time and cost involved with physically moving parts across the factory to other departments.

EXHIBIT 4-25 Equipment Arrangement in Traditional and Lean Production Systems

PANEL A-Traditional Production System Each type of machine is grouped together in one area of the plant.

Cutting ____. Shaping -----.------- Grinding ----. smoothing Department Department •~•"mii• Department Department finished •:gppfPFU! ,..,.,... ....,.. ~ drill

work in work in process process

PANEL 8-Lean Production System Different machines are arranged in self-contained production cells.

....,.. finished drill bits

cutting shaping grinding smoothing machine machine machine machine

Drill Bit Production Cell 2 .... ..

cutting shaping grinding smoothing machine machine machine machine

finished drill bits

m work in process

Ratchet Production Cell 1

cutting shaping grinding smoothing machine machine machine machine

Ratchet Production Cell 2 ~ l. t..111 ;, . .

cutting shaping grinding smoothing machine machine machine machine

Employee Empowerment: Broad Roles and the Use of Teams

To combat the waste of not utilizing people to their full potential, lean companies focus on employee empowerment. Employees typically hold broader roles than their counterparts at traditional companies. For example, employees working in production cells do more than operate a single machine. They also conduct maintenance, perform setups, inspect

bits

finished ratchets

finished ratchets

finished ratchets

202 CHAPTER 4

their own work, and operate other machines. For example, look at Panel B of Exhibit 4-25. A worker in the Drill Bit Production Cell 1 would be cross-trained to operate all of the machines (cutting, shaping, grinding, and smoothing) in that cell. This cross-training boosts morale, lowers costs, and creates a more flexible and versatile workforce. As a result, individual workloads become much more balanced, leading to a more equitable distribution of work and a more satisfied workforce.

Lean companies also empower employees by using small teams to identify waste and develop potential solutions to the problems identified. Problem solving at lean companies involves searching for and fixing the root cause of a problem, rather than making cosmetic changes to surface issues. To find the root cause of a problem, teams are encouraged to ask "Why?" at least five times. For example, say you received a "D" grade on an exam. Your initial response might be that you didn't understand the material. However, as you dig deeper by continually asking "Why?" you might find that the root cause was not a simple failure to understand the material, but having an overloaded schedule that didn't allow you sufficient time to study and practice the material. The solution might be to lighten your semester course load or not to participate in so many extracurricular activities. Without fixing the root cause of the problem, you are apt to run into similar problems in the future.

Often, lean companies institute profit-sharing plans so that employees at all levels of the company are compensated for improving the company's overall performance. Because of employee empowerment, lean companies typically report higher job satisfaction and better employee morale.

5S Workplace Organization Lean companies use a workplace organization system called "5S" to keep their work cells clean and organized. The mantra of 5S is, "a place for everything and everything in its place." By having a clean, well-organized, ergonomic workplace, every employee within the work cell knows where to find the tools and supplies they need to do each job in the cell as efficiently as possible. A clean workplace also leads to fewer defects (due to fewer contaminants), a safer workplace, and fewer unscheduled machine repairs. The 5S stands for the following:

• Sort: Infrequently used tools and supplies are removed from the workplace.

• Set in order: Visual management tools, such as color-coding, are used to create a logical layout of tools, supplies, and equipment in the work cell so that anyone could walk into the cell and visually understand the current situation.

• Shine: All machines, floors, tools, and workstations are thoroughly cleaned.

• Standardize: Procedures are put in place to ensure the cleanliness and organization of the workplace does not deteriorate.

• Sustain: Daily upkeep of the workstations is maintained, and 5S inspections are rou- tinely performed.

Continuous Flow Lean organizations attempt to smooth the flow of production through the plant so that the rate of production is the same as the rate of demand, thus reducing the wastes of over- production, waiting, and inventory. The goal is to make only as many units as needed by the next customer, whether that be the next machine operator or the final, external cus- tomer. Takt time, a critical concept in lean manufacturing, is the rate of production needed to meet customer demand, yet avoid overproduction. The term comes from a German word for rhythm or beat. For example, if a product line has a takt time of five minutes, it means that one unit needs to be produced every five minutes. By carefully monitoring takt time, lean companies are able to identify bottlenecks, balance the workloads of different processes, avoid inventory build-up, and satisfy customer demand.

Pull System In a traditional production system, batches of product are "pushed" through production according to forecasted demand. However, in a lean production system, no products are

Activity-Based Costing, Lean Operations, and the Costs of Quality 203

made until a customer's order has been received. The customer order triggers the start of the production process and "pulls" the batch through production. Even the necessary raw materials are usually not purchased until a customer order is received. Obviously, for this to work, companies must employ various tactics that will allow the company to quickly satisfy the customer's order. We discuss these tactics next.

Shorter Manufacturing Cycle Times Because products are not started until a customer order is received, lean companies must focus on reducing their manufacturing cycle time: the time that elapses between the start of production and the product's completion. According to most experts, the majority of manufacturing cycle time is spent on non-value-added activities. Shorter manufacturing times also protect companies from foreign competitors whose cheaper products take longer to ship. Delivery speed has become a competitive weapon.

Smaller Batches Manufacturing cycle time is highly dependent on batch size. Large batch sizes cause wasted wait time. Therefore, one of the key elements of lean production is the use of smaller batches. For example, assume that a customer has ordered 10 units and that each unit requires three unique, sequential processes: A, B, and C. Furthermore, assume that each process takes 1 minute to complete on each unit. The manufacturing cycle time is illustrated in Exhibit 4-26, where each "x" stands for one unit of the product, and the capital "X" stands for the first unit in the batch. Exhibit 4-26 shows that the entire order would take 30 minutes to complete if the manufacturer uses a batch size of 10. Exhibit 4-26 also shows that 21 minutes have elapsed before the first unit in the batch is completed.

EXHIBIT 4-26 Manufacturing Cycle Time with a Batch Size of 10

Time (in minutes) -----------

1-10min 11-20 min 21-30 min

Process A Xxxxxxxxxx

Process B Xxxxxxxxxx

Process C Xxxxxxxxxx

Alternatively, Exhibit 4-27 shows that the entire order could be completed in just 12 minutes if the manufacturer uses a batch size of 1. In addition, the first unit in the batch is completed after a mere 3 minutes has elapsed. Why the difference? With large batch sizes, each unit spends the bulk of the manufacturing cycle time waiting. Customer response time can be greatly reduced through the use of smaller batch sizes.

EXHIBIT 4-27 Manufacturing Cycle Time with a Batch Size of 1

Time (in minutes) ----------

1 2 3 4 5 6 7 8 10 11 12

Process A X x x x x x x x x x

Process B

Process C

Reduced Setup Times

X X X X X X X X X X

X X X X X X X X X X

One key component of manufacturing cycle time is the time required to set up a machine that is used to manufacture more than one product. Employee training and technology

204 CHAPTER 4

helped Toyota cut setup times from several hours to just a few minutes. As a result, the company became more flexible in scheduling production to meet customer orders.

Point-of-Use Storage Point-of-use storage /POUS) is a storage system used to reduce the waste of transportation and movement. In essence, tools, materials, and equipment are stored in proximity to where they will be used most frequently, rather than in a centralized storage crib. In a similar vein, those items that are used infrequently are removed from the cells and stored elsewhere.

Emphasis on Quality Lean companies focus on producing their products right the first time, every time. Why? First, they have no backup stock to give to waiting customers if they run into production problems. Second, defects in materials and workmanship can slow or shut down produc- tion. Lean companies cannot afford the time it takes to rework faulty products. Lean companies emphasize "building in" quality rather than relying on a final inspection point to catch defects. This approach to quality, called quality at the source, refers to shifting the responsibility for quality adherence to the operators at each step in the value stream, rather than relying on supervisors or quality assurance personnel to catch errors. Each operator checks the incoming work, as well as his or her own outgoing work, so that de- fective units do not get passed on to downstream production processes.

Many lean companies also pursue the dogma of Six Sigma, which is the goal of pro- ducing near perfection, with less than 3.4 defects per million opportunities. The name arises from its statistical probability: a defect that is six standard deviations from the mean is

highly unlikely to occur. You may hear the term Lean/Six Sigma together because the two approaches often go hand in hand. Six

II Why is this important? Sigma was developed by Motorola in the 1980s but has been adopted by many successful companies. GE credits Six Sigma with saving the company over $10 billion in the first five years of its use.8 Lean/Six Sigma companies use standardization tools, such as checklists and detailed step-by-step operating procedures, to ensure employees know how to complete each process correctly. They also use visual management, root cause analysis, and other tools to "mistake-proof" each process. "Poka-yoke" is the Japanese term used in lean companies for mistake-proofing a process. Let's look at an example: at gas stations, the nozzle for diesel gasoline is larger than the nozzle for regular unleaded gas, making it virtually impossible for absent-minded customers to accidentally put diesel fuel into a car that runs on regular fuel. The process of refueling

"In order to compete and remain profitable , companies must cut costs by becoming as efficient as possible. Lean thinking helps organizations cut costs by eliminating waste from the system." has been mistake-proofed for owners of the majority of vehicles in

the United States.

Supply-Chain Management Because there are no inventory buffers, lean production requires close coordination with suppliers. These suppliers must guarantee on-time delivery of defect-free materials. Supply-chain management is the exchange of information with suppliers and customers to re- duce costs, improve quality, and speed delivery of goods and services from the company's suppliers, through the company itself, and on to the company's end customers. Suppliers that bear the ISO 9001 certification have proven their ability to provide high-quality prod- ucts and thus tend to be suppliers for lean manufacturers.

Backflush Costing Due to the emphasis on JIT inventory (little to no raw materials or finished goods), short manufacturing cycle times, and a "pull" system (customer is awaiting production), many lean producers use a simplified accounting system, called backflush costing, that better mirrors their production environment and eliminates wasteful bookkeeping steps. In a backflush costing system, the production costs are not assigned to the units until they 8 www.sixsigmadaily.com/why-six-sigma-certification-and-training-reduces-company-costs/

Activity-Based Costing, Lean Operations, and the Costs of Quality 205

are finished, or even sold, thereby saving the bookkeeping steps of moving the product through the various inventory accounts. To get an accurate measurement of the inventory accounts and Cost of Goods Sold at the end of the period, the cost of any unfinished or unsold product is "flushed" out of Cost of Goods Sold and placed back in the Work in Process Inventory and Finished Goods Inventory accounts.

Are There Any Drawbacks to a Lean Production System? While many companies credit lean thinking with saving them millions of dollars, the sys- tem is not without problems. With no inventory buffers, lean producers are vulnerable when problems strike suppliers or distributors. For example, natural disasters, such as the tsunamis in Japan, and man-made disasters, such as terrorist attacks, have caused produc- tion shutdown at several lean manufacturers.

Lean Operations in Service and Merchandising Companies The eight wastes and lean principles discussed previously also apply to service and mer- chandising firms. In fact, lean practices have become extremely popular in service com- panies, such as banks and hospitals, as well as merchandising companies, such as IKEA. Entire books have been written on the subject of "lean health care" and "lean offices." Through the use of lean tools, offices have been able to identify the waste caused by exces- sive document processing, layers of unnecessary authorization, unbalanced workloads, poor office layouts, and unclear communication channels. Through streamlining their internal operations, hospitals, such as the world-renowned Cleveland Clinic, have found that they are able to decrease patient wait time, thereby creating higher levels of customer satisfaction while at the same time decreasing their own costs.

Which of the following would you expect to see at a company that espouses lean thinking?

1. Larger inventories

2. Smaller batch sizes

3. More organized workstations

4. Longer setup times

5. Lower-level small-team problem solving

6. Centralized storage cribs

7. Pull system

Please see page 244 for solutions.

Sustainability and Lean Thinking

Sustainability and lean thinking have many similarities: both practices seek to reduce waste. However, lean operations focus on eliminating waste and em- powering employees in an effort to increase economic profits. On the other hand, "lean and green" operations focus on eliminating waste and empowering employees not only to increase economic profits, but also to preserve the planet and improve the lives of all people touched by the company. Whereas lean prac- tices tend to center on internal operational waste, green practices also consider the external waste that may occur as a result of the product. To become more sustainable, a lean company should be particularly cognizant of all waste that could harm the planet: packaging waste, water waste, energy waste, and emis- sions waste that would occur from both manufacturing the product and from consumers using and eventually disposing of the product.

See Exercises E4-21A and E4-32B

206 CHAPTER 4

5 .Describe and use ---: :the costs of qua lity

· framework

How Do Managers Improve Quality? Because lean companies rarely hold extra inventory to fall back on in the event of errors or defects, they use the management philosophy of total quality management (TQMl to focus on consistently generating high-quality products. The goal of TQM is to provide customers with superior products and services. Each business function in the value chain continually examines its own activities to improve quality and elimi- nate defects.

Costs of Quality (COO) As part of TQM, many companies prepare costs of quality reports. Costs of quality reports categorize and list the costs incurred by the company related to quality. Once managers know the extent of their costs of quality, they can start to identify ways for the company to improve quality while at the same time controlling costs.

Quality-related costs generally fall into four different categories: prevention costs, appraisal costs, internal failure costs, and external failure costs. These categories form the framework for a costs of quality report. We'll briefly describe each next.

Prevention Costs Prevention costs are costs incurred to avoid producing poor-quality goods or services. Often, poor quality is caused by the variability of the production process or the complex- ity of the product design. To reduce the variability of the production process, companies often automate as much of the process as possible. Employee training can help decrease variability in nonautomated processes. In addition, reducing the complexity of the prod- uct design or manufacturing process can prevent the potential for error: The fewer parts or processes, the fewer things that can go wrong. Frequently, companies need to literally "go back to the drawing board" (the R&D and design stages of the value chain) to make a significant difference in preventing production problems.

Appraisal Costs Appraisal costs are costs incurred to detect poor-quality goods or services. Intel incurs ap- praisal costs when it tests its products. One procedure, called burn-in, heats circuits to a high temperature. A circuit that fails the burn-in test is also likely to fail in customer use. Nissan tests 100% of the vehicles that roll off the assembly lines at its plant in Canton, Mississippi. Each vehicle is put through the paces on Nissan's all-terrain test track. Any problems are identified before the vehicle leaves the plant.

Internal Failure Costs

Internal failure costs are costs incurred on defective units before delivery to customers. For example, if Nissan does identify a problem, the vehicle is reworked to eliminate the defect before it is allowed to leave the plant. In the worst-case scenario, a product may be so defective that it cannot be reworked and must be completely scrapped. In this case, the entire cost of manufacturing the defective unit, plus any disposal cost, would be an internal failure cost.

External Failure Costs

External failure costs are costs incurred because the defective goods or services are not detected until after delivery is made to customers. News reports are filled with stories of product recalls that damage a company's reputation and can significantly harm the company's future sales. Furthermore, consumers have harnessed the power of social media and online rating sites to "spread the word" to millions of potential customers about any unsatisfying experiences they have had with products or services. As a result, a company's reputation for either good or poor quality can increase at an exponen- tial rate. To capture the extent of a reputation for poor quality, external failure costs should include an estimate of how much profit the company is losing due to having a bad reputation.

Activity-Based Costing, Lean Operations, and the Costs of Quality 207

Relationship Among Costs Exhibit 4-28 lists some common examples of the four different costs of quality. Prevention and appraisal costs are sometimes referred to as conformance costs since they are the costs incurred to make sure the product or service is not defective and therefore conforms to its intended design. On the other hand, internal and external failure costs are sometimes referred to as nonconformance costs. These costs are incurred when the product or service is defective and therefore does not conform to its intended design.

EXHIBIT 4-28 Four Types of Quality Costs

Prevention Costs

Training personnel

Evaluating potential suppliers

Using better materials

Preventive maintenance

Improved equipment

Redes igning product or process

Internal Failure Costs

Production loss caused by downtime

Rework

Abnormal quantities of scrap

Rejected product units

Disposal of rejected units

Machine breakdowns

Appraisal Costs

Inspection of incoming materials

Inspection at various stages of production

Inspection of final products or services

Product testing

Cost of inspection equipment

External Failure Costs

Lost profits from lost customers

Warranty costs

Service costs at customer sites

Sales returns and allowances due to

quality problems

Product liability claims

Cost of recalls

Most companies find that if they invest more in prevention costs at the front end of the value chain (R&D and design), they can generate even more savings in the back end of the value chain (production and customer service). Why? Because carefully designed products and manufacturing processes can significantly reduce the number of inspec- tions, defects, rework, and warranty claims. Managers must make trade-offs between these costs. Companies that embrace TQM, such as Toyota, design and build quality into their products rather than having to inspect and repair later, as many traditional manufacturers do.

Costs of Quality at Service and Merchandising Companies

The costs of quality are not limited to manufacturers. Service firms and merchandising companies also incur costs of quality. For example, certified public accounting (CPA) firms spend a lot of money providing ongoing professional training to their staff. They also develop standardized audit checklists to minimize the variability of the audit proce- dures performed for each client. These measures help to prevent audit failures. Both audit managers and partners review audit work papers to appraise whether the audit proce- dures performed and evidence gathered are sufficient on each audit engagement. If audit procedures or evidence are deemed to be lacking (internal failure), the audit manager or partner will instruct the audit team to perform additional procedures before the firm will issue an audit opinion on the client's financial statements. This parallels the "rework" a manufacturer might perform on a product that isn't up to par. Finally, audit failures, such as those at Enron and WorldCom, illustrate just how expensive and devastating external failure can be to a CPA firm. The once-prestigious international CPA firm Arthur Ander- sen & Co. actually went out of business because of the reputation damage caused by its audit failure at Enron.

208 CHAPTER 4

Using Costs of Quality Reports to Aid Decisions Now that we have examined the four costs of quality, let's see how they can be pre- sented to management in the form of a costs of quality report. Let's assume Global

II Why is this important? Fitness, another manufacturer of fitness equipment, is having difficulty competing with Life Fitness because it doesn't have the reputation for high quality that Life Fitness enjoys. To examine this issue, management has prepared the costs of quality report shown in Exhibit 4-29.

"Businesses compete with each other on the basis of price and

quality. Costs of Quality reports help managers determine how they

are spending money to ensure that consumers get the best- quality product for the price."

Notice how Global Fitness identifies, categorizes, and quanti- fies all of the costs it incurs relating to quality. Global Fitness also calculates the percentage of total costs of quality that is incurred in each cost category. This helps company managers see just how little they are spending on conformance costs {prevention and appraisal). Most of their costs are internal and external failure costs. The best way to reduce these nonconformance costs is to invest more in prevention and appraisal. Global Fitness manag- ers can now begin to focus on how they might be able to prevent these failures from occurring.

EXHIBIT 4-29 Globa l Fitness's Costs of Qua lity Report

_I A B C D

Global Fitness Costs of Quality Report Costs Total Costs Percentage 1 Year Ended December 31 Incurred of Quality ofTotalCOQ 2 3 Prevention Costs: 4 Emolovee training s 125 000 5 Total prevention costs $ 125,000 6.1% 6 7 Annraisal Costs: 8 Testing $ 175,000 9 Total appraisal costs $ 175 000 8.5% 10 11 Internal Failure Costs: 12 Rework $ 300 000 13 Cost of rejected units 50,000 14 Total internal failure costs $ 350,000 17.0% 15 16 External Failure Costs: 17 Lost profits from lost sales due to poor reputation 5 1,000,000 18 Sales return processing 175,000 19 Warranty costs 235,000 20 Total external failure costs $ 1410000 68.4% 21 22 1 Total costs ot gua1Itx $ 2,060,000 100.0% 23

NOTE : The percentage is calculated as the total cost of the category divided by the total costs of all categories combined.

After analyzing the costs of quality report, the CEO is considering spending the fol- lowing amounts on a new quality program:

Inspect raw materials ......................................................................................... .

Reengineer the production process to improve product quality .......................... .

Supplier screening and certification .................................................................... .

Preventive maintenance on plant equipment ....................................................... .

Total costs of implementing quality programs .................................................... .

$100,000

750,000

25,000

75,000

$950,000

Activity-Based Costing, Lean Operations, and the Costs of Quality 209

Although these measures won't completely eliminate internal and external failure costs, Global Fitness expects this quality program to reduce costs by the following amounts:

Reduction in lost profits from lost sales due to impaired reputation ................ .

Fewer sales returns to be processed ................................................................. .

Reduction in rework costs ............................................................................... .

Reduction in warranty costs ............................................................................ .

Total cost savings ............................................................................................ .

$ 800,000

150,000

250,000

225,000

$1,425,000

According to these projections, Global Fitness's quality initiative will cost $950,000 but result in total savings of $1,425,000-for a net benefit of $475,000. This cost-benefit analysis can also be organized using the costs of quality frame- work as shown in Exhibit 4-30. By spending $850,000 more on prevention costs and $100,000 more on appraisal costs, Global Fitness will be able to save $250,000 in internal failure costs and $1,175,000 in external failure costs. In total, Global Fitness expects a net benefit of $475,000 from this quality initiative. As is usually the case, Global Fitness will be able to reduce its overall costs of quality by spending more on conformance costs.

EXHIBIT 4-30 Cost -Benefit Ana lysis of Global Fitness 's Proposed Quality Program

.!J A B C D

Global Fitness Quality Initiative (Costs) and Total (Costs)

1 Cost Benefit Analysis Cost Savings and Cost Savings 2 3 Prevention Costs: 4 Reengineer the oroduction orocess $ (750 000) 5 Suoolier screening and certification (25 000) 6 Preventive maintenance on eauipment (75,000) 7 Total additional prevention costs $ (850,000) 8 9 Appraisal Costs: 10 Inspect raw materials $ (100,000) 11 Total additional appraisal costs $ (100 000) 12 13 Internal Failure Costs: 14 Reduction of rework costs $ 250,000 15 Total internal failure cost savings $ 250,000 16 17 External Failure Costs: 18 Reduction of lost profits from lost sales s 800,000 19 Reduction of sales return 150,000 20 Reduction of warranty costs 225,000 21 Total external failure cost savings $ 1,175,000 22 23 Total savines (costs) from aualitv proerams $ 475,000 24

The analysis shown in Exhibit 4-30 appears very straightforward. However, qual- ity costs can be hard to measure. The largest external failure cost-profits lost because of the company's reputation for poor quality-does not even appear in the accounting records. This cost must be estimated based on the experiences and judgments of the Sales Department. Because these estimates may be subjective, TQM programs also emphasize nonfinancial measures such as defect rates, number of customer complaints, and number of warranty repairs that can be objectively measured.

210 CHAPTER 4

Lean Operations and the Costs of Quality Toyota, the largest car manufacturer in the world, is famous for its complete commitment to both lean thinking and TOM . The following are several decisions Toyota's managers made when they helped develop and implement these two modern management techniques .

Decision

How will we begin to identify waste in our organization?

What operational features will help us become more lean?

Guidelines

Most companies find that the majority of waste occurs in eight specific areas . The "eight wastes" can be remembered as DOWNTIME :

• Defects

• Overproduction

• Waiting

• Not utilizing people to their full potential

• Transportation

• Inventory

• Movement

• Excess processing

Lean operations are typically characterized by many of the following features :

• Just-in-time (JIT) inventory

• Value stream mapping

• Production in self-contained work cells

• Employee empowerment through broader roles and use of small teams

• SS workplace organization

• Point-of-use storage (POUS)

• Continuous flow

• Pull system

• Shorter manufacturing cycle times

• Reduced setup times

• Smaller batches

• Emphasis on quality and Six Sigma

• Supply-chain management

• Backflush costing

What are the four types of quality 1. Prevention costs-costs incurred to avoid producing poor-quality goods and costs? services .

How do we make trade-offs among the four types of quality costs?

2. Appraisal costs-costs incurred to detect poor-quality goods and services .

3. Internal failure costs-costs incurred on defective goods and services before they are delivered to the customer .

4. External failure costs-costs incurred because defective goods or services are not detected until after delivery is made to the customer .

Investment in prevention costs and appraisal costs reduces internal and external failure costs and usually reduces the overall costs of quality .

Activity-Based Costing, Lean Operations, and the Costs of Quality 211 - SUMMARY PROBLEM 2 . • _.

The CEO of IAP is concerned with the quality of its products and the amount of resources currently spent on customer returns . The CEO would like to analyze the costs incurred in conjunction with the quality of the product.

The following information was collected from various departments within the company :

Warranty returns................................................................................................. $120,000

Training personnel.............................................................................................. 10,000

Litigation on product liability claims................................................................... 175,000

Inspecting 10% of final products......................................................................... 5,000

Rework............................................................................................................... 10,000

Production loss due to machine breakdowns....................................................... 45,000

Inspection of raw materials................................................................................. 5,000

Requirements

1. Prepare a costs of quality report . In addition to listing the costs by category, deter- mine the percentage of the total costs of quality incurred in each cost category .

2. Do any additional subjective costs appear to be missing from the report?

3. What can be learned from the report?

21 2 CHAPTER 4

• SOLUTIONS Requirement 1

.!.J A B C D

Costs Total Costs Percentage 1 IAP Costs of Quality Report Incurred of Quality ofTotalCOQ 2 3 Prevention Costs: 4 Personnel training s 10000 5 Total prevention costs $ 10000 2.7% 6 7 Annraisal Costs: 8 Inspecting raw materials $ 5,000 9 Inspecting 10% of final products 5000 10 Total appraisal costs s 10000 2.7% 11 12 Internal Failure Costs: 13 Rework $ 10000 14 Production loss due to machine breakdown 45 000 15 Total internal failure costs $ 55,000 14.9% 16 17 External Failure Costs: 18 Litigation from product liability claims $ 175 000 19 Warranty return costs 120 000 20 Total external failure costs $ 295 000 79.7% 21 22 Total costs of aualitv $ 370,000 100.0% 23

Requirement 2 Because the company has warranty returns and product liability litigation, it is very pos- sible that the company suffers from a reputation for poor-quality products. If so, it is losing profits from losing sales . Unsatisfied customers will probably avoid buying from the company in the future and may tell their friends and family not to buy from the company . Worse yet, unsatisfied customers may let their complaints be known to millions of poten- tial customers through the use of social media and on line customer satisfaction websites . As a result, this report should include an estimate of the lost profits arising from the com- pany's reputation for poor-quality products .

Requirement 3 The costs of quality report shows that very little is being spent on prevention and appraisal, which is probably why the internal and external failure costs are so high . Management should use this information to develop quality initiatives in the areas of prevention and appraisal. Such initiatives should reduce future internal and external failure costs .

Learning Objectives • 1 Develop and use departmental overhead rates to allocate indirect costs

• 2 Develop and use activity-based costing (ABC) to allocate indirect costs

• 3 Understand the benefits and limitations of ABC/ABM systems

• 4 Describe lean operations

• 5 Describe and use the costs of quality framework

Accounting Vocabulary SS. (p. 202) A workplace organ ization system comprised of the following steps: sort, set in order, shine, standardize, and susta in.

Activity-Based Costing (ABC). (p. 184) Focus ing on activi- ties as the fundamental cost objects. The costs of those activi- ties become bu ilding b locks for compil ing the indirect costs of products, services, and customers.

Activity-Based Management (ABM). (p. 191) Using activity- based cost information to make decisions that increase profits while satisfying customers' needs.

Appraisal Costs. (p. 206) Costs incurred to detect poor - quality goods or services.

Backflush Costing. (p. 204) A simplified accounting system in which production costs are not assigned to the units unt il they are finished, or even sold, thereby saving the bookkeep ing steps of moving the product through the various inventory accounts.

Batch-Level Activities. (p. 190) Activities and costs incurred for every batch, regard less of the number of units in the batch.

Conformance Costs. (p. 207) The combination of prevention and appraisal costs; the costs incurred to make sure a prod- uct or service is not defect ive and therefore conforms to its intended design.

Cost Distortion . (p. 177) Overcost ing some products whi le undercosting other products.

Costs of Quality Report. (p. 206) A report that lists the costs incurred by the compa ny related to qua lity. The costs are categorized as prevention costs, appraisal costs, internal fail- ure costs, and external fai lure costs.

Customer Response Time . (p. 198) The time that elapses between receipt of a customer order and de livery of the prod- uct or service.

Departmental Overhead Rates. (p. 180) Separate manufac- turing overhead rates establ ished for each department.

DOWNTIME. (p. 198) An acronym for the eight wastes: defects, overproduction, waiting, not utilizing people to their full potentia l, transportation, inventory, movement, excess processing.

Eight Wastes. (p. 198) Defects, overproduction, wait ing, not ut ilizing people to their fu ll potentia l, transportat ion, inven- tory, movement, excess processing.

External Failure Costs. (p. 206) Costs incurred when the company does not detect poor-quality goods or services unti l after de livery is made to customers.

Facility-Level Activities. (p. 190) Activities and costs incurred no matter how many units, batches, or products are produced in the plant.

Internal Failure Costs. (p. 206) Costs incurred when the company detects and corrects poor-quality goods or services before making de livery to customers.

Just in Time (Jin. (p. 200) An inventory management phi - losophy that focuses on purchasing raw mater ials just in time for production and complet ing finished goods just in time for delivery to customers.

Kaizen. (p. 198) A Japanese word meaning "change for the better."

Lean Thinking. (p. 198) A management phi losophy and strategy focused on creating va lue for the customer by elimi- nating waste.

Manufacturing Cycle Time. (p. 203) The time that elapses between the start of production and the product 's completion.

Nonconformance costs. (p. 207) The combination of inter- na l fa ilure and externa l failure costs; the costs incurred when a product is defect ive and therefore does not conform to its intended design.

Non-Value-Added Activities. (p. 192) Activities that neither enhance the customer's image of the product or service nor provide a compet itive advantage; a lso known as waste activities.

Plantwide Overhead Rate. (p. 178) When overhead is a llocated to every product using the same manufacturing overhead rate.

Point of Use Storage (POLIS). (p. 204) A storage system used to reduce the waste of transportat ion and movement in which too ls, materials, and equ ipment are stored in proximity to where they will be used most frequently.

Prevention Costs. (p. 206) Costs incurred to avoid poor - qua lity goods or services.

Product-Level Activities. (p. 190) Activities and costs incurred for a particular product, regardless of the number of units or batches of the product produced.

Quality at the Source. (p. 204) A term that refers to shift- ing the responsibi lity for qua lity adherence to the operators at each step in the va lue stream, rather than relying on supervi - sors or a quality assurance department to catch errors.

Six Sigma. (p. 204) The goal of producing near perfection, with less than 3.4 defects per million opportunities.

Takt Time . (p. 202) The rate of product ion needed to meet customer demand, yet avoid overproduct ion.

213

214 CHAPTER 4

Total Quality Management (TQM). (p. 206) A management phi losophy of delight ing customers with superior products and serv ices by cont inua lly setting higher goals and improv ing the performance of every business function.

Unit-Level Activities. (p. 190) Act ivities and costs incurred for every unit produced.

Value-Added Activities. (p. 192) Activities for which the customer is willing to pay because these activities add value to the final product or service.

Waste Activities. (p. 192) Activities that neither enhance the customer's image of the product or service nor provide a competi- tive advantage; also known as non-value -added activities.

MyAccounting lab Go to http://myaccountinglab.com/ for the following Quick Check, Short Exercises, Exercises, and Problems. They are available with immediate grading, explanations of correct and incorrect answers, and interactive media that act as your own on line tutor.

Quick Check 1. (Learning Objective 1) Cost distortion is more likely to

occur when

a. departments incur different types of overhead and the products or jobs use the departments to a differ- ent extent .

b. a company manufactures one type of product .

c. all products require the same amount and type of processing activities .

d. a company uses departmental overhead rates rather than a single plantwide overhead rate .

2. (Learning Objective 2) The first step in computing and using ABC is which of the following?

a. Calculating activity cost allocation rates

b. Identifying the company's primary activities

c. Allocating some MOH to each job

d. Selecting appropriate allocation bases

3. (Learning Objective 2) Activities incurred regardless of how many units, batches, or products are produced are called activities .

a. unit-level

b. batch-level

c. product-level

d. facility-level

4. (Learning Objective 3) Which of the following is true? a. ABC is only applicable to manufacturers .

b. Value-added activities are also referred to as waste activities .

c. ABM refers to using activity-based cost information to make decisions .

d. The goal of ABM is to decrease the amount of value-added activities .

5. (Learning Objective 3) The potential benefits of ABC/ ABM are generally higher for companies that

a. produce high volumes of some products and low volumes of other products .

b. have low manufacturing overhead costs .

c. are in noncompetitive markets .

d. produce one product .

6. (Learning Objective 4) Lean operations are generally characterized by

a. employee empowerment .

b. JIT inventory systems .

c. production in self-contained cells .

d. all of the listed answers .

7. (Learning Objective 4) Which of the following is not one ofthe "eight wastes" included in the acronym DOWNTIME?

a. Overproduction

b. Transportation

c. Inventory

d. Neglect

8. (Learning Objective 4) Concerning lean operations, which of the following is false? a. Focus on internal and external waste

b. Are quickly becoming the dominant business paradigm

c. Can be found in all sectors, not just manufacturing

d. Can leave companies vulnerable to supply-chain disruptions

9. (Learning Objective 5) Which of the following is not one of the costs of quality categories?

a. Prevention costs

b. Appraisal costs

c. External failure costs

d. Transportation costs

10. (Learning Objective 5) Which of the following would be considered an external failure cost?

a. Rework costs

b. Cost to train personnel

c. Cost of inspecting incoming raw materials

d. Warranty costs

Quick Check Answers

P "OLP "6 e "8 P "LP ·9 e ·s ::> ·17 P "£ q ·z e . L

Activity-Based Costing, Lean Operations, and the Costs of Quality 215

Short Exercises

54-1 Understanding key terms (Learning Objectives 1, 2, 3, 4, & 5) The following is a list of several terms . Complete each of the following statements with one of these terms . You may use a term more than once, and some terms may not be used at all.

Activity-based costing External failure costs Manufacturing cycle time TOM

Activity-based management Facility-level costs POUS

Appraisal costs Internal failure costs Prevention costs

Batch-level costs Kaizen Product-level costs

DOWNTIME Lean thinking Takt time

a. The time that elapses between the start of production and the product's completion is known as

b. __ is the management philosophy and strategy focused on creating value for the customer by eliminating waste .

c. The costs incurred for every batch, regardless of the number of units in the batch, are known as

d. Costs incurred to avoid poor-quality goods or services are __ .

e. Using activity-based costing information to make decisions that increase profits while satisfying customers' needs is __ .

f. An acronym for the eight wastes is __ .

g. The costs incurred for a particular product, regardless of the number of units or batches of the product produced, are known as __ .

h. __ focuses on activities as fundamental building blocks in compiling the indirect costs of products, services, and customers .

i. __ are costs incurred when defects in poor-quality goods or services are corrected before making delivery to customers .

j. __ are incurred for every single unit of product produced .

k. Costs incurred when the company does not detect poor-quality goods or services until after delivery is made to customers are __ .

I. _ _ are costs incurred no matter how many units, batches, or products are produced .

m. _ _ is a Japanese word meaning "change for the better ."

n. Costs incurred to detect poor-quality goods or services are __ .

o. The rate of production needed to meet customer demand, yet avoid overproduction, is known as

p. __ is a storage system used to reduce the waste of transportation and movement, in which tools, materials, and equipment are stored in proximity to where they will be used most frequently .

q. __ is a management philosophy of delighting customers with superior products and services by continually setting higher goals and improving every business function .

54-2 Use departmental overhead rates to allocate manufacturing overhead (Learning Objective 1)

Whitney Furniture uses departmental overhead rates (rather than a plantwide overhead rate) to allocate its manufacturing overhead to jobs . The company's two production de- partments have the following departmental overhead rates :

Cutting Department : $9 per machine hour

Finishing Department : $18 per direct labor hour

Unit-level costs

21 6 CHAPTER 4

Job 484 used the following direct labor hours and machine hours in the two manu- facturing departments:

JOB 484 Cutting

Department Finishing

Department

Direct Labor Hours ................................................ .

Machine Hours .... .......... ................. ............. .......... .

2

8

1. How much manufacturing overhead should be allocated to Job 484?

7

4

2. Assume that direct labor is paid at a rate of $24 per hour and Job 484 used $2,400 of direct materials . What was the total manufacturing cost of Job 484?

54-3 Compute departmental overhead rates (Learning Objective 1) Snyder Snacks makes potato chips, corn chips, and cheese puffs using three different pro- duction lines within the same manufacturing plant . Currently, Snyder uses a single plant- wide overhead rate to allocate its $3,311,500 of annual manufacturing overhead . Of this amount, $2,070,000 is associated with the potato chip line, $763,000 is associated with the corn chip line, and $478,500 is associated with the cheese puff line. Snyder's plant is currently running a total of 17,900 machine hours: 11,500 in the potato chip line, 3,500 in the corn chip line, and 2,900 in the cheese puff line. Snyder considers machine hours to be the cost driver of manufacturing overhead costs .

1. What is Snyder's plantwide overhead rate?

2. Calculate the departmental overhead rates for Snyder's three production lines . Round all answers to the nearest cent .

3. Which products have been overcosted by the plantwide rate? Which products have been undercosted by the plantwide rate?

54-4 Compute activity cost allocation rates (Learning Objective 2) NatureMade Snacks produces different styles of sweet potato chips (ruffled, flat, thick- cut, gourmet) for different corporate customers . Each style of sweet potato chip requires different preparation time, different cooking and draining times (depending on desired fat content}, and different packaging (single serving versus bulk). Therefore, NatureMade has decided to try ABC to better capture the manufacturing overhead costs incurred by each style of chip . NatureMade has identified the following activities related to yearly manufacturing overhead costs and cost drivers associated with producing sweet potato chips:

Activity

Preparation ........................................... .

Cooking and draining ............. .............. .

Packaging .............. .......... ................. .... .

Manufacturing Overhead

$510,000

$928,000

$400,000

Cost Driver

Preparation time

Cooking and draining time

Units packaged

Compute the activity cost allocation rates for each activity assuming the following total estimated activity for the year: 8,500 preparation hours, 32,000 cooking and drain- ing hours, and 4 million packages .

54-5 Continuation of 54-4: Use ABC to allocate overhead (Learning Objective 2)

NatureMade Snacks just received an order to produce 12,000 single-serving bags of gourmet, fancy-cut, sweet potato chips . The order will require 21 preparation hours and 36 cooking and draining hours . Use the activity rates you calculated in S4-4 to compute the following :

1. What is the total amount of manufacturing overhead that should be allocated to this order?

2. How much manufacturing overhead should be assigned to each bag?

3. What other costs will the company need to consider to determine the total manufac- turing costs of this order?

Activity-Based Costing, Lean Operations, and the Costs of Quality 217

54-6 Calculate a job cost using ABC (Learning Objective 2) Oliver Industries, a small, family-run manufacturer, has adopted an ABC system . The fol- lowing manufacturing activities, indirect manufacturing costs, and usage of cost drivers have been estimated for the year :

Estimated Total Manufacturing

Activity Overhead Costs

Machine setup ............................................ $ 161,650

Machining ............ .............. ............. .......... .. $1 ,100,000

Quality control .... ....... .......... .......... ............ $360,000

Estimated Total Usage of Cost

Driver

3,050 setups

5,000 machine hours

4,500 tests run

During May, Jeff and Arabella Oliver machined and assembled Job 557 . Jeff worked a to- tal of 10 hours on the job, while Arabella worked 4 hours on the job . Jeff is paid a $25 per hour wage rate, while Arabella is paid $28 per hour because of her additional experience level. Direct materials requisitioned for Job 557 totaled $1,250 . The following additional information was collected on Job 557 : the job required 2 machine setups, 6 machine hours, and 3 quality control tests .

1. Compute the activity cost allocation rates for the year .

2. Complete the following job cost record for Job 557 :

Manufacturing Job Cost Record Job 557 Costs

Direct materials ................................................................................ ?

Direct labor ...................................................................................... ?

Manufacturing overhead ...... .......... .......... ............. ................. .......... ?

Total job cost .................................................................................... $?

54-7 Classifying costs within the cost hierarchy (Learning Objective 2) Classify each of the following costs as either unit-level, batch-level, product-level, or facility-level.

a. Engineering costs for new product

b. Order processing

c. Depreciation on factory

d. Direct labor

e. Shipment of an order to a customer

f. Product line manager salary

g. Machine setup costs that are incurred whenever a new production order is started

h. Patent for new product

i. Factory utilities

j. Direct materials

k. Cost to inspect each product as it is finished

I. CEO salary

218 CHAPTER 4

54-8 Classifying costs within the cost hierarchy (Learning Objective 2) Robbins Manufacturing produces a variety of plastic containers using an extrusion blow molding process . The following activities are part of Robbins Manufacturing's operating process :

1. Patents are obtained for each new type of container mold .

2. Each type of container has its own unique molds .

3. Routine maintenance is performed on the extrusion machines .

4. The sales force incurs travel expenses to attend various trade shows throughout the country to market the containers .

5. Plastic resins are used as the main direct material for the containers.

6. The extrusion machine is calibrated for each batch of containers made .

7. A plant manager oversees the entire manufacturing operation .

8. Rent is paid for the building that houses the manufacturing processes .

9. Each container product line has a product line manager .

10. Each container is cut from the mold once the plastic has cooled and hardened .

Classify each activity as either unit-level, batch-level, product-level, or facility-level.

54-9 Determine the usefulness of refined costing systems in various situations (Learning Objective 3) In each of the following situations, determine whether the company would be more likely or less likely to benefit from refining its costing system .

1. In bidding for jobs, managers lost bids they expected to win and won bids they ex- pected to lose .

2. The company operates in a very competitive industry .

3. The company produces few products, and the products consume resources in a simi- lar manner .

4. The company has very few indirect costs .

5. The company produces high volumes of some of its products and low volumes of other products .

6. The company has reengineered its production process but has not changed its ac- counting system .

54-10 Determine the type of cost pool and utility of ABC/ ABM (Learning Objectives 2 & 3)

In a Wall Street Journal article ("The Price You Pay for Water at the Airport," Scott McCartney, April 22, 2015), the cost of a bottle of water at various airports was compared to the cost of that same bottle of water at a convenience store . A 20-ounce bottle of Dasani water typically costs about $0 .99 at a convenience store . At the JFK International airport in New York City, that bottle of Dasani water is $2 .89 .

An airport store operator interviewed for the WSJ story stated that the costs of operating airport shops are more expensive than other retail stores for a few reasons . Off- airport warehouses are needed due to limited inventory space . In addition, deliveries to stores inside airports are usually made during off-peak hours . Finally, deliveries must be made in small batches so that everything can go through airport security screening .

1. Would the cost of an off-airport warehouse be considered to be a unit-level, batch- level, product-level, or facility-level cost as it relates to :

a. The airport store

b. An individual bottle of water

2. Would the costs of a delivery of two cases of Dasani water to the store inside the airport from the off-airport warehouse be considered to be unit-level, batch-level, product-level, or facility-level costs as they relate to (consider each cost you listed in the first requirement separately) :

a. The airport store

b. An individual bottle of water

3. Would the airport store be likely to use the ABC cost for water pricing? Why or why not?

4. Would activity-based costing or activity-based management be useful for the airport store? Why or why not?

Activity-Based Costing, Lean Operations, and the Costs of Quality 219

54-11 Identifying costs as value-added or non-valued-added (Learning Objective 3)

Identify which of the following manufacturing overhead costs are value-added and which are non-value-added .

a. Costs of reworking of defective units

b. Cost of moving raw materials into production

c. Costs arising from backlog in production

d. Salary for supervisor on the factory floor

e. Wages of the workers assembling products

f. Costs of warehousing raw materials

g. Engineering design costs for a new product

h. Product inspection

54-12 Identify lean production characteristics (Learning Objective 4) Indicate whether each of the following is characteristic of a lean production system or a traditional production system .

a. There is an emphasis on building in quality .

b. The final operation in the production sequence "pulls" parts from the preceding operation .

c. Employees do a variety of jobs, including maintenance and setups as well as opera- tion of machines.

d. Suppliers make frequent deliveries of small quantities of raw materials .

e. Each employee is responsible for inspecting his or her own work . f. Suppliers can access the company's intranet .

g. Large stocks of finished goods protect against lost sales if customer demand is higher than expected .

h. The workflow is continuous to attempt to balance the rate of production with the rate of demand .

i. Setup times are long .

j. A workplace organization system called "55" is frequently used to keep work spaces clean and organized .

k. The manufacturing cycle times are longer .

I. Management works with suppliers to ensure defect-free raw materials .

m. Products are produced in large batches .

54-13 Identify the DOWNTIME activities at a manufacturer (Learning Objective 4)

The following is a list of eight waste activities found at a furniture manufacturing plant. Classify each one as a type of waste as represented by the acronym DOWNTIME (De- fects, Overproduction, Waiting, Not utilizing people to their full potential, Transportation, Inventory, Movement, and Excess processing) .

a. The plant manager makes all decisions in the plant; employees follow directions .

b. Furniture is shipped fully assembled to customers, incurring extra shipping costs because of the additional bulk .

c. Employees must search for tools at the beginning of each work shift since there is no standard storage spot for each tool.

d. Because the drill p ress is broken, the furniture assembly workers cannot do any work until it is fixed .

e. The tables made yesterday need to have new umbrella holes drilled in them because the current holes are too small.

f. Tables are made in large batches because machine setup time is costly .

g. Raw materials are delivered to materials warehousing area; when production is ready for the raw materials, tow motor drivers drive the materials to the production area .

h. Twice as much raw material inventory as needed for current production is stocked in case defects are found in the raw material during production .

220 CHAPTER 4

54-14 Identifying waste activities in an office (Learning Objective 4) The following is a list of waste activities found in an office. Classify each one as a type of waste as represented by the acronym DOWNTIME (Defects, Overproduction, Waiting, Not utilizing people to their full potential, Transportation, Inventory, Movement, and Excess processing) .

a. The office is run by the office manager; employees do as they are told .

b. The computer system requires frequent restarting; restarting takes five minutes .

c. To retrieve inventory records, clerks must click through several menus in the program to get to the record needed.

d. Orders in the system are frequently missing information .

e. Paperwork (that might change) is printed before it is needed.

f. Sales orders are put into the computer by the sales people in the field, and paper reports are generated; these sales orders are then entered into the order processing system by clerks who type the orde rs based on the paper reports .

g. The files needed for loan approval are carried to and from the file storage office when the files are needed .

h. Approval of loans is done in batches once a week rather than as the loan paperwork is finished for each individual loan .

i. Pending vacation requests must be taken to the third floor offices to get the signature of the human resources manager .

j. Employees do not have the authority and responsibility to make routine decisions .

54-15 Classifying costs of quality (Learning Objective 5) Classify each of the following quality-related costs as prevention costs, appraisal costs, internal failure costs, or external failure costs .

1. Warranty repairs

2. Legal fees from customer lawsuits

3. Training employees

4. Cost incurred producing and disposing of defective units

5. Lost productivity due to machine b reakdown

6. Inspecting products that are halfway through the production process

7. Inspecting incoming raw materials

8. Repairing defective units found during inspection

9. Incremental cost of using a higher-grade raw material

10. Redesigning the production process

54-16 Quality initiative decision (Learning Objective 5) Boswell manufactures high-quality speakers . Suppose Boswell is considering spending the following amounts on a new quality program:

Additional 20 minutes of testing for each speaker .............................. .

Negotiating with and training suppliers to obtain higher-quality materials and on-time delivery ......................................................... .

Redesigning the speakers to make them easier to manufacture ......... .

Boswell expects this quality program to save costs as follows :

Reduced warranty repair costs ........ .......... .......... ............. ................. ... .

Avoid inspection of raw materials ........................................................ .

Rework avoided because of fewer defective units .............................. .

It also expects this program to avoid lost profits from the following:

Lost sales due to disappointed customers ........................................... .

Lost production time due to rework ............. ............. .......... ....... ......... .

$ 607,000

$ 300,000

$1,402,000

$205,000

$403,000

$652,000

$853,000

$305,000

1. Classify each of these costs into one of the four categories of quality costs (preven- tion, appraisal, internal failure, external failure) .

2. Should Boswell implement the quality program? Give your reasons .

Activity-Based Costing, Lean Operations, and the Costs of Quality 221

54-17 Assess the impact of a quality initiative (Learning Objective 5) Dayton Industries is contemplating some operational changes to reduce its overall costs of quality . The company believes that if it upgrades one component of its product at an additional cost of $2 .00 per unit, it will be able to decrease its current warranty repair rate by 90% . The company also believes it will be able to sell 1,000 more units over the next year due to an enhanced reputation for quality . Dayton currently has enough excess ca- pacity to make the 1,000 extra units needed to meet the increased demand . The follow- ing data reflect current ope rations (prior to making the operational changes) :

Current production and sales level (in units) ............ ................................ .

Sales price per unit ........... .......... .......... ............. ....... .......... .......... .......... .. .

Current variable cost of making and selling one unit ................. .............. .

Variable warranty repair costs per unit repaired .... ....... ............. .......... .... .

Current warranty repair rate of units produced ....................................... .

100,000

$150

$ 80

$ 30

10%

What is the anticipated annual effect on operating income from adopting this quality ini- tiative? To answer this question, first calculate the total costs of quality before making the operational changes and then calculate the total costs of quality after making the opera- tional changes . Compute the difference between the "before" and the "after ."

54-18 Identify ethical standards violated (Learning Objectives 1, 2, 3, 4, & 5) For each of the situations listed, identify the primary standard from the IMA Statement of Ethical Professional Practice that is violated (competence, confidentiality, integrity, or credibility) . Refer to Exhibit 1-7 for the complete standard .

1. Alexandria receives an iPad from a salesperson at a lean consulting group . She keeps the iPad, even though she knows that her department will be responsible for selecting a consulting firm to come in to offer lean training sessions next year .

2. Bowes Company operates in a highly competitive environment and has developed some proprietary processes that allow it to maintain a market lead . Franklin, the CFO, does not have employees sign nondisclosure agreements because he feels that they are all family . He avoids talking about the topic .

3. Tammary Corporation has an activity-based costing system . Stephen prepares reports each month that are long and full of facts . The reports are hard to understand for any- one but Stephen .

4. Cliff, an accountant at the Wall Corporation, did not attend the training for the new activity-based costing system because he figures it will not be much different from the current allocation system .

5. Mack, the plant manager, does not disclose the quality issues he is aware of in the current production process . He figures that he can get them resolved in the next few months .

EXERCISES Group A E4-19A Compare traditional and departmental cost allocations

(Learning Objective 1)

Sanderson's Fine Furnishings manufactures upscale custom furniture . Sanderson's currently uses a plantwide overhead rate based on direct labor hours to allocate its $1,000,000 of manufacturing overhead to individual jobs . However, Margaret Garmon, owner and CEO, is considering refining the company's costing system by using departmental overhead rates . Currently, the Machining Department incurs $660,000 of manufacturing overhead, while the Finishing Department incurs $340,000 of manufacturing overhead . Garmon has identified machine hours (MH) as the primary manufacturing overhead cost driver in the Machining Department and direct labor (DL) hours as the primary cost driver in the Finishing Department .

( __ )

2 2 2 CHAPTER 4

SUSTAINABILITY

The Sanderson's plant completed Jobs 450 and 455 on May 15 . Both jobs incurred a total of 5 DL hou rs throughout the entire production process . Job 450 incurred 3 MH in the Machining Department and 4 DL hours in the Finishing Department (the other DL hour occurred in the Machining Department) . Job 455 incurred 4 MH in the Machining Department and 3 DL hours in the Finishing Department (the other two DL hours oc- curred in the Machining Department) .

Requirements

1. Compute the plantwide overhead rate assuming that Sanderson's expects to incur 20,000 total DL hours during the year .

2. Compute departmental overhead rates assuming that Sanderson's expects to incur 15,000 MH in the Machining Department and 17,000 DL hours in the Finishing De- partment during the year .

3. If Sanderson's continues to use the plantwide overhead rate, how much manufactur- ing overhead would be allocated to Job 450 and Job 455?

4. If Sanderson's uses departmental overhead rates, how much manufacturing overhead would be allocated to Job 450 and Job 455?

5. Based on your answers to Requi rements 3 and 4, does the plantwide overhead rate overcost or undercost either job? Explain . If Sanderson's sells its furniture at 125% of cost, will its choice of allocation systems affect product pricing? Explain .

E4-20A Compute activity rates and apply to jobs (Learning Objective 2) Fuller Company uses ABC to account for its chrome wheel manufacturing process . Com- pany managers have identified four manufacturing activities that incur manufacturing overhead costs : materials handling, machine setup, insertion of parts, and finishing . The budgeted activity costs for the upcoming year and their allocation bases are as follows :

Activity

Materials handling .......................... .

Machine setup ............................... .

Insertion of parts .............. ....... ........ .

Finishing .................................. ....... .

Total ............................................... .

Total Budgeted Manufacturing Overhead Cost Allocation Base

$ 12,000 Number of parts

3,400 Number of setups

48,000 Number of parts

80 000 Finishing direct labor hours

$143 400

Fuller Company expects to produce 1,000 chrome wheels during the year. The wheels are expected to use 3,000 parts, require 10 setups, and consume 2,000 hours of finishing time.

Job 420 used 200 parts, required 2 setups, and consumed 130 finishing hours .

Job 510 used 425 parts, required 4 setups, and consumed 350 finishing hours .

Requirements

1. Compute the cost allocation rate for each activity .

2. Compute the manufacturing overhead cost that should be assigned to Job 420 .

3. Compute the manufacturing overhead cost that should be assigned to Job 510 .

E4-21 A Apply activity cost allocation rates (Learning Objective 2) Holiday Industries manufactures a variety of custom products . The company has traditionally used a plantwide manufacturing overhead rate based on machine hours to allocate manu- facturing overhead to its products . The company estimates that it will incur $970,000 in total manufacturing overhead costs in the upcoming year and will use 10,000 machine hours .

Up to this point, hazardous waste disposal fees have been absorbed into the plant- wide manufacturing overhead rate and allocated to all products as part of the manu- facturing overhead process . Recently, the company has been experiencing significantly increased waste-disposal fees for hazardous waste generated by certain products, and as a result, profit margins on all products have been negatively impacted . Company man- agement wants to implement an activity-based costing system so that managers know the cost of each product, including its hazardous waste disposal costs .

Activity-Based Costing, Lean Operations, and the Costs of Quality 223

Expected usage and costs for manufacturing overhead activities for the upcoming year are as follows :

Estimated Estimated Activity for

Description of Cost Pool Cost Cost Driver This Year

Machine maintenance costs ....... . $400,000 Number of machine 10,000 hours

Engineering change orders ........ . $150,000 Number of change 3,000 orders

Hazardous waste disposal .......... . $ 420 000 Pounds of hazardous 1,500 materials generated

Total overhead cost .................... . $ 970 000

During the year, Job 356 is started and completed . Usage for this job follows :

Requirements

290 pounds of direct materials at $35 per pound

20 direct labor hours used at $20 per labor hour

60 machine hours used

9 change orders

60 pounds of hazardous waste generated

1. Calculate the cost of Job 356 using the traditional plantwide manufacturing overhead rate based on machine hours .

2. Calculate the cost of Job 356 using activity-based costing.

3. If you were a manager, which cost estimate would provide you more useful informa- tion? How might you use this information?

E4-22A Using ABC to bill clients at a service firm (Learning Objective 2) Kushner & Company is an architectural firm specializing in home remodeling for private clients and new office buildings for corporate clients .

Kushner charges customers at a billing rate equal to 130% of the client's total job cost . A client's total job cost is a combination of (1) professional time spent on the client ($63 per hour cost of employing each professional) and (2) operating overhead allocated to the client's job . Kushner allocates operating overhead to jobs based on professional hours spent on the job . Kushner estimates its five professionals will incur a total of 10,000 professional hours working on client jobs during the year .

All operating costs other than professional salaries (travel reimbursements, copy costs, secretarial salaries, office lease, and so forth) can be assigned to the three activities . Total activity costs, cost drivers, and total usage of those cost drivers are estimated as follows:

Activity

Total Activity

Cost Cost Driver

Total Usage by Corporate

Clients

Transportation to clients .............. $ 6,000 Round-trip mileage to clients ........... 4,500 miles

Blueprint copying ........................ . 32,000 Number of copies ............. ............. .. . 250 copies

Office support ............................. . 195 000 Secretarial time ................................. 2,500 secretarial

Total operating overhead ........ .... $ 233 000

Yimeng Li hired Kushner to design her kitchen remodeling . A total of 25 professional hours were incurred on this job . In addition, Li's remodeling job required one of the pro- fessionals to travel back and forth to her house for a total of 125 miles . The blueprints had to be copied four times because Li changed the plans several times . In addition, 15 hours of secretarial time were used lining up the subcontractors for the job .

hours

Total Usage by Private

Clients

10,500 miles

750 copies

2,500 secretarial hours

224 CHAPTER 4

Requirements

1. Calculate the current indirect cost allocation rate per professional hour .

2. Calculate the total amount that would be billed to Li given the current costing structure.

3. Calculate the activity cost allocation rates that could be used to allocate operating overhead costs to client jobs .

4. Calculate the amount that would be billed to Li using ABC costing .

5. Which type of billing system is more fair to clients? Explain .

E4-23A Compare traditional and ABC allocations at a pharmacy (Learning Objective 2)

Dover Pharmacy, part of a large chain of pharmacies, fills a variety of prescriptions for customers . The complexity of prescriptions filled by Dover varies widely; pharmacists can spend between five minutes and six hours on a prescription order . Traditionally, the phar- macy has allocated its overhead based on the number of prescriptions .

The pharmacy chain's controller is exploring whether activity-based costing (ABC) may better allocate the pharmacy overhead costs to pharmacy orders . The controller has gath- ered the following information :

Total Annual Cost Pools Estimated Cost Cost Driver

Total Annual Estimated Cost Driver Activity

Pharmacy occupancy costs (utilities, Technician hours .................... .. 85,000 rent, and other costs) ........................... $ 102,000

Packaging supplies (bottles, bags, Number of prescriptions ......... 24,000 and other packaging) ........................... $ 45,600

Professional training and insurance Pharmacist hours .................... . 20,000 costs .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .... .. .. .. .. .. .. . $ 180 000

Total pharmacy overhead ........................ $ 327 600

The clerk for Dover has gathered the following information regarding two recent pharmacy orders:

Customer Order Number

1247

1248

Requirements

Technician Hours

0 .5

0.5

Number of Prescriptions

4

2

Pharmacist Hours

1.0

2 .5

1. What is the traditional overhead rate based on the number of prescriptions?

2. How much pharmacy overhead would be allocated to customer order number 1247 if traditional overhead allocation based on the number of prescriptions is used?

3. How much pharmacy overhead would be allocated to customer order number 1248 if traditional overhead allocation based on the number of prescriptions is used?

4. What are the following cost pool allocation rates?

a. Pharmacy occupancy costs

b. Packaging supplies

c. Professional training and insurance costs

5. How much would be allocated to customer order number 1247 if activity-based costing (ABC) is used to allocate the pharmacy overhead costs?

6. How much would be allocated to customer order number 1248 if activity-based costing (ABC) is used to allocate the pharmacy overhead costs?

7. Which allocation method (traditional or activity-based costing) would produce a more accurate product cost? Explain your answer .

Activity-Based Costing, Lean Operations, and the Costs of Quality 225

E4-24A Compare traditional and ABC allocations on a job (Learning Objective 2) Radley Products has adopted an ABC costing system . The following manufacturing activi- ties, indirect manufacturing costs, and cost drivers have been identified:

Activity

Machine setup Machining

Polishing

Quality control

Facility-level costs

Total manufacturing overhead (MOH)

Total estimated MOH costs related to activity

$ 120,000 $1,050,000

$ 80,000

$ 280,000

$ 120 000

$1650000

Total estimated amount of allocation base activity

2,000 setups 6,000 machine hours

10,000 polishing cloths

4,000 tests run

50,000 DL hours

The Job Cost Record for Job #624 revealed that direct materials requisitioned for the job totaled $1,050 . The Job Cost Record also showed that direct labor for this job totaled 10 hours at a wage rate of $25 per hour .

Other data collected on the resources used by Job #624 included:

1 machine setup required

5 machine hours

2 polishing cloths

2 quality control tests run

Requirements

1. Calculate the activity cost allocation rate for each of the five pools listed in the table.

2. Calculate the total cost of Job #624 (use an ABC costing system).

3. Why would ABC provide a more accurate allocation of manufacturing overhead (MOH) than a plantwide rate?

4. Assume that Radley Products used a traditional costing system rather than an ABC sys- tem. Its plantwide MOH rate would have been determined using direct labor (DL) hours as the allocation base . How much cost distortion would have occurred on this job?

E4-25A Use ABC to allocate manufacturing overhead (Learning Objective 2) Several years after reengineering its production process, Dettling Corporation hired a new controller, Alana Metzgar . She developed an ABC system very similar to the one used by Dettling's chief rival. Part of the reason Metzgar developed the ABC system was because Dettling's profits had been declining, even though the company had shifted its product mix toward the product that had appeared most profitable under the old system . Before adopting the new ABC system, the company had used a plantwide overhead rate based on direct labor hours that was developed years ago .

For the upcoming year, Dettling's budgeted ABC manufacturing overhead allocation rates are as follows :

Activity

Materials handling ...................... .

Machine setup ................... ......... .

Insertion of parts ......................... .

Finishing ...................................... .

Allocation Base

Number of parts

Number of setups

Number of parts

Finishing direct labor hours

Activity Cost Allocation Rate

$ 4 .50 per part

$325 .00 per setup

$ 31.00 per part

$ 51 .00 per hour

The number of parts is now a feasible allocation base because Dettling recently installed a plantwide computer system . Dettling produces two wheel models: Standard and Deluxe. Budgeted data for the upcoming year are as follows:

Parts per wheel ............................................................... .

Setups per 1,000 wheels ................................................ .

Finishing direct labor hours per wheel ........................... .

Total direct labor hours per wheel .................................. .

Standard

4.0

20 .0

1.0

2.7

Deluxe

6.0

20 .0

3 .0

3.8

The company's managers expect to produce 1,000 units of each model during the year .

226 CHAPTER 4

Requirements

1. Compute the total budgeted manufacturing overhead cost for the upcoming year .

2. Compute the manufacturing overhead cost per wheel of each model using ABC.

3. Compute the company's traditional plantwide overhead rate. Use this rate to de- termine the manufacturing overhead cost per wheel under the traditional system .

E4-26A Continuation of E4-25A: Determine product profitability (Learning Objectives 2 & 3)

Refer to your answers in E4-25A. In addition to the manufacturing overhead costs, the fol- lowing data are budgeted for the company's Standard and Deluxe models for next year:

Sales price per wheel ...................................... .

Direct materials per wheel ............................ ..

Direct labor per wheel .................................. ..

Requirements

Standard

$460 .00 $ 33 .50 $ 45.70

Deluxe $630.00 $ 48 .00 $ 52.00

1. Compute the gross profit per wheel if managers rely on the ABC unit cost data com- puted in E4-25A.

2. Compute the gross profit per wheel if the managers rely on the plantwide allocation cost data .

3. Which product line is more profitable for the company?

4. Why might the controller have expected ABC to pass the cost-benefit test? Were there any warning signs that the company's old direct-labor-based allocation system was broken?

E4-27 A Differentiate between traditional and lean operations (Learning Objective 4) Categorize each of the following characteristics as being either more representative of a traditional organization or a lean organization .

1. Manufacturing plants tend to be organized with self-contained production cells.

2. Maintain greater quantities of raw materials, work in process, and finished goods inventories .

3. Setup times are longer .

4. High quality is stressed in every aspect of production.

5. Produce in smaller batches .

6. Emphasis is placed on shortening manufacturing cycle times .

7. Manufacturing plants tend to group like machinery together in different parts of the plant.

8. Setup times are shorter .

9. Produce in larger batches .

10. Strive to maintain low inventory levels.

11. Cycle time tends to be longer .

12. Quality tends to be "inspect-in" rather than "build-in ."

E4-28A Classify costs and make a quality-initiative decision (Learning Objective 5) Sinclair Corp. manufactures radiation-shielding glass panels . Suppose Sinclair is consider- ing spending the following amounts on a new TOM program :

Strength-testing one item from each batch of panels ......................... .

Training employees in TOM ................................................................. .

Training suppliers in TOM .................................................................... .

Identifying preferred suppliers that commit to on-time delivery of perfect quality materials ................................................................... .

Sinclair expects the new program to save costs through the following:

Avoid lost profits from lost sales due to disappointed customers ...... .

Avoid rework and spoilage ................................................................. .. Avoid inspection of raw materials ........................................................ .

Avoid warranty costs ..................... ................................. ...................... .

$63,000 $27,000 $39,000

$52,000

$93,000

$64,000 $52,000 $19,000

Activity-Based Costing, Lean Operations, and the Costs of Quality 227

Requirements

1. Classify each item as a prevention cost , an appraisal cost, an internal failure cost, or an external failure cost .

2 . Should Sinclair implement the new quality program? Give your reason .

E4-29A Prepare a Costs of Quality report (Learning Objective 5) Goodchill Industries manufactures freezers . Here is some information about its "LX17" line of freezers over the past year :

Numbe r of units manufactured and sold .............................................. .

Selling price per unit ............................................................................. .

Variable manufacturing and selling costs per unit ................................ .

Hours spent by engineers improving design ........................................ .

Testing and inspection hours per unit ................... .................... ............ .

Percentage of units reworked in the plant after inspection .................. .

Average variable rework costs pe r freezer ........................................... .

Percentage of units repaired under warranty at customers' homes ..... .

Average variable repair costs at customers ' homes per freezer ........... .

Estimated lost sales due to quality reputation ............................... ....... .

Design engineer's labor rate (includes benefits and payroll taxes) ....... .

Inspection costs per hour ............... .......... .......... ................. ............. ..... .

Requirements

5,000 units

$1,500

$800

1,000

0 .5 hours

10%

$400

8%

$450

300 units

$75 per hour

$40 per hour

1. Prepare a Cost of Quality (COO) report . In addition to calculating the total costs of each category, calculate the percentage of each COO category of the total COO .

2. Why would the variable repair cost at the customers' home generally be highe r than the "in factory" rework cost?

3. How can use of the COO report lead to improvements in the production process or in the quality of the product itself?

EXERCISES Group B E4-30B Compare traditional and departmental cost allocations

(Learning Objective 1)

Albertson 's Fine Furnishings manufactures upscale custom furniture . Albertson's currently uses a plantwide overhead rate, based on direct labor hours, to allocate its $1,100,000 of manu- facturing overhead to individual jobs . However, Debbie Howard, owner and CEO, is consider- ing refining the company's costing system by using departmental overhead rates . Currently, the Machining Department incurs $740,000 of manufacturing overhead, while the Finishing Department incurs $360,000 of manufacturing overhead . Howard has identified machine hours (MH) as the primary manufacturing overhead cost driver in the Machining Department and direct labor (DL) hours as the primary cost driver in the Finishing Department .

Albertson's plant completed Jobs 450 and 455 on May 15. Both jobs incurred a total of 5 DL hours throughout the entire production process . Job 450 incurred 2 MH in the Machining Department and 4 DL hours in the Finishing Department (the othe r DL hour occurred in the Machining Department) . Job 455 incurred 7 MH in the Machining Depart- ment and 3 DL hours in the Finishing Department (the other two DL hours occurred in the Machining Department).

Requirements

1. Compute the plantwide overhead rate, assuming Albertson's expects to incur 27,500 total DL hours during the year .

2. Compute departmental overhead rates, assuming Albertson's expects to incur 14,800 MH in the Machining Department and 18,000 DL hours in the Finishing Department during the year .

2 2 8 CHAPTER 4

3. If the company continues to use the plantwide overhead rate, how much manufactur- ing overhead would be allocated to Job 450 and Job 455?

4. If the company uses departmental overhead rates, how much manufacturing over- head would be allocated to Job 450 and Job 455?

5. Based on your answers to Requirements 3 and 4, does the plantwide overhead rate overcost or undercost either of the jobs? Explain . If the company sells its furniture at 125% of cost, will its choice of allocation systems affect product pricing? Explain .

E4-31 B Compute activity rates and apply to jobs (Leaming Objective 2) Farraway Company uses ABC to account for its chrome wheel manufacturing process . Company managers have identified four manufacturing activities that incur manufacturing overhead costs : materials handling, machine setup, insertion of parts, and finishing . The budgeted activity costs for the upcoming year and their allocation bases are as follows :

Total Budgeted Manufacturing

Activity Overhead Cost Allocation Base

Materials handling ............................ $ 13,200 Number of parts

Machine setup .................................. 5,200 Number of setups

Insertion of parts ............................... 49,500 Number of parts

Finishing ........................................... 86 100 Finishing direct labor hours

Total ................................................. $154 000

Farraway expects to produce 1,000 chrome wheels during the year . The wheels are expected to use 3,300 parts, require 20 setups, and consume 2,100 hours offinishing time .

Job 420 used 200 parts, required 2 setups, and consumed 150 finishing hours . Job 510 used 400 parts, required 4 setups, and consumed 320 finishing hours .

Requirements

1. Compute the cost allocation rate for each activity .

2. Compute the manufacturing overhead cost that should be assigned to Job 420 .

3. Compute the manufacturing overhead cost that should be assigned to Job 510 .

E4-32B Apply activity cost allocation rates (Leaming Objective 2)

SUSTAINABILITY Newman Industries manufactures a variety of custom products . The company has tra- ditionally used a plantwide manufacturing overhead rate based on machine hours to allocate manufacturing overhead to its products . The company estimates that it will incur $1,440,000 in total manufacturing overhead costs in the upcoming year and will use 12,000 machine hours .

Up to this point, hazardous waste disposal fees have been absorbed into the plant- wide manufacturing overhead rate and allocated to all products as part of the manu- facturing overhead process . Recently, the company has been experiencing significantly increased waste-disposal fees for hazardous waste gene rated by certain products, and, as a result, profit margins on all products have been negatively impacted . Company man- agement wants to implement an activity-based costing system so that managers know the cost of each product, including its hazardous waste-disposal costs .

Expected usage and costs for manufacturing overhead activities for the upcoming year are as follows :

Estimated Estimated Activity for

Description of Cost Pool Cost Cost Driver this Year

Machine maintenance costs .................. $ 840,000 Number of machine hours ...... 12,000

Engineering change orders ................... 20,000 Number of change orders ...... 1,000

Hazardous waste disposal .................... . 580 000 Pounds of hazardous materials generated .............. .. 2,000

Total overhead cost.. ................ ............ . $1 440 000

Activity-Based Costing, Lean Operations, and the Costs of Quality 229

During the year, Job 356 is started and completed . Usage data for this job are as follows:

Requirements

250 pounds of direct materials at $45 per pound

60 direct labor hours used at $25 per labor hour

90 machine hours used

6 change orders

30 pounds of hazardous waste generated

1. Calculate the cost of Job 356 using the traditional plantwide manufacturing overhead rate based on machine hours .

2. Calculate the cost of Job 356 using activity-based costing .

3. If you were a manager, which cost estimate would provide you more useful informa- tion? How might you use this information?

E4-33B Using ABC to bill clients at a service firm (Learning Objective 2) Warren & Company is an architectural firm specializing in home remodeling for private clients and new office buildings for corporate clients .

Warren charges customers at a billing rate equal to 126% of the client's total job cost . A client's total job cost is a combination of 1) professional time spent on the client ($63 per hour cost of employing each professional) and 2) operating overhead allocated to the client's job . Warren allocates operating overhead to jobs based on professional hours spent on the job . Warren estimates its five professionals will incur a total of 10,000 profes- sional hours working on client jobs during the year .

All operating costs other than professional salaries (travel reimbursements, copy costs, secretarial salaries, office lease, and so forth) can be assigned to the three activities . Total activity costs, cost drivers, and total usage of those cost drivers are estimated as follows :

Activity

Total Activity

Cost Cost Driver

Total Usage by Corporate

Clients

Transportation to clients ............. . $ 12,000

32,000

185 000

Round-trip mileage to clients ........... 4,500 miles

Blueprint copying ....................... . Number of copies ................. ............ 500 copies

Office support ............................ . Secretarial time ................................. 2,900 secretarial

Total operating overhead ........... . $229 000

Meredith Blaz hired Warren & Company to design her kitchen remodeling . A total of 20 professional hou rs were incurred on this job . In addition, Blaz's remodeling job required one of the professionals to travel back and forth to her house for a total of 140 miles . The blueprints had to be copied four times because Blaz changed the plans several times . In addition, 20 hours of secretarial time were used lining up the subcontractors for the job .

Requirements

1. Calculate the current operating overhead allocation rate per professional hour .

2. Calculate the total amount that would be billed to Meredith Blaz given the current costing structure .

3. Calculate the activity cost allocation rates that could be used to allocate operating overhead costs to client jobs .

4. Calculate the amount that would be billed to Meredith Blaz using ABC costing .

5. Which type of billing system is more fair to clients? Explain .

hours

Total Usage by Private

Clients

10,500 miles

500 copies

2,100 secretarial hours

230 CHAPTER 4

E4-34B Compare traditional and ABC cost allocations at a pharmacy (Learning Objective 2)

Gracen Pharmacy, part of a large chain of pharmacies, fills a variety of prescriptions for customers . The complexity of prescriptions filled by Gracen varies widely; pharmacists can spend between five minutes and six hours on a prescription order . Traditionally, the pharmacy has allocated its overhead based on the number of prescriptions.

The pharmacy chain's controller is exploring whether activity-based costing (ABC) may better allocate the pharmacy ove rhead costs to pharmacy orders . The controller has gath- e red the following information :

Total Annual Estimated Cost

Cost Pools Total Annual

Estimated Cost Cost Driver Driver Activity

Pharmacy occupancy costs (utilities, rent, and other costs) .................... .......... ... .

Packaging supplies (bottles, bags, and other packaging) ......... ....... .......... ....... .

Professional training and insurance costs ...... .

Total pharmacy overhead ........ ....... .......... ..... .

$36,000

39,100

125 000

$ 200 100

Technician hours ....... ....... ........ 90,000

Number of prescriptions ......... 23,000

Pharmacist hours ................. .... 25,000

The clerk for Gracen Pharmacy has gathered the following information regarding two recent pharmacy orders :

Customer Order Technician Number of Pharmacist Number Hours Prescriptions Hours

1102 0 .5 3 2 .0

1103 0 .5 1 2 .5

Requirements

1. What is the traditional overhead rate based on the number of prescriptions?

2. How much pharmacy overhead would be allocated to customer order number 1102 if traditional overhead allocation based on the number of prescriptions is used?

3. How much pharmacy overhead would be allocated to customer order number 1103 if traditional overhead allocation based on the number of prescriptions is used?

4. What are the following cost pool allocation rates?

a. Pharmacy occupancy costs

b. Packing supplies

c. Professional training and insurance costs

5. How much would be allocated to customer order number 1102 if activity-based costing (ABC) is used to allocate the pharmacy overhead costs?

6. How much would be allocated to customer order number 1103 if activity-based costing (ABC) is used to allocate the pharmacy overhead costs?

7. Which allocation method (traditional or activity-based costing) would produce a more accurate product cost? Explain your answer .

Activity-Based Costing, Lean Operations, and the Costs of Quality 231

E4-35B Compare traditional and ABC allocations on a job (Learning Objective 2) Cornwell Products has adopted an ABC costing system . The following manufacturing activities, indirect manufacturing costs, and cost drivers have been identified:

Activity Total estimated MOH

costs related to activity Total estimated amount of

allocation base activity

Machine setup ......................................... .

Machining ................................................ .

Polishing .................................................. . Quality control ......................................... .

Facility-level costs ................................... . Total manufacturing overhead (MOH) .... .

$ 180,000 $1,050,000

$ 100,000

$ 320,000

$ 150 000

$1 800 000

2,000 setups

12,000 machine hours

5,000 polishing cloths 4,000 tests run

50,000 DL hours

The Job Cost Record for Job #804 revealed that direct materials requisitioned for the job totaled $1,250 . The Job Cost Record also showed that direct labor for this job totaled 12 hours at a wage rate of $30 per hour .

Other data collected on the resources used by Job #804 included:

1 machine setup required

6 machine hours

4 polishing cloths

3 quality control tests run

Requirements

1. Calculate the activity cost allocation rate for each of the five pools listed in the table .

2. Calculate the total cost of Job #804 (use an ABC costing system).

3. Why would ABC provide a more accurate allocation of manufacturing overhead (MOH) than a plantwide rate?

5. Assume that Cornwell Products used a traditional costing system rather than an ABC sys- tem . Its plantwide MOH rate would have been determined using direct labor (DL) hours as the allocation base . How much cost distortion would have occurred on this job?

E4-36B Use ABC to allocate manufacturing overhead (Learning Objective 2) Several years after reengineering its production process, King Corporation hired a new controller, Christine Erickson . She developed an ABC system very similar to the one used by King's chief rival. Part of the reason Erickson developed the ABC system was because King's profits had been declining, even though the company had shifted its product mix toward the product that had appeared most profitable under the old system . Before adopting the new ABC system, the company had used a plantwide overhead rate, based on direct labor hours developed years ago .

For the upcoming year, King's budgeted ABC manufacturing overhead allocation rates are as follows :

Activity Allocation Base

Materials handling .......................... Number of parts

Machine setup ................................ Number of setups

Insertion of parts ............................ Number of parts

Activity Cost Allocation Rate

Finishing ......................................... Finishing direct labor hours

$ 4 .00 per part

$375.00 per setup

$ 28 .00 per part

$ 54 .00 per hour

The number of parts is now a feasible allocation base because King recently pur- chased bar-coding technology . King produces two wheel models : Standard and Deluxe . Budgeted data for the upcoming year are as follows:

Parts per wheel ................................................................. .

Setups per 1,000 wheels ................................................... . Finishing direct labor hours per wheel .............................. .

Total direct labor hours per wheel .................................... .

Standard

8 .0

20 .0 2 .0

2 .6

Deluxe

10 .0

20 .0 3 .5

3.4

23 2 CHAPTER 4

The company's managers expect to produce 1,000 units of each model during the year .

Requirements

1. Compute the total budgeted manufacturing overhead cost for the upcoming year .

2. Compute the manufacturing overhead cost per wheel of each model using ABC.

3. Compute the company's traditional plantwide overhead rate . Use this rate to deter- mine the manufacturing overhead cost per wheel under the traditional system .

E4-37B Continuation of E4-36B Determine product profitability (Learning Objectives 2 & 3)

Refer to your answers in E4-36B. In addition to the manufacturing overhead costs, the fol- lowing data are budgeted for the company's Standard and Deluxe models for next year :

Sales price per wheel .............. .......................................... .

Direct materials per wheel ...... .......................................... .

Direct labor per wheel ...................................................... .

Requirements

Standard

$575 .00

$ 33 .00

$ 45 .90

Deluxe

$735 .00

$ 46 .75

$ 54 .00

1. Compute the gross profit per wheel if managers rely on the ABC unit cost data .

2. Compute the gross profit per unit if the managers rely on the plantwide allocation cost data .

3. Which product line is more profitable for the company?

4. Why might the controller have expected ABC to pass the cost-benefit test? Were there any warning signs that the company's old direct-labor-based allocation system was broken?

E4-38B Differentiate between traditional and lean production (Learning Objective 4)

Categorize each of the following characteristics as being either more representative of a traditional organization or a lean organization .

1. High quality is stressed in every aspect of production .

2. Manufacturing plants tend to group like machinery together in different parts of the plant .

3. Setup times are longer .

4. Strive to maintain low inventory levels .

5. Setup times are shorter .

6. Produce in smaller batches .

7. Manufacturing plants tend to be organized with self-contained production cells. 8. Quality tends to be "inspect-in" rather than "build-in ."

9. Maintain greater quantities of raw materials, work in process, and finished goods inventories .

10. Emphasis is placed on shortening manufacturing cycle times.

11. Produce in larger batches .

12. Cycle time tends to be longer.

E4-39B Classify costs and make a quality-initiative decision (Learning Objective 5) Bradshaw Corp . manufactures radiation-shielding glass panels. Suppose the company is considering spending the following amounts on a new TOM program:

Strength-testing one item from each batch of panels .............................. .

Training employees in TOM ............................................................ .......... .

Training suppliers in TOM ......................................................................... .

Identifying preferred suppliers that commit to on-time delivery of perfect quality materials ................................................................... .

$62,000

$21,000

$31,000

$55,000

Activity-Based Costing, Lean Operations, and the Costs of Quality 233

The company expects the new program would save costs through the following :

Avoid lost profits from lost sales due to disappointed customers ........... .

Avoid rework and spoilage ....................................................................... .

Avoid inspection of raw materials ............................................................ .

Avoid warranty costs ................................................................................ .

Requirements

$89,000

$65,000

$50,000

$25,000

1. Classify each item as a prevention cost, an appraisal cost, an internal failure cost, or an external failure cost.

2. Should the company implement the new quality program? Give your reason .

E4-40B Prepare a Costs of Quality report (Learning Objective 5) Frostline Industries manufactures freezers . Here is some information about its "LX17" line of freezers over the past year :

Number of units manufactured and sold ................................................ .

Selling price per unit ............................................................................... .

Variable manufacturing and selling costs per unit ....... .......... .......... ....... .

Hours spent by engineers improving design ........... ................. ............. . .

Testing and inspection hours per unit ...... ............. ....... .......... .......... ....... .

Percentage of units reworked in the plant after inspection ................... .

Average variable rework costs per freezer .... .......... ....... .......... ............. . .

Percentage of units repaired under warranty at customers' homes ....... .

Average variable repair costs at customers' homes per freezer. ............ .

Estimated lost sales due to quality reputation ........................................ .

Design engineer's labor rate (includes benefits and payroll taxes) ........ .

Inspection costs per hour ........................................................................ .

Requirements

6,000 units

$1,800

$700

1,000

1.0 hours

10%

$600

8%

$650

400 units

$85 per hour

$45 per hour

1. Prepare a Cost of Quality (COO) report . In addition to calculating the total costs of each category, calculate the percentage of each COO category of the total COO .

2. Why would the variable repair cost at the customers' homes generally be higher than the "in factory" rework cost?

3. How can use of the COO report lead to improvements in the production process or in the quality of the product itself?

PROBLEMS Group A P4-41A Implementation and analysis of departmental rates (Learning Objective 1)

Hughes Products manufactures its products in two separate departments : Machining and Assembly . Total manufacturing overhead costs for the year are budgeted at $1,056,000 . Of this amount, the Machining Department incurs $600,000 (primarily for machine opera- tion and depreciation}, while the Assembly Department incurs $456,000. The company estimates that it will incur 4,000 machine hours (all in the Machining Department) and 9,600 direct labor hours (1,600 in the Machining Department and 8,000 in the Assembly Department) during the year .

Hughes Products currently uses a plantwide overhead rate based on direct labor hours to allocate overhead . However, the company is considering refining its overhead al- location system by using departmental overhead rates . The Machining Department would allocate its overhead using machine hours (MH}, but the Assembly Department would al- locate its overhead using direct labor (DL) hours .

234 CHAPTER 4

Activity

The following chart shows the machine hours (MH) and direct labor (DL) hours in- curred by Jobs 500 and 501 in each production department:

Job 500 ................ .......... ................. .......... .......... .

Job 501 ............................................................... .

Machining Department

10 MH

2 DL hours

20MH

2 DL hours

Assembly Department

15 DL hours

15 DL hours

Both Jobs 500 and 501 used $1,000 of direct materials . Wages and benefits total $30 per direct labor hour. Hughes Products prices its products at 120% of total manufacturing costs .

Requirements

1. Compute the company's current plantwide overhead rate .

2. Compute refined departmental overhead rates .

3. Which job (Job 500 or Job 501) uses more of the company's resources? Explain.

4. Compute the total amount of overhead allocated to each job if the company uses its current plantwide overhead rate .

5. Compute the total amount of overhead allocated to each job if the company uses de- partmental overhead rates .

6. Do both allocation systems accurately reflect the resources that each job used? Explain.

7. Compute the total manufacturing cost and sales price of each job using the compa- ny's current plantwide overhead rate .

8. Based on the current (plantwide) allocation system, how much profit did the company think it earned on each job? Based on the departmental overhead rates and the sales price determined in Requirement 7, how much profit did it really earn on each job?

9. Compare and comment on the results you obtained in Requirements 7 and 8.

P4-42A Use ABC to compute full product costs (Learning Objective 2) Arnett Corp . manufactures computer desks in its White Bear Lake, Minnesota, plant . The company uses activity-based costing to allocate all manufacturing conversion costs (direct labor and manufacturing overhead) . Its activities and related data follow :

Budgeted Cost of Activity Allocation Base

Cost Allocation Rate

Materials handling ...... .......... ...... . $ 330,000 $2,500,000

$ 170,000

Number of parts $ 0 .80

$12.00

$ 4 .90

Assembling ................................. . Direct labor hours

Number of painted desks Painting ....................................... .

Product

Arnett produced two styles of desks in March : the Standard desk and the Unpainted desk. Data for each follow:

Total Units

Produced Total Direct

Materials Costs Total Number

of Parts

Total Assembling Direct

Labor Hours

Standard desk ............................. . 7,500

1,500

$178,950 118,500 6,000

Unpainted desk ........................... . $ 6,300 28,500 1,200

Requirements

1. Compute the per-unit manufacturing product cost of Standard desks and Unpainted desks .

2. Premanufacturing activities, such as product design, were assigned to the Standard desks at $6 each and to the Unpainted desks at $2 each . Similar analyses were con- ducted of post-manufacturing activities, such as distribution, marketing, and customer service . The post-manufacturing costs were $22 per Standard and $19 per Unpainted desk . Compute the full product costs per desk .

3. Which product costs are reported in the external financial statements? Which costs are used for management decision making? Explain the difference .

4. What price should Arnett's managers set for Standard desks to earn a $42 profit per desk?

Activity-Based Costing, Lean Operations, and the Costs of Quality 235

P4-43A Comprehensive ABC implementation (Learning Objectives 2 & 3) Durbin Pharmaceuticals manufactures an over-the-counter allergy medication called Breathe . Durbin is trying to win market share from Sudafed and Tylenol. The company has developed several different Breathe products tailored to specific markets . For example, the company sells large commercial containers of 1,000 capsules to health-care facilities and travel packs of 20 capsules to shops in airports, train stations, and hotels .

Durbin's controller, Katarina Hoffman, has just returned from a conference on ABC. She asks Bradley Williams, supervisor of the Breathe product line, to help her develop an ABC system . Hoffman and Williams identify the following activities, related costs, and cost allocation bases :

Estimated Indirect Activity Costs Allocation Base

Materials handling ... ................................... . $160,000 Kilos

Packaging ................................................... . 390,000 Machine hours

Quality assurance ....................................... . 112 000 Samples

Total indirect costs ...................................... . $662 000

The commercial-container Breathe product line had a total weight of 8,700 kilos, used 900 machine hours, and required 270 samples . The travel-pack line had a total weight of 4,450 kilos, used 300 machine hours, and requi red 370 samples . Durbin produced 3,000 commercial containers of Breathe and 20,000 travel packs .

Requirements

1. Compute the cost allocation rate for each activity .

2. Use the activity-based cost allocation rates to compute the indirect cost of each unit of the commercial containers and the travel packs . (Hint: Compute the total activity costs allocated to each product line and then compute the cost per unit .)

3. The company's original single-allocation-based cost system allocated indirect costs to products at $350 per machine hour . Compute the total indirect costs allocated to the commercial containers and to the travel packs unde r the original system . Then com- pute the indirect cost per unit for each product .

4. Compare the activity-based costs per unit to the costs from the original system . How have the unit costs changed? Explain why the costs changed as they did .

P4-44A Using ABC in conjunction with quality decisions (Learning Objectives 2 & 5) Giant Construction Toys Corp . is using a costs-of-quality approach to evaluate design enginee ring efforts for a new toy robot . The company's senior manage rs expect the engi- neering work to reduce appraisal, internal failure, and external failure activities . The pre- dicted reductions in activities over the two-year life of the toy robot follow . Also shown are the cost allocation rates for the activities .

Predicted Reduction in

Activity Activity Units

Inspection of incoming materials .............................................................. . 390

Inspection of finished goods ....... ............. .......... ....... .......... .......... ............ . 390

Number of defective units discovered in-house ....................................... . 3,500

Number of defective units discovered by customers ............................... . 875

Lost sales to dissatisfied customers .............. .......... ....... .......... .......... ....... . 310

Requirements

1. Calculate the predicted quality cost savings from the design engineering work .

2. The company spent $70,000 on design engineering for the new toy robot . What is the net benefit of this "preventive" quality activity?

3 . What major difficulty would management have had in implementing this costs-of-quality approach? What alternative approach could it use to measure quality improvement?

Estimated Quantity of Allocation Base

20,000 kilos

2,000 hours

1,600 samples

Activity Cost Allocation Rate

per Unit

$19

$33

$ 17

$43

$61

236 CHAPTER 4

P4-45A Comprehensive ABC (Learning Objectives 2 & 3)

Activity

Workflow Systems specializes in servers for work-group, e-commerce, and enterprise resource planning (ERP) applications . The company's original job cost system has two direct cost categories : direct materials and direct labor . Overhead is allocated to jobs at the single rate of $27 per direct labor hour .

A task force headed by Workflow's CFO recently designed an ABC system with four activities . The ABC system retains the current system's two direct cost categories . Thus, it budgets only overhead costs for each activity . Pertinent data follow :

Allocation Base Cost

Allocation Rate

Materials handling ............................................. Number of parts $ 1.10

Machine setup ................................................... Number of setups

Assembling ........................................................ Assembling hours

Shipping ............................................................ Number of shipments

$ 470 .00

$ 120 .00

$1,280 .00

Workflow Systems has been awarded two new contracts that will be produced as Job A and Job B. Budget data relating to the contracts follow :

Number of parts ............................................................... .

Number of setups ............................................................. .

Number of assembling hours ............................................ .

Number of shipments ....................................................... .

Total direct labor hours ..................................................... .

Number of output units .......... .......... ....... .......... .......... ..... .

Direct materials cost ......................................................... .

Direct labor cost ................................................................ .

Requirements

Job A

17,000

6

1,700

1

9,900

100

$195,700

$155,000

Job B

4,000

2

400

1

880

20

$100,640

$25,000

1. Compute the product cost per unit for each job using the original costing system (with two direct cost categories and a single overhead allocation rate).

2. Suppose Workflow Systems adopts the ABC system . Compute the product cost per unit for each job using ABC.

3. Which costing system more accurately assigns to jobs the costs of the resources con- sumed to produce them? Explain.

4. A dependable company has offered to produce both jobs for Workflow for $6,000 per output unit . Workflow may outsource (buy from the outside company) Job A only, Job B only, or both jobs . Which course of action will Workflow managers take if they base their decision on (a) the original system? (b) ABC system costs? Which course of ac- tion will yield more income? Explain .

PROBLEMS Group B P4-46B Implementation and analysis of departmental rates (Learning Objective 1)

Powell Products manufactures its products in two separate departments: Machining and Assembly. Total manufacturing overhead costs for the year are budgeted at $1,050,000 . Of this amount, the Machining Department incurs $650,000 (primarily for machine operation and depreciation) while the Assembly Department incurs $400,000 . The company estimates it will incur 5,000 machine hours (all in the Machining Department) and 10,000 direct labor hours (2,000 in the Machining Department and 8,000 in the Assembly Department) during the year.

Activity-Based Costing, Lean Operations, and the Costs of Quality 237

Powell currently uses a plantwide overhead rate based on direct labor hours to al- locate overhead. However, the company is considering refining its overhead allocation system by using departmental overhead rates . The Machining Department would allocate its overhead using machine hours (MH}, but the Assembly Department would allocate its overhead using direct labor (DL) hours .

The following chart shows the machine hours (MH) and direct labor (DL) hours in- curred by Jobs 500 and 501 in each production department .

Job 500 ............................................................... .

Job 501 ............................................................... .

Machining Department

4 MH

2 DL hours

8 MH

2 DL hours

Assembly Department

10 DL hours

10 DL hours

Both Jobs 500 and 501 used $1,000 of direct materials . Wages and benefits total $20 per direct labor hour . Powell prices its products at 110% of total manufacturing costs.

Requirements

1. Compute the company's current plantwide overhead rate .

2. Compute refined departmental overhead rates .

3. Which job (Job 500 or Job 501) uses more of the company's resources? Explain .

4. Compute the total amount of overhead allocated to each job if the company uses its current plantwide overhead rate.

5. Compute the total amount of overhead allocated to each job if the company uses de- partmental overhead rates.

6. Do both allocation systems accurately reflect the resources that each job used? Explain.

7. Compute the total manufacturing cost and sales price of each job using the company's current plantwide overhead rate.

8. Based on the current (plantwide) allocation system, how much profit did the company think it earned on each job? Based on the departmental overhead rates and the sales price determined in Requirement 7, how much profit did it really earn on each job?

9. Compare and comment on the results you obtained in Requirements 7 and 8 .

P4-47B Use ABC to compute full product costs (Learning Objective 2) Kimbro Furniture manufactures computer desks in its Austin, Texas, plant . The company uses activity-based costing to allocate all manufacturing conversion costs (direct labor and manufacturing overhead) . Its activities and related data follow :

Budgeted Cost Activity of Activity Allocation Base

Materials handling. .......... .......... $ 310,000 Number of parts

Assembling ................................ $2,400,000 Direct labor hours

Cost Allocation

Rate

Painting ..................................... $ 190,000 Number of painted desks

$ 0 .90

$17 .00

$ 5.00

The company produced two styles of desks in March: the Standard desk and the Un- painted desk . Data for each follow :

Total Direct Total Total Assembling Total Units Materials Number of Direct Labor

Product Produced Costs Parts Hours

Standard desk .................... 7,500 $165,450 119,500 6,000

Unpainted desk ........ .......... 1,500 $ 21,350 29,500 800

23 8 CHAPTER 4

Requirements

1. Compute the per-unit manufacturing product cost of Standard desks and Unpainted desks .

2. Premanufacturing activities, such as product design, were assigned to the Standard desks at $4 each and to the Unpainted desks at $2 each . Similar analyses were con- ducted of post-manufacturing activities such as distribution, marketing, and customer service . The post-manufacturing costs were $21 per Standard and $19 per Unpainted desk . Compute the full product costs per desk .

3. Which product costs are reported in the external financial statements? Which costs are used for management decision making? Explain the difference .

4. What price should management set for Standard desks to earn a $39 profit per desk?

P4-48B Comprehensive ABC implementation (Learning Objectives 2 & 3) Percival Pharmaceuticals manufactures an over-the-counter allergy medication called Breathe . Percival is trying to win market share from Sudafed and Tylenol. The company has developed several different Breathe products tailored to specific markets . For example, the company sells large commercial containers of 1,000 capsules to health- care facilities and travel packs of 20 capsules to shops in airports, train stations, and hotels.

Percival's controller, Donna Swanson, has just returned from a conference on ABC. She asks Carol Yost, supervisor of the Breathe product line, to help her develop an ABC system . Swanson and Yost identify the following activities, related costs, and cost alloca- tion bases :

Activity

Materials handling ...................... .

Packaging ............ .......... .......... ... .

Quality assurance ........................ .

Total indirect costs ...................... .

Estimated Indirect

Activity Costs

$180,000

460,000

116 000

$756 000

Allocation Estimated Quantity Base of Allocation Base

Kilos 18,000 kilos

Machine hours 2,600 hours

Samples 1,500 samples

The commercial-container Breathe product line had a total weight of 8,500 kilos, used 1,200 machine hours, and 240 required samples . The travel-pack line had a total weight of 6,000 kilos, used 400 machine hours, and required 340 samples . The company pro- duced 2,500 commercial containers of Breathe and 80,000 travel packs.

Requirements

1. Compute the cost allocation rate for each activity .

2. Use the activity-based cost allocation rates to compute the indirect cost of each unit of the commercial containers and the travel packs . (Hint : Compute the total activity costs allocated to each product line and then compute the cost per unit.)

3. The company's original single-allocation-based cost system allocated indirect costs to products at $350 per machine hour . Compute the total indirect costs allocated to the commercial containers and to the travel packs under the original system . Then, com- pute the indirect cost per unit for each product .

4. Compare the activity-based costs per unit to the costs from the simpler original system . How have the unit costs changed? Explain why the costs changed as they did.

P4-49B Using ABC in conjunction with quality decisions (Learning Objectives 2 & 5)

Big Yellow Construction Toys Corporation is using a costs-of-quality approach to evaluate design engineering efforts for a new toy robot. The company's senior managers expect the engineering work to reduce appraisal, internal failure, and external failure activities . The predicted reductions in activities over the two-year life of the toy robot follow. Also shown are the cost allocation rates for the activities .

Activity-Based Costing, Lean Operations, and the Costs of Quality 239

Predicted Activity Cost Reduction in Allocation Rate

Activity Activity Units per Unit

Inspection of incoming materials ........... .......... .......... .......... ....... . 305

Inspection of finished goods .......... .......... .......... .................... .... . 305

Number of defective units discovered in-house ......................... . 3,100

Number of defective units discovered by customers ....... .......... . 825

Lost sales to dissatisfied customers .... .......... .......... ....... .......... ... . 280

Requirements

1. Calculate the predicted quality cost savings from the design engineering work.

2. The company spent $65,000 on design engineering for the new toy robot . What is the net benefit of this "preventive" quality activity?

3. What major difficulty would management have had in implementing this costs-of-quality approach? What alternative approach could it use to measure quality improvement?

P4-50B Comprehensive ABC (Learning Objectives 2 & 3) FirstServer Systems specializes in servers for work-group, e-commerce, and enterprise resource planning (ERP) applications . The company's original job cost system has two direct cost categories : direct materials and direct labor. Overhead is allocated to jobs at the single rate of $20 per direct labor hour .

A task force headed by FirstServer's CFO recently designed an ABC system with four activities . The ABC system retains the current system's two direct cost categories. Thus, it budgets only overhead costs for each activity . Pertinent data follow :

Activity Allocation Base

Materials handling ...................................... Number of parts

Machine setup ............................................ Number of setups

Assembling ................................................. Assembling hours

Shipping .................. ................................... Number of shipments

Cost Allocation Rate

$ 1.10

$ 500 .00

$ 80 .00

$1,700 .00

FirstServer Systems has been awarded two new contracts that will be produced as Job A and Job B. Budget data relating to the contracts follow :

Number of parts ...... .......... ............. .......... .......... ....... ... .

Number of setups ........................................................ .

Number of assembling hours ....................................... .

Number of shipments ............. .......... .......... .......... ....... .

Total direct labor hours ................................................ .

Number of output units ............................................... .

Direct materials cost ..................................................... .

Direct labor cost .................... .......... .......... ............. ...... .

Job A

10,000

20

1,000

9,200

100

$246,000

$180,000

Job B

2,000

8

200

500

10

$46,900

$18,000

$22

$34

$11

$41

$58

240 CHAPTER 4

Requirements

1. Compute the product cost per unit for each job using the original costing system (with two direct cost categories and a single overhead allocation rate).

2. Suppose FirstServer Systems adopts the ABC system. Compute the product cost per unit for each job using ABC.

3. Which costing system more accurately assigns to jobs the costs of the resources con- sumed to produce them? Explain .

4. A dependable company has offered to produce both jobs for FirstServer for $5,600 per output unit . FirstServer may outsource (buy from the outside company) Job A only, Job B only, or both jobs . Which course of action will FirstServer managers take if they base their decision on (a) the original system? (b) ABC system costs? Which course of action will yield more income? Explain .

Serial Case C4-51 Calculate and interpret activity cost pool rates (Learning Objective 2) This case is a continuation of the Caesars Entertainment Corporation serial case that began in Chapter 1. Refer to the introductory story in Chapter 1 (see page 43) for additional back- ground . (The components of the Caesars serial case can be completed in any order .) Caesars Entertainment Corporation (CEC) has several properties in Las Vegas, Nevada, which it owns or manages . The following list of selected property-related data is taken from CEC's 2014 Form 10-K, Item 2, pages 31-32 .

Caesars Entertainment Corporation

Selected property data adapted from Form 10K, Item 2, pages 31-32

As of December 31, 2014

Hotel Casino space- Slot Table rooms &

Property square feet machines games suites

Flamingo Las Vegas 72,300 1,110 120 3,460

Harrah's Las Vegas 90,600 1,280 90 2,720

Paris Las Vegas 95,300 1,020 100 2,920

Rio All-Suites Hotel & Casino 117,300 1,070 90 2,520

Baily's Las Vegas 66,200 1,000 70 2,810

The Cromwell 28,100 450 60 188

Planet Hollywood 64,500 1,100 90 2,500

The LINO Hotel & Casino 62,200 750 70 2,250

Caesars Palace Las Vegas 123,700 1,300 170 3,960

Totals 720,200 9,080 860 23,328

Calculate a cost activity pool rate for each of the following pools . Use an activity measure for the denominator from the above table . Justify your choice of the cost driver for each of the cost pools . Please note that there may not be just one correct answer for one or more of these cost pools .

Item Cost pool Total

a . Slot machine maintenance costs $ 1,952,200

b . Casino utilities expenses $43,212,000

C . Property taxes $ 6,200,000

d . Housekeeper wages and benefits $12,947,040

e . Casino dealer wages and benefits $15,050,000

Activity-Based Costing, Lean Operations, and the Costs of Quality 241

CRITICAL THINKING Discussion & Analysis A4-52 Discussion Questions

1. Explain why departmental overhead rates might be used instead of a single plantwide overhead rate .

2. Using activity-based costing, why are indirect costs allocated while direct costs are not allocated?

3. How can using a single p redetermined manufacturing overhead rate based on a unit-level cost driver cause a high-volume product to be overcosted?

4. Assume a company uses a plantwide predetermined manufacturing overhead rate that is calculated using direct labor hours as the cost driver . The use of this plantwide predeter- mined manufacturing overhead rate has resulted in cost distortion . The company's high- volume products are overcosted, and its low-volume products are undercosted . What effects of this cost distortion will the company most likely be experiencing? Why might the cost distortion be harmful to the company's competitive position in the market?

5. A hospital can use activity-based costing (ABC) for costing its services . In a hospital, what activities might be considered to be value-added activities? What activities at that hospi- tal might be considered to be non-value-added?

6. A company makes shatterproof, waterproof cases for the $-series of Samsung smart- phones . The company makes only one model and has been very successful in marketing its cases; no other company in the market has a similar product . The only customization available to the customer is the color of the case . There is no manufacturing cost differ- ence among the different colors of the cases . Since this company has a high-volume prod- uct, its controller thinks that the company should adopt activity-based costing . Why might activity-based costing not be as beneficial for this company as for other companies?

7. Compare a traditional production system with a lean production system . Discuss the simi- larities and the differences.

8. Think of a product with which you are familiar. Explain how activity-based costing could help the company that makes this product in its efforts to be "green ."

9. It has been said that external failure costs can be catastrophic and much higher than the other categories. What are some examples of external failure costs? Why is it often dif- ficult to arrive at the cost of external failures?

10. What are the four categories of quality-related costs? Name a cost in each of the four cat- egories for each of the following types of organizations :

a. Restaurant

b. Hospital

C. Law firm

d. Bank

e. Tire manufacturer

f. University

11. What are the similarities between sustainability and lean thinking? What are the differ- ences between sustainability and lean thinking?

12. Why might a company want to take lean thinking a step further by including operations and methods associated with sustainability?

242 CHAPTER 4

Application & Analysis Mini Cases

A4-53 ABC in Real Companies Choose a company in any of the following categories: airline, florist, bookstore, bank, grocery store, restaurant, college, retail clothing shop, movie theater, or lawn service . In this activity, you will be making reasonable estimates of the types of costs and activities associated with this company; companies do not typically publish internal cost or process information . Be reason- able in your cost estimates and include your assumptions used in selecting costs .

Basic Discussion Questions

1. Describe the company selected, including its products or services.

2. List eight key activities performed at this company . Choose at least one activity in the areas of production, sales, human resources, and accounting.

3. For each of the key activities, list a potential cost driver for that activity and describe why this cost driver would be appropriate for the associated activity .

A4-54 Value-Added versus Non-Value-Added at a Restaurant Go to a fast-food restaurant (or think of the last time you were at a fast-food restaurant). Observe the steps involved in providing a meal to a customer . You will be watching for value- added steps and non-value-added steps . Answer the following questions .

Basic Discussion Questions

1. Describe the steps involved with delivering the meal to the customer that you can observe .

2. Describe the "behind-the-scenes" processes that are likely in the restaurant, such as cleaning, stocking, and cooking activities .

3. With your answers for Questions 1 and 2, list all of the possible activities, materials, and information that you think might be included on a value stream map for the restaurant. Include all of the steps you can think of (not necessarily only those you can observe) .

4. Make a list of the eight wastes as denoted by the acronym DOWNTIME (Defects, Over- production, Waiting, Not utilizing people to their full potential, Transportation, Inven- tory, Movement, and Excess processing). Next to each waste category, list at least one possible non-value-added activity that might or might not be in the processes in that restaurant .

5. Go back to the list of items for the potential value stream map . Circle potential areas for improvement and explain which wastes might be involved in those areas .

A4-55 Ethics involved with ABC and hazardous waste costs (Learning Objectives 2 & 3)

Sparkle Unlimited is a costume jewelry manufacturer located in the United States that uses electroplating . Electroplating is a process that involves applying a decorative metal coating to a base metal. The electroplating solution, or the water that is used in this pro- cess, becomes dirty over time and needs to be replaced . This used solution for electro- plating is referred to as "spent" solution .

The spent solution contains dissolved metals such as gold, silver, platinum, copper, and other metals . Cyanide can also be present in the spent solution . Because of this con- tent, spent solution is considered to be hazardous waste. This waste is more expensive to dispose of than regular waste .

Currently, Sparkle is using a traditional, volume-based costing system for its jewelry . Total manufacturing overhead for the period is allocated to the jewelry based on machine hours used .

Recently hired, Jacob is the controller for Sparkle. He previously worked at a manufac- turer that produced custom furniture . At this prior job, he implemented an activity-based costing system that helped the company to determine the profitability of different product lines. He has been learning about Sparkle's operations and thinks activity-based costing might be a good tool for Sparkle's management to use to help to manage its operations .

Activity-Based Costing, Lean Operations, and the Costs of Quality 243

Jacob's good friend, Michelle, is the division manager for the Silver line of jewelry at Sparkle . She runs an efficient production line and has earned bonuses for each of the past sev- eral years based on her division's productivity and profitability. Division managers are evaluated based on profits generated by their divisions as calculated by the internal reporting system .

If activity-based costing is used to allocate costs and hazardous waste costs are al- located to the products that generate spent solutions, the calculated internal profit from the Silver product line will decrease significantly . This decrease in profitability is because the cost of handling the spent solution is quite high, and this cost would be directly as- signed to the Silver line if activity-based costing we re to be used.

Michelle takes Jacob out to lunch at an expensive restaurant and steers the conversa- tion toward the upcoming activity-based costing implementation . She is concerned that her division's profits will decrease due to the spent-solution costs charged to her division . Michelle asks Jacob if he can reduce the amount of hazardous waste costs allocated to her line .

Jacob values the working relationship he has with Michelle . She is one of the people who has input on his evaluation when it comes time for raises and promotions . He wants to keep her happy .

As a result, Jacob does not set up any cost pool for hazardous waste-disposal costs . Since the hazardous waste cost has always been part of the manufacturing process, he will continue to bury it in the other cost pools . His reasoning is that the activity-based costing system with hazardous waste-removal cost buried is still better than the tra- ditional cost system; other costs are properly allocated and the costs are much more accurate than unde r the old system . He feels that no one is getting hurt . Since the activ- ity-based costing cannot be used for external reporting, Jacob feels that what he is doing is not illegal.

Requirements Using the IMA Statement of Ethical Professional Practice (Exhibit 1-7) as an ethical framework, answer the following questions :

1. What is(are) the ethical issue(s) in this situation?

2 . Activity-based costing cannot be used for external financial reporting . Does this fact influ- ence your analysis of whether Jacob has violated any ethical principles? Why or why not?

3 . Do you agree that no one is hurt by the burying of the hazardous waste costs into general cost pools? Explain .

4 . What are Jacob 's responsibilities as a management accountant? What should he do now?

A4-56 Lean production costs and sustainability (Learning Objectives 4 & 5) Cal-Maine Foods, Inc., is the largest producer of shell eggs in the United States . In 2012, it sold approximately 884 .3 million dozen shell eggs, which was approximately 19% of shell eggs sold domestically .9 Walmart and Sam 's Club (owned by the same parent) com- bined account for almost one-third of Cal-Maine's net sales dollars in 2012 .10

Per U.S. Department of Agriculture (USDA) regulations, every egg carton sold in the United States must be marked with information about the eggs inside the carton, includ- ing the eggs' grade, size, traceability code, and freshness date . The traceability code provides information about the egg farm, the region, and the specific building from which those eggs originate . This traceability information is necessary in case of health-related safety recalls (for example, salmonella outbreaks) .

If one egg in a carton is broken or damaged, the entire carton must be disca rded due to USDA regulations . The reason that the entire carton has to be thrown away rather than replacing just one egg with an unbroken one is that the eggs in the carton all must be from the same exact batch with identical traceability codes and freshness dates . The consumer would have no guarantee that the replacement egg matches the other eggs in the carton .

It is estimated that as many as one in every ten dozen eggs is broken and the carton thrown away .11 This breakage ratio (10%) means that ofthe 884 .3 million dozen eggs sold by Cal-Maine Foods in 2012, over 88.4 million dozen eggs, or over a billion individual eggs, were discarded .

9 Cal-Maine Foods, Inc., 2012 Annual Report, www.calmain efoods.com/investor_relation s/financial_report s.htm 10 Ib id. 11 "Th e Secret Lives of Bees," YouTube video pro duced by Walman , htt ps://www.youtub e.com/watch?v=fat8ThBjo fM

REAL LIFE

SUSTAINABILITY

244 CHAPTER 4

A Cal-Maine egg farm in Bushnell, Florida, in partnership with Wal mart, two other suppliers, and the USDA, has developed a solution to significantly reduce the waste caused by egg breakage . Organic laser ink is used to mark each egg individually with its grade, size, traceability code, and freshness date . Now instead of throwing away the entire carton of eggs when a broken egg is discovered, the broken egg can be replaced with another egg that has the same grade, size, traceability code, and freshness date .

If this program is successful, Wal mart alone will save over half a billion eggs from be- ing thrown away each year (the broken or damaged eggs will still be discarded) . Other egg sellers will have similar savings .

Requirements

1. Think about the value chain for a carton of eggs that is sold in the grocery store . (Start from the chicken and continue to the point of sale in the grocery store .) List as many steps in the value chain as you can imagine . At what points in the value chain does waste most likely occur?

2 . In this chapter, the eight wastes of traditional operations were discussed . Which types of waste are in the value chain that you identified in Question 1?

3 . Answer the following questions from the standpoint of Cal-Maine Foods, Inc., and its egg farms :

a. What costs will be incurred to individually stamp each egg?

b. What impact on revenue would the process of individually stamping each egg have?

c. What wastes in the value chain occur at Cal-Maine Foods (and its egg farms)?

4 . Now answer the following questions from the standpoint of Wal mart :

a. What costs might decrease as a result of purchasing eggs that are stamped indi- vidually with grade, size, traceability code, and freshness date information?

b. What costs might increase as a result of purchasing individually stamped eggs?

c. What wastes in the value chain occur at Walmart?

5 . Who should bear the cost of the individual egg-stamping operations : Cal-Maine Foods, Walmart, or the consumer? Because of the tremendous amount of waste involved with the current system of discarding entire cartons, should individual egg stamping be mandated by the government? Why or why not?

Try It Solutions page 184:

1. Plantwide:

2. Machining Dept.:

Assembly Dept.:

Total MOH

$16 per DL hour X 5 DL hours = $§Q

$32 per DL hour X 3 DL hours = $96

$12 per DL hour X 2 DL hours = $24

3. The plantwide overhead rate undercosts the job by $40 (= $120 - $80).

page 205:

2, 3, 5, 7.

Wendy M. Tietz

Source: http: //j ellybe lly.com

Process Costing

Learning Objectives

• 1 Distinguish between the flow of costs in process costing and job costing

• 2 Compute equivalent units

• 3 Use process costing in the first production department

• 4 Prepare journal entries for a process costing system

• 5 Use process costing in a second or later production department

What's your favorite Jelly Belly flavor? Chocolate Pudding? Peanut Butter? Or maybe Pina Colada? Have you ever wondered how these tasty gems are made? Each

tiny Jelly Belly jelly bean spends seven to ten days going through eight different production

processes : (1) Cooking the centers; (2) Shaping hot liquid centers into jelly beans; (3) Drying;

(4) Sugar shower; (5) Shell-building; (6) Polishing; (7) Stamping the name of the company on each

bean; and (8) Packaging . Since Jelly Belly mass produces its jelly beans, the accounting system

it uses to find the cost of making each pound of jelly beans differs from the job costing system

Life Fitness uses . Jelly Belly uses process costing to separately measure the manufacturing costs

incurred in each of the eight production processes . Next, the company spreads these costs over

the pounds of jelly beans that passed through each process during the month. By doing so,

Jelly Belly is able to calculate the average cost of making a pound of jelly beans in each process,

as well as the average cost of making a pound of jelly beans, from start to finish . Jelly Belly's

managers use this information to measure profits and make business decisions . They also use

this information to determine how efficiently each process is operating in order to control costs .

246 CHAPTER 5

1 _Distinguish between -: ---the flow of costs in

process costing and job costing

A s the chapter-opening story shows, managers need to know how much each unit of their product costs to make. Why? So that they can control costs, set selling prices, and make profitable business decisions. But finding unit cost at companies that mass-manufacture requires a different approach than it does at companies that manufacture small batches of unique products. This chapter will illustrate the costing system used by mass manufacturers.

Process Costing: An Overview Let's start by contrasting the two basic types of costing systems: job costing and process costing.

Two Basic Costing Systems: Job Costing and Process Costing We saw in Chapter 3 that Life Fitness and Boeing use job costing to determine the cost of producing unique goods in relatively small batches. Service companies such as law firms and hospitals also use job costing to determine the cost of serving individual clients. In contrast, companies such as Jelly Belly and Shell Oil use a series of steps ( called processes) to make large quantities of identical units. These companies typically use process costing systems.

To simplify our discussion, we'll consolidate Jelly Belly's eight separate processes into three processes. We'll combine cooking, shaping, and drying the jelly bean centers into a single process called Centers. We'll also combine the sugar shower, shell-building, polishing, and stamping steps into a second process called Shells. The third and final process is Packaging.

Jelly Belly accumulates the costs of each process and then assigns these costs to the units (pounds of jelly beans) passing through that process.

Suppose the Centers process incurs $1,350,000 of costs to produce centers for 1,000,000 pounds of jelly beans, the Shells process incurs $800,000, and Packaging in- curs $700,000. The total cost to produce a pound of jelly beans is the sum of the cost per pound for each of the three processes.

$1,350,000

1,000,000 lb.

$1.35/lb.

+

+

+

$800,000

1,000,000 lb.

• .. b. +

Packaging proceu

~ Total cost

$700,000

1,000,000 lb.

$11.71111b. $2.85/lb.

Jelly Belly's owners use the cost per pound of each process to help control costs. For exam- ple, they can compare the actual cost of producing centers for a pound of jelly beans (assumed to be $1.35 in our example) to the budget or plan. If the actual cost of the Centers process exceeds the budget, they can look for ways to cut costs in that process. Jelly Belly's owners also consider the total cost of making a pound of jelly beans (assumed to be $2.85 in our example) when setting selling prices. The price should be high enough to cover costs and to return a profit. Jelly Belly also uses the total cost of making a pound of jelly beans for financial reporting:

• To value the ending inventory of jelly beans for the balance sheet ($2.85 per pound still in ending inventory)

• To value the cost of goods sold for the income statement ($2.85 per pound sold)

The simple computation of the cost to make a pound of jelly beans is correct only if there are no work in process inventories, but it takes 7 to 10 days to complete all of the processes. So, Jelly Belly does have inventories of partially complete jelly beans. These in- ventories make the costing more complicated. In the rest of this chapter, you'll learn how to use process costing when there are work in process inventories.

How Does the Flow of Costs Differ Between Job and Process Costing? Exhibit 5-1 compares the flow of costs in

• a job costing system for Life Fitness (Panel A), and

• a process costing system for Jelly Belly (Panel B).

EXHIBIT 5-1 Flow of Costs in Job Costing (Pane l A) and Process Costing (Pane l B)

PANEL A-JOB COSTING Life Fitness

Manufacturing Costs:

1 I Direct materials 2) Direct labor

3) Manufacturing overhead

Raw Materials Inventory Work in Process Finished Goods Cost of Goods Sold I xx----~ Inventory Inventory

Wages 1: a_ble ____ ~ Txx T Manufacturing Overhead / - xx I

l xx----

PANEL B-PROCESS COSTING Jelly Belly

Manufacturing Costs:

1 I Direct materials 2) Direct labor

Process Costing 247

3) Manufacturing overhead

Finished goods

inventory II ' ' Raw Materials Inventory

I~-~ rk in Process Work in Process Work in Process Finished Cost of ventory- Inventory- Inventory- Goods Goods

Wages Paya Centers Shells Packaging Inventory Sold

l~~ T~T ~ -T -~

248 CHAPTER 5

Panel A shows that Life Fitness's job costing system has a single Work in Process In- ventory control account supported by individual job cost records for each job that is being worked on. Life Fitness assigns direct materials, direct labor, and manufacturing overhead to individual jobs, as explained in Chapter 3. When a job is finished, its costs flow directly into Finished Goods Inventory. When the job is sold, the cost flows out of Finished Goods Inventory and into Cost of Goods Sold.

In contrast to Life Fitness's individual jobs, Jelly Belly uses a series of three manufac- turing processes to produce jelly beans. The movement of jelly beans through these three processes is shown in Exhibit 5-2.

Take a moment to follow along as we describe Exhibit 5-2. In the first process (Centers process), Jelly Belly converts sugar and flavorings (the direct materials) into jelly bean centers using direct labor and manufacturing overhead, such as depreciation on the mixing vats. Once the jelly bean centers are made, they are transferred to the Shells process. In the Shells process, Jelly Belly uses different labor and equipment to coat the jelly bean centers with sugar, syrup, and glaze (the direct materials) to form the crunchy shells. Once that process is complete, the finished jelly beans are transferred to the Packaging process. In the Packaging process, Jelly Belly packages the finished jelly beans into various boxes and bags (direct materials), using other labor and equipment. The boxed and bagged jelly beans are then transferred to finished goods inventory until they are sold.

Now, let's see how Panel B of Exhibit 5-1 summarizes the flow of costs through this process costing system. Study the exhibit carefully, paying particular attention to the fol- lowing key points:

1. Each process (Centers, Shells, and Packaging) has its own separate Work in Process Inventory account.

2. Direct materials, direct labor, and manufacturing overhead are assigned to each processing department's Work in Process Inventory account based on the man- ufacturing costs incurred by that process. Exhibit 5-2 shows that each of Jelly Belly's processes has different direct materials, direct labor, and manufacturing overhead costs.

3. Exhibit 5-2 shows that when the Centers process is complete, the jelly bean centers are physically transferred out of the Centers process and transferred in to the Shells process. Likewise, the cost of the centers is also transferred out of Work in Process Inventory-Centers and transferred in to Work in Process Inventory-Shells. The transfer of costs between accounts is pictured in Panel B of Exhibit 5-1 as a series of green xs. Keep the following important rule of thumb in mind:

In process costing, the manufacturing costs assigned to the product must always follow the physical movement of the product. Therefore, when units are physically transferred out of one process and into the next, the costs assigned to those units must also be transferred out of the appropriate Work in Process Inventory account and into the next.

To simplify the accounting, the journal entry to record the transfer of costs be- tween accounts is generally made once a month to reflect all physical transfers that occurred during the month.

4. When the Shells process is complete, the finished jelly beans are transferred out of the Shells process and into the Packaging process. Likewise, the cost assigned to the jelly beans thus far (cost of making the centers and adding the shells) is trans- ferred out of Work in Process Inventory-Shells and transferred in to Work in Process Inventory-Packaging.

EXHIBIT 5-2 Flow of Costs in Production of Jelly Beans

(sugar, flavorings)

(workers operating mixing vats)

(depreciation on mixing vats)

(sugar, syrup, confectioner's glaze)

(workers operating polishing machines)

(depreciation on polishing machines)

(boxes, cellophane)

(workers operating packaging equipment)

(depreciation on packaging equipment)

Centers process

Jelly Bean Centers

Shells process

Finished Jelly Beans

Packaging process

Boxes of Jelly Bellies

Ready for Sale

+ Finished Goods

Inventory

Process Costing 249

J

250 CHAPTER 5

2 .-Compute equivalent _: units

5. When the Packaging process is complete, the finished packages of jelly beans are transferred to finished goods inventory. Likewise, the cost assigned to the jelly beans thus far (cost of making and packaging the jelly beans) is transferred out of Work in Process-Packaging and into Finished Goods Inventory. In process costing, costs are transferred into Finished Goods Inventory only from the Work in Process Inventory of the last manufacturing pro- cess. The transferred cost includes all costs assigned to the units from every process the units have completed (Centers, Shells, and Packaging). Finally, when the jelly beans are sold, their cost is transferred out of Finished Goods Inventory and into Cost of Goods Sold.

Keep the following rule of thumb in mind:

Process costing is like rolling a snowball into a snowman. The product (snowball) keeps picking up cost (snow) as it rolls through each production process. Thus, the cost assigned to the product (snowball) keeps getting larger and larger as costs from each department are progressively added to it through the transfer of costs.

Dept1 Dept2 Dept3 Dept4

What Are the Building Blocks of Process Costing? Before we illustrate process costing, we must first learn about the three building blocks of process costing: conversion costs, equivalent units, and inventory flow assumptions.

Conversion Costs Chapter 2 introduced three kinds of manufacturing costs: direct materials, direct labor, and manufacturing overhead. Most companies, like Jelly Belly, that mass-produce a prod- uct use automated production processes. Therefore, direct labor is only a small part of total manufacturing costs. Companies that use automated production processes often con- dense the three manufacturing costs into two categories:

1. Direct materials

2. Conversion costs ( = Direct Labor + MOH)

Recall from Chapter 2 that conversion costs are the combination of direct labor plus manufacturing overhead costs. Combining these costs in a single category simplifies the process costing procedures. We call this category conversion costs because it takes direct labor and manufacturing overhead to convert direct materials into new finished prod- ucts-hence the name, conversion costs.

Equivalent Units Companies with work in process inventories use the concept of equivalent units to express the amount of work done during a period in terms of fully completed units of output.

To illustrate equivalent units, let's look at Callaway Golf, a manufacturer of golf balls and golf clubs. Let's assume that Callaway's golf ball production plant has 5,000 partially completed balls in ending work process inventory. Each ball is 80% of the way through the production process. If conversion costs are incurred evenly throughout the process, then get- ting each of 5,000 balls 80% of the way through the process takes about the same amount of work as getting 4,000 balls (5,000 X 80%) all the way through the process.

Equivalent units are calculated as follows:

Number of physical units X Percentage of completion = Number of equivalent units

So, the number of equivalent units of conversion costs in Callaway's ending work process inventory is calculated as follows:

5,000 X 80% = 4,000

Conversion costs are usually incurred evenly throughout production. However, direct materials are often added at a particular point in the process. For example, Exhibit 5-3 shows that Callaway adds rubber at the beginning of the production process but doesn't add packaging materials until the end. How many equivalent units of rubber and packag- ing materials are in the ending inventory of 5,000 balls?

EXHIBIT 5-3 Ca llaway Production Plant Time Line

13·1,M§hl·i,13·Hf11,131 1;;g.;§l;§,l@jMttffiMt@il·l1l·l;·I3ii 80% 100%

Start complete completion r Rubber added Packaging Transferred OUT added to finished goods

5,000 golf balls started but notfinished

All 5,000 balls are 80% complete, so they all have passed the point at which rubber is added. Each ball has its full share of rubber (100% ), so the balls have 5,000 equivalent units of rubber. In contrast, the time line in Exhibit 5-3 shows that none of the 5,000 balls has made it to the end of the process, where the packaging materials are added. The end- ing inventory, therefore, has zero equivalent units of packaging materials.

To summarize, the 5,000 balls in ending work in process inventory have the following:

• 5,000 equivalent units of rubber (5,000 units X 100% of rubber)

• 0 equivalent units of packaging materials (5,000 units X 0% of packaging materials)

• 4,000 equivalent units of conversion costs (5,000 units X 80% converted)

Dairymaid makes organic yogurt. The only ingredients, milk and bacteria cultures, are added at the very beginning of the fermentation process. At month end, Dairymaid has 100,000 cups of yogurt that are only 25% of the way through the fermentation process . Use the equivalent unit formula to answer the following:

a. How many equivalent units of direct materials are in ending work in process?

b. How many equivalent units of conversion costs are in ending work in process?

Please see page 306 for solutions .

Inventory Flow Assumptions Firms compute process costing using either the weighted-average or first-in, first-out (FIFO) method. Throughout the rest of the chapter, we will use the weighted-average method of process costing. The two costing methods differ only in how they treat begin- ning inventory. The FIFO method requires that any units in beginning inventory be costed separately from any units started in the current period. The weighted-average method combines any beginning inventory costs with the current period's costs to get a weighted- average cost. Many firms prefer to use the weighted-average method because it is simpler and the differences between the two methods' results are usually immaterial.

Process Costing 251

252 CHAPTER 5

3 .Use process costing -: -.-in the first production

· department

How Does Process Costing Work in the First Processing Department? To illustrate process costing, we'll be following Sea View, a manufacturer that mass-produces swim masks. We'll see how Sea View uses the weighted-average method of process costing to measure (1) the average cost of producing each swim mask and (2) the cost of the two major processes it uses to make the masks (Shaping and Insertion).

Exhibit 5-4 illustrates Sea View's production process. The Shaping Department begins with plastic and metal fasteners (direct materials) and uses labor and equipment (conver- sion costs) to transform the materials into shaped masks. The direct materials are added at the beginning of the process, but conversion costs are incurred evenly throughout the process. After shaping, the masks move to the Insertion Department, where the shaped masks are polished and then the clear faceplates are inserted.

EXHIBIT 5-4 SeaView's Production Process

(plastic, metal fasteners)

(workers operating molding machines)

(maintenance and depreciation on

molding machines)

(plastic faceplates)

(workers operating faceplate insertion

machines)

Manufacturing overhead

(maintenance and --w depreciation on faceplate

insertion machines)

Shaping process

Shaped masks

Insertion process

Completed masks

Let's assume that the Shaping Department begins October with no work process in- ventory. During October, the Shaping Department incurs the following costs while work- ing on 50,000 masks:

Beginning work in process inventory .............................................. . $ 0

Direct materials .............................................................................. . 140,000

Conversion costs:

Direct labor............................................................................. $21,250

Manufacturing overhead.......................................................... 46,750

Total conversion costs ............................................................. 68,000

Total costs to account for................................................................ $208,000

Process Costing 253

How did SeaView arrive at these costs? SeaView traces di- rect materials and direct labor to each processing department using materials requisitions and labor time records (just as we used these documents to trace direct materials and direct labor to individual jobs in Chapter 3 ). Sea View allocates manufacturing overhead to each processing department using either a plantwide rate, departmental overhead rates, or ABC (just as we allocated manufacturing overhead to individual jobs in Chapters 3 and 4 ).

II Why is this important?

If, at the end of October, all 50,000 masks have been com- pletely shaped and transferred out of the Shaping Department and into the Insertion Department, the entire $208,000 of man- ufacturing cost associated with these masks should likewise be transferred out of Work in Process-Shaping and into Work in Process-Insertion. In this case, the unit cost for just the shaping process is $4.16 per mask ($208,000/50,000 masks).

But what if only 40,000 masks are completely through the shaping process? Let's say that at October 31, the Shaping De- partment still has 10,000 masks that are only one-quarter of the

"Most food and consumer products

are mass-produced . Managers need to know (1) the cost of each manufacturing process, to make each one as cost-efficient as possible; and (2) the cost of each unit, to aid in pricing and other business decisions."

way through the shaping process. How do we split the $208,000 between the following?

• 40,000 completely shaped masks transferred to the Insertion Department

• 10,000 partially shaped masks remaining in the Shaping Department's ending work in process inventory

In other words, how do we determine the cost of making the completely shaped masks versus the cost of making the partially shaped masks? We can't simply assign $4.16 to each mask because a partially shaped mask does not cost the same to make as a com- pletely shaped mask. To figure out the cost of making a completely shaped mask versus a partially shaped mask, we must use the following five-step process costing procedure:

STEP 1: Summarize the flow of physical units.

STEP 2: Compute output in terms of equivalent units.

STEP 3: Summarize total costs to account for.

STEP 4: Compute the cost per equivalent unit.

STEP 5: Assign total costs to units completed and to units in ending Work in Process inventory.