cost accounting

Nouradahamm

BUS224.rar

Home >Business & Finance homework help >Accounting homework help >cost accounting

BUS 224/Assignment I/BUS 224 - Assignment I.docx

JUC Logo

JUBAIL UNIVERSITY COLLEGE

DEPARTMENT OF BUSINESS ADMINISTRATION

Assignment I

BUS 224 Cost Accounting

Semester 382

Team Name

Student ID	Student Name

Teacher: Dr. Abirami Devi

Instructions:

· This is a group assignment with only 4 members. As discussed and explained in the class, this assignment is a Case study.

· The students should read and analyze the Case study and submit their report.

· The report should contain the following:

The Assignment should cover the following points:

1. Brief Overview (Describe the Company and issues discussed)

2. Situation Analysis (SWOT)

3. Key Issues (Symptoms/Problems)

4. Alternatives (A set of strategic alternatives that have a potential to solve the problem)

5. Evaluation of Alternatives (How well does the alternative address the issue stated? / List the pros and cons of each alternative)

6. Recommendation

7. Implementation Plan (Steps to follow constrained by budget and timeline/Short term and long term plan/Always look for appendices)

8. Risk and Mitigation (List all the challenges that would prevent the company from successfully implementing the proposed solution/List risk mitigation strategies for every challenge)

Rubric for Report: 20 marks

BUS 224/Assignment I/Cases/03_case_study_activity_based_budgeting_at_agricultural_hold_ings_in_lithuania.pdf

Vol.4, No. 2, 2008 ISSN 1822-3346 Economics and Rural Development

CASE STUDY: ACTIVITY BASED BUDGETING AT AGRICULTURAL HOLDINGS IN LITHUANIA Ramun÷ Pockevičiūt÷ Alytus City Municipality Administration

Successful business operations are hardly possible without planning. Therefore presently there are extensive discussions about

the importance of planning business activities and estimating the resources required to achieve the objectives set by an enterprise. For this purpose, scientists and practitioners suggest that enterprises should implement a budgeting system. This paper introduces a budg- eting model for agricultural holdings using the Activity Based Costing (ABC) approach. The topic of the paper was chosen in view of the fact that such a combination of accounting management elements is not broadly used by Lithuanian agricultural holding. The key objective of this paper is to present the budgeting system as an important tool in planning and managing the business of an agricul- tural enterprise. This paper looks into the theoretical principles and provides a practical model of the budgeting system. The per- formed research leads to a conclusion that more accurate production cost calculations, budgeting, and budget control are the safe- guards, which help to prevent business failures in the changing and adverse business environment.

Key words: budget, budgeting system, cost, costs, activity, Activity Based Costing (ABC). JEL Classification: M41.

Introduction2

This paper examines the practical aspects of develop- ing and controlling budgeting models, which use the Ac- tivity Based Costing (ABC) approach. The topic of the paper was chosen in view of the fact that such a combina- tion of accounting management elements is not broadly used by Lithuanian agricultural holding. The analysis of relevant empirical and theoretical research works con- ducted by Lithuanian and foreign scientists revealed that detailed research and analysis deal with the ABC benefits separately from the practicality of the budgeting system. Consequently, the Activity Based Budgeting could be an alternative system for improving business management at agricultural holdings.

Budgets measure the set objectives and prompt a rational behaviour of a business as well as determine a systematic approach towards the economic activities of the organisa- tion. Many countries, including Japan, the United States, and Western European countries acknowledge this conception. In the current tough economic environment with increasing inflation rates, shrinking sales volumes, and rocketing busi- ness expenses as well as due to many other factors influenc- ing agricultural activities, the Activity Based Budgeting sys- tem could be a safeguard in coordinating and stabilizing all the fields of the enterprise operations.

Research aim: to present the Activity Based Budget- ing system as an important tool for planning and coordi- nating the business of an agricultural holding.

Research tasks: 1. to implement the budgeting system model in an

agricultural holding (i.e. a dairy company) as a viable business alternative;

2. based on the obtained results, to make suggestions for further business development.

Research object: the process of business planning and control at an agricultural holding.

Research methods: The first part of the paper analy- ses theoretical aspects of the budgeting system efficiency. The second part of the paper deals with empirical re- search aimed at revealing the aspects of the Activity Based Budgeting system related to milk production cost calculations using the ABC method and compiling a budget of the dairy company. The research focused on the dairy business owing to the fact that dairy farms, on a par with other agricultural holdings, are going through diffi- cult times: the purchasing price of milk in Lithuania is among the lowest in Europe.

Theoretical validation of the budgeting system Studies reveal by that the concepts and methods used in

management accounting are similar all over the world. However national studies suggest that a changing environ- ment of an organisation has a direct impact on the modifica- tions in the management accounting. A management ac- counting system is closely related to the projected changes of the internal management system of an organization. The faster modifications in the management system take place, the faster management accounting changes. The conducted studies show that new management accounting methods are rather successfully adopted by fast developing countries, in- cluding Lithuania (Valančien÷, Gimžauskien÷, 2007).

Experts in agricultural economics (White (2007), Greaser and Harper (1994), Doye, Sahs (2005)) maintain that budgets of organisations are designed to provide ag- ricultural production with a decision framework for short

Vol.4, No. 2, 2008 ISSN 1822-3346 Economics and Rural Development

term and long term economic analyses. The budgeting system of an organisation facilitates a better understand- ing of costs and returns from a production operation. It helps to identify potential risk sources and to appraise the alternatives. Budgeting knowledge and the ability to use it helps producers to make sound business decisions.

The main uses of an agricultural holding budget in- clude:

1. clear identification of all inputs required for pro- duction;

2. easy identification of 5 major expenses for the purpose of cost control management;

3. identification of potential changes in the operations; 4. determining the revenue likely to be generated by

the organisation; 5. breakeven price and breakeven yield analysis. Literature separately deals with the advantages of im-

plementing the ABC and a budgeting system. Nonethe- less the synthesis of the ABC and the budgeting system is considered to be an advanced alternative for planning op- erating costs of an enterprise (Greaser and Harper, 1994). The ABC approach was developed and introduced by R. Cooper and R. Kaplan. Quite shortly this system gained popularity and a large number of scientists and practitio- ners contributed to its further advancement (Roztocki et al.). In literature, this approach is referred to as one of the best modern accounting methods. Other researchers con- sider this method to be self-contradictory and conse- quently they maintain that it can not be successfully used by organisations as it provides the internal consumers with even less accurate information than classical ac- counting methods (Armstrong, 1999). However, the analysis of the ABC method shows that it can produce more accurate calculations of the production cost and lead to more precise budgets.

No modern enterprises can successfully achieve their objectives unless they plan their activities. The planning process starts with pinpointing the course of future opera- tions, choosing the methods of working towards the set objectives, and forecasting the potential results. Budget planning is an important precondition for efficient coor- dination of the operations of an organisation. Budget con- trol mechanisms trigger a further progress of the opera- tions, which is crucial in meeting the financial objectives. Such control makes it possible to identify problems and to solve them at an early stage (Jagminas, 2004). Thus, a budget is a plan, which defines the indices of the business activities of an organisation measured in cash and quanti- tative numbers in order to achieve the objectives of the organisation (Mackevičius, 2003).

Generally speaking, planning is required to determine methods for meeting the objectives. An organisation op- erating under the market conditions should plan:

• the quantities and types of products be produced and the product mixes which are best capable of satisfy- ing the existing market conditions;

• the amount of the organisation resources to be used and the required amounts to be borrowed;

• the methods of production and technologies to be used and organizations the enterprise will have to co- operate with;

• the prospective buyers of the products and the methods of distribution to the customers and consumers;

• the ability of the organization to change and adapt itself to market changes (Bagdžiūnien÷, 2005).

Budget planning is about forecasting the financial needs. The success of the operations of an organisation depends on the availability of relevant resources, and fi- nancial resources in particular. Financial needs differ and so does their availability. Thus, in order to analyse the availability of resources required for the operations of an enterprise, large organizations are broken down into smaller and easier to manage units, which are called re- sponsibility centres. A responsibility centre can be de- scribed as a function or a unit of an organisation, where relevant decisions can be made and resources can be con- trolled. It can assume the responsibility for the decisions taken and the results achieved (Valančien÷, 2003). There- fore, the responsibility centres mean decentralization of the operations of an organisation. Each responsibility centre is in charge of a separate function of the enterprise. As a result of such break down of the activities of the or- ganisation, managers can have greater control over the revenue and expenditure flows pertinent to a relevant ac- tivity. Budgets are planned based on the analysis of the information provided by responsibility centres. The budgets show whether the resources of the organisation are sufficient for a particular purpose.

Practical application of the budgeting system Description of dairy operations The largest part of revenue earned by Enterprise “X”

comes from dairy production. Therefore, when we con- sider creating value at a milk processing enterprise, it is important to focus on the value chain as an enterprise can be characterised by its ability to organize and manage its workflows and the value chain of dairy production. When a business budget is drafted, it is assumed that the costs are caused by certain activities; therefore, the main objec- tive is to control the causes of costs, rather than the costs themselves. Owing to the fact that not all activities gener- ate value, it is important to define how much value is cre- ated by each of them (see Figure 1).

Vol.4, No. 2, 2008 ISSN 1822-3346 Economics and Rural Development

Fig. 1. Value chain at Enterprise “X”

The analysis of Enterprise “X” dairy operations reveals value-adding activities and non-value adding activities. In order to improve the value chain, special emphasis should be placed on scientific research, because the business objectives of Enterprise “X” include supplying organic produce to milk buyers. Even though supplying milk to milk buyers does not represent an important production design activity, the proc- esses of upgrading livestock feeding, watering, and milking systems indirectly create value (see Figure 1.). We can see that a continuous improvement of the existing operating sys- tem based on the experience of other European Union coun- tries is among the strengths of Enterprise “X”.

Production cost calculation and interpretation Table 1 provides the calculation of the production

cost of 1 kilogram of milk based on the information re- flected in the documentation of the agricultural holding.

Table 1. Method of milk production cost calculation at

Enterprise “X”

Total annual expenses attrib- uted to milk production, LTL

Milk quan- tity kg

Milk produc- tion cost LTL/kg

1.245.149 1.767.000 0.705 The above method of accounting for milk production

expenses fails to reveal the amounts of overheads and di- rect expenses attributable to 1 kilogram of milk. Thus it can be assumed that calculations of the production cost of milk products may contain variations. Due to missing in- formation, the implementation of the budgeting system at Enterprise “X” would fail to be efficient, i.e. it would in-

flate the expenses incurred by the Enterprise rather than produce benefit.

The process of measuring costs attributable to 1 kilo- gram of milk based on the traditional costs accounting system can be described as follows:

1. identification of the cost object, i.e. the product, the costs whereof are going to be measured;

2. identification of direct costs attributable to milk yield;

3. selection of the indirect cost allocation base; 4. calculation of the actual indirect cost rate per cost

driver unit; 5. product costs are calculated with respect of the di-

rect and indirect products cost.

Table 2. Enterprise “X” expenses

Type of activities Expenses LTL Forage 448.479 Pharmaceuticals 29.573 Veterinary services 3.432 Repair of agricultural buildings 7.769 Spare parts 27.313 Other materials 36.267 Administrative costs 482.694 Utilities 153.749 Other 2.440 Depreciation 67.833 Total costs: 1.259.549

Firstly, costs related to milk production, i.e. keeping

and feeding milkers, are provided in a centralised manner (see Table 2). The annual milk yield, which amounts to 1.767.000 kilograms, was chosen as the cost allocation base (see Table 3).

Research studies in cattle breeding; Bovine health screening proce- dures; Forage nutrient composition analy- sis and control (use of chemical products and other materials inconsistent with the EU forage stan- dards).

Preparation of the feeding system; Preparation of the water- ing system; Installation of milking equipment; Installation of auxiliary facilities; Installation of the exterior of bovine facilities; Installation of an auto- mated milk pipe line washing system.

Installation of milk cooling equipment;

Milk yield;

Forage prepara-

tion;

Installation of milking equip-

ment;

Installation of an automated milk pipe line

washing system.

Construction of access roads.

Receipt of LT- 01-01F health mark certificate for dairy prod- ucts; Milk deliveries to milk process- ing enterprises.

Research Production design

Production activities

Distribution activities

Costumer service

not added added added added Value: not added

Vol.4, No. 2, 2008 ISSN 1822-3346 Economics and Rural Development

Table 3. Allocation base calculations

No Allocation base calculations Milk kg 1. Milk yield kg/cow 6.449 2. Number of cows 274 3. Annual milk yield kg 6,449×274= 1.767.000

The information on the costs incurred in agricultural

production revealed in the reporting of Enterprise “X” is useful as it offers exhaustive details on the annual costs of the livestock unit as well as total partial costs incurred by the cost centres. However, as it was mentioned above, it does not reveal the amounts of overheads and total ex- penses attributable to the dairy sector. Thus, the devel- opment of business at Enterprise “X” could be best re- flected by the Activity Based Accounting (ABC) system.

The process of measuring costs attributable to the product using the ABC system:

1. Identification of the main operations. 2. Identification of cost drivers for each operation. 3. Identification of cost centres for each operation. 4. Calculation of the production costs. The overheads accounted for by Enterprise “X” are

given in Table 4. Once the total annual overheads are calculated, the

costs can be allocated using the annual milk yield as a cost drive (see Table 5).

Table 4. Calculation of overheads incurred over a period of 1 year

No COSTS Amount LTL 1. Oil products and gas 98.804 2. Electricity 54.945 3. Veterinary services 3.432 4. Depreciation of long-term assets 67.833 5. Spare parts 27.313 6. Other materials 36.267 7. Repair of agricultural buildings 7.769

Total: 296.363

The influence of the calculated amount of overhead costs is reflected in the profit budget (see Table 5). The overhead costs represent 23.53% of the total costs incurred by the livestock unit. The low profitability of the milk production at the enterprise was caused by the awkward system of milk purchasing prices: 1 kilogram of milk is sold to the state at a price which is almost equal to its production cost. The unfa- vourable agricultural policy framework mainly affects dairy farms and other agricultural holdings.

Table 6 provides a profit budget produced using the traditional budget accounting system.

Table 5. Allocation of overhead costs

No Allocation of overhead costs Milk 1. Total overhead costs LTL 296.363 2. Annual milk yield kg 1.767.000 3. Overhead costs allocated to 1 kg of milk

(Line 1 / Line 2) 0.18 LTL/kg

Table 6. Profit budget using the traditional accounting system

Items Amount LTL Turnover from sales of products LTL 1.431.270 Total directs costs LTL 948.786 Overheads LTL 296.363 Cost of products sold LTL 1.245.149 Gross profit LTL 186.121 Administrative expenses LTL 11.684 Profit from operations LTL 174.437 Profit tax LTL 0 Net profit LTL 174.437

When the traditional method is used to calculate the production cost of 1 kg of milk, which was the case at Enterprise “X”, it is not possible to identify specific op- erations causing higher costs. Therefore, the ABC method enables to identify auxiliary activities involving indirect costs (see Table 7). The allocation base is a material cost driver, i.e. the annual milk yield, kg.

Table 7. Production and overhead costs

Item Costs LTL Cost driver Allocation base Standard Cost distribution %

Production costs Forage production 448.479 milk yield kg/year 1.767.000 0.254 54.33 Wages 376.925.28 milk yield kg/year 1.767.000 0.213 45.67 Overheads Total 0.467 100 Pharmaceuticals 29.573 milk yield kg/year 1.767.000 0.017 6.81 Veterinary services 3.432 milk yield kg/year 1.767.000 0.002 0.79 Repair of agricultural buildings 7.769 milk yield kg/year 1.767.000 0.004 1.79 Administrative costs 105.768.72 milk yield kg/year 1.767.000 0.060 24.36 Oil products and gas 98.804 milk yield kg/year 1.767.000 0.056 22.76 Electricity 54.945 milk yield kg/year 1.767.000 0.031 12.66 Spare parts 27.313 milk yield kg/year 1.767.000 0.015 6.29 Other materials 36.267 milk yield kg/year 1.767.000 0.021 8.35 Depreciation 67.833 milk yield kg/year 1.767.000 0.038 15.62 Other 2.440 milk yield kg/year 1.767.000 0.001 0.56

Total costs: 1.259.549 Total: 0.246 100 Production cost of 1 kg milk 0.713 LTL/kg

Vol.4, No. 2, 2008 ISSN 1822-3346 Economics and Rural Development

The data in Table 7 show that the highest costs in- clude administrative costs (24.4 %), oil products and gas (22.8 %), depreciation (15.6 %), and electricity (12.7 %). The obtained findings should warn the management of the organisation that disregard of individual activities and a failure to analyse the causes of costs may result in a fur- ther increase of the cost price of the products.

The overview of the cost allocation system at Enter- prise “X” shows that in pursuance of higher profits pre- dominant emphasis should be placed on individual opera- tions and the costs incurred thereby. Furthermore, it is vi- tal to choose a relevant production cost calculation method. Since Enterprise “X” is a multi-activity organisa- tion, it generates profit in any case. However the dairy operations require improvements in management and business organization. Moreover, sources of financing should be sought to expand the business and to improve the quality of marketed milk.

Drafting master budgets for the dairy sector

In order to assess the efficiency of a budgetary sys- tem, it is necessary to produce a fragment of the annual budget of the dairy sector, i.e. a one-month budget. The main operations of Enterprise "X" are those, which have the largest impact on milk production. The costs caused by such activities are direct costs. The master budget in- cludes: 1) direct materials budget, 2) direct labour budget, and 3) other direct and manufacturing overhead budget.

Enterprise “X” budget fragment is compiled for Feb- ruary 2009. In February it is expected to produce 148.340 kilograms of milk and to sell it for LTL 0.81 per kilogram (see Table 8). The estimated sales volumes and price are based on the information for the previous months.

Table 8. Sales budget

Product Estimated sales kg

Price per unit LTL

Estimated sales LTL

Milk 148.340 0.81 120.155.40

Typically, the production budget is based on the stock of unsold products at the beginning of the relevant period, the production capacities of the organisation, and the es- timated stock of finished products at the end of the pe- riod. While planning the production volumes, it is neces- sary to take into account the potential seasonal demand

fluctuations and the availability of human and material resources (Table 9). In the analysed case, there is no stock of milk: the products produced by cows are imme- diately delivered for sales.

Table 9. Production budget

No Index Dairy products 1. Estimated sales volumes kg 148.340 2. Estimated stock of finished products at

the end of the year kg 0

3. Demand for production (Line 1 + Line 2) 148.340 4. Factual stock of finished products at

the beginning of the budget year kg 0

5. Budgeted finished product volumes kg (Line 3 – Line 4)

148.340

The master budget of Enterprise “X” includes forage, forage additives, water, etc. The forage is produced onsite depending on the number of cattle and horses and the available land resources. The calculations of a one-month relevant raw material rate per one cow are based on the analysis of the data on the annual bovine forage and wa- ter demand (the enterprise has 274 cows), (see Table 10).

Table 10. Direct materials budget

Raw materi- als LTL

Monthly raw material rate LTL/cow

Estimated raw mate- rial demand LTL

Forage 145.14 39.768.00 Water 6.57 1.800.50

Total 41.568.50

The direct labour budget is drawn up based on the number of people employed in the dairy unit, the pay rate per one working day, and the number of working hours per month. The daily wages amount to LTL 23 per em- ployee. The working day is 8 hours. The estimated labour budget accounts for LTL 9.177. The direct labour budget is presented in Table 11.

The overhead budget is provided in Table 12. In the budgeted month, the overhead costs of Enterprise “X” ac- count for LTL 39.796.60.

The overhead budget is prepared for the whole stock- breeding unit. The overheads are allocated to the dairy unit in conformity with the estimated expense rate per 1 kg of milk. Given the total amount of overhead expenses and the monthly yield, 1 kg of milk is allocated LTL 0.268. The calculations are presented in Table 13.

Table 11. Direct labour budget

Activity Number of employees

Fixed number of monthly working hours per one per-

son

Total work- ing hours

Total workdays

Directs labour costs (total workdays × daily wages amount to LTL23 per em-

ployee) Dairy op- erations

21 152 3.192 399 9.177

Vol.4, No. 2, 2008 ISSN 1822-3346 Economics and Rural Development

Table 12. Overhead budget

No Costs items Amount LTL 1. Pharmaceuticals 2.710.86 2. Veterinary services 314.60 3. Repair of agricultural buildings 712.16 4. Administrative costs 9.695.47 5. Oil products and gas 9.057.03 6. Electricity 5.036.63 7. Spare parts 2.503.69 8. Other materials 3.324.48 9. Depreciation 6.218.03 10. Other 223.67

Total 39.796.60

Table 13. Overhead allocation to 1 kg of milk

No ITEMS Amount LTL

1. Total overhead expenses LTL 39.796.60 2. Monthly milk yield kg 148.340 3. Overhead expenses per 1 kg of milk (Line 1

/ Line 2) 0.268

Once all the above budgets are compiled, the produc-

tion cost budget per 1 kg of milk can be produced. This budget shall specify the direct materials, direct labour, and overhead expenses, as well as the costs of finished goods, which reflect the sum of the above (see Table 14).

Table 14. Estimated production cost budget of 1 kg of milk

No Indices Expense rate LTL/1 kg

1. Forage 0.268 2. Water 0.012 3. Direct labour costs 0.062 4 Overhead expenses 0.268 Total production cost per one unit 0.61

Functional budgets serve a basis for planning the mas- ter budget of the dairy operations at Enterprise “X”. The master budget reflects the financial position of a relevant operation. It summarizes and finalizes the budgetary cy- cle. The master budget forecasts the financial position of the business activity in the future. The cash flow budget

requires performance figures for a period of one month or less. Cash flow means receipts and payments attributable to individual operations. It is presented in Table 15.

Table 15. Receipt and expense budget

No Receipt

budget Amount LTL

No Expense budget

Amount LTL

1. Receipts 120.155.40 1. Forage and water

41.568.50

2. Trade creditors

8.113.25 2. Wages 9.177.00

3. Total re- ceipts

128.268.65 3. Overhead expenses

39.796.60

4. Total ex- penses

90.541.6

The efficiency of operations is best disclosed by the cash budget, which reflects all financial and cash transactions. The cash budget is based on the receipt and expense budgets (the figures are taken from Table 15) (see Table 16).

Table 16. Cash budget

No Items Amount LTL 1. Income 128.268.65 2. Expenses 90.541.6 3. Cash at the beginning of the month 10.450.20 4. Cash at the end of the month 48.177.25

Cash budgeting helps to measure the contribution of

the dairy operations in the overall performance of the or- ganisation over a period of one month. The forecasted cash comes up to LTL 48.177.25. The information pro- vided by this budget may help to take notice of the prob- lems, which require adjustments to be made not only to the financial (cash) budget but also to the functional budgets (e.g., review of the operating expenses, etc.).

The described operating expense budgets comprise the budget system of Enterprise “X” dairy operations. The said budgets are made compatible with each other and consequently their interaction reflects the coordina- tion of all dairy production responsibility centres and their joint activities (see Figure 2).

Fig. 2. Budgeting system of Enterprise “X” dairy operations

Innovation and research budget

Raw material consumption budget

Direct labour budget

Cash flow budget

Budget of fi- nancing re- quirements

Production programme

Overhead budget

Vol.4, No. 2, 2008 ISSN 1822-3346 Economics and Rural Development

Such budgeting system enables to plan the activities and to meet the objectives and consequently to increase the sales of milk yield and earn bigger profits. In the con- text of the dairying budgeting system, the cash-flow budget plays an important role. It helps to make estima- tions of the upcoming cash-flow surplus that can be used for short-term investments or enables to make early rele- vant arrangements for the likely shortage of money and thus to cut down the level of potential risks over the bud- geted period.

Control of the key budgets of the dairy production

After one month of operations, the chief executive of

the organisation and a budget expert can compare the ac- tual performance figures of the dairy operations with the planned (budgeted) figures based on the actual informa- tion on the revenue earned and expenses incurred over that period.

Firstly, in February 2009 a static budget is drawn up, which reflects the expected milk purchasing price and the direct and overhead expenses (see Table 17).

Table 17. Static budget

Data Milk Selling price LTL/kg 0.81 Directs costs (materials and wages) LTL 0.28 Sales volumes kg/month 147.320 Allocated overhead costs LTL 39.796.60

In March 2009, the below performance figures were

reported (see Table 18). The actual overhead costs were lower than the budgeted figure entered in February. The more favourable situation resulted from the milk purchas- ing price policy: the milk was sold at a higher price than it was expected (see Table 18).

Table 18. Actual budget

Data Milk Selling price LTL/kg 0.85 Directs costs (materials and wages) LTL 0.302 Sales volumes kg/month 148.230 Allocated overhead costs LTL 40.250.44

The actual Profit and Loss Account compiled in Feb- ruary 2009 reveals that the profit increased due to lower variable and overhead costs (see Table 20).

Table 19. Actual production cost budget per 1 kg milk

No Indices Expense rate LTL/kg

1. Directs costs (material and wages) LTL 0.302 2. Overhead costs 0.27 Total production unit cost 0.572

The actual production cost of 1 kg of milk is calcu- lated in Table 19. The actual production cost shrank by LTL 0.038 compared to the budgeted figure of LTL 0.61 per kilogram.

Table 20. Actual Profit and Loss Account LTL

Items Amount LTL

Sales volume kg 148.230 Turnover from sales 125.995.5 Variable costs 44.765.46 Marginal income 81.230.04 Fixed costs 40.250.44 Profit 40.979.60

Once the static operating budget is compiled, a flexible

use of the budget is essential for the control purposes. The performance results can be controlled by comparing the ac- tual expenses to the budget expenses. The flexible budgeting method is not complicated, but the obtained results are accu- rate only when the changes in costs comply with the pro- jected trends. This budget is presented in Table 21.

Table 21. Static and flexible budget planning

Static budget Flexible budget Sales volume kg 148.340 148.230 Turnover from sales 120.155.40 120.066.3 Variable costs 50.732.28 50.694.66 Marginal income 69.423.12 69.371.64 Fixed costs 39.796.60 39.796.60 Profit 29.626.52 29.575.04

In the analysed case, level 1 and 2 activities are con- trolled. Level 1 variance analysis reveals only superficial in- consistencies in the profit results, thus the actual reasons for their occurrence are not disclosed (see Table 22).

Table 22. Level 1 analysis. General (static budget) variance

DeflectionVariance LTL Amount LTL Revenue 5.840.1 Production cost: 5.512.98

Variable costs -5.966.82 Fixed costs 453.84

Profit 327.12

Once a flexible budget is prepared (revised in accor- dance with the actual sales volumes), the Level 2 control allows to evaluate the impact of the changes in price and sales volume on the performance results. The price vari- ance is reflected by the difference between the profits of the actual price and flexible budgets, while the sales vol- ume variances are revealed by the difference between the profits in the flexible and static budgets (see Table 23).

A general (static) budget variance indicates that the actual profit differs from the budgeted one by LTL 327.12 (see Table 22). The Level 2 control reveals the reasons behind this difference. The actual milk sales vol-

Vol.4, No. 2, 2008 ISSN 1822-3346 Economics and Rural Development

umes (148.230 kg) are slightly lower than budgeted (148.340 kg), thus, in view of the actual results, the budgeted profit decreased by LTL 51.12. When a forecast of the purchasing price was made, the earnings were ex- pected to be lower. However the variance between the ac- tual and forecasted price amounted to LTL 0.04, i.e. the

actual price was higher than the forecasted price. Due to this reason the budgeted profit increased by LTL 11.404.56. The management of Enterprise “X” should fo- cus on the forecasted milk purchasing prices, since the price variance has the largest impact on the changes in profit.

Table 23. Level 2 analysis. Sales volume and price variances LTL

Actual budget Static budget Flexible budget Sales volume variance Price variance Profit 40.979.60 29.626.52 29.575.04 -51.12 11.404.56

The current position of Enterprise “X” can lead to a

conclusion that the future of the dairy enterprise will de- pend on the breeding system and a careful selection work rather than prices. Primary responsibility is placed on the research staff, as the studies and findings represent the basis for the future operations of the enterprise. The di- rector of the organisation and the budgeting expert, who organise the control of all units of the enterprise, includ- ing stockbreeding, will be able to identify the main con- straints in the development of Enterprise “X”.

Discussion In summary, considering the current general position of

the dairy enterprise it can be assumed that the future of this organisation and other agricultural holdings will depend on the improvement of the breeding system and a careful se- lection rather than prices. Primary responsibility is placed on the research staff, as the studies and findings represent the basis for the future operations of the enterprise. Subject to a designed budget system of the organisation and incor- poration of the Activity Based Costing into the existing ac- counting system and control of operations of the enterprise, the management of the organisation will have a possibility of identifying the major constraints in the development of the enterprise and the advantages for maintaining future operations. Furthermore, a question could be raised wheth- er the budgeting system of the organisation is based on the new Activity Based Costing (ABC) approach will be bene- ficial for the enterprise or will it just inflate the operational costs. Those questions should be answered by the man- agement of the enterprise, who decide whether they should linger at the current level of costs management or whether they prefer to choose a more up-to-date management ac- counting tool (i.e. cost budgeting system).

Conclusions 1. The empiric research brings to a conclusion that:

a) the calculations of the production cost of the milk yield (the cost driver) provide a detailed overview of the ex- penses and their relative percentage in the total produc- tion cost of the milk yield. Furthermore, based on the ob-

tained findings decisions can be made regarding the func- tions where changes could be made depending on the value created by the function to the end user; b) on the other hand, a more accurate production cost of milk raw material calculated using the ABC principles allows to make more exact budgets of the organisation that facili- tate a rational estimation and allocation of the enterprise resources in tackling the goals of the enterprise; c) the control of the compiled budgets provides variances be- tween the actual and budgeted results of the function. Economically, the obtained variances are treated as fa- vourable or negative with respect of the performance of the enterprise. Any variances that are significant in the performance of the enterprise require thorough analysis in order to identify the reasons of their occurrence and to take preventive measures in the future.

2. According to scientific and empiric researches, the application of the cost budgeting system at agricultural holdings could be an alternative measure under the changeable and variable economic and business circum- stances.

References

1. Anderson, Needles, Caldwell. (1989). Managerial accounting. Bos- ton: Houghton Mifflin Enterprise.

2. Bagdžiūnien÷ V. (2006). Biudžetai ir jų vykdymo kontrol÷. Vilnius: Conto litera.

3. Jagminas V. (2004). Įmon÷s biudžetų esm÷ ir jų parengimas // Ap- skaitos ir mokesčių apžvalga, 2004 09.

4. Jagminas V. (2005). Kaštų apskaita pagal veiklas// Apskaitos ir mokesčių apžvalga, - 2005 04.

5. Jurkštien÷ A. (2002). Valdymo apskaita. Kaunas: Technologija. 6. Doye D., Sahs R. (2005). Using Enterprise Budgets in Farm Financial

Planning. Oklahoma Cooperative Extension Service, pp.243-1 – 243-7. Available at: http://osufacts.okstate.edu (visited 02.02.2009).

7. Drury C. (1996). Management and Cost Accounting. 4rd edition. International Thomson business press. pp. 374-375.

8. Drury C. Management and Cost Accounting. 5rd edition. – London: Thomson learning, 2000. pp.321.

9. Друри К. (1994). Введение в управленческий производственый учет. Москва: Аудит.

10. Greaser G. L., Harper J. K. (1994) Enterprise Budget Analysis. Available at: http://alternatives.aers.edu/Publications/enterprise_ budget_analysis.pdf (visited 02.02.2009).

11. James A. F. Stoner, R. Edward Freeman, Daniel R. Gilbert, Jr. (1999). Vadyba. Kaunas: Poligrafija ir Informatika.

Vol.4, No. 2, 2008 ISSN 1822-3346 Economics and Rural Development

12. Horngren Ch. T. (2004) Management Accounting: Some Com- ments. Journal of Management Accounting Research, Volume Six- teen, pp.207-211.

13. Kalčinskas G. (2004). Įmon÷s biudžetai – vadybos atramos taškas//Vadovo pasaulis, 2004 01. pp. 39-42.

14. Kalčinskait÷ R. (2005). Kokią savikainą geriau skaičiuoti?// Apskaitos ir mokesčių apžvalga, 2005 10. pp.34-37.

15. Kalčinskait÷ R. (2006). Biudžetas: kaip jį parengti//Vadovo pasaulis, 2006 06.

16. Lucey T. (1990). A First Course in Cost and Management account- ing. London: DP PUBLICATIONS LTD.

17. Mackevičius J. (2003). Valdymo apskaita. Koncepcija, metodika, politika.Vilnius: TEV.

18. Radzevičien÷ R. (2001). Įmon÷s biudžeto sudarymas//Apskaitos, audito ir mokesčių aktualijos, 2001 09.

19. Roztocki N. (2005). Introduction to Activity Based Costing (ABC). Available at: http://www.pitt.edu/~roztocki/ abc/abctutor/index.htm (visited 2009-02-01).

20. Taraškevičien÷ M. (2009). Pieno ūkiai – perdirb÷jų nerangumo gni- aužtuose. Available at: http://www.zebra.lt/lt/aktualijos/ verslaslie- tuvoje/Pieno-ukiai-perdirbeju-nerangumo-gniauztuose-2009-02- 09.html (visited 2009-02-10).

21. Valančien÷ L. (2003). Atsakomyb÷s centrų valdymas. – Kaunas: Technologija.

22. Valančien÷ L. Gimžauskien÷ E. (2007). Changing Role of Man- agement Accounting: Lithuanian Experience Case Stud- ies//Engineering economics 2007, No 5 (55). pp.16-22.

23. White A. (2007) Financial Analysis of an Agricultural Business – the Enterprise Budget. Available at: http://www.ext.vt.edu/news/ periodicals/fmu/2007-04/financial_analysis.htmlvisited 19.02.2009).

24. Zabielavičien÷ I. (2005). Valdymo apskaita, analiz÷ ir sprendimai įmon÷je. Vilnius: Technika.

BUS 224/Assignment I/Cases/A Financial Comparison .pdf

________________________________________________________________________________________________________________ HBS Professor V.G. Narayanan and Joel L. Heilprin, Professor at Hult International Business School, prepared this case. This case was developed from published sources. Brief Cases are developed solely as a basis for class discussion and not as an endorsement, a source of primary data, or an illustration of effective or ineffective management. Although based on real events and despite occasional references to actual companies, this case is fictitious and any resemblance to actual persons or entities is coincidental. Copyright © 2017 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. This publication may not be digitized, photocopied, or otherwise reproduced, posted, or transmitted without the permission of Harvard Business School.

V . G . N A R A Y A N A N

J O E L L . H E I L P R I N

AT&T Versus Verizon: A Financial Comparison

In February 2015, Diane Tagert, a first-year associate with Danagger Capital Management, was covering the communications industry. In her first assignment, she was asked to prepare a report that compared the financial and operating performances of AT&T and Verizon. Although both firms had wireless and wireline businesses offering voice, data, and video solutions, they had experienced widely divergent results. See Exhibits 1A, 1B, 2A, and 2B for AT&T’s and Verizon’s respective income statements and balance sheets. Tagert felt she needed to understand the root cause of these differences to provide a report that could be incorporated into an actionable investment thesis.

Communication Industry Overview

Over the past two decades, the communications industry had evolved from a set of fragmented technologies, sectors, and firms that employed discrete platforms for delivering voice, data, and video into a converged industry that could deliver multiple forms of communication on a single platform. Numerous technologies could achieve these goals, but the most salient point of differentiation was whether the platform was wireless or wireline.

Wireless Sector

The wireless communications industry had been intensely competitive and was evolving quickly. Most wireless providers had migrated from 3G to 4G networks, which allowed them to maximize the density of their spectrum.a As they did so, they improved capacity and efficiency and decreased their costs. The resulting improvements had catalyzed the steady move toward 4G devices among consumers. Smartphones represented most new phone activations in the United States, while tablets, navigation, and monitoring devices had continued their rapid market penetration.1

The technological evolution had also ushered in changes in customer and competitor behavior. Most industry observers believed the continued convergence of voice, data, and video on wireless

aWireless spectrum refers to the radio frequency bands resulting from electromagnetic radiation. Due to interference, no two stations can occupy the same frequency within the same geographic area at the same time.

9 - 9 1 7 - 5 4 3 J U N E 2 3 , 2 0 1 7

D o

N ot

C op

y or

P os

This document is authorized for educator review use only by Abirami Devi Sivakumar, Jubail University College until November 2018. Copying or posting is an infringement of copyright. [email protected] or 617.783.7860

917-543 | AT&T Versus Verizon: A Financial Comparison

2 BRIEFCASES | HARVARD BUSINESS SCHOOL

platforms represented the next catalyst for industry growth. Providers had responded by bundling services to attract and retain customers. At the same time, the proliferation of internet-enabled products had shifted most customers away from buying subsidized phones that locked them into long-term service contracts.2 Most customers were buying handsets on an installment basis, which allowed them to upgrade their phones more frequently, incur lower monthly service charges, and eliminate service contracts. To discourage customers from dropping their service, providers required customers to pay the outstanding equipment balance in full if they switched phone companies. The shift from subsidized devices toward installment plans had also shifted providers’ revenue models. In the past, carriers had often used equipment as a loss leader and instead maximized service revenues and margins. As customers shifted toward installment plans, however, service revenues and margins had decreased, while equipment revenues and margins had increased.3

Ninety-four percent of the U.S. population lived in an area with at least four providers.4 Apple, Google, Microsoft, and Skype, as well as regional and bulk resellers, enabled customers to make wireless calls.5 Most competition focused on price, network coverage, reliability, customer service, and the availability of new products and services.6 Network utilization and spectrum efficiency were key competitive drivers.

Wireline Sector

Wireline networks provided voice, data, and video services to consumers, large and small enterprises, and other carriers on a wholesale basis.b Legacy circuit-switched networks had continued to decline as more customers cut the cord, opting for wireless service or Voice over Internet Protocol (VoIP) and data services using cable or fiber optics.c The growth of mobile platforms did not mean, however, that fixed networks would be extinct. Most of a packet’s journey was made over a wire; only the transmission between the device and a cell tower or WiFi router was wireless.d

Like in the wireless sector, trends in customer and carrier behavior were intertwined with advances in technology. These advances had improved network capacity, decreasing the marginal cost of moving a packet from point A to point B. In turn, improved efficiency and lower costs made new products and services available. This pattern was most evident in the movement toward IP-based data and video, where streaming entertainment services and use of cloud-based applications had become more popular. In addition, the movement toward IP-based networks changed the competitive dynamic. In most markets, network providers competed on the pricing of bundled services as well as on broadband capacity and reliability.7

Net Neutrality

On February 26, 2015, the Federal Communications Commission (FCC) reclassified internet broadband services as telecommunications services. The ruling favored net neutrality, meaning that network providers of fixed broadband could not employ differential pricing or service quality based on application, site, user, or content. Traffic over fixed networks must be handled on a first-come, first- served basis. The ruling mandated the following: (i) internet broadband providers could not block

Wireline, or landline, is physical wire or cable that connects two endpoints in a communications network. The term is synonymous with traditional telephony using twisted pairs of copper wire. c Legacy circuit-switched networks using twist pair refers to the traditional means of establishing a telecommunications channel using copper wires. This type of networking establishes a single physical connection between two endpoints that remains for the duration of a call. d

Packets are units of data that are encoded based on internet protocol (IP) and travel along a network. Data packets contain raw information as well as routing information and certain types of metadata. D

o N

ot C

op y

or P

os t

AT&T Versus Verizon: A Financial Comparison | 917-543

HARVARD BUSINESS SCHOOL | BRIEFCASES 3

access to lawful content, services, applications, (ii) internet broadband providers could not discriminate, or throttle, the transmission of network traffic, (iii) broadband providers could not offer paid prioritization of traffic, and (iv) fixed broadband providers had to be transparent about how they managed their networks.8

Overview of AT&T9

AT&T was a communications network provider. It offered consumers and businesses wireless, wireline, broadband data, and video services along with managed networking and wholesale services. AT&T was organized into two operating units: wireless and wireline. Its wireless business covered every major metropolitan area within the United States, and through roaming agreements, many foreign countries. The wireline segment was the incumbent local exchange carrier (ILEC) in 21 states with retail and wholesale operations.e

Wireless Sector

AT&T’s wireless networks covered 300 million people, and the company’s total subscriber base had grown from 85.1 million at the end of 2009 to 120.6 million at the end of 2014. (See Exhibit 1C for data on AT&T’s wireless business.) Its most important segment of customers—postpaid subscribers, who usually had a contract and switched carriers less frequently—had grown by a compound annual rate of only 3.3% over the same period. Tagert believed this had led to a less favorable customer mix by decreasing average revenue per user (ARPU). She also noted that AT&T had mentioned spectrum constraints in its public filings. To ameliorate these constraints, AT&T planned to free up spectrum by migrating its 2G customers to the faster 3G and 4G networks.

On the expense side, AT&T’s increased equipment sales and continued penetration of smartphones had resulted in a $2.67 billion increase in the cost of goods sold (COGS), reflected in operations and support expense.f Higher network maintenance, energy, and lease expenses had increased the systems costs by another $578 million. Selling, general, and administrative (SG&A) expenses had also increased by $1.1 billion due to higher marketing and customer retention costs, bad debt expense, and higher professional service costs. Tagert believed the confluence of customer mix, ARPU, network constraints, and increasing costs had caused AT&T’s wireless operating margins to shrink by 2.5% from 2013.

Wireline Sector

AT&T’s wireline business provided traditional and IP-based voice connections, as well as broadband and video services to consumer and wholesale markets. Traditional circuit-switched voice services had been in decline as customers migrated to wireless and VoIP solutions. (See Exhibit 1D for data on AT&T’s wireline business.) To stem the tide, AT&T’s management adopted a bundled services strategy that combined broadband internet and video over its U-verse network along with wireless services. Tagert noticed that both U-verse offerings had enjoyed steady customer growth; according to the company’s management, advanced IP-data services represented 35% of wireline revenue. She wondered whether these services could fill the hole left by the decline in circuit-switched business.

e Incumbent local exchange carriers are the local, or regional, telephone companies that had a monopoly on providing telecom services prior to the industry opening to competition. In the United States, these companies were the Regional Bell Operating Companies (RBOCs) that began operating when AT&T was divested into separate entities. f Note the company does not break out the cost of goods sold independently from the cost of service revenue or other operating expenses. D o

N ot

C op

y or

P os

917-543 | AT&T Versus Verizon: A Financial Comparison

4 BRIEFCASES | HARVARD BUSINESS SCHOOL

The broadband, video, and VoIP offered through U-verse had shown consistently high growth for several years. U-verse was available in more than 57 million locations by the end of 2014. However, operating margins for the wireline segment had fallen since 2010, and U-verse content costs had increased by $621 million in 2014. Tagert also believed that many of the company’s business customers who had discontinued traditional voice and data services that had moved to competitors’ networks.

Finally, there was some uncertainty surrounding U-verse video services, which were regulated as a TV service. Numerous municipalities and cable companies had petitioned to have U-verse regulated as a cable service. This classification would affect how AT&T provisioned public, educational, and governmental programming. According to AT&T’s management, there could be a material adverse effect on the cost and extent of U-verse’s offerings if the petitioners were successful.

Recent Acquisitions

 In July 2013, AT&T had agreed to acquire Leap Wireless, a prepaid wireless provider operating under the Cricket brand name. The transaction was valued at $1.26 billion, plus a contingent payment from the sale of 700 MHz spectrum in the Chicago market. Leap had a CDMA network covering approximately 96 million people and an LTE network covering an additional 21 million people. It had 4.5 million subscribers.

 In September 2013, AT&T had agreed to acquire Atlantic Tele-Network for $806 million in cash. Atlantic Tele-Network had 550,000 wireless subscribers.

 In December 2013, AT&T had consummated a transaction with Crown Castle International for 9,675 cell towers. The transaction was valued at $4.8 billion, and AT&T had agreed to lease the towers at market rates for an average of 10 years. As the leases expired, Crown Castle would have the option to purchase the towers. The approximate value of the purchase options was $4.2 billion.

 In May 2014, AT&T agreed to purchase DIRECTV for a combination of cash and stock that valued DIRECTV at $48.5 billion. The transaction was expected to close during the first half of 2015. DIRECTV had 20 million digital TV subscribers in the United States and an additional 18 million subscribers in Latin America. Within three years of closing, AT&T expected to realize $1.6 billion in annual synergies from increased video scale.

 In January 2015, AT&T had completed the acquisition of GSF Telecom. The transaction was valued at $2.5 billion, less net debt of $700 million. GSF was a wireless provider operating in Mexico, with a network covering approximately 70% of the country’s 120 million people.

 In January 2015, AT&T had also entered an agreement to purchase Nextel Mexico from NII for approximately $1.88 billion. Nextel Mexico had 3.0 million subscribers.

Overview of Verizon Communications10

Verizon Communications was a communications network provider that serviced businesses, governments, and consumers with voice, data, and video solutions using wireless and wireline networks. Its wireless network was available in over 500 markets, covering 98% of the U.S. population. It was the largest wireless provider in the United States in terms of revenue and customers. The company’s wireline business offered voice, data, and video, as well as data center, networking, cloud, and security services to businesses, consumers, government, and other carriers. In 2014, Verizon was the second-largest ILEC in the United States, with operating revenue of $38.4 billion.

D o

N ot

C op

y or

P os

AT&T Versus Verizon: A Financial Comparison | 917-543

HARVARD BUSINESS SCHOOL | BRIEFCASES 5

Wireless Sector

Verizon Wireless was the largest wireless provider in the United States in terms of revenue. It offered voice, data, and video services nationwide to more than 108 million customers. The business had been organized as a joint venture, with Vodafone of the United Kingdom owning 45% of the unit. However, in September 2013, Verizon had agreed to purchase Vodafone’s interest for $130 billion. That transaction closed in February 2014.

Verizon Wireless’s 108.2 million subscriber base comprised 102 million postpaid users and 6.1 million prepaid customers. (See Exhibit 2C for data on Verizon’s wireless business.) Further, Tagert noticed that although the compound annual growth in total subscribers was only 2.3%, the growth in postpaid subscribers was 4.9%. In contrast, Verizon’s base of prepaid users had declined by 17.5%. She viewed the shifting customer mix as favorable. In the most recent 10-K filing, management had cited growth in 4G smartphones and tablets and growth in connections per postpaid account as service revenue drivers. (Table A below shows this growth.)

Table A Growth in Revenue and Postpaid Accounts for Verizon, 2009–2014

2009 2010 2011 2012 2013 2014

Average Monthly Revenue Per Postpaid Account ($) NA 125.75 134.51 144.04 153.93 159.86 Postpaid Accounts (000s)

NA 34,268 34,561 35,057 35,083 35,616

Source: Verizon Communications, Inc. December 31, 2014 10-K, filed February 23, 2015.

The shift away from subsidized sales and toward installment sales had affected Verizon. According

to Verizon’s management, the $5.3 billion increase in the cost of services and sales was driven primarily by increases in device sales and unit costs. Tagert saw that a shift in operating costs had occurred. Selling, general, and administrative costs as a percent of operating revenue had decreased, and the percentage costs of service revenue had increased. She also noted the segment operating margin had decreased.

Wireline Sector

Like AT&T, Verizon’s wireline business offered voice, data, and video services, as well as networking, data center, security, and cloud-based solutions. Its wireline business had suffered, as customers had moved away from traditional voice and circuit-switched services. The number of circuit-switched connections had decreased steadily, leading to a decrease in revenue. (See Exhibit 2D for data on Verizon’s wireline business.) To counter these trends, Verizon’s management had focused on higher growth and margin businesses such as wireless and IP-based wireline services including broadband, video, network management, and cloud-based services. It had also reduced its wireline footprint. In 2010 and 2015, it shed much of its ILEC business to Frontier Communications in successive transactions. (See recent acquisitions below.)

Again, like AT&T, Verizon’s IP-based broadband and video services had improved this segment’s results. Verizon’s FiOS internet and video services had grown over 15% on a compound annual basis over the preceding five years, and the company’s most recent 10-K filing noted that these services had constituted 76% of wireline consumer retail revenue by the end of 2014. At that time, FiOS services were available to nearly 20 million premises, and internet and video services had penetration rates of 41.1% and 35.8%, respectively. Management believed the company’s passive optical network technology would continue to be a catalyst for growth as consumers demanded more bandwidth for applications like streaming video, which would require more symmetric services for cloud-based storage and solutions. Nonetheless, Tagert noticed the global enterprise and wholesale segments had D o

N ot

C op

y or

P os

917-543 | AT&T Versus Verizon: A Financial Comparison

6 BRIEFCASES | HARVARD BUSINESS SCHOOL

declined in recent years, and wondered about competition and margins in those segments. She noted management’s comment that the recent declines in the cost of services and selling, general, and administrative expenses were due mainly to a reduction in headcount.

Recent Transactions

 In July 2010, Verizon completed the spinoff of its ILEC businesses in 14 states to Frontier Communications. Verizon shareholders received approximately $8.6 billion, of which $5.3 billion was in Frontier stock.

 In April 2011, Verizon acquired Terremark Worldwide for approximately $1.3 billion. Terremark was a global provider of IT and cloud-based services with a focus on the government market.

 In June 2012, Verizon acquired Hughes Telematics for $600 million. Telematics was used for vehicular information, tracking, and control.

 In February 2014, Verizon completed the acquisition of Vodafone PLC’s 45% interest in Verizon Wireless for cash, stock, and other consideration totaling approximately $130.0 billion.

 In February 2015, Verizon sold its ILEC businesses in California, Texas, and Florida to Frontier Communications for approximately $10.5 billion. Frontier agreed to acquire the associated FiOS customers, which included 1.5 million internet and 1.2 million video customers. The business units sold generated approximately $5.4 billion of revenue.

 In February 2015, American Tower agreed to pay Verizon $5.0 billion upfront, and received the right to operate and lease 11,300 cell towers for 28 years. Verizon agreed to lease the towers at market rates for 10 years.

Understanding Historical Performance

Tagert also noticed both firms had large, highly-unionized workforces with substantial benefit obligations to retirees. These obligations came with significant actuarial gains and losses. This meant changes in assumptions related to the returns on plan assets (among other things) could have a significant impact on operating results, as these non-cash gains and losses flowed through the income statement.11 It also meant she needed to decide how to handle these benefit obligations in her analysis.

Table B shows the non-cash gains and losses that affected operating income for AT&T and Verizon.

Table B Non-Cash Actuarial Gains and Losses at AT&T and Verizon, 2009–2014 ($ millions)

2009 2010 2011 2012 2013 2014

AT&T (215) (2,521) (6,280) (9,994) 7,584 (7,869) Verizon

(2,964) (3,988) (7,426) (8,198) 5,052 (8,130)

Sources: AT&T, Inc. December 31, 2014 10-K, filed February 20, 2015 and Verizon Communications, Inc. December 31, 2014 10- K, filed February 23, 2015.

Tagert felt the past could provide insight about how each firm got to its respective position and how

these positions might influence each firm’s future. She decided she needed to understand each firm’s operating performance, investment in operations, free cash flow generation, and operating efficiency.

D o

N ot

C op

y or

P os

AT&T Versus Verizon: A Financial Comparison | 917-543

HARVARD BUSINESS SCHOOL | BRIEFCASES 7

Exhibit 1A AT&T Income Statements

Operating Results ($ millions): 2010 2011 2012 2013 2014

Total Operating Revenue 124,280 126,723 127,434 128,752 132,447 Less: Cost of Services (Excluding Depreciation) 52,379 57,374 55,228 51,464 60,611 Less: Selling, General & Administrative 32,864 38,844 41,066 28,414 39,697 Less: Impairment & Other Charges 85 2,910 0 0 2,120 EBITDA 38,952 27,595 31,140 48,874 30,019 Less: Depreciation & Amortization 19,379 18,377 18,143 18,395 18,273 EBIT 19,573 9,218 12,997 30,479 11,746 Less: Interest Expense 2,994 3,535 3,444 3,940 3,613 Plus: Equity in Net Income of Affiliates 762 784 752 642 175

Plus: Other Incomea 1,676 249 134 596 1,652 EBT 19,017 6,716 10,439 27,777 9,960 Less: Taxes (1,162) 2,532 2,900 9,224 3,442 Net Income 20,179 4,184 7,539 18,553 6,518 Less: Income Attributable to Minority Interest 315 240 275 304 294 Net Income Attributable to AT&T Shareholders 19,864 3,944 7,264 18,249 6,224

a Other income for 2010 includes $779 million of income from discontinued operations.

Source: Adapted from Company 10-Ks.

Exhibit 1B AT&T Balance Sheets

Assets ($ millions): 2009 2010 2011 2012 2013 2014

Cash & Cash Equivalents 3,741 1,437 3,045 4,868 3,339 8,603 Accounts Receivable 14,845 13,610 13,231 12,657 12,918 14,527 Prepaid Expenses 1,562 1,458 1,102 1,035 960 831 Deferred Taxes 1,247 1,170 1,470 1,036 1,199 1,142 Other Current Assets 3,792 2,276 4,137 3,110 4,780 6,925 Total Current Assets 25,187 19,951 22,985 22,706 23,196 32,028

Property, Plant & Equipment 99,519 103,196 107,087 109,767 110,968 112,898 Licenses 48,741 50,372 51,374 52,352 56,433 60,824 Goodwill & Other Intangibles 78,276 79,041 76,054 74,805 75,052 75,831 Customer Lists 7,393 4,708 2,757 1,391 0 0 Investments in Affiliates 2,921 4,515 3,718 4,581 3,860 250 Other Assets 6,275 6,705 6,467 6,713 8,278 10,998 Total Assets

268,312 268,488 270,442 272,315 277,787 292,829

Liabilities & Owners’ Equity ($ millions): Accounts Payable & Accrued Liabilities 21,260 20,055 19,956 20,911 21,107 23,592 Prepaid Revenue & Customer Deposits 4,170 4,086 3,872 3,808 4,212 4,105 Deferred Taxes 1,681 72 1,003 1,026 1,774 1,091 Dividends Payable 2,479 2,542 2,608 2,556 2,404 2,438 Current Portion of Long-Term Debt 7,361 7,196 3,453 3,486 5,498 6,056 Total Current Liabilities 36,951 33,951 30,892 31,787 34,995 37,282

Long-Term Debt 64,720 58,971 61,300 66,358 69,290 76,011 Post-Retirement Obligations 27,847 28,803 34,011 41,392 29,946 37,079 Deferred Taxes 23,579 22,070 25,748 28,491 36,308 37,544 Other Long-Term Liabilities 13,226 12,743 12,694 11,592 15,766 17,989

Total Owners’ Equity 101,989 111,950 105,797 92,695 91,482 86,924 Total Liabilities & Owners’ Equity 268,312 268,488 270,442 272,315 277,787 292,829

Source: Adapted from Company 10-Ks.

D o

N ot

C op

y or

P os

917-543 | AT&T Versus Verizon: A Financial Comparison

8 BRIEFCASES | HARVARD BUSINESS SCHOOL

Exhibit 1C AT&T Wireless Segment Data

Wireless Operating Results ($ millions):a 2009 2010 2011 2012 2013 2014

Service Revenue 48,563 53,510 56,726 59,186 61,552 61,032 Equipment Revenue 4,941 4,990 6,486 7,577 8,347 12,960 Total Segment Operating Revenue 53,504 58,500 63,212 66,763 69,899 73,992 Less: Operations & Support Expense 33,631 36,746 41,581 43,296 44,508 48,924 Less: Depreciation & Amortization 6,043 6,497 6,324 6,873 7,468 7,941 Total Segment Operating Income 13,830 15,257 15,307 16,594 17,923 17,127 Plus: Net Income (Loss) in Affiliates 9 9 (29) (62) (75) (112) Total Wireless Segment Income

13,839 15,266 15,278 16,532 17,848 17,015

Wireless Subscribers (000s): 2009 2010 2011 2012 2013 2014

Postpaid 64,627 68,041 69,309 70,497 72,638 75,931 Prepaid 5,350 6,524 7,225 7,328 7,384 10,986 Resellers 10,439 11,645 13,644 14,875 14,028 13,855 Connected Devices 4,704 9,326 13,069 14,257 16,326 19,782 Total Wireless Subscribers

85,120 95,536 103,247 106,957 110,376 120,554

Net Wireless Additions (000s): Postpaid 4,199 2,153 1,429 1,438 1,776 3,290 Prepaid (801) 952 674 128 (13) (775) Reseller 1,803 1,140 1,874 1,027 (1,074) (346) Connected Devices 2,077 4,608 3,722 1,171 2,032 3,439 Total Net Wireless Additions

7,278 8,853 7,699 3,764 2,721 5,608

Total Churn Rate 1.47% 1.31% 1.37% 1.35% 1.37% 1.45% Postpaid Churn Rate

1.13% 1.09% 1.18% 1.09% 1.06% 1.04%

a Segment results are net of actuarial gains and losses from post-retirement benefits.

Source: Adapted from Company 10-Ks.

Exhibit 1D AT&T Wireline Segment Data

Wireline Operating Results ($ millions):a 2009 2010 2011 2012 2013 2014

Service Revenue NA NA NA 58,271 57,700 57,405 Equipment Revenue NA NA NA 1,302 1,114 1,020 Total Segment Operating Revenue 63,621 61,300 59,765 59,573 58,814 58,425 Less: Operations & Support Expense 42,439 41,096 40,879 41,207 41,638 42,471 Less: Depreciation & Amortization 12,743 12,371 11,615 11,123 10,907 10,323 Total Segment Operating Income 8,439 7,833 7,271 7,243 6,269 5,631 Plus: Equity in Income (Loss) of Affiliates 17 11 0 (1) 2 0 Total Wireline Segment Income 8,456 7,844 7,271 7,242 6,271 5,631

Wireline Broadband Connections (000s): 2009 2010 2011 2012 2013 2014

U-verse High Speed Internet NA NA NA 7,717 10,375 12,205 DSL & Other Broadband Connections NA NA NA 8,673 6,050 3,823 Total Wireline Broadband Connections 15,789 16,309 16,427 16,390 16,425 16,028

Wireline Video Connections (000s): U-verse Video Connections 2,065 2,987 3,791 4,536 5,460 5,943

Wireline Voice Connections (000s): Consumer Switched Access 26,378 22,515 18,954 15,707 12,403 9,243 Business Switched Access 18,486 17,006 15,613 11,483 10,363 8,939 Wholesale Switched Access 2,590 2,300 2,120 1,776 1,627 1,514 Total Switched Access Lines

47,454 41,821 36,687 28,966 24,393 19,696

U-verse VoIP Connections NA NA NA 2,905 3,849 4,759 Total Wireline Voice Connections 47,454 41,821 36,687 31,871 28,242 24,455

a Segment results are net of actuarial gains and losses from post-retirement benefits.

Source: Adapted from Company 10-Ks. D o

N ot

C op

y or

P os

AT&T Versus Verizon: A Financial Comparison | 917-543

HARVARD BUSINESS SCHOOL | BRIEFCASES 9

Exhibit 2A Verizon Income Statements

Operating Results ($ millions): 2010 2011 2012 2013 2014

Total Operating Revenue 106,565 110,875 115,846 120,550 127,079 Less: Cost of Services (Excluding Depreciation) 44,149 45,875 46,275 44,887 49,931 Less: Selling, General & Administrative 31,366 35,624 39,951 27,089 41,016 EBITDA 31,050 29,376 29,620 48,574 36,132 Less: Depreciation & Amortization 16,405 16,496 16,460 16,606 16,533 EBIT 14,645 12,880 13,160 31,968 19,599 Less: Interest Expense 2,523 2,827 2,571 2,667 4,915 Plus: Equity in Net Income of Affiliates 508 444 324 142 1,780 Plus: Other Income (Expense) 54 (14) (1,016) (166) (1,194) EBT 12,684 10,483 9,897 29,277 15,270 Less: Taxes 2,467 285 (660) 5,730 3,314 Net Income 10,217 10,198 10,557 23,547 11,956 Less: Income Attributable to Noncontrolling Interest 7,668 7,794 9,682 12,050 2,331 Net Income Attributable to Verizon Shareholders 2,549 2,404 875 11,497 9,625

Source: Adapted from Company 10-Ks.

Exhibit 2B Verizon Balance Sheets

Assets ($ millions): 2009 2010 2011 2012 2013 2014

Cash & Cash Equivalents 2,009 6,668 13,362 3,093 53,528 10,598 Short-Term Investments 490 545 592 470 601 555 Accounts Receivable 12,573 11,781 11,776 12,576 12,439 13,993 Inventory 1,426 1,131 940 1,075 1,020 1,153 Prepaid Expenses & Other Current Assets 5,247 2,223 4,269 4,021 3,406 3,324 Total Current Assets

21,745 22,348 30,939 21,235 70,994 29,623

Property, Plant & Equipment 91,985 87,711 88,434 88,642 88,956 89,947 Wireless Licenses 72,067 72,996 73,250 77,744 75,747 75,341 Goodwill & Other Intangibles 29,236 27,818 29,235 30,072 30,434 30,367 Investments in Unconsolidated Businesses 3,118 3,497 3,448 3,401 3,432 802 Other Assets 8,756 5,635 5,155 4,128 4,535 6,628 Total Assets

226,907 220,005 230,461 225,222 274,098 232,708

Liabilities & Owners’ Equity ($ millions): Accounts Payable & Accrued Liabilities 15,223 15,702 14,689 16,182 16,453 16,680 Other Current Liabilities 6,708 7,353 11,223 6,405 6,664 8,649 Current Portion of Long-Term Debt 7,205 7,542 4,849 4,369 3,933 2,735 Total Current Liabilities

29,136 30,597 30,761 26,956 27,050 28,064

Long-Term Debt 55,051 45,252 50,303 47,618 89,658 110,536 Post-Retirement Obligations 32,622 28,164 32,957 34,346 27,682 33,280 Deferred Taxes 19,190 22,818 25,060 24,667 28,639 41,578 Other Long-Term Liabilities 6,765 6,262 5,472 6,092 5,653 5,574

Total Equity Attributable to Shareholders 41,382 38,569 35,970 33,157 38,836 12,298 Plus: Non-Controlling Interest 42,761 48,343 49,938 52,376 56,580 1,378 Total Owners’ Equity

84,143 86,912 85,908 85,533 95,416 13,676

Total Liabilities & Owners’ Equity 226,907 220,005 230,461 225,212 274,098 232,708

Source: Adapted from Company 10-Ks.

D o

N ot

C op

y or

P os

917-543 | AT&T Versus Verizon: A Financial Comparison

10 BRIEFCASES | HARVARD BUSINESS SCHOOL

Exhibit 2C Verizon Wireless Segment Data

Wireless Operating Results ($ millions)a 2009 2010 2011 2012 2013 2014

Service Revenue 52,046 55,629 59,157 63,733 69,033 72,630 Equipment & Other Revenue 8,279 7,778 10,997 12,135 11,990 15,016 Total Segment Revenue 60,325 63,407 70,154 75,868 81,023 87,646 Less: Cost of Service Revenue 19,348 19,245 24,086 24,490 23,648 28,825 Less: Selling, General & Administrative 17,309 18,082 19,579 21,650 23,176 23,602 Less: Depreciation & Amortization 7,030 7,356 7,962 7,960 8,202 8,459 Segment Operating Income 16,638 18,724 18,527 21,768 25,997 26,760

Wireless Subscribers (000s):b 2009 2010 2011 2012 2013 2014

Postpaid 80,495 83,125 87,382 92,530 96,752 102,079 Prepaid 16,000 19,121 20,416 5,700 6,047 6,132 Total Wireless Subscribers

96,495 102,246 107,798 98,230 102,799 108,211

Net Wireless Additions (000s):c Postpaid 3,987 2,529 4,252 5,024 4,118 5,482 Prepaid 948 2,988 1,167 893 354 86 Total Net Wireless Additions

4,935 5,517 5,419 5,917 4,472 5,568

Total Churn Rate 1.41% 1.38% 1.26% 1.19% 1.27% 1.33% Postpaid Churn Rate

1.07% 1.02% 0.95% 0.91% 0.97% 1.04%

Average Monthly Revenue Per Postpaid Account ($) NA 125.75 134.51 144.04 153.93 159.86 Postpaid Accounts (000s) NA 34,268 34,561 35,057 35,083 35,616 Postpaid Connections Per Account

NA 2.43 2.53 2.64 2.76 2.87

a Pension and other post-retirement benefits are excluded from segment results. b As of the end of the period. c Excludes acquisition adjustments.

Source: Adapted from Company 2009 to 2014 10-Ks.

Exhibit 2D Verizon Wireline Segment Data

Wireline Operating Results ($ millions)a 2009 2010 2011 2012 2013 2014

Consumer & Small Business 16,115 16,256 16,337 16,746 17,383 18,047 Global Enterprise 15,289 15,316 15,622 14,577 14,182 13,684 Global Wholesale 9,533 8,746 7,973 7,094 6,594 6,222 Other Revenue 1,514 909 750 528 465 476 Total Segment Revenue 42,451 41,227 40,682 38,945 38,624 38,429 Less: Cost of Services & Sales 22,693 22,618 22,158 21,657 21,396 21,332 Less: Selling, General & Administrative 9,947 9,372 9,107 8,860 8,571 8,180 Less: Depreciation & Amortization 8,238 8,469 8,458 8,424 8,327 7,882 Segment Operating Income 1,573 768 959 4 330 1,035 Wireline Broadband Connections (000s): 2009 2010 2011 2012 2013 2014

FiOS Internet Subscribers 3,286 4,082 4,817 5,424 6,072 6,616 Circuit-Switched Broadband 4,874 4,310 3,853 3,371 2,943 2,589 Total Wireline Broadband Connections 8,160 8,392 8,670 8,795 9,015 9,205

FiOS Video Subscribers

2,750 3,472 4,173 4,726 5,262 5,649

Total Voice Connections

28,323 26,001 24,137 22,503 21,085 19,795

a Pension and other post-retirement benefits are excluded from segment results.

Source: Adapted from Company 2009 to 2014 10-Ks.

D o

N ot

C op

y or

P os

AT&T Versus Verizon: A Financial Comparison | 917-543

HARVARD BUSINESS SCHOOL | BRIEFCASES 11

Endnotes

1 AT&T Inc, December 31, 2014 Form 10-K, filed February 20, 2015, accessed June 2017.

2 Ibid.

3 Verizon Communications, Inc. December 31, 2014 Form 10-K. Filed February 23, 2015, accessed June 2017.

4 Ibid.

5 Ibid.

6 Ibid.

7 Ibid.

8 “FCC Adopts Strong, Sustainable Rules to Protect the Open Internet,” Federal Communications Commission press release (Washington, DC, February, 26, 2015), http://transition.fcc.gov/Daily_Releases/Daily_Business/2015/db0226/DOC-332260A1.pdf, accessed May 2017.

9 All the references in the Overview of AT&T section come from AT&T Inc, December 31, 2014 Form 10-K, filed February 20, 2015, accessed June 2017.

10 All the references in the Overview of Verizon section come from Verizon Communications, Inc. December 31, 2014 Form 10-K, filed February 23, 2015, accessed June 2017.

11 AT&T Inc, December 31, 2014 Form 10-K, filed February 20, 2015, accessed June 2017 and Verizon

Communications, Inc. December 31, 2014 Form 10-K, filed February 23, 2015, accessed June 2017.

D o

N ot

C op

y or

P os

http://transition.fcc.gov/Daily_Releases/Daily_Business/2015/db0226/DOC-332260A1.pdf

BUS 224/Assignment I/Cases/ABC for Manufacturing Com.pdf

IOSR Journal of Business and Management (IOSR-JBM)

e-ISSN: 2278-487X, p-ISSN: 2319-7668. Volume 16, Issue 11.Ver. I (Nov. 2014), PP 39-45 www.iosrjournals.org

www.iosrjournals.org 39 | Page

The Benefits of the Application of Activity Based Cost System -

Field Study on Manufacturing Companies Operating In

Allahabad City – India

Mr. Shaban E. A. Salem 1 , Dr. Shabana Mazhar

1 (Ph.D. Research Scholar, Business Administration Department, Joseph School of Business Studies, SHIATS,

India) 2 (Associate Professor, Business Administration Department, Joseph School of Business Studies, SHIATS, India)

Abstract: This study aims to identifying the benefits of the application of ABC system throuth a field study on companies operating in allahabad-india. In order to achieve such aims, a questionnaire was developed and

distributed to the population of study. Spss program was used in the analysis.

The study concluded with some results. The most apparent is that the expected benefits of behind the application

of ABC system from the standpoint of these companies are ABC system helps to calculate the cost of the product

more accurately, leads to enhance the costs control and ABC system provides the financial and non-financial information that help in taking sound administrative decisions such as fixing selling prices of products and

exclusion of activities that do not add value to the product.

The study recommends the companies should start gradually in applying ABC system by persuading the

management of these companies on the importance of application the system because of its advantages and

benefits.

Keywords: ABC System, Traditional Cost System, Overhead.

I. Introduction In the present era, companies produce wide range of products and direct labour represent only a small

percentage of total costs, the intense global competition has made decision errors due to poor cost information more problem and more costly, also in this computer age of advancing technologies and automation, the

proportion and importance of overhead in the manufacturing operations is increasing and direct costs are being

relegated to the background. Overhead is the aggregate of indirect materials, indirect wages and indirect

expenses (M. N. Arora,2013).

it is a well-known fact that the traditional cost systems utilize a single volume-based cost driver, this is the reason why the traditional cost system distorts the cost of products (V. K. Saxena, et al, 2011). In most cases

this type of costing system assigns the overhead costs to products on the basis of their relative usage of direct

labour. For this reason traditional cost systems often report inaccurate product costs. Therefore, there is a need

for a more sophisticated system of accounting for overhead so that more accurate costs of products and services

may be ascertained.

activity based cost system which known as (ABC system) is an alternative to traditional way of overhead accounting, it is an upcoming and more refined approach of charging overhead to ascertain more

accurate product costs (V. Rajasekaran, et al, 2011). ABC system arose in the 1980s from the increasing lack of

relevance of traditional cost accounting methods, it is developed by cooper and kalpan for assigning overhead to

end products, jobs and processes, it aims to rectify the problem of inaccurate cost information due to selection of

wrong bases of overhead apportionment (Charles t. Horngren,et al, 2013).

this study comes as an attempt to explain the concept of ABC system, in addition to determine the

expected benefits of application of ABC system in companies under study.

II. The Study Problem In light of the growing interest in topic of importance and benefits of the application of ABC system in

manufacturing companies this study problem attempts to answer the following question: are there any benefits

from the application of ABC in companies?

III. The Study Objectives This study aims to attain the following objectives:

 To highlight the concept of ABC system in addition to know the advantages and disadvantages of ABC system.

 Being acquainted with the benefits of application of ABC system in companies.

The Benefits Of The Application Of Activity Based Cost System - Field Study On Manufacturing Companies …..

www.iosrjournals.org 40 | Page

IV. Literature Review There are many studies and previous researches which dealt with various aspects of the ABC system, some of these studies which addressed the benefits of ABCsystem as following:

Lee (1990): This study aimed to assess the effectiveness of the application of ABC at cal electronic circuits -u.s.

company-, where this study indicated that the company has reaped positive results exceeded the exact cost of the

product to include increased production efficiency and competitiveness of this company in addition to

increasing the efficiency of the decision-making process as a result of the provision of accurate information

about the costs of products.

Pigott (1992): This study stated that the implementation of this system has resulted in achieving several

advantages was the most prominent re-pricing of products after was reached to cost products more accurate, as

proven that application of this system that traditional systems that were applied in this company tend to increase

the certain products costs and reduce the other products costs, for example found that 38 of products were inflated costs by up to 55% and the cost of about 85 of products were reduced by up to 92.5% which

necessitated re-analyze and evaluate the profitability of different products.

Turney Peter and Stratton Alan (1992): This study was applied on one of the companies which is using the

ABC system to improve the decisions of products costs and provide needed information to rationalize the efforts

of continuous improvement. This study concluded to several of the most important results that process of linking

information with system ABC led to facilitate the process of preparing the total quality costs in company also

this study found that ABC system helps to reduce costs and improve the quality of informations.

As per kaplan (1992): The need to ABC system data is not only for managers to be able to progress in

conditions of prevailing competitive environment, but in order achieve integration of the information system

with the other rest systems and in addition, ABC system helps companies to understand the relationship between programs of improvement process and increase profit.

Merz and Hardy (1993): This study indicated that ABC system enabled accountants to involve in product

design process also help engineers and production officials in understanding the nature of the behavior of

industry costs in addition, ABC system leads to a high level of professional life for accountants and produce

good cost information.

Cooper and Kaplan (1998): This study found that the application of ABC system will lead to exclude activities

that do not add value to the product unit and keep the activities that add value to the product unit which in turn

lead to reduce the cost of products.

This study showed that

Narayanan and Ratna (1999): this study showed that the information provided by the ABC system useful in

the decision-making process related to the products and customers alike, where the system works on the

accuracy of the products pricing and the dealing cost with customers. In addition, this study concluded that if the

company applied ABC system will achieve two important benefits: firstly, working on the development of the

internal processes of the company, which lead to raise the efficiency of the use of resources and secondly,

reduce costs in general and in particular the additional costs, which enhances the ability of the company to

achieve more profitability in mixed products.

Neumann et al (2004): This study aims to use activities based costing system as an alternative to the traditional

cost system, in order to develop new ways to manage and control the costs. The study concluded multiple results, including: ABC system provides an accurate tool to manage and measure the costs efficiently, especially

in the light of globalization and recent trends towards the intensity of competition.

Concept of ABC System.

Cooper and Kaplan has presented ABC system project in the 1980s as an alternative to be more suitable

to the allocation of indirect costs to end products than the traditional cost system, it aims to rectify the problem

of inaccurate cost information due to selection of wrong bases of indirect cost apportionment. In the words of

Cooper and Kaplan, ABC system calculate the costs of individual activities and assign costs to cost objects such

as products and services on the basis of activities undertaken to produce each product and service.

The Benefits Of The Application Of Activity Based Cost System - Field Study On Manufacturing Companies …..

www.iosrjournals.org 41 | Page

According to C.I.M.A., London, ABC system is: Cost attribution to cost units on the basis of benefits

received from indirect activities, i.e., ordering, setting up, assuring quality, etc (Arora, 2013). ABC system is

that costing in which costs are first traced to activities and then to products, ABC is costing system which

focuses on activities performed to produce products (Jawahar Lal , 2009).

The logic behind ABC system is products consume activities and activities consume resources. The

relationships between activities and products have been shown as follows:

Fig 1: ABC System Process.

Advantages and Disadvantages of ABC System.

1- Advantage of ABC System.

ABC system offers the following advantages (Jawahar Lal, 2009):

 ABC system brings accuracy and reliability in product cost determination by focusing on cause and effect relationship in the cost incurrence. It recognizes that is activities which cause costs, not products

and it is product which consumes activities.

 In advanced manufacturing environment and technology where support functions overhead constitute a large share of total costs, ABC system provides more realistic product costs.

 ABC system identifies the real nature of cost behavior and helps in reducing costs and identifying activities which do not add value to the product. With ABC system, managers are able to control many

fixed overhead costs by exercising more control over the activities which have caused these fixed

overhead costs. This is possible since behavior of many fixed overhead costs in relation to activities

now become more visible and clear.

 ABC system uses multiple cost drivers, many of which are transaction based rather than product volume. Further, ABC system is concerned with all activities within and beyond the factory to trace

more overheads to the products.

 ABC system traces costs to areas of managerial responsibility, processes, customers, department besides the product costs.

 ABC system improves greatly the manager’s decision making as they can use more reliable product cost data.

 ABC system helps usefully in fixing selling prices of products as more correct data of product cost is now readily available.

 ABC system products reliable and correct product cost data in cause of greater diversity among the products manufactured such as low-volume products, high-volume products. Traditional costing

system is likely to bring errors and approximation in product cost determination due to using arbitrary

apportionment and absorption methods.

 ABC system provides cost driver rates and information on transaction volumes which are very useful to management and performance appraisal of responsibility centers. Cost driver rates can be used

advantageously for the design of new products or existing products as they indicate overhead costs that

are likely to be applied in costing the product.

 ABC system provides not only a base for calculating more accurate product cost but also a mechanism for managing costs.

2- Disadvantage of ABC System.

ABC system typically provides better information than traditional overhead allocation process. Still it

is not the presence for all managerial problems. Following criticism has been leveled against ABC system

(Jawahar Lal, 2009) and ( Saxena, et al, 2010):

 ABC system has numerous cost pool and multiple cost drivers and therefore can be more complex than traditional product costing systems.

 Some difficulties emerge in the implementation of ABC system, such as selection of cost drivers, assignment of common costs, varying cost driver rates etc.

 ABC system has different level of utility for different organization such as large manufacturing firm can use it more usefully than the smaller firms. Also, it is likely that firms depending on cost-plus

pricing can take advantages from ABC system as it gives accurate product cost. But those firms who

use market based prices may not favour ABC system. The level of technology and manufacturing

environment prevailing in different firms also effect the application of ABC system.

Resources or

Factors

Activities Products

The Benefits Of The Application Of Activity Based Cost System - Field Study On Manufacturing Companies …..

www.iosrjournals.org 42 | Page

 ABC system implementation requires significant amount of time and cost to implement.

 An environment of change must be created for implementation of ABC system. It requires overcoming a variety of individuals, organisation and environmental barriers as follows:

- Fear of unknown and shift in status quo, - Potential loss of status, - A necessity to learn new skill.

 To overcome these barriers, a firm must recognise that these barriers exist. The causes of the barriers should be investigated. Then organisation should communicate information about, ‘what’, ‘why’ and ‘how’ of ABC system to all concerned parties. It presents limitation of ABC system.

 Employees and managers must be educated in some non-traditional techniques that include new terminology, concepts and performance measurements.

 Additional time will be required to analyse the activities taking place in the activity centers, trace cost to those activities and determining the cost drivers.

V. Study Methodology Nature of Data

The data required for the study has been collected from secondary sources by relying on the scientific books, published papers and researches.

Data Collection Method

The present study has been adopted on the comprehensive survey of the population of the study which

consists of entire the manufacturing companies operating in allahabad - india, whether they government or

private and large or medium companies. The population of study consists of 18 companies.

To gather data a questionnaire had been designed and distributed on the population of study a

questionnaire for each company. The questionnaire includes a set of questions with aim to explore the views of

the manufacturing companies about the expected benefits from the application of ABC system in these

companies.

VI. Findings/Discussions The study data has been analyzed by using spss program (statistical packing for social sciences) and the

following table showed the results:

Table 1: Frequency Distribution and Percentages of the Responses of the Study Participants about the

Benefits of Application of ABC System in Companies. No Questions

Percentage% Strongly

agree

Agree Neutral Disagree Strongly

disagree

Number

1 ABC system is considered one

of modern systems of cost

accounting

Number 13 5 - - -

Percentage% 72.2% 27.8% - - -

2 ABC system helps to calculate

the cost of the product more

accurately

Number 11 6 1 - -

Percentage% 61.1% 33.3% 5.6% - -

3 ABC system helps in

understanding the behavior of

costs and thus helps to find out

the causes of indirect costs

Number 14 3 1

Percentage% 77.7% 16.7% 5.6% - -

4 Indirect costs accounted for a

large proportion of the cost

structure, which requires

application ABC system

Number 6 3 6 3 -

Percentage% 33.3% 16.7% 33.3% 16.7% -

5 ABC system identifies the real

nature of cost behaviour and

helps in reducing costs

Number 13 5 - - -

Percentage% 72.2% 27.8% - - -

6 ABC system helps in tracing

costs to areas of managerial

responsibilit

Number 10 3 5 - -

Percentage% 55.6% 16.7% 27.8% - -

The Benefits Of The Application Of Activity Based Cost System - Field Study On Manufacturing Companies …..

www.iosrjournals.org 43 | Page

7 ABC system leads to enhance

the costs control

Number

15 3 - - -

Percentage% 83.3% 16.7% - - -

8 ABC system provides the

financial and non-financial

information that help in taking

sound administrative decisions

Number 10 4 4 - -

Percentage% 55.6% 22.2% 22.2% - -

9 ABC system improves greatly

the manager’s decision making

as they can use more reliable

product cost data

Number 11 4 3 - -

Percentage% 61.1% 22.2% 16.7% - -

10 ABC system helps usefully in

fixing selling prices of products Number 9 7 1 1 -

Percentage% 50% 38.9% 5.6% 5.6% -

11 As result of the diversity of the

company's products, which

requires the application of the

ABC system

Number 7 5 5 1 -

Percentage% 38.9% 27.8% 27.8% 5.6% -

12 ABC system helps to improve

the production process and the

development of the

performance in co

Number 11 6 1 - -

Percentage% 61.1% 33.3% 5.6% - -

13 ABC system leads to improve

the competitive position of the

companywith other companies

Number 9 7 2 - -

Percentage% 50% 38.9% 11.1 - -

14 ABC system leads to the

exclusion of activities that do

not add value to the company

Number 10 5 2 1 -

Percentage% 55.6% 27.8% 11.1% 5.6% -

The previous table shows the following results:

 That 100% of the companies surveyed said that ABC system is considered one of modern systems of cost accounting.

 That 94.4% of the companies surveyed said that ABC system helps to calculate the cost of the product more accurately.

 That 94.4% of the companies surveyed see that ABC system helps in understanding the behavior of costs and thus helps to find out the causes of indirect costs.

 That 50% of the companies surveyed think that indirect costs accounted for a large proportion of the cost structure, which requires application ABC system.

 That 100% of the companies surveyed see that ABC system identifies the real nature of cost behaviour and helps in reducing costs.

 That 72.3% of the companies surveyed said that ABC system helps in tracing costs to areas of managerial responsibility.

 That 100% of the companies surveyed think that ABC system leads to enhance the costs control.

 That 77.8% of the companies surveyed said that ABC system provides the financial and non-financial information that help in taking sound administrative decisions.

 That 83.3% of the companies surveyed said that ABC system improves greatly the manager’s decision making as they can use more reliable product cost data.

 That 88.9% of the companies surveyed see that ABC system helps usefully in fixing selling prices of products.

 That 66.7% of the companies surveyed think that as result of the diversity of the company's products, which requires the application of the ABC system.

 That 66.7% of the companies surveyed think that ABC system helps to improve the production process and the development of the performance in company.

The Benefits Of The Application Of Activity Based Cost System - Field Study On Manufacturing Companies …..

www.iosrjournals.org 44 | Page

 That 88.9% of the companies surveyed see that ABC system leads to improve the competitive position of the company with other companies.

 That 83.4% of the companies surveyed see that ABC system leads to the exclusion of activities that do not add value to the company.

From the previous results it is clear that the companies under study are consistent with a high degree in

the categories (strongly agree and agree) about the benefits of ABC system, this gives an indication that these

companies understand and realize the expected benefits from the application of ABC system.

The following table shows the mean and standard deviation of the questions related the benefits of application of ABC system in companies.

Table 2: Mean and Standard Deviation of the Responses of the Study Participants about the Benefits of

Application of ABC System in Companies. No Questions

Mean Std. Deviation

1 ABC system is considered one of modern systems of cost

accounting 4.72 .46

2 ABC system helps to calculate the cost of the product more

accurately 4.56 .62

3 ABC system helps in understanding the behavior of costs and

thus helps to find out the causes of indirect costs

4.72 .57

4 Accounted for indirect costs a large proportion of the cost

structure, which requires application ABC system

3.67 1.14

5 ABC system identifies the real nature of cost behaviour and

helps in reducing costs 4.72 .46

6 ABC system helps in tracing costs to areas of managerial

responsibility 4.28 .89

7 ABC system leads to enhance the costs control 4.83 .38

8 ABC system provides the financial and non-financial

information that help in taking sound administrative decisions 4.33 .84

9 ABC system improves greatly the manager’s decision making as

they can use more reliable product cost data 4.44 .78

10 ABC system helps usefully in fixing selling prices of products 4.33 .84

11 As result of the diversity of the company's products, which

requires the application of the ABC system 4 .97

12 ABC system helps to improve the production process and the

development of the performance in company

4.56 .62

13 ABC system leads to improve the competitive position of the

company with other companies 4.39 .70

14 ABC system leads to the exclusion of activities that do not add

value to the company

4.33 .91

From the above table it is that clear the mean of all the benefits is high, which means that the

companies under the study strongly agree and agree with the benefits of application of ABC system in

companies, as the values of standard deviation indicate extent of consensus the views of the participants in the

study about the questions which relate to benefits of application of ABC system in companies.

VII. Conclusions Based on the study of participants' answers to the inquiry and after analyzing the study data, the study had reached the following conclusions:

 ABC system arose from increasing lack of relevance in traditional cost accounting methods, where is considered an alternative to traditional way of overhead accounting.

 The logic behind ABC system is products consume the activities and activities consume the resources.

 All the companies surveyed believe that activity based cost system achieves the following benefits:  ABC system helps to calculate the cost of the product more accurately, leads to enhance the costs

control and ABC system provides the financial and non-financial information that help in taking sound

administrative decisions such as fixing selling prices of products and exclusion of activities that do not

add value to the product.

 ABC system helps in understanding the behavior of costs and thus helps to find out the causes of overhead in addition, ABC system helps in tracing costs to areas of managerial responsibility.

 ABC system helps to improve the production process and development performance in companies in addition ABC system leads to improve the competitive position of the company with other companies.

The Benefits Of The Application Of Activity Based Cost System - Field Study On Manufacturing Companies …..

www.iosrjournals.org 45 | Page

VIII. Recommendations  Companies should start gradually in applying ABC system by persuading the management of these

companies on the importance of application the system because of its advantages and benefits.

 Companies must interest in training programs accountants from both practical and professional, taking into account the development of these programs.

 Companies need to hold significant shifts in order to accommodate the technological changes in the modern business environment and keep abreast of all that is new and useful, and the application of modern costs

systems to their importance in the current stage.

References [1]. Cooper. R. & Kaplan. R. (1998). Cost Cutting Activity. Economist, 57-67. [2]. Charles T. Horngren,Et Al. ( 2013). Cost Accounting. New Delhi. Dorling Kindersley (India) Pvt. Ltd.

[3]. Jawahar Lal. (2009). Cost Accounting. New Delhi: Tata Mcgaw-Hill Publishing. [4]. Kaplan Robert. (1992). In Defense Of Activity – Based Cost Management. Management Accounting, 58-63. [5]. Lee. Y. (1990). Activity- Based Costing At Cal Electronic Circuits. Management Accounting. Oct, 36-38.

[6]. M. N. Arora. (2013). Cost Accounting. New Delhi: Vikas Publishing House Pvt Ltd. [7]. Merz Mike & Hardy Arlen. (1993). ABC Puts Accountants On Design Team At HP. Management Accounting. Sep, 22-27. [8]. Narayanan. G. & Ratna. S. (1999). Activity Based Costing At In Steel Industries. National Bureau Of Economic Research. Working

Paper No. 7270.

[9]. Neumann Bruce R., Gerlach James H., Moldaure Edwin., Finch Michael And Olson Christine. (2004). Cost Management Using ABC For IT Activities & Services. Management Accounting Quarterly, 29-40.

[10]. Pigott D. (1992). ABC In Apharmaceutical Company A Remedy. Management Accounting, 18-21. [11]. V. K. Saxena & C. D. Vashist. (2010). Advanced Management Accounting. New Delhi. Sultan Chand & Sons. [12]. Turney Peter & Stratton Alan. (1992). Using ABC To Support Continuous Improvement. Management Accounting, 46-50. [13]. V.Rajasekaran & R. Lalitha. (2011). Cost Accounting. New Delhi. Dorling Kindersley (India) Pvt. Ltd.

BUS 224/Assignment I/Cases/Analysing the opportunity in the hotel business.pdf

________________________________________________________________________________________________________________ HBS Professor Emeritus Howard H. Stevenson and former senior lecturer Michael J. Roberts prepared this case solely as a basis for class discussion and not as an endorsement, a source of primary data, or an illustration of effective or ineffective management. The assistance of Michael Depatie, former CEO of Kimpton Hotels, is gratefully acknowledged. Although based on real events, and despite occasional references to actual companies, this case is fictitious and any resemblance to actual persons or entities is coincidental. Copyright © 2016 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. This publication may not be digitized, photocopied, or otherwise reproduced, posted, or transmitted, without the permission of Harvard Business School.

H O W A R D H . S T E V E N S O N

M I C H A E L J . R O B E R T S

Hotel Vertu: Analyzing the Opportunity in the Boutique Hotel Industry

Yvonne D’Arcy and Elisabeth Whiting sat across from each other, contemplating the decision that confronted them about their fledgling venture. It was early May of 2015, and the two women were soon to graduate with their MBAs. They had spent most of their second year working together on an independent project. First, they had explored the boutique hotel industry. Then, after deciding it was an attractive space, they had made significant progress toward a plan to open a boutique hotel in Savannah, Georgia. Now, D’Arcy and Whiting had a property under contract, architectural plans and estimates for a renovation, and a tentative proposal for debt financing.

The women were meeting to discuss how to approach investors. Whiting observed:

We feel like we have made a lot of progress, and Mr. D’Arcy—Elisabeth’s father—has offered to introduce us to some of his friends whom he believes would be interested. He has also said he is willing to match their funding dollar for dollar. So, if we need a bit over $13 million in equity, we really need to find only $6.5 million from outside investors and Mr. D’Arcy would provide the remainder. It has been a great project and we’ve learned a lot. But, once we go out to investors, then I feel like we are really committed. I want to be sure it is as attractive an opportunity as we think it is.

For her part, D’Arcy added:

We’ve become really excited about the boutique hotel industry and this opportunity in particular. I put a lot of stock in the fact that my father is enthusiastic enough to put up half the money. I think we have nothing to lose and a lot of upside.

Yvonne D’Arcy and Elisabeth Whiting D’Arcy and Whiting were fellow second-year MBA students at a business school in the Midwestern

United States. D’Arcy was born in Brussels and then moved to Paris when her father’s base of business shifted. Following her graduation from Oxford University with a degree in economics, she worked in

9 - 9 1 7 - 5 0 1 S E P T E M B E R 2 8 , 2 0 1 6

D o

N ot

C op

y or

P os

917-501 | Hotel Vertu: Analyzing the Opportunity in the Boutique Hotel Industry

2 BRIEFCASES | HARVARD BUSINESS SCHOOL

London for a large investment bank. Her father was the principal of a small, well-known real-estate investment firm and had developed and financed residential and commercial properties all over Europe.

Whiting had grown up in San Francisco and attended Stanford University. She had then worked in the internship program of an international hotel chain. Whiting spent the first 18 months in various managerial roles at two separate hotels, eventually serving as the assistant general manager of a 250- room hotel in New York City. Her next position was in the firm’s London headquarters in a strategic planning role, investigating potential locations for new resort hotels in Portugal, Spain, and Mexico.

The two women had met on their first day of business school. Their friendship had grown during their first year and deepened during the summer of 2014, when they both worked for the same consulting firm.

At the start of their second year, D’Arcy had enlisted Whiting’s help in a field-study project that D’Arcy had structured with her father’s encouragement:

My father has financed a lot of different hotels around Europe, and one of his latest investments was a boutique hotel in London. He didn’t know much about the broader boutique industry and trends, so he wanted to know what was happening in the boutique hotel business, and it sounded interesting to me. I liked my time in private equity and consulting, but I knew it was a grueling lifestyle and I wasn’t sure I wanted to sign up for that. I’d done a lot of travelling and was fascinated with the hotel business and thought there might be an interesting career there. I reached out to Elisabeth because of our friendship and the great background she had in this business. I’ve seen the kind of flexibility and success my father has had as an entrepreneur, and that’s extremely appealing to me.

Whiting described her motivation for getting involved:

I tested the waters in consulting over the summer. It was intellectually stimulating, but I missed the more tangible, operations-oriented kind of experience I had enjoyed in the hotel business. So I was thinking about going back to this industry and also looking at other roles that seemed similarly operational in nature. When Yvonne came up with this independent project proposal, it seemed like a great opportunity to dig into a niche of the hotel business to which I’d not had much exposure. Also, it seemed like a great time to pursue an entrepreneurial opportunity. I really felt like we had very little to lose.

D’Arcy was similarly motivated: “I was always envious of the people who were more involved in the operations, when I worked in private equity. We’d spend three months digging into a company and then move on to the next deal. I missed the opportunity to be involved with ongoing operations.“

The Hotel and Boutique Hotel Industry In 2013, the hotel industry was a large part of the $900 billion U.S. tourism market. Hotel spending

accounted for $163 billion in sales in 2013 and included nearly 53,000 properties and almost five million guestrooms.1 The industry was relatively concentrated: Hilton, Marriott, Wyndham, Choice, and InterContinental, controlled nearly 46% of rooms with 62 different hotel brands between them.2

Boutique hotels were an emerging segment in the hotel industry. They were generally defined as intimate, luxurious, and upscale hotels that featured unique architecture and design that targeted a D

o N

ot C

op y

or P

os t

Hotel Vertu: Analyzing the Opportunity in the Boutique Hotel Industry | 917-501

HARVARD BUSINESS SCHOOL | BRIEFCASES 3

younger, more upscale audience and often included a restaurant/bar designed to attract customers who were not guests of the hotel itself. Boutique hotels were typically smaller, with fewer than 100 rooms, and often avoided some of the major capital expenditures required for larger hotels, such as large rooms, lobbies, and extensive meeting facilities. Boutique hotels offered higher profit margins than a typical hotel did because they were priced at the premium end of the market and were often successful at avoiding price competition by differentiating themselves through design and service.3

In 2015, boutique hotels were estimated to account for $6.3 billion in revenue and generated $1.1 billion in profit. Room charges accounted for about 69% of that revenue, while 25% came from food and beverage, and 6.5% from spa and wellness services. The growth of the boutique segment had outperformed the industry overall, with 5.6% annual growth between 2010 and 2015. Growth was forecast to continue outpacing the overall hotel business, with growth rates of 5.9% forecast for the five-year period 2015–2020. In the boutique segment, business travelers booked 68% of room nights, leisure travelers booked 29%, and other travelers booked the remainder. In most states, boutique properties were still a small (less than 3%) share of the hotel market overall, but they represented about 11% of properties in California; 4% of hotels in New York; 7% in Florida; and 3.2% in North Carolina. Boutique hotels had a 2.2% share in South Carolina and 3.4% in Georgia.4

Travel spending was forecast to grow 3.5% annually in international arrivals and 2.9% annually in domestic travel. Industry analysts believed that the target market for boutique hotels was more willing to pay for the unique accommodation experience offered by boutique hotels. Moreover, the growth in high-income households (income over $100,000), and the forecast of continued growth in that segment, led to optimism that the boutique segment would continue to outperform.5

Early boutique hotels were frequently one-off properties, but the pioneer in the field, Kimpton Hotels, had grown to a 60-hotel chain by 2015 and was acquired by InterContinental Hotel Group (IHG) for $430 million in late 2014.6 Westin created its W brand in 1998 and by 2015 had 44 properties and 12,610 rooms under that brand. Marriott established the Edition brand as its boutique entry, with two hotels opened in 2015 and 15 more slotted for opening. Richard Branson’s Virgin Group had announced its plans to open a boutique hotel chain under the Virgin brand.7

Observers believed that changes in the market had allowed smaller, independent boutique hotels to exist. In particular, the advent of the Internet allowed hotels to market themselves directly and via online travel agencies (OTAs) such as Expedia, TripAdvisor, hotels.com, and so on, rather than to rely on the reservation systems of the major brands. In response to the success of the boutiques marketing through OTAs, some major hotel chains were modifying their policies so that independent hotels could use their proprietary websites and reservation systems without actually being part of the overall brand. Marriott had launched Autograph, Hilton, Curio, Starwood, and Tribute, as programs under which independent hotels marketed their rooms through these larger chains’ reservation systems, paying roughly a 5% fee. This was far lower than the 20% and more that OTAs typically charged.

The economics of the hotel business were driven by simple math. The average nightly room rate multiplied by the occupancy rate equaled Revenue per Average Room (RevPAR). This was a key statistic used in evaluating the economic performance of a property, and increases in RevPAR were driven by increasing occupancy rate and/or by increases in the average nightly room rate.

The Independent Project

D’Arcy and Whiting worked diligently throughout the fall and were excited by the shape of the opportunities they had discovered. D’Arcy related some of their findings: D o

N ot

C op

y or

P os

917-501 | Hotel Vertu: Analyzing the Opportunity in the Boutique Hotel Industry

4 BRIEFCASES | HARVARD BUSINESS SCHOOL

People of our generation want an experience. A Marriott or Hilton is simply a transaction where you pay as little as you can to reserve a room. The boutique hotel guest wants to feel a connection to the property. Research shows that the key to a boutique property’s success is personalizing the experience by making the guest feel as though she is known to the staff, has a connection to the restaurant, and is doing something cool. And, she wants to seem cool when telling her Facebook friends where she is staying.

Whiting explained other conclusions they had reached:

For a boutique hotel—especially a new one, without a proven brand name—you want to be in a good market, with limited supply. You need to drive trial. If the existing properties have a 55% occupancy, people won’t try something else. You need sell-outs that drive people to try new properties. Social media has really democratized the marketing of boutique properties. The experts we talked to thought that we could market a property ourselves, that is, we wouldn’t need the brand name, marketing, and reservation system provided by one of the major chains. TripAdvisor is a huge driver, as are Facebook and other social media platforms. Google AdWords is also a great tool.

Their work convinced D’Arcy and Whiting that this was an industry in which they could start an interesting company and grow it by developing additional hotels under their brand, or sell their first property (or properties) if they became disenchanted with the business. D’Arcy explained: “There is a ready market for the sale of properties. The big guys are always interested in growing their footprint.”

D’Arcy planned to be in London during the holidays and invited Whiting to come over for a brief working vacation: “My father is in the real estate investment business and is a very savvy investor. I thought we could get a lot of insight from him and test our ideas.”

Whiting recounted the experience:

Yvonne’s father was throwing a big New Year’s Eve party at a fancy hotel in London. Several hundred people, including some of the leading lights in business, entertainment, and politics in the UK, and from all over Europe, attended. I had known that Yvonne came from a pretty posh background, but then I saw her in a whole new light.

We spent the next morning with Mr. D’Arcy, and he was most impressed with the growth in the industry and the fact that the fundamentals made it possible to do this as a one-off project, as there were few barriers to entry and few economies of scale. In the best of all worlds, he said, we would create a brand that we could expand into a small chain. Elisabeth and I agreed we’d do another field study during our final semester, develop a real business plan, and then try to raise some financing, so that we could hit the ground when we graduated.

Mr. D’Arcy said he would introduce us to some people who financed projects like this, and agreed to match any financing we pulled together from outside sources, one-to-one. We were excited that he was willing to pull out his own checkbook to support it.

In the winter and spring of 2015, D’Arcy and Whiting set to work trying to find a suitable location for the prospective hotel. As the semester began, Whiting was aware that other students were working on independent projects that were oriented toward starting a business. Having heard about some unfortunate incidents in which teams had blown up over disagreements over roles, titles, and equity ownership, she initiated a series of discussions concerning their roles, titles, and equity stakes in their nascent business, which culminated in the letter of agreement shown in Exhibit 1. D

o N

ot C

op y

or P

os t

Hotel Vertu: Analyzing the Opportunity in the Boutique Hotel Industry | 917-501

HARVARD BUSINESS SCHOOL | BRIEFCASES 5

Unearthing an Opportunity

Through her contacts in the hotel industry, Whiting had put out the word that she was looking for potential hotel properties. The women received a number of leads, which they explored by reviewing the pitch books that the respective brokers had prepared on various properties. They learned a lot through this process and made two trips south to look at several properties. Whiting reflected: “We saw dumps that could not become the kind of property we wanted. We also saw some lovely places that were priced at top dollar, and we couldn’t imagine how we would add value.”

Then, in early February, a contact of Whiting’s at a big hotel chain passed along a lead on the Peach Tree Inn in Savannah, Georgia. Whiting’s friend had reviewed the deal and passed on it because it was too small for the chain, but commented that it was an interesting property in a solid market. The inn was a converted stately office building built in the late 1800s. The Peach Tree had been converted to an inn in the early 1980s and was a “tired” property. However, D’Arcy and Whiting believed it was well located and had good underlying structure. While the rooms and infrastructure would need considerable updating, the basic layout of the building and the rooms was sound and convenient. The property had 145 rooms and was on the market for $21 million. See Exhibit 2 for the historical financial performance of the inn.

D’Arcy and Whiting were especially enthusiastic because Savannah had a vibrant historic district at its center and a thriving tourist industry built around that district. The number of hotels there was limited by available property and zoning considerations. The Peach Tree had an ideal location, and the woman believed they could add real value by turning it from a 2.5- or 3-star property into a 4-star hotel. They settled on renaming it The Vertu.

The Business Plan After negotiations with the owners, D’Arcy and Whiting procured a three-month option to buy the

property for $20 million, with $25,000 for the option, which they drew from their personal savings. That $25,000 would be deducted from the ultimate purchase price, which represented a multiple of 13.2 times the expected 2015 cash flow.1

The Savannah Market

Savannah was an appealing market for several reasons. First, it was located near several popular beach communities such as Hilton Head, South Carolina. Savannah had approximately 350,000 residents and was growing steadily. It was one of the state’s fastest growing areas, with several significant employers, including Gulfstream Aerospace, Memorial Health, and St. Joseph’s Health. The city was home to the nation’s fifth-largest container port (Garden City Terminal). Tourism was one of the its significant industries. A bestselling book, Midnight in the Garden of Good and Evil, had generated ongoing interest in Savannah. The city attracted more than 12 million visitors in 2014, with 50% staying the night; 62% stayed approximately 2.2 nights each. In total, 83% of visitors were considered leisure visitors while the remaining 17% were there for business purposes. Overall, visitor spending exceeded $2 billion in 2013, with 38% of that spent on lodging and 26% on food and beverage. Activity in

1 Note: Cash flow was equivalent to Net Operating Income in the real estate business; buyers and sellers typically talked in terms of a cap rate rather than a multiple. The cap rate was the inverse of the multiple, i.e., the rate at which cash flow was capitalized to get a price. In this example, the cash flow of $1,515,000 divided by the price of $20 million = a cap rate of 7.6%, the inverse of the 13.2 x multiple. D o

N ot

C op

y or

P os

917-501 | Hotel Vertu: Analyzing the Opportunity in the Boutique Hotel Industry

6 BRIEFCASES | HARVARD BUSINESS SCHOOL

Savannah was steady, although spring was the busiest time of year. The city was well served by interstate highways and a relatively new airport.8 See Exhibit 3 for a summary of key lodging statistics.

Competition

Nine existing hotels constituted the competition, also shown in Exhibit 3. As mentioned above, D’Arcy and Whiting planned to position The Vertu as a 4-star property, and to compete in the range served by the nationally branded hotels, but at a price point below the Bohemian property, the premium hotel in the market, by approximately $50 per night. On average, they expected The Vertu to stabilize at a price point of 120%, or so, of the average of its competition. Potential additions to the supply of rooms were limited, given the lack of available land and restrictive zoning laws in the area.

Renovations and Repositioning

Working with her contacts in the hotel industry, Whiting found experienced architects in the Georgia area who had worked on similar projects. They were impressed with the building and its potential, and developed a plan for upgrading the hotel. The Vertu would have large rooms, ranging from 380 to 560 sq. feet, and would include 35 king rooms, 85 double rooms, and 25 suites. The pool area would be refurbished and expanded to include an outdoor dining area adjacent to the renovated restaurant space. HVAC systems would be upgraded to give each room individual control. Sprinklers and fire alarms would be replaced and elevators improved. The lobby would be transformed into a modern and inviting space with a lounge/bar area. The restaurant and bar would be visible from the lobby and street entrance, thereby enhancing the draw. All guestrooms would be upgraded to an appropriate level of furnishings and fixtures, with a significant emphasis on the bathrooms and entertainment facilities in each room. The suites would receive particular attention, including the addition of soaking tubs and multi-head showers.

Based on their experience in the field, the architects estimated a total renovation cost of approximately $7.8 million. Additional fees and expenses of approximately $10 million brought the total capital requirement to $37.9 million. See Exhibit 4 for details of the project budget.

Moving Forward

By mid-April, D’Arcy and Whiting believed that an important piece of the puzzle had fallen into place. They had found a property they were excited about and then obtained a reasonable estimate for the renovation costs. They now needed to develop a detailed financial plan and explore sources of bank financing. Mr. D’Arcy expressed his continued willingness to help finance the deal himself as well as to provide introductions to his friends and associates. Yet, as the plan became more concrete, Whiting began to feel less comfortable:

I am excited about all we’ve done, but I want to be sure we are doing the right thing. As we start to think about financing the project, I worry that Yvonne’s father will have undue influence if all the money comes from him and his friends. On the other hand, you always have investors and they always have some degree of power. Maybe the devil you know…

D o

N ot

C op

y or

P os

Hotel Vertu: Analyzing the Opportunity in the Boutique Hotel Industry | 917-501

HARVARD BUSINESS SCHOOL | BRIEFCASES 7

Exhibit 1 Letter of Agreement between D’Arcy and Whiting

Whereas Yvonne D’Arcy and Elisabeth Whiting (“the Founders”) have worked together and have jointly contributed to the idea and intellectual property that constitutes the basis of the initial business plan for The Vertu Hotel (“the Venture”); and,

Whereas the Founders mutually desire to continue working on this idea toward the objective of launching the Venture; and,

Whereas each Founder wishes to have her rights acknowledged and acknowledges those of the other, the Founders now agree as follows:

1. Founders shall continue to work on this idea during their final semester of studies, and each shall be compensated with equity in the business, should a business be founded as a result of their efforts;

2. If the business is founded, and if each Founder forgoes other full-time employment to devote her full-time efforts to the Venture following graduation, then the Founders shall each be entitled to a 50% interest in the business, to be diluted equally by any subsequent financing events, and subject to the vesting provisions discussed below.

3. If one Founder does continue with the Venture on a full-time basis and forgoes other employment upon graduation, but the other does not, then the Founder who remains with the business shall receive 90% of the initial equity and the nonparticipating Founder 10% of the equity in the business; again, all subject to the vesting provisions discussed below.

4. If both parties continue as equal Founders, their shares shall be subject to vesting provisions, in which 20 percentage points of each Founder’s equity share shall vest upon the actual incorporation or legal founding of the business (and the signing of contemplated employment agreements with the business) and the remaining 30 percentage points vests equally in equal monthly installments over the remaining 30 months.

5. In the case where one Founder continues with the venture and one does not, then the Founder who is NOT continuing with the venture shall receive her 10 percentage points’ share free and clear upon the incorporation of legal founding of the business (i.e., without vesting) and the remaining Founder shall receive 30 percentage points of her equity ownership upon the actual incorporation or legal founding of the business, and the remaining 60 percentage points in equal monthly installments over the ensuing 30 months. Note that it is anticipated that both parties’ ownership stakes shall be diluted by subsequent financing events and subsequent issuance of stock, although it is anticipated that the issuing of any additional “founder’s stock” shall come from the continuing Founder(s) initial share(s).

6. In the case where one Founder elects not to continue with the business on a full-time basis, she will execute an agreement giving the Venture full right to all inventions, intellectual property, and confidential business information, and irrevocably assign any and all rights in all inventions, including without limitation improvements, formulae, processes, techniques, knowhow, data, whether or not patentable, that she may have made, conceived, or reduced to practice or learned, either alone or jointly with others, during the course of her work on the project, and that the 10% ownership stake articulated above shall be full and just compensation for this transfer and any and all work done up until that point on the venture.

7. The Founders recognize that these terms may be changed in response to requests from investors who may elect to finance the Venture, and nothing in this agreement shall be construed to restrict the Founders from amending this agreement to conform to the requirements of securing financing.

8. The Founders recognize that this agreement is silent on the issue of which individual may fill specific roles in the business, and that this lack of specificity is a necessary consequence of the early stage of this work and the uncertainty that exists. The Founders pledge to use their good-faith efforts to resolve these issues in a manner that seems consistent with the ultimate success of the business and with any requirement to obtain financing for the Venture.

SIGNED and AGREED

________________________________________ ________________________________________ Yvonne D’Arcy Elisabeth Whiting

________________________________________ ________________________________________ Date Date

Note: Some language here is adapted from “Addressing difficult issues of role, commitment and equity ownership,” by Michael J. Roberts, HBS class note, unpublished.

D o

N ot

C op

y or

P os

91 7-

50 1

-8

E xh

ib it

2 Pe

ac h

T re

e In

n H

is to

ri ca

l P er

fo rm

an ce

a nd

F in

an ci

al s

ea ch

T re

e In

n –

H is

to ri

ca l

P er

fo rm

an ce

20 10

20 12

20 14

15 a

# r

oo m

s 14

5 14

oo m

s so

35 59

7 35

87 9

36 02

8 36

14 8

35 55

3 35

67 0

O cc

up an

67 .3

67 .8

68 .1

68 .3

67 .2

67 .4

A D

R (1

) 13

0. 34

2. 22

7. 65

9. 27

0. 65

2. 21

D R

% C

ha ng

1. 4%

1. 2%

1. 1%

ev PA

R (2

) 87

.6 7

89 .6

3 93

.7 0

95 .1

2 94

.4 8

95 .8

ev PA

R %

C ha

ng e

4. 5%

-0 .7

1. 4%

ea ch

T re

e In

n F

in an

ci al

20 13

20 15

00 0)

er R

$( 00

P er

R m

00 0)

er R

R ev

en ue

oo m

5 ,0

82 .0

1 39

.2 7

5 ,0

81 .5

40 .6

,0 73

.4 %

42 .2

od &

B ev

15 .5

6. 28

1 ,0

16 .6

28 .6

,0 12

.2 %

2 8.

el ep

ho ne

0. 0%

0 .0

0. 03

Pa rk

in g

1. 5%

.5 3

1. 5%

th er

2. 5%

0 .6

1. 57

T O

T A

6 ,1

10 0.

1 69

.8 1

6 ,1

10 0.

72 .5

,2 35

0. 0%

74 .7

xp en

se s

R oo

m s

9 81

.0 %

2 7.

,1 78

.2 %

.1 3

1 ,2

19 .5

4. 03

Fo od

& B

7 86

.8 %

2 1.

8 12

.2 %

.8 4

14 .0

4. 39

T el

ep ho

1. 08

0. 7%

.1 8

0. 7%

rk in

0. 0%

O th

2. 30

0. 3%

.4 8

0. 1%

O T

A L

,8 89

.8 %

5 2.

,0 49

.4 %

.6 3

2 ,1

34 .2

9. 77

ot al

O pe

ra ti

ng P

ro fi

4 ,2

69 .2

1 17

.5 5

4 ,0

66 .6

14 .9

,1 03

.8 %

15 .0

na llo

ca te

d O

pe ra

ti ng

E xp

en se

en er

al &

A d

m in

8. 2%

1 3.

5 75

16 .1

5 56

5. 59

Sa le

s &

M ar

ke ti

1 82

5. 03

4. 9%

.5 2

4. 8%

op er

ty O

pe ra

tio ns

5. 0%

2 37

6 .6

2 89

8. 10

E ne

rg y

2 02

5. 59

3. 5%

.0 2

3. 1%

O T

A L

,1 93

.4 %

3 3.

,3 29

.7 %

.3 8

1 ,3

21 .5

7. 51

D o

N ot

C op

y or

P os

-9 -

9 17

-5 01

E xh

ib it

2 P

ea ch

T re

e In

n H

is to

ri ca

l P er

fo rm

an ce

a nd

F in

an ci

al s

(c on

ti nu

ed )

G ro

ss O

pe ra

ti ng

P ro

fi t

05 6

.8 %

84 .5

75 8

.9 %

7. 56

2, 76

44 .3

.5 1

Fi xe

d Ex

pe ns

Pr op

er ty

T ax

5. 5%

.3 8

31 1

.7 5

27 6

7 .7

In su

ra nc

e 9

1. 5%

.5 2

1. 4%

2 .3

1. 6%

.8 6

an ag

em en

t F ee

23 4

6 .4

4. 0%

6 .9

4. 0%

.0 6

an ch

is e

Fe e

9. 2%

15 .6

6. 2%

0. 74

37 0

.3 7

th er

F ix

1 6

0 .4

- 0.

T O

T A

1, 24

20 .3

.4 4

1, 02

16 .7

2 8.

00 0

.0 %

28 .0

In co

m e

be fo

re R

es er

81 1

.5 %

50 .1

73 4

.3 %

8. 76

1, 76

28 .3

.4 7

es er

ve fo

r R

ep la

ce m

en t (

4. 0%

.7 2

24 7

.9 5

25 0

7 .0

N et

O pe

ra ti

ng In

co m

e /

C as

h Fl

56 8

.5 %

43 .3

48 7

.2 %

1. 81

1, 51

24 .3

.4 6

a N

ot e

20 15

is a

ct ua

l f or

fi rs

t 6 m

on th

s an

d fo

re ca

st fo

r re

m ai

nd er

o f y

ea r

(i .e

., th

ro ug

h D

ec 3

1, 2

01 5)

13 .2

pu rc

ha se

m ul

ti pl

D ar

cy a

nd W

hi ti

ng b

el ie

ve d

th e

fo re

ca st

to b

e ac

cu ra

07 6

ap r

at e

(1 )

A D

R =

A ve

ra ge

D ai

ly R

at e,

th e

av er

ag e

ra te

p er

r oo

m , w

he n

a ro

om is

s ol

d (2

) R

ev PA

R =

R ev

en ue

p er

A ve

ra ge

R oo

m =

to th

e A

D R

x th

e oc

cu pa

nc y

ra te

) In

t he

h ot

el i

nd us

tr y,

r at

he r

th an

u se

d ep

re ci

at io

n, c

om pa

ni es

f ac

to re

d i

n a

re se

rv e

fo r

re pl

ac em

en t,

w hi

ch w

as d

es ig

ne d

to c

ap tu

re t

he a

nn ua

l co

st a

ss oc

ia te

d w

it h

m ai

nt ai

ni ng

a nd

u pg

ra di

ng t

he pr

op er

ty , e

ve n

th ou

gh it

m ig

ht n

ot b

e sp

en t i

n th

e ye

ar in

w hi

ch it

w as

b oo

ke d.

D o

N ot

C op

y or

P os

91 7-

50 1

-1

E xh

ib it

3 K

ey L

od gi

ng S

ta ti

st ic

s in

S av

an na

h M

ar ke

Sa va

nn ah

(O ve

ra ll

) M ar

ke t

D at

Y ea

r S

u p

p ly

C ha

n ge

em an

d C

h an

O cc

u p

an cy

cc u

p an

A D

R ev

P A

R ($

) R

ev P

A R

) (%

) C

h an

($ )

C h

an ge

(% )

h an

ge (%

)

20 11

2. 60

.1 0

-0 .8

0 13

0. 87

-3

.3 %

.7 4

-5 .1

9. 00

66 .8

0 -4

.7 0

13 1.

0. 4%

.7 5

-4 .4

2. 30

.9 0

72 .6

0 8.

13 0.

-0 .9

94 .5

0 7.

0. 00

72 .7

0 0.

13 6.

4. 9%

.2 6

5. 0%

20 15

a 0.

1. 80

.9 0

1. 80

0. 73

10 4.

4. 8%

Sa va

nn ah

C om

pe ti

ti on

ro p

er ty

T yp

e R

oo m

s 20

14 O

cc u

p an

A nd

B ou

ti qu

e 15

1 80

.2 %

ut og

ra ph

M an

si on

ou ti

qu e

12 5

68 .4

B oh

em ia

n H

ot el

ou ti

qu e

88 .2

R es

id en

ce In

n N

at io

na l C

ha in

9 87

.4 %

ar sh

al l H

ou se

ou ti

qu e

N A

an te

rs In

n B

ou ti

qu e

N A

ya tt

R eg

en cy

at io

na l C

ha in

1 80

.9 %

ar ri

ot t

N at

io na

l C ha

38 7

65 .9

R iv

er S

tr ee

t I nn

ou ti

qu e

N A

S p

ec if

ic S

ta ts

f or

S av

an n

ah c

om pe

ti ti

ve s

et (9

h ot

el s

ab ov

20 10

20 12

20 14

15 a

A D

14 5.

15 1.

15 3.

15 7.

16 1.

16 3.

16 7.

O cc

up an

74 .3

75 .4

74 .3

73 .6

72 .4

73 .5

74 .3

a Fo

re ca

st fo

r 20

D o

N ot

C op

y or

P os

Hotel Vertu: Analyzing the Opportunity in the Boutique Hotel Industry | 917-501

HARVARD BUSINESS SCHOOL | BRIEFCASES 11

Exhibit 4 Project Budget ($000)

Property Acquisition 20,000 Construction / renovation 7,770

Other Fees & Expenses Architects, designers 519 Hotel & Rest F&F 3,348 Information Technology 584 Operating supplies / Equipment 1,081 Pre-opening & Marketing 858 Property Taxes & Insurance 62 Financing Fees & Expenses 233 Construction Period Debt Payment 2,029 Accounting & Legal 123 Reserve / Working capital 250 Contingency 1,000 Total “other” 10,087

Grand Project Total 37,857

Financing Structure Debt Capacity 65% Total Debt 24,607

Total Equity 13,249

D o

N ot

C op

y or

P os

917-501 | Hotel Vertu: Analyzing the Opportunity in the Boutique Hotel Industry

12 BRIEFCASES | HARVARD BUSINESS SCHOOL

Endnotes

1 2013 data from American Hotel and Lodging Association, 2014 Lodging Industry Profile, https://www.ahla.com/content.aspx?id=36332

2 “Americas: Lodging,” Goldman Sachs, May 15, 2013, p. 12

3 “Boutique Hotels in the US,” Ibis world Industry Report OD5464, Andrew Alvarez, ibisworld, January 2015, pp. 7–8, 18.

4 Ibid, pp. 4—16.

5 Ibid. pp. 9–12.

6 Ibid, p. 23.

7 Ibid, p. 23.

8 Savannah Chamber of Commerce, “Visit Savannah,” www.savannahchamber.com

D o

N ot

C op

y or

P os

https://www.ahla.com/content.aspx?id=36332

BUS 224/Assignment I/Cases/Financial Advisor Pinewood Mobile Homes .pdf

________________________________________________________________________________________________________________

HBS Professor Emeritus William Fruhan and Professor Wei Wang, Queen’s School of Business, Kingston, Ontario, prepared this case solely as a basis for class discussion and not as an endorsement, a source of primary data, or an illustration of effective or ineffectiv e management. Although based on real events, and despite occasional references to actual companies, this case is fictitious and any resemblance to actual persons or entit ies is coincidental. Copyright © 2015 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. This publication may not be digitized, photocopied, or otherwise reproduced, posted, or transmitted, without the permission of Harvard Business School.

W I L L I A M F R U H A N

W E I W A N G

Pinewood Mobile Homes, Inc.

In March 2011, Kenneth Walker, CEO of Pinewood Mobile Homes, sat in his office and considered a restructuring plan that his CFO had prepared with the assistance of the company’s financial advisors. The restructuring proposal’s key element was an exchange offer that would allow Pinewood’s creditors to swap their existing claims for new securities. If the company was unable to obtain the necessary approval from its creditors, it would be at imminent risk of having either to file for Chapter 11 bankruptcy or to sell a majority of its assets. Walker knew that he had to act quickly. Pinewood had exhausted its credit lines, and it had to pay the principal on its short-term debt in the next month.

Company Background

Pinewood Mobile Homes, based in Dallas, Texas, was a large manufacturer of prefabricated homes. It manufactured one-story, ranch-style houses; two-story, single-section and Cape Cod modular homes; and townhomes, apartments, and duplexes. It also produced modular commercial structures, including two- and three-story buildings and barracks for U.S. military bases. Pinewood had 24 home- building facilities located in 10 states and two provinces in Canada and more than 3,000 employees.

Founded in 1952 by Walker’s grandfather, Pinewood Mobile Homes had been exclusively family owned until 1997, when it filed for an initial public offering (IPO) and listed its stock on the NASDAQ stock exchange. Walker took over the company from his grandfather shortly before the IPO. After the IPO, Walker invested in energy-efficient products and expanded the company’s geographic reach by building new production facilities in the southern United States. The expansion strategy worked well over the following few years and resulted in fast revenue growth and high profit margins. Meanwhile, Walker had adopted a conservative financial policy to support Pinewood’s growth strategy. He maintained a low leverage ratio and financed investments through internally generated cash flows.

In 2000, Walker decided to raise debt for Pinewood’s rising working capital and investment needs. He initiated a revolving credit facility of $110 million with a consortium of seven U.S. banks, led by National Bank of Dallas. The facility’s interest rate was set at LIBOR plus 1%. Virtually all the assets of the company were pledged as collateral. The bank debt contained various restrictions, including (1)

9 - 9 1 5 - 5 4 7 M A R C H 4 , 2 0 1 5

D o

N ot

C op

y or

P os

915-547 | Pinewood Mobile Homes, Inc.

2 BRIEFCASES | HARVARD BUSINESS SCHOOL

affirmative covenants pertaining to the company’s net worth and liquidity position; (2) negative covenants restricting its ability to further issue debt with higher seniority than the bank debt; and (3) prohibitions to raise dividends before paying off the bank debt. Subsequently, Pinewood issued a ten- year, senior unsecured note with a face value of $285 million in 2004, and a ten-year, subordinated convertible debenture with a face value of $170 million in 2006, to finance its capital investments and acquisitions. In addition, Walker renewed the revolving credit facility in late 2005, while increasing the credit line to $215 million.

Between 2003 and 2006, Walker acquired several small- and medium-sized manufacturers in the western United States and Canada by using funds raised through debt issues. As a result, Pinewood’s U.S. market share reached 18% by the end of 2006. However, the housing market crash of 2007–2008 hit the company hard. Pinewood’s revenue declined by more than 40%, from its peak in 2006. Its financial condition deteriorated further after 2008, as the prefabricated home-manufacturing industry recovered slowly from the financial crisis. The company generated negative operating cash flows from 2006 through 2009. In 2009, Walker initiated an asset restructuring program that generated liquidity by divesting several non-core assets previously acquired by the company. (Exhibit 1 presents the consolidated balance sheets and income statements of Pinewood from 2001 to 2010.)

Nonetheless, Pinewood was well-respected for its high-quality products and services by wholesale and retail customers. It won the Manufactured Housing Institute’s Manufacturer of the Year award several times. Moreover, Pinewood was considered an innovator in the product market because of its line of energy-efficient homes, which included modular “green” homes with bamboo flooring and solar power. The company marketed its mobile-home products under several different brands, including Pinewood Homes, EcoLiving Homes, and Elite Homes.

Industry Background

The prefabricated home-manufacturing industry was severely affected by the housing market crash. The industry’s sluggish recovery after the crisis was partly attributed to the slow recovery of housing prices and to a long-term shift in consumer preferences toward conventional housing. As a consequence, many small companies were forced to close operations and liquidate. Several large mobile-home producers either filed for bankruptcy or were acquired. Large, national companies acquired regional competitors to gain access to key markets and cheaper labor. There were more than $15 billion in deals completed between 2005 and 2010. As of 2011, there were fewer than 200 prefabricated home manufacturers in the United States. Many of these companies generated sales of less than $50 million.

Operating margins were low due to the industry’s labor-intensive manufacturing processes and high material costs. Companies needed to develop new products in order to stay competitive. For example, many manufacturers added premium features to their products, such as high-end kitchen furnishings, and continued to improve product quality. Industry sales were expected to grow at an

average annual rate of 3.6% from 2012 to 2019.1 Further industry consolidation was also expected.

The Situation

Pinewood increased its revenue and operating margin from 2009 to 2010. The EcoLiving product line generated nearly half Pinewood’s total sales in 2010. However, the company continued to generate

1Source: IBIS World industry report, 32199a – Prefabricated Homes Manufacturing in the U.S. D

o N

ot C

op y

or P

os t

Pinewood Mobile Homes, Inc. | 915-547

HARVARD BUSINESS SCHOOL | BRIEFCASES 3

operating losses, which, along with limited proceeds from divestitures, undermined Walker’s restructuring strategy. At the end of 2010, Pinewood’s book common equity was negative $8 million. Preferred and common dividends had been suspended for six quarters. Debt service obligations, including interest and amortized debt principal payments, were substantially higher than the internally generated operating cash flows were. The ongoing cash drain resulted in further drawdowns of the revolving credit facility.

In late 2010, Pinewood reached the limit of its revolving credit facility. Walker could not negotiate an increase in the credit limit with bank lenders, who were concerned about Pinewood’s leverage and its breached covenants. However, he did manage to obtain month-to-month waivers of breached covenants and a three-month renewal of outstanding loans due March 31, 2011. Further, the company had to cancel the issuance of new preferred stock due to a lack of interest from existing shareholders. (Exhibit 2 presents the consolidated capitalization as of December 31, 2010.)

On March 1, 2011, it was clear that Pinewood would be unable to pay interest on its existing debt and on a $40.7 million sinking-fund payment due April 15 on its long-term senior unsecured notes, which were held by several life insurance companies and pension funds. Moreover, National Bank of Dallas informed Walker that it would not approve any more one-month extensions unless Pinewood immediately made a 10% principal payment or entered into a letter of intent for the sale of the company on terms satisfactory to the banks. Walker knew that the banks would oppose the company paying interest on the senior unsecured notes before it reduced the bank loan, but was not sure how the holders of the senior unsecured notes would react if they did not receive contractual payments.

National Bank of Dallas also disclosed that a few smaller banks in the syndicate had begun to lobby for foreclosure on the collateral. However, these lenders understood that such action would trigger a voluntary bankruptcy filing by Pinewood and that this filing would immediately impose a stay on foreclosures. Walker knew that the large lenders were opposed to forcing the company into Chapter 11 before efforts to reach an out-of-court restructuring were exhausted. In addition to debt service payments, Pinewood also needed about $50 million in cash by June 30, 2011, to finance an increase in seasonal inventory and receivables, as well as capital expenditures in new products. With cash on hand of $20 million, and proceeds from recent asset sales equaling approximately $35 million, Walker believed Pinewood could meet its cash needs. However, he saw no way for Pinewood both to service its debt and to invest in its operations. He believed Pinewood risked losing consumer confidence and revenue if it did not fund its working capital and new investment needs, but knew that the company would default if it did not service its debt. (Exhibit 3 presents a summary of Pinewood’s contractual debt service requirements for the subsequent 12 months.)

As of March 1, 2011, Pinewood’s senior unsecured notes were trading at 65 ½ cents on the dollar. Its subordinated debenture was trading at 24 ¼ cents on the dollar. Its common shares were trading for $1.09 on the NASDAQ. Further, based on quotes from private transactions, its preferred shares were trading at $1.35.

Asset Sale and Chapter 11

In late 2010, a group of Wall Street investors proposed taking the company private by injecting fresh capital; the investors valued the company at $545 million. Because several of Pinewood’s board members were not satisfied with the purchase price, the deal fell through. Nonetheless, the offer sparked interest in the EcoLiving Home division. Walker was approached by Dycon Industries, a medium-sized producer in the prefabricated home-manufacturing industry that was willing to pay $365 million to acquire the division. Dycon was primarily motivated by its desire to acquire Pinewood’s D o

N ot

C op

y or

P os

915-547 | Pinewood Mobile Homes, Inc.

4 BRIEFCASES | HARVARD BUSINESS SCHOOL

technology in green home production. Several large bank lenders were advocating the sale because proceeds from it could be used to be used to pay down debt. However, the CFO and the board viewed the proposed purchase price for EcoLiving as too low, and believed it reflected Pinewood’s current financial troubles rather than the true value of EcoLiving Home under effective management. They believed that first-class management and hard work could make Pinewood regain its competitive position, assuming the company retained all of its core assets.

If EcoLiving were sold, Walker could either continue running the company with its remaining, less promising brands, or liquidate the remaining assets to pay off other creditors and equity holders. Based on third-party appraisals, the sale of the remaining assets would yield about $230 million in proceeds over the next one- to two-year period. Administrative expenses associated with the sale would total $25 million. Walker also estimated that a quick sale through auctions, which would require minimum administrative efforts, would bring approximately $180 million to $200 million in proceeds. With the assistance of Pinewood’s CFO, he drafted two cash flow projections for the next five years: one in which Pinewood kept the EcoLiving division, and another in which it was sold. The CFO also collected information about capital markets and comparable statistics for selected prefabricated home manufacturers. Further, Pinewood’s financial advisors told Walker that the company’s major assets would be sold for at least a 20% discount off their book value if they were sold piecemeal. (Exhibit 4 presents the five-year cash flow projections for Pinewood. Exhibit 5 presents information from selected capital markets and Pinewood’s common equity beta. Exhibit 6 presents comparable market and operating information for four prefabricated home producers.)

Walker considered a voluntary Chapter 11 filing as an alternative to an out-of-court debt restructuring. The management team expressed various opinions as to the potential benefits and costs of a formal bankruptcy filing.

Potential benefits included:

 an automatic stay on foreclosures would be triggered, and all interest and principal payments on pre-petition debt would be suspended until a reorganization or liquidation plan was confirmed by the bankruptcy court;

 management would continue to run the business as debtor-in-possession (DIP) and have 120 days of exclusivity to file a reorganization plan, with the possibility that the court would extend the exclusivity period to as long as 18 months;

 Pinewood could raise financing through super-seniority, DIP financing, which existing or new lenders could provide, to continue the business operations;

 the company would be able to close under-performing plants and reject or reassign undesirable leases and executory contracts;

 a majority vote by each class of creditors would confirm the plan of reorganization (the required majority was defined as a simple majority of the actual creditors and more than two-thirds of the face value of claims in each class). In contrast, an out-of-court restructuring would require virtually all of the debtor’s principal creditors to accept the plan; and

 it would allow for the adoption of special retention and incentive plans to key employees to improve enterprise value and operating performance.

Potential costs and risks included: D o

N ot

C op

y or

P os

Pinewood Mobile Homes, Inc. | 915-547

HARVARD BUSINESS SCHOOL | BRIEFCASES 5

 large legal and professional fees due to the bankruptcy proceedings; such fees might amount to $2 million to $3 million a month for paying services provided to the debtor and creditors;

 bankruptcy could cause damage to the company’s reputation, which in turn could affect how the company would interact with suppliers and customers, potentially resulting in tightened credit terms and the loss of sales;

 management time and energy would be spent preparing court documents, participation in hearings, and gathering information for court-appointed official committees of creditors or shareholders; also, critical employees could be lost to competitors;

 it could lead to a substantial increase in the amount of allowed claims because claims that otherwise would not be immediately made, such as unfunded pensions, product liability, employee injuries, and disputed payments, would probably be filed;

 the board could lose some control over strategic decisions to both secured and unsecured creditors (e.g., strict covenants contained in DIP loans would impose restrictions on corporate investment policies; the official unsecured creditors’ committees could scrutinize and file objections to management initiatives; both secured and unsecured creditors, if dissatisfied with the management, could file petitions to the court to replace the management and the board with a court-appointed trustee); and

 the outcome would be uncertain because of the broad discretion of the bankruptcy judge and each class of claim holders, which could be new activist hedge funds that challenged and frustrated management initiatives as they pursued their own interests (which could lead to fire sales and an inefficient liquidation of the company).

Walker felt that the potential costs of a Chapter 11 filing were not worth the benefits. However, a minority of the board members argued that a formal bankruptcy filing would shield management and the board from the banks’ immense pressure. With more time, these members believed the company could find more buyers for the assets that it would consider selling.

The Exchange Offer

The restructuring proposal offered to exchange all of Pinewood’s existing creditor claims for new secured debt, new unsecured debt, common stock, and warrants. The main purpose of the exchange offer was to reduce debt service requirement to a level that was consistent with cash flows and eliminate preferred equity from the capital structure. (Exhibit 7 outlines the terms of this offer.)

If the company received 100% acceptance from all classes of debt, its debt would be reduced from $507 million to $346 million, and common equity would increase from a negative $8 million to a positive $228 million. The exchange offer would defer all principal payments for at least two years and would reduce the annual interest payments significantly. (Exhibit 8 presents the pro forma effects of the proposed exchange offer on Pinewood’s capitalization.)

Decisions about this plan depended largely on whether major creditors believed they could recover their claims and whether the management team could turn Pinewood around. A Chapter 11 filing or selling EcoLiving Homes would be unavoidable if an accord could not be reached. Walker wondered how the creditors would react, and how he might save the business his grandfather had begun. D o

N ot

C op

y or

P os

9 1 5

-5 4 7

- 6

E x

h ib

it 1

im p

li fi

e d

P in

e w

o o

d M

o b

il e H

o m

e s

In c.

F in

a n

ci a

l S

ta te

m e n

ts ,

2 0

0 1

– 2

0 1 0

( U

.S .

$ m

il li

o n

0 0 1

2 0 0 2

2 0 0 3

2 0 0 4

2 0 0 5

2 0 0 6

2 0 0 7

2 0 0 8

2 0 0 9

2 0 1 0

In co

m e

S ta

te m

en ts

e t

sa le

s 9

4 3

9 8 8

1 ,0

8 0

1 ,2

1 6

1 ,3

5 8

1 ,5

0 1

1 ,2

7 1

9 1 8

8 2 5

8 7 5

C o

st o

f g

o o

d s

so ld

8 4

8 2 3

8 9 8

1 ,0

1 6

1 ,1

3 1

1 ,2

6 5

1 ,1

4 3

8 3 2

7 4 6

7 7 5

G ro

ss p

ro fi

t 1

5 8

1 6 5

1 8 1

1 9 9

2 2 6

2 3 5

1 2 8

8 5 .4

8 .4

9 .8

G &

1 0 8

1 1 0

1 1 9

1 3 5

1 5 0

1 6 9

1 6 0

1 1 8

1 0 5

9 8 .9

e p

re ci

a ti

o n

a n

d a

m o

rt iz

a ti

o n

1 5 .8

6 .1

9 .7

4 .5

5 .1

1 .2

0 .0

2 .5

5 .3

O p

e ra

ti n

g p

ro fi

t 4

3 .5

8 .5

5 .5

4 .8

1 .5

0 .9

3 .0

) (7

3 .1

) (5

9 .7

) (2

4 .4

) R

e st

ru ct

u ri

n g

c h

a rg

e s

- -

2 0 .8

2 .4

o ss

o n

a ss

e t

im p

a ir

m e n

t -

- -

2 2 .2

6 .3

2 .8

te re

st e

x p

e n

2 .4

1 .0

1 1 .5

4 .4

2 .6

4 .1

9 .8

8 .2

co m

e t

a x

e x

p e n

1 4 .4

3 .0

5 .6

4 .9

0 .5

(3 3

.1 )

(4 1

.2 )

(3 6

.0 )

(2 1

.0 )

N e t

in co

m e

2 6 .7

4 .1

8 .9

7 .6

9 .5

0 .7

2 .5

) (7

8 .2

) (9

0 .7

) (6

6 .9

)

u m

b e r

o f

p re

fe rr

e d

s h

a re

s o

u ts

ta n

d in

g (

m il

li o

n )

2 5 .0

5 .0

re fe

rr e d

d iv

id e n

d s

(U .S

. $

m il

li o

n s)

4 .5

$ 4 .5

$ 2 .2

- N

u m

b e r

o f

co m

m o

n s

h a

re s

o u

ts ta

n d

in g

( m

il li

o n

) 6

4 .8

P S

( co

m m

o n

s to

ck )

$ 0 .3

$ 0 .2

$ 0 .1

$ (1

.0 3

) $

(1 .2

8 )

$ (1

.4 3

) $

(1 .0

3 )

C o

m m

o n

d iv

id e n

d p

e r

sh a

$ 0 .1

$ 0 .0

- S

h a

re p

ri ce

1 0

.5 0

$ 1 2

.6 0

$ 1 3

.4 1

$ 1 3

.3 0

$ 1 2

.7 0

$ 1 0

.7 4

$ 8 .4

$ 4 .1

$ 1 .5

$ 1 .0

0 0 1

2 0 0 2

2 0 0 3

2 0 0 4

2 0 0 5

2 0 0 6

2 0 0 7

2 0 0 8

2 0 0 9

2 0 1 0

B a

la n

ce s

h ee

a sh

0 .5

4 .2

3 .7

0 .8

7 .2

0 3

6 3 .2

5 .6

2 .6

0 .3

cc o

u n

ts r

e ce

iv a

b le

3 .7

6 .4

9 .7

0 3

1 2 5

1 5 1

1 7 9

1 4 8

1 3 7

1 3 0

In v

e n

to ry

3 0

1 4 3

1 5 5

1 7 1

1 8 8

2 1 0

1 9 0

1 6 7

1 4 5

1 3 8

O th

e r

cu rr

e n

t a

ss e ts

5 .1

5 .0

4 .9

7 .9

7 .8

C u

rr e n

t a

ss e ts

5 6

2 6 9

2 9 3

3 5 0

3 9 7

4 7 0

4 3 8

3 6 9

3 2 2

2 9 6

G ro

ss P

P &

2 3 7

2 5 7

3 2 1

5 3 8

5 8 0

6 9 7

7 2 2

6 6 2

5 9 8

5 5 8

C u

m u

la ti

v e

d ep

re ci

at io

2 6 .5

2 .3

8 .4

8 .1

1 2

1 4 7

1 8 9

2 2 9

2 6 1

2 8 6

N e t

P P

& E

1 1

2 1 4

2 6 2

4 6 0

4 6 8

5 4 9

5 3 3

4 3 3

3 3 7

2 7 2

In v

e st

m e n

ts a

n d

o th

e r

a ss

e ts

6 .0

7 .0

7 .4

6 .5

5 .9

T o

ta l

a ss

e ts

7 3

4 9 0

5 6 2

8 1 8

8 7 3

1 ,0

2 7

9 7 9

8 0 9

6 6 6

5 7 4

A cc

o u

n ts

p a

y a

b le

0 .6

5 .7

3 .6

2 .5

0 6

1 1 6

1 0 8

8 4 .9

6 .9

9 .9

cc ru

e d

t a x

e s

1 6 .4

7 .4

9 .4

1 .1

9 .0

5 .6

1 .1

) (4

1 .5

) (6

7 .3

) (7

9 .2

) S

h o

rt -t

e rm

b a

n k

b o

rr o

w in

4 9 .5

7 .0

2 .1

5 .2

9 .9

7 .3

5 8

1 6 2

1 9 0

2 1 5

C u

rr e n

t p

o rt

io n

o f

lo n

g -t

e rm

d e b

t -

- -

4 0 .7

0 .7

C u

rr e n

t li

a b

il it

ie s

1 3 6

1 4 0

1 9 5

1 4 8

1 9 5

2 2 0

2 8 6

2 4 6

2 4 0

2 5 6

T o

ta l

lo n

g -t

e rm

d e b

t -

- -

2 8 5

4 1 4

3 7 3

3 3 2

2 9 2

2 5 1

L T

D eb

t: 1

0 -y

ea r

bo n

d (

se n

io r)

- -

2 8 5

2 4 4

2 0 3

1 6 2

1 2 2

8 1 .4

T D

eb t:

7 -y

ea r

bo n

d (

ju n

io r)

- -

1 7 0

T o

ta l

li a b

il it

ie s

1 3 6

1 4 0

1 9 5

4 3 3

4 8 0

6 3 4

6 6 0

5 7 9

5 3 2

5 0 7

P re

fe rr

e d

s h

a re

h o

ld e rs

’ e q

u it

7 5 .0

5 .0

o m

m o

n s

h a

re h

o ld

e rs

’ e q

u it

2 6 1

2 7 4

2 9 2

3 0 9

3 1 7

2 4 4

1 5 5

5 8 .8

.1 )

T o

ta l

li a b

il it

ie s

a n

d e

q u

it y

7 3

4 9 0

5 6 2

8 1 8

8 7 3

1 ,0

2 7

9 7 9

8 0 9

6 6 6

5 7 4

D o

N ot

C op

y or

P os

Pinewood Mobile Homes, Inc. | 915-547

HARVARD BUSINESS SCHOOL | BRIEFCASES 7

Exhibit 2 Consolidated Capitalization, as of December 2010 (U.S. $ millions)

Short-term debt

Variable/LIBOR +1% p.a., revolving loan facility, due 3/31/2011 $215.0

Current portion of senior unsecured notes, due 4/15/2011a $40.7

Long-term debt

Fixed/3.5% p.a., senior unsecured notes, due 4/15/2014 $81.4

Fixed/6.5% p.a., subordinated convertible debenture, due 6/15/2016 $170.0

Total Debt $507.1

Equity

$3.00 preferred stockb $75.0

Common stockc ($8.1)

Total equity $66.9

Total capitalization $574.0

a Due date for current portion of long-term debt only

b Cumulative preferred stock; 25,000,000 shares outstanding; $75 million liquidation value

c 64,800,000 shares outstanding

Exhibit 3 Debt Service Requirement for Next 12 Months, as of December 2010 (U.S. $ millions)

Interest Principal Total

Variable/LIBOR +1% p.a. of 3/31/2011a 0.8 215.0 215.8

Fixed/3.5% p.a. of 4/15/2014 2.9 40.7 43.6

Fixed/6.5% p.a. of 6/15/2016 11.1 - 11.1

Bank debt 0.8 215.0 215.8

Long-term debt 13.9 40.7 54.6

Total debt 14.7 255.7 270.4

a Principal repayments of revolving facility assume no extension of maturity

D o

N ot

C op

y or

P os

915-547 | Pinewood Mobile Homes, Inc.

8 BRIEFCASES | HARVARD BUSINESS SCHOOL

Exhibit 4a Five-Year Cash Flow Projection for Pinewood — Assuming No Sale of EcoLiving, 2011– 2015 (U.S. $ millions)

2011 2012 2013 2014 2015

Sales growth 6.8% 6.0% 5.5% 4.5% 3.5%

Gross margin 12.5% 13.0% 13.5% 13.5% 13.5%

Operating margin 2.0% 3.0% 4.0% 4.5% 4.5%

Sales 934.8 990.9 1,045.4 1,092.5 1,130.7

Gross profits 116.9 128.8 141.1 147.5 152.6

Operating profits 18.7 29.7 41.8 49.2 50.9

Income tax 6.5 10.4 14.6 17.2 17.8

Net operating profits after tax 12.2 19.3 27.2 32.0 33.1

Depreciation & amortization 26.6 27.8 29.9 30.8 31.1

Change in Net WC and accrued taxes 4.9 (9.7) (9.6) (5.9) (5.1)

Capex 18.2 11.2 11.5 11.9 9.9

FCFa 15.7 45.6 55.2 56.8 59.4

a Perpetual growth of Free Cash Flow after 2015 is assumed to be 3.5%

Exhibit 4b Five-Year Cash Flow Projection for Pinewood — Assuming Sale of EcoLiving, 2011–2015 (U.S. $ millions)

2011 2012 2013 2014 2015

Sales growth 3.5% 3.5% 3.0% 2.5% 2.5%

Gross margin 11.5% 11.5% 12.0% 12.0% 12.5%

Operating margin 1.0% 2.0% 2.5% 3.0% 3.0%

Sales 507.3 525.1 540.8 554.4 568.2

Gross profits 58.3 60.4 64.9 66.5 71.0

Operating profits 5.1 10.5 13.5 16.6 17.0

Income tax 1.8 3.7 4.7 5.8 6.0

Net operating profits after tax 3.3 6.8 8.8 10.8 11.1

Depreciation & amortization 12.2 13.0 13.5 13.8 14.0

Change in Net WC and accrued taxes 2.2 (3.5) (3.3) (2.2) (1.4)

Capex 4.1 2.6 2.8 2.9 2.1

FCFa 9.2 20.7 22.8 25.7 26.2

a Perpetual growth of Free Cash Flow after 2015 is assumed to be 2.5%

D o

N ot

C op

y or

P os

Pinewood Mobile Homes, Inc. | 915-547

HARVARD BUSINESS SCHOOL | BRIEFCASES 9

Exhibit 5 Selected Capital Markets Information and Pinewood’s Equity Beta, as of March 1, 2011

Treasury ratesa

3-month Treasury bill 0.14%

1-year Treasury note 0.23%

10-year Treasury note 3.41%

Corporate bond yieldsb

Aaa 5.09%

Aa 5.31%

A 5.73%

Baa 6.00%

Ba 6.81%

Market risk premiumc 6.10%

Pinewood common equity betad 2.79

a Source: Federal Reserve System

b Source: Moody’s

c Based on 30-year annualized S&P 500 return (dividends assumed reinvested)

d Equity beta is estimated based on daily equity returns over the previous 36 months

Exhibit 6 Comparative Market and Operating Data for Selected Prefabricated Home Manufacturers, as of the End of 2010

Key financial ratios

Revenue (U.S. $

million)

3-Yr. growth

rate Gross

margin Operating

margin

Net profit

margin Debt to

capitalization

Debt to

equity Market

cap Equity

beta

King Enterprises $1,315.6 (9.7%) 10.4% (1.3%) (3.6%) 56.1% 127.8% $995.2 2.02

Dycon Industries $699.1 (11.9%) 12.2% 4.3% 1.2% 63.6% 174.7% $558.4 2.42

Timeline Homes Inc. $146.2 (22.8%) 7.5% (6.3%) (8.6%) 30.1% 43.1% $111.5 1.48

Cove Harbor Homes Co. $302.8 (15.6%) 19.6% (1.6%) (6.9%) 69.7% 230.0% $238.9 2.69

D o

N ot

C op

y or

P os

9 1 5

-5 4 7

- 1 0

E x

h ib

it 7

u tl

in e o

f th

e P

ro p

o se

d E

x ch

a n

g e O

ff e r

O ld

s e

cu ri

ti e

s P

ri n

c ip

a l

v a

lu e

O ri

g in

a l

in te

re s t/

iv id

e n

d r

a te

a tu

ri ty

e cu

ri ty

M a

rk e

t p

ri c e a

s o

f M

a rc

h 2

0 1 1

P ro

p o

se d

e x c h

a n

g e

o ff

e r

R e

q u

ir e

a c ce

p ta

n c e

te re

s t

o n

e w

d e

b t

M a

tu ri

o f

n e w

d e

b t

R e v

o lv

in g

L o

a n

a ci

li ty

2 1 5

L IB

O R

p lu

s 1

0 3 /

3 1 /

1 1

F ir

st l

ie n

v ir

tu a ll

a ll

a ss

e ts

1 0 0

F o

r e a

ch $

1 ,0

0 0 f

a ce

v a

lu e o

f e x

is ti

n g

d e b

t, r

e ce

iv e $

1 ,0

5 0

o f

n e w

t e rm

l o

a n

. P

ri n

ci p

a l

te rm

s o

f n

e w

d e b

t: i

n te

re st

r a

te :

L IB

O R

lu s

1 .5

% ;

m a

tu ri

ty ,

M a

rc h

3 1

, 2 0 1

6 ;

a m

o rt

iz a

ti o

sc h

e d

u le

: e q

u a l

a n

n u

a l

a m

o rt

iz a ti

o n

a y

m e n

b e g

in n

in g

a rc

h 3

1 ,

2 0

1 3

; o

p ti

o n

a l

re d

e m

p ti

o n

: p

e rm

it te

d f

o r

w h

o le

ri n

ci p

a l

a t

a n

y t

im e a

ft e r

M a

rc h

3 1 ,

2 0

1 3

; se

cu ri

ty :

fi rs

t li

e n

n v

ir tu

a ll

y a

ll a

ss e ts

; re

st ri

ct iv

e c

o v

e n

a n

ts :

sa m

e a

s u

n d

e r

o ld

d e b

t co

n tr

a ct

, b

u t

d if

fe re

n t

th re

sh o

ld s.

1 0 0

L ib

o r

p lu

s 1

.5 %

3 /

3 1 /

1 6

U n

se cu

re d

e n

io r

N o

te s

$ 1 2 2

3 .5

0 4 /

1 5 /

1 4

N o

n e

6 5 ½

o r

e a

ch $

1 ,0

0 0 f

a ce

v a

lu e o

f e x

is ti

n g

d e b

t, r

e ce

iv e $

6 4 0

o f

n e w

s e n

io r

u n

se cu

re d

n o

te s,

p lu

s 5

1 7

s h

a re

s o

f n

e w

c o

m m

o n

o ck

, re

p re

se n

ti n

g 2

1 .3

2 %

o f

re o

rg a

n iz

e d

c o

m m

o n

e q

u it

y .

P ri

n ci

p a

l te

rm s

o f

n e w

b o

n d

: co

u p

o n

r a

te :

5 .5

% ;

m a

tu ri

ty :

M a

rc h

, 3 1

, 2

0 1 8

; a

m o

rt iz

a ti

o n

h e d

u le

: e q

u a

l a

n n

u a l

p a

y m

e n

ts b

e g

in n

in g

a rc

h 3 1

, 2

0 1 3

, to

ti re

5 %

f th

p ri

n ci

p a l

b e fo

m a

tu ri

ty ;

o p

ti o

n a l

re d

e m

p ti

o n

: n

o n

e ;

se cu

ri ty

: se

co n

li e n

v ir

tu a ll

a ll

ss e ts

; re

st ri

ct iv

co v

e n

a n

ts : id

e n

ti ca

l to

c o

v e n

a n

ts i

n n

e w

b a

n k

d e b

8 5

5 .5

0 3 /

3 1 /

1 8

S u

b o

rd in

a te

C o

n v

e rt

ib le

e b

e n

tu re

$ 1 7 0

6 .5

0 6 /

1 5 /

1 6

N o

n e

2 4 ¼

o r

e a

ch $

1 ,0

0 0 f

a ce

v a

lu e o

f e x

is ti

n g

d e b

t, r

e ce

iv e $

2 5 0

o f

n e w

b o

rd in

a te

d b

o n

d ,

p lu

s 6 4 4

a re

s o

f n

e w

m m

o n

o ck

, re

p re

se n

ti n

g 3

6 .9

7 %

o f

th e r

e o

rg a

n iz

e d

c o

m m

o n

s to

ck ,

p lu

s 1 0

-y e a

r w

a rr

a n

ts t

o p

u rc

h a

se 5

0 s

h a

re s

o f

n e w

c o

m m

o n

o ck

w it

h a

s tr

ik e p

ri ce

o f

$ 7

. P

ri n

ci p

a l

te rm

s o

f th

e n

e w

o n

d :

in te

re st

te :

7 %

; m

a tu

ri ty

: D

e ce

m b

e r,

1 5

, 2 0

1 9 ;

p ri

n ci

p a l

d u

e a

t m

a tu

ri ty

; o p

ti o

n a l re

d e m

p ti

o n

: p

e rm

it te

d f

o r

w h

o le

p ri

n ci

p a l

a t

a n

y t

im e a

ft e r

D e ce

m b

e r

3 1 , 2 0

1 5

; se

cu ri

ty :

n o

t se

cu re

d ;

re st

ri ct

iv e c

o v

e n

a n

ts : n

o n

e .

8 5

7 .0

1 2 /

1 5 /

1 9

P re

fe rr

e d

E q

u it

y a

$ 8 1

6 .0

n /

N o

n e

$ 1 .3

5 /

sh a

F o

r e a ch

p re

fe rr

e d

s h

a re

, re

ce iv

e 2

.3 5

s h

a re

s o

f n

e w

c o

m m

o n

o ck

, re

p re

se n

ti n

g 1

9 .8

4 %

o f

th e r

e o

rg a

n iz

e d

c o

m m

o n

s to

ck ,

p lu

s 1 0

-y e a

r w

a rr

a n

ts t

o p

u rc

h a

se 1

s h

a re

o f

n e w

c o

m m

o n

o ck

w it

h a

s tr

ik e p

ri ce

o f

$ 7

6 7

n /

C o

m m

o n

E q

u it

$ 1 2 9

n /

N o

n e

$ 1 .0

9 /

sh a

R e ta

in 6

4 .8

m il

li o

n o

u ts

ta n

d in

g c

o m

m o

n s

h a

re s,

r e p

re se

n ti

n g

1 .8

8 %

o f

th e r

e o

rg a n

iz e d

c o

m m

o n

s to

ck .

/ a

n /

a P

ri n

ci p

a l

v a

lu e i

n cl

u d

e s

li q

u id

a ti

o n

v a

lu e ,

p lu

s a

cc u

m u

la te

d a

rr e a ra

g e o

f $ 6

.7 5 m

il li

o n

D o

N ot

C op

y or

P os

Pinewood Mobile Homes, Inc. | 915-547

HARVARD BUSINESS SCHOOL | BRIEFCASES 11

Exhibit 8 Pro Forma Effects of Proposed Exchange Offer on Pinewood Capitalization (U.S. $ millions)

Pre-Exchange

100%

Acceptancea

Minimum Needed

Acceptanceb

Short-term debt

Secured bank revolving facility 215.0 - -

Current portion of senior unsecured notesc 40.7 - 6.1

Long-term debt

Secured bank revolving facility - 225.8 225.8

Senior unsecured notes 81.4 78.2 78.7

Subordinated convertible debenture 170.0 42.5 61.6

Total Debt 507.1 346.4 372.1

Equity

$3.00 preferred stock 75.0 - 24.8

Common stock (8.1) 227.6 177.1

Total equity 66.9 227.6 201.9

Total capitalization 574.0 574.0 574.0

Common shares (000) 64,800 296,156 250,877

a Assumes 100% acceptance of the exchange offer in Exhibit 7 by holders of Pinewood debt

b Assumes acceptance by the minimum amounts of debt and preferred stock needed to make the exchange effective, per Exhibit 7

c Due date for current portion of long-term debt only

D o

N ot

C op

y or

P os

BUS 224/Assignment I/Cases/Financial manager in Classic Fixtures & hardware company .pdf

________________________________________________________________________________________________________________ HBS Professor W. Carl Kester and Senior Instructor Craig Stephenson, Leeds School of Business at the University of Colorado, Boulder prepared this case solely as a basis for class discussion and not as an endorsement, a source of primary data, or an illustration of e ffective or ineffective management. Although based on real events and despite occasional references to actual companies, this case is fictitious and any resemblance to actual persons or entities is coincidental. Copyright © 2014 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. This publication may not be digitized, photocopied, or otherwise reproduced, posted, or transmitted, without the permission of Harvard Business School.

W . C A R L K E S T E R

C R A I G S T E P H E N S O N

Classic Fixtures & Hardware Company

”What’s really happening at Classic Fixtures & Hardware Company?” It was August 6, 2008, and Gary Matocha, a senior lending officer at Southwest National Bank, kept rolling this question through his mind as he prepared for tomorrow’s meeting with Dan Watkins, the company’s Chief Financial Officer. The amounts borrowed under Classic’s seasonal loan facility had been significantly above forecast during the last few months, and Mr. Watkins had just informed Mr. Matocha that the company would likely be unable to pay off the balance of the loan in the fall of 2008, as both Classic and the bank had originally anticipated. This admission that the company would not be “out of the loan” was especially troublesome to Matocha, and he had immediately scheduled the meeting with Watkins at their headquarters in East Texas. The agenda for tomorrow was straightforward; discuss the company’s current financial situation, identify the reasons why Classic would be unable to liquidate the loan balance, and develop solutions to remedy Classic’s current financial problems.

Classic Fixtures & Hardware Company was a successful manufacturer and distributor of a wide range of kitchen and bathroom fixtures and trim, as well as lock sets and hardware for doors and windows. These products, known for their quality, classic design, and timeliness, were sold to individuals and contractors in large home-improvement retailers, smaller hardware and lumber stores, and directly to large home builders through a small internal sales force. Home improvement expenditures and housing construction were both impacted by the weather in the northern tier of states, resulting in more sales for Classic in the spring and summer (approximately 60% of yearly sales), and fewer sales in autumn and winter (approximately 40%). The company’s plan for 2008, developed and approved by management in late 2007, anticipated moderate increases in housing starts and home improvement activity, and Classic ramped up its production and sales efforts to meet this expected increase in demand. The company’s forecasted monthly income statements and monthly balance sheets presented in Exhibit 1 and Exhibit 2, respectively, show detailed information about the year 2008 plan.

All manufacturing took place in rural East Texas, and Classic produced inventory at a level rate through the year to meet forecast demand. Level production minimized the stress on the production facilities, and provided steady income for employees, making Classic an important employer in the county and region. Sales, however, were highly seasonal, and the mismatch between level production

9 - 9 1 5 - 5 2 3 F E B R U A R Y 5 , 2 0 1 5

D o

N ot

C op

y or

P os

915-523 | Classic Fixtures & Hardware Company

2 BRIEFCASES | HARVARD BUSINESS SCHOOL

and seasonal sales caused inventory levels and the supporting working capital financing to expand and contract with sales and collections of accounts receivable. As a family-owned firm, Classic had limited access to the capital markets and therefore depended on its loan facility with Southwest to finance its working capital needs. Southwest had been Classic’s lead bank for many years, and the company understood the bank believed that working capital financing was by definition short-term instead of permanent financing; Southwest strongly preferred short-term borrowings be fully paid off at least one month per year. Classic’s seasonal sales and collections pattern resulted in higher inventory and working capital loan balances in the first half of the year, and declining inventory and loan balances in the second half of the year. This pattern of building inventory levels in the winter and spring, heavy sales in the spring and summer, and large collections in the summer and fall had always allowed Classic to fully pay down its loan facility during the fourth quarter of the year. That is, until 2008.

The first sign that Classic’s year 2008 performance wasn’t meeting the plan came in early April. Matocha noticed the company’s end of March loan balance was $4 million above forecast, leading to a phone call with the CFO to discuss the variance. Watkins attributed the increase to cost overruns in the company’s plant expansion and modernization program, which was launched in January, and was expected to be completed in early December, with total capital expenditures forecast at $30 million. Actual expenditures in the first quarter of 2008 had come in higher than expected, but Mr. Watkins explained that program costs in future months were expected to be at or below forecast. The CFO expressed confidence that loan balances would quickly return to forecast levels, and Matocha accepted this explanation, although he wondered if Classic was actually using short-term bank credit for longer- term capital projects, or if other problems were the true cause of the increased borrowings.

In early June, Matocha had another conversation with Watkins about the continuing variance versus plan in amounts borrowed by the company under the loan facility. The CFO stated that sales during April and May had been well below forecast, with May’s results nearly 12% below expectations. Watkins also explained that sales were down in both the retail and direct-to-builder channels, and the decrease in sales and collections had forced the company to increase borrowings until the company could adjust operations to match current economic conditions. The maximum funding available to the company was $90 million, so Classic was well within the terms of the seasonal loan facility, but Matocha was increasingly concerned about the company’s product markets and management’s actions.

The third, and most alarming phone conversation between the senior loan officer and CFO, occurred early on August 6th, when Watkins admitted that even though the loan balance had fallen by $8 million during July, he believed that Classic would likely be unable to pay off the balance of the loan this year, and before the seasonal upturn in funds requirements in 2009. Collections from customers would allow the company to reduce the amount borrowed, but sales had continually failed to meet forecast through the summer, so cash receipts would probably not be sufficient to pay off the entire amount borrowed. Matocha asked if Classic’s inability to repay the seasonal loan facility this year was due to a permanent change in the company’s funding needs, perhaps caused by the expansion and modernization program, or if the company’s financial problems were instead the result of significant changes in Classic’s product markets. Watkins was not able to answer this question with any certainty, and they both agreed to a meeting at Classic’s headquarters to discuss the situation.

To prepare for the meeting, Matchoa began to analyze the company’s actual monthly income statements and monthly balance sheets provided by Mr. Watkins, as presented in Exhibit 3 and Exhibit 4, respectively. Beyond this information, Matocha also collected the data presented in Exhibit 5, so he could better understand conditions in the home improvement and housing construction industries. He expected his analysis of Classic’s financial performance would reveal why it would be unable to repay its loan balance this year, and hopefully identify actions to correct the company’s financial problems. D

o N

ot C

op y

or P

os t

9 1 5

-5 2 3

3 -

E x

h ib

it 1

Y e a

r 2 0

0 8 F

o re

ca st

e d

M o

n th

ly I

n c o

m e S

ta te

m e n

ct u

a l

2 0 0 8

($ i

n t

h o

u sa

n d

s )

2 0 0 7

Ja n

e b

a r

A p

r M

a y

Ju l

A u

S e

O c t

N o

D e c

Y e a

N e t

sa le

s 8

8 1

,4 2

5 6 ,3

3 0

6 2 ,4

1 0

7 3 ,1

6 0

8 9 ,1

4 0

9 2 ,2

5 0

9 8 ,1

1 0

9 9 ,5

8 0

9 1 ,4

7 0

8 2 ,4

9 0

6 9 ,5

3 0

5 3 ,6

4 0

5 2 ,8

9 0

9 2 1

,0 0

C o

st o

f g

o o

d s

so ld

9 0

,1 0

3 7 ,8

5 4

4 1 ,9

4 0

4 9 ,1

6 4

5 9 ,9

0 2

6 1 ,9

9 2

6 5 ,9

3 0

6 6 ,9

1 8

6 1 ,4

6 8

5 5 ,4

3 3

4 6 ,7

2 4

3 6 ,0

4 6

3 5 ,5

4 1

6 1 8

,9 1

G ro

ss p

ro fi

t 2

9 1

,3 1

1 8 ,4

7 6

2 0 ,4

7 0

2 3 ,9

9 6

2 9 ,2

3 8

3 0 ,2

5 8

3 2 ,1

8 0

3 2 ,6

6 2

3 0 ,0

0 2

2 7 ,0

5 7

2 2 ,8

0 6

1 7 ,5

9 4

1 7 ,3

4 9

3 0 2

,0 8

S e ll

in g

, g

e n

e ra

l &

a d

m in

is tr

a ti

v e e

x p

e n

se s

2 0 8

,3 9

1 7 ,9

0 0

1 7 ,9

0 0

1 7 ,9

0 0

1 7 ,9

0 0

1 7 ,9

0 0

1 7 ,9

0 0

1 7 ,9

0 0

1 7 ,9

0 0

1 7 ,9

0 0

1 7 ,9

0 0

1 7 ,9

0 0

1 7 ,9

0 0

2 1 4

,8 0

O p

e ra

ti n

g i

n co

m e

8 2 ,9

2 6

5 7 6

2 ,5

7 0

6 ,0

9 6

1 1 ,3

3 8

1 2 ,3

5 8

1 4 ,2

8 0

1 4 ,7

6 2

1 2 ,1

0 2

9 ,1

5 7

4 ,9

0 6

-3 0 6

-5 5 1

8 7 ,2

8 8

In te

re st

e x

p e n

8 ,5

8 7

5 3 9

6 2 1

7 3 6

7 8 6

7 8 4

7 6 0

6 7 9

5 7 1

5 3 3

5 2 8

7 ,6

0 3

I n

co m

e b

e fo

re i

n co

m e t

a x

e s

7 4 ,3

3 9

3 7

1 ,9

4 9

5 ,3

6 0

1 0 ,5

5 2

1 1 ,5

7 4

1 3 ,5

2 0

1 4 ,0

8 3

1 1 ,5

3 1

8 ,6

2 4

4 ,3

7 3

-8 3 9

-1 ,0

7 9

7 9 ,6

8 5

In co

m e t

a x

e s

2 6 ,9

1 1

2 6

7 0 3

1 ,9

1 4

3 ,7

7 6

4 ,1

4 4

4 ,8

4 7

5 ,0

6 2

4 ,1

5 8

3 ,1

1 7

1 ,5

8 7

-2 8 9

-3 7 6

2 8 ,6

6 9

N e t

in co

m e

4 7 ,4

2 8

1 1

1 ,2

4 6

3 ,4

4 6

6 ,7

7 6

7 ,4

3 0

8 ,6

7 3

9 ,0

2 1

7 ,3

7 3

5 ,5

0 7

2 ,7

8 6

-5 5 0

-7 0 3

5 1 ,0

1 6

D iv

id e n

d s

1 6 ,0

0 0

4 ,4

0 0

4 ,4

0 0

4 ,4

0 0

4 ,4

0 0

1 7 ,6

0 0

A d

d it

io n

t o

r e ta

in e d

e a

rn in

g s

3 1 ,4

2 8

1 1

1 ,2

4 6

-9 5 4

6 ,7

7 6

7 ,4

3 0

4 ,2

7 3

9 ,0

2 1

7 ,3

7 3

1 ,1

0 7

2 ,7

8 6

-5 5 0

-5 ,1

0 3

3 3 ,4

1 6

C u

m u

la ti

v e a

d d

it io

n t

o r

e ta

in e d

e a

rn in

g s

1 ,2

5 7

3 0 3

7 ,0

7 9

1 4 ,5

0 9

1 8 ,7

8 2

2 7 ,8

0 3

3 5 ,1

7 6

3 6 ,2

8 3

3 9 ,0

6 9

3 8 ,5

1 9

3 3 ,4

1 6

D o

N ot

C op

y or

P os

9 1 5

-5 2 3

4 -

E x

h ib

it 2

Y e a

r 2 0

0 8 F

o re

ca st

e d

M o

n th

ly B

a la

n ce

S h

e e ts

ct u

a l

0 0 8

($ i

n t

h o

u sa

n d

s )

1 2

-3 1

-2 0

0 7

Ja n

e b

a r

A p

r M

a y

Ju l

A u

S e

O c t

N o

D e c

C a

1 0 7

,0 6

8 8 ,2

0 2

8 6 ,5

2 0

8 7 ,0

3 0

8 7 ,5

4 0

8 8 ,0

5 0

8 8 ,5

7 0

8 9 ,0

8 0

8 9 ,5

4 0

9 7 ,3

7 3

1 1 6

,6 2

1 2 7

,0 4

1 1 2

,4 0

A cc

o u

n ts

r e ce

iv a

b le

1 0 4

,4 0

1 0 7

,8 3

1 1 8

,7 4

1 3 5

,5 7

1 6 2

,3 0

1 8 1

,3 9

1 9 0

,3 6

1 9 7

,6 9

1 9 1

,0 5

1 7 3

,9 6

1 5 2

,0 5

1 2 3

,1 7

1 0 6

,5 3

In v

e n

to ri

e s

1 2 1

,6 7

1 3 5

,4 4

1 4 5

,1 2

1 4 7

,5 9

1 3 9

,6 3

1 2 9

,5 9

1 1 5

,6 1

1 0 0

,9 8

9 1 ,7

9 5

8 8 ,6

4 3

9 4 ,5

3 5

1 1 1

,1 0

1 2 8

,1 8

O th

e r

cu rr

e n

t a

ss e ts

9 ,7

4 4

1 9 ,7

7 4

1 9 ,8

0 3

1 9 ,8

3 3

1 9 ,8

6 4

1 9 ,8

9 5

1 9 ,9

2 7

1 9 ,9

5 7

1 9 ,9

8 8

2 0 ,0

1 7

2 0 ,0

4 1

2 0 ,0

6 2

2 0 ,0

8 0

C u

rr e n

t a

ss e ts

5 2

,8 9

3 5 1

,2 4

3 7 0

,1 9

3 9 0

,0 2

4 0 9

,3 4

4 1 8

,9 3

4 1 4

,4 7

4 0 7

,7 0

3 9 2

,3 7

3 7 9

,9 9

3 8 3

,2 4

3 8 1

,3 8

3 6 7

,1 9

N e t

p la

n t

& e

q u

ip m

e n

t 1

6 5

,6 8

1 6 7

,3 3

1 7 0

,1 0

1 7 1

,9 1

1 7 5

,2 6

1 7 6

,8 9

1 7 8

,1 5

1 7 9

,4 7

1 8 0

,7 9

1 8 1

,3 9

1 8 2

,6 4

1 8 3

,8 4

1 8 4

,6 3

T o

ta l

a ss

e ts

1 8

,5 7

5 1 8

,5 8

5 4 0

,2 9

5 6 1

,9 4

5 8 4

,6 0

5 9 5

,8 2

5 9 2

,6 3

5 8 7

,1 8

5 7 3

,1 6

5 6 1

,3 8

5 6 5

,8 9

5 6 5

,2 2

5 5 1

,8 2

A cc

o u

n ts

p a

y a

b le

1 8 ,2

4 7

1 8 ,1

0 0

1 8 ,1

0 0

1 8 ,1

0 0

1 8 ,1

0 0

1 8 ,1

0 0

1 8 ,1

0 0

1 8 ,1

0 0

1 8 ,1

0 0

1 8 ,1

0 0

1 8 ,1

0 0

1 8 ,1

0 0

1 8 ,1

0 0

S h

o rt

-t e rm

b a

n k

d e b

t c

3 6

1 9 ,6

6 5

4 7 ,3

1 3

5 9 ,3

4 1

5 8 ,8

3 5

5 4 ,4

5 0

3 4 ,8

3 4

9 ,0

5 1

In co

m e t

a x

e s

p a

y a

b le

2 6

7 2 9

-4 ,5

2 4

-7 4 8

3 ,3

9 6

1 ,0

7 6

6 ,1

3 8

1 0 ,2

9 6

6 ,2

4 5

7 ,8

3 2

7 ,5

4 3

O th

e r

cu rr

e n

t li

a b

il it

ie s

2 7 ,5

9 7

2 7 ,6

8 3

2 7 ,8

1 7

2 8 ,0

2 3

2 8 ,1

0 8

2 8 ,2

5 9

2 8 ,3

9 8

2 8 ,4

7 9

2 8 ,7

1 4

2 8 ,9

3 4

2 9 ,0

6 6

2 9 ,2

3 4

2 9 ,3

8 3

C u

rr e n

t li

a b

il it

ie s

4 5 ,8

4 4

4 5 ,8

4 5

6 6 ,3

1 1

8 8 ,9

1 2

1 0 4

,8 0

1 0 8

,5 9

1 0 2

,0 2

8 7 ,5

5 1

6 6 ,1

6 1

5 3 ,2

7 9

5 4 ,9

9 8

5 4 ,8

7 7

4 7 ,4

8 3

L o

n g

-t e rm

d e b

t e

8 6 ,2

5 0

8 6 ,2

5 0

8 6 ,2

5 0

8 6 ,2

5 0

8 6 ,2

5 0

8 6 ,2

5 0

8 5 ,3

5 0

8 5 ,3

5 0

8 5 ,3

5 0

8 5 ,3

5 0

8 5 ,3

5 0

8 5 ,3

5 0

8 4 ,4

5 0

C o

m m

o n

s to

8 1 ,6

3 9

8 1 ,6

3 9

8 1 ,6

3 9

8 1 ,6

3 9

8 1 ,6

3 9

8 1 ,6

3 9

8 1 ,6

3 9

8 1 ,6

3 9

8 1 ,6

3 9

8 1 ,6

3 9

8 1 ,6

3 9

8 1 ,6

3 9

8 1 ,6

3 9

R e ta

in e d

e a

rn in

g s

3 0 4

,8 3

3 0 4

,8 4

3 0 6

,0 9

3 0 5

,1 4

3 1 1

,9 1

3 1 9

,3 4

3 2 3

,6 2

3 3 2

,6 4

3 4 0

,0 1

3 4 1

,1 2

3 4 3

,9 0

3 4 3

,3 5

3 3 8

,2 5

O w

n e rs

' e q

u it

3 8 6

,4 7

3 8 6

,4 8

3 8 7

,7 3

3 8 6

,7 8

3 9 3

,5 5

4 0 0

,9 8

4 0 5

,2 5

4 1 4

,2 8

4 2 1

,6 5

4 2 2

,7 6

4 2 5

,5 4

4 2 4

,9 9

4 1 9

,8 9

T o

ta l

li a b

il it

ie s

& o

w n

e rs

' e q

u it

5 1 8

,5 7

5 1 8

,5 8

5 4 0

,2 9

5 6 1

,9 4

5 8 4

,6 0

5 9 5

,8 2

5 9 2

,6 3

5 8 7

,1 8

5 7 3

,1 6

5 6 1

,3 8

5 6 5

,8 9

5 6 5

,2 2

5 5 1

,8 2

a A

ss u

m e s

a 2

m o

n th

c o

ll e ct

io n

p e ri

o d

b A

ss u

m e s

a 1

m o

n th

p a

y m

e n

t p

e ri

o d

o n

p u

rc h

a se

c T

h e i

n te

re st

r a

te o

n s

h o

rt -t

e rm

b a

n k

d e b

t is

5 %

d E

st im

a te

d t

a x

e s

o f

$ 7

,1 6

7 ,2

5 0

a re

p a id

i n

M a

rc h

, Ju

n e ,

S e p

te m

b e r,

a n

d D

e ce

m b

e r,

b a

se d

o n

f o

re ca

st e d

y e a

r 2

0 0 8

i n

co m

e t

a x

e s

e T

h e i

n te

re st

r a

te o

n l

o n

g -t

e rm

d e b

t is

7 .5

D o

N ot

C op

y or

P os

9 1 5

-5 2 3

5 -

E x

h ib

it 2

( C

o n

ti n

u e d

- F

o re

ca st

e d

M o

n th

ly I

n v

e n

to ri

e s)

2 0 0 8

($ i

n t

h o

u sa

n d

s )

Ja n

e b

a r

A p

r M

a y

Ju l

A u

S e

O c t

N o

D e c

R a w

m a

te ri

a ls

e g

in n

in g

b a

la n

2 4 ,1

5 0

2 4 ,1

5 0

2 4 ,1

5 0

2 4 ,1

5 0

2 4 ,1

5 0

2 4 ,1

5 0

2 4 ,1

5 0

2 4 ,1

5 0

2 4 ,1

5 0

2 4 ,1

5 0

2 4 ,1

5 0

2 4 ,1

5 0

+ P

u rc

h a

se s

1 8 ,1

0 0

1 8 ,1

0 0

1 8 ,1

0 0

1 8 ,1

0 0

1 8 ,1

0 0

1 8 ,1

0 0

1 8 ,1

0 0

1 8 ,1

0 0

1 8 ,1

0 0

1 8 ,1

0 0

1 8 ,1

0 0

1 8 ,1

0 0

- T

ra n

sf e rs

t o

w o

rk i

n p

ro g

re ss

8 ,1

0 0

1 8 ,1

0 0

1 8 ,1

0 0

1 8 ,1

0 0

1 8 ,1

0 0

1 8 ,1

0 0

1 8 ,1

0 0

1 8 ,1

0 0

1 8 ,1

0 0

1 8 ,1

0 0

1 8 ,1

0 0

1 8 ,1

0 0

E n

d in

g b

a la

n ce

4 ,1

5 0

2 4 ,1

5 0

2 4 ,1

5 0

2 4 ,1

5 0

2 4 ,1

5 0

2 4 ,1

5 0

2 4 ,1

5 0

2 4 ,1

5 0

2 4 ,1

5 0

2 4 ,1

5 0

2 4 ,1

5 0

2 4 ,1

5 0

W o

rk i

n p

ro g

re ss

B e g

in n

in g

b a la

n ce

6 ,1

0 3

3 6 ,1

0 3

3 6 ,1

0 3

3 6 ,1

0 3

3 6 ,1

0 3

3 6 ,1

0 3

3 6 ,1

0 3

3 6 ,1

0 3

3 6 ,1

0 3

3 6 ,1

0 3

3 6 ,1

0 3

3 6 ,1

0 3

+ A

d d

it io

n s

fr o

m r

a w

m a

te ri

a ls

8 ,1

0 0

1 8 ,1

0 0

1 8 ,1

0 0

1 8 ,1

0 0

1 8 ,1

0 0

1 8 ,1

0 0

1 8 ,1

0 0

1 8 ,1

0 0

1 8 ,1

0 0

1 8 ,1

0 0

1 8 ,1

0 0

1 8 ,1

0 0

+ D

ir e ct

l a

b o

r 1

1 ,8

6 1

1 1 ,8

6 1

1 1 ,8

6 1

1 1 ,8

6 1

1 1 ,8

6 1

1 1 ,8

6 1

1 1 ,8

6 1

1 1 ,8

6 1

1 1 ,8

6 1

1 1 ,8

6 1

1 1 ,8

6 1

1 1 ,8

6 1

+ M

a n

u fa

ct u

ri n

g o

v e rh

e a

2 1 ,6

6 5

2 1 ,6

6 5

2 1 ,6

6 5

2 1 ,9

9 0

2 1 ,9

9 0

2 1 ,9

9 0

2 2 ,3

2 0

2 2 ,3

2 0

2 2 ,3

2 0

2 2 ,6

5 5

2 2 ,6

5 5

2 2 ,6

5 5

- T

ra n

sf e rs

t o

f in

is h

e d

g o

o d

s 5

1 ,6

2 6

5 1 ,6

2 6

5 1 ,6

2 6

5 1 ,9

5 1

5 1 ,9

5 1

5 1 ,9

5 1

5 2 ,2

8 1

5 2 ,2

8 1

5 2 ,2

8 1

5 2 ,6

1 6

5 2 ,6

1 6

5 2 ,6

1 6

E n

d in

g b

a la

n ce

6 ,1

0 3

3 6 ,1

0 3

3 6 ,1

0 3

3 6 ,1

0 3

3 6 ,1

0 3

3 6 ,1

0 3

3 6 ,1

0 3

3 6 ,1

0 3

3 6 ,1

0 3

3 6 ,1

0 3

3 6 ,1

0 3

3 6 ,1

0 3

F in

is h

e d

g o

o d

B e g

in n

in g

b a la

n ce

1 ,4

1 7

7 5 ,1

8 9

8 4 ,8

7 5

8 7 ,3

3 7

7 9 ,3

8 6

6 9 ,3

4 5

5 5 ,3

6 6

4 0 ,7

2 9

3 1 ,5

4 2

2 8 ,3

9 0

3 4 ,2

8 2

5 0 ,8

5 2

+ A

d d

it io

n s

fr o

m w

o rk

i n

p ro

g re

5 1 ,6

2 6

5 1 ,6

2 6

5 1 ,6

2 6

5 1 ,9

5 1

5 1 ,9

5 1

5 1 ,9

5 1

5 2 ,2

8 1

5 2 ,2

8 1

5 2 ,2

8 1

5 2 ,6

1 6

5 2 ,6

1 6

5 2 ,6

1 6

- C

o st

o f

g o

o d

s so

3 7 ,8

5 4

4 1 ,9

4 0

4 9 ,1

6 4

5 9 ,9

0 2

6 1 ,9

9 2

6 5 ,9

3 0

6 6 ,9

1 8

6 1 ,4

6 8

5 5 ,4

3 3

4 6 ,7

2 4

3 6 ,0

4 6

3 5 ,5

4 1

E n

d in

g b

a la

n ce

5 ,1

8 9

8 4 ,8

7 5

8 7 ,3

3 7

7 9 ,3

8 6

6 9 ,3

4 5

5 5 ,3

6 6

4 0 ,7

2 9

3 1 ,5

4 2

2 8 ,3

9 0

3 4 ,2

8 2

5 0 ,8

5 2

6 7 ,9

2 7

T o

ta l

e n

d in

g i

n v

e n

to ri

e s

1 3 5

,4 4

1 4 5

,1 2

1 4 7

,5 9

1 3 9

,6 3

1 2 9

,5 9

1 1 5

,6 1

1 0 0

,9 8

9 1 ,7

9 5

8 8 ,6

4 3

9 4 ,5

3 5

1 1 1

,1 0

1 2 8

,1 8

D o

N ot

C op

y or

P os

9 1 5

-5 2 3

6 -

E x

h ib

it 3

Y e a

r 2 0

0 8 A

ct u

a l

M o

n th

ly I

n co

m e S

ta te

m e n

ct u

a l

2 0 0

($ i

n t

h o

u sa

n d

2 0

0 7

F e

M a

r A

p r

M a

Ju n

N e t

sa le

s 8

8 1 ,4

2 4

5 ,4

9 6

6 0

,2 0 4

6 8

,3 2 0

8 0

,5 0 7

8 1

,5 9 3

8 4

,8 6 8

8 4

,7 6 0

C o

st o

f g

o o

d s

so ld

9 0 ,1

0 6

7 ,2

6 0

4 0

,3 7 9

4 5

,8 9 7

5 4

,1 4 9

5 4

,8 5 5

5 7

,1 2 5

5 7

,0 1 7

G ro

ss p

ro fi

t 2

9 1 ,3

1 8

8 ,2

3 6

1 9

,8 2 5

2 2

,4 2 3

2 6

,3 5 8

2 6

,7 3 8

2 7

,7 4 3

2 7

,7 4 3

S e ll

in g

, g

e n

e ra

l &

a d

m in

is tr

a ti

v e e

x p

e n

se s

2 0

8 ,3

9 2

7 ,9

1 4

1 7

,8 9 7

1 7

,9 2 2

1 7

,9 0 6

1 7

,9 1 8

1 7

,8 7 3

1 7

,9 0 9

O p

e ra

ti n

g i

n co

m e

8 2

,9 2 6

2 2

1 ,9

2 8

4 ,5

0 1

8 ,4

5 2

8 ,8

2 0

9 ,8

7 0

9 ,8

3 4

In te

re st

e x

p e n

8 ,5

8 7

4 2

6 2

7 5

8 1

8 4

8 6

8 3

I n

co m

e b

e fo

re i

n co

m e t

a x

e s

7 4

,3 3 9

-2

2 0

1 ,3

0 4

3 ,7

5 0

7 ,6

3 4

7 ,9

7 6

9 ,0

0 3

9 ,0

0 1

In co

m e t

a x

e s

2 6

,9 1 1

-6

4 7

1 ,3

3 2

2 ,7

2 1

2 ,8

4 0

3 ,2

0 5

3 ,2

0 9

N e t

in co

m e

4 7

,4 2 8

-1

5 3

8 3

2 ,4

1 8

4 ,9

1 3

5 ,1

3 6

5 ,7

9 8

5 ,7

9 2

D iv

id e n

d s

1 6

,0 0 0

,4 0

4 ,4

0 0

d d

it io

n t

o r

e ta

in e d

e a rn

in g

s 3

1 ,4

2 8

-1

5 3

8 3

-1 ,9

8 2

4 ,9

1 3

5 ,1

3 6

1 ,3

9 8

5 ,7

9 2

C u

m u

la ti

v e a

d d

it io

n t

o r

e ta

in e d

e a

rn in

g s

-1 5 3

6 8

-1 ,3

0 1

3 ,6

1 2

8 ,7

4 8

1 0

,1 4 6

1 5

,9 3 8

D o

N ot

C op

y or

P os

9 1 5

-5 2 3

7 -

E x

h ib

it 4

Y e a

r 2 0

0 8 A

ct u

a l

M o

n th

ly B

a la

n ce

S h

e e ts

ct u

a l

2 0 0

($ i

n t

h o

u sa

n d

1 2

-3 1

-2 0 0

F e

M a

r A

p r

M a

Ju n

C a

1 0

7 ,0

6 7

8 ,2

4 6

8 6

,4 3 6

8 6

,9 6 6

8 6

,5 2 5

8 5

,7 8 0

8 1

,3 8 2

8 0

,6 6 3

A cc

o u

n ts

r e ce

iv a

b le

0 4 ,4

0 9

0 7 ,0

9 6

1 1

5 ,7

6 3

1 3

0 ,4

1 1

1 5

2 ,4

3 9

1 6

7 ,9

0 7

1 7

9 ,3

4 2

8 4 ,3

1 4

In v

e n

to ri

e s

1 2

1 ,6

7 0

3 6 ,2

3 6

1 4

7 ,4

4 7

1 5

3 ,6

2 7

1 5

2 ,0

3 6

1 4

9 ,2

7 6

1 4

4 ,0

5 1

3 9 ,0

3 9

O th

e r

cu rr

e n

t a

ss e ts

9 ,7

4 4

9 ,8

0 2

1 9

,8 1 3

1 9

,8 2 7

1 9

,8 8 4

1 9

,9 0 7

1 9

,9 2 4

1 9

,9 5 3

C u

rr e n

t a

ss e ts

5 2 ,8

9 0

5 1 ,3

8 0

3 6

9 ,4

5 9

3 9

0 ,8

3 1

4 1

0 ,8

8 4

4 2

2 ,8

7 0

4 2

4 ,6

9 9

2 3 ,9

6 9

N e t

p la

n t

& e

q u

ip m

e n

t 1

6 5 ,6

8 1

6 7 ,9

7 4

1 7

1 ,0

1 5

1 7

3 ,0

4 8

1 7

6 ,8

9 8

1 7

8 ,8

4 2

1 8

0 ,6

1 8

8 2 ,0

2 8

T o

ta l

a ss

e ts

1 8 ,5

7 1

1 9 ,3

5 4

0 ,4

7 4

5 6

3 ,8

7 9

5 8

7 ,7

8 2

6 0

1 ,7

1 2

6 0

5 ,3

1 7

0 5 ,9

9 7

A cc

o u

n ts

p a

y a

b le

8 ,2

4 7

8 ,4

8 6

1 8

,4 1 1

1 8

,8 6 6

1 9

,1 1 2

1 8

,7 1 4

1 8

,6 1 8

1 8

,4 1 0

S h

o rt

-t e rm

b a

n k

d e b

t 0

6 8

2 0

,4 4 6

5 0

,9 4 7

6 6

,9 2 9

7 3

,0 9 8

8 0

,1 5 3

7 1

,9 8 6

In co

m e t

a x

e s

p a

y a

b le

-6

4 0

-5 ,4

3 2

-2 ,7

1 1

1 2

-3 ,8

3 4

-6 2 5

O th

e r

cu rr

e n

t li

a b

il it

ie s

2 7

,5 9 7

7 ,6

7 5

2 7

,8 0 6

2 8

,0 7 2

2 8

,1 1 3

2 8

,2 9 6

2 8

,4 0 7

2 8

,4 6 1

C u

rr e n

t li

a b

il it

ie s

4 5

,8 4 4

6 ,7

8 0

6 7

,0 6 6

9 2

,4 5 3

1 1

1 ,4

4 3

1 2

0 ,2

3 7

1 2

3 ,3

4 4

1 8 ,2

3 2

L o

n g

-t e rm

d e b

t 8

6 ,2

5 0

6 ,2

5 0

8 6

,2 5 0

8 6

,2 5 0

8 6

,2 5 0

8 6

,2 5 0

8 5

,3 5 0

8 5

,3 5 0

C o

m m

o n

s to

8 1

,6 3 9

1 ,6

3 9

8 1

,6 3 9

8 1

,6 3 9

8 1

,6 3 9

8 1

,6 3 9

8 1

,6 3 9

8 1

,6 3 9

R e ta

in e d

e a

rn in

g s

3 0

4 ,8

3 8

0 4 ,6

8 5

3 0

5 ,5

1 9

3 0

3 ,5

3 7

3 0

8 ,4

5 0

3 1

3 ,5

8 6

3 1

4 ,9

8 4

2 0 ,7

7 6

O w

n e rs

' e q

u it

3 8

6 ,4

7 7

8 6 ,3

2 4

3 8

7 ,1

5 8

3 8

5 ,1

7 6

3 9

0 ,0

8 9

3 9

5 ,2

2 5

3 9

6 ,6

2 3

0 2 ,4

1 5

T o

ta l

li a

b il

it ie

s &

o w

n e rs

' e q

u it

5 1

8 ,5

7 1

1 9 ,3

5 4

0 ,4

7 4

5 6

3 ,8

7 9

5 8

7 ,7

8 2

6 0

1 ,7

1 2

6 0

5 ,3

1 7

0 5 ,9

9 7

a E

st im

a te

d t

a x

e s

o f

$ 7 ,1

6 7

,2 5 0

a re

p a id

i n

M a

rc h

, Ju

n e ,

S e p

te m

b e r,

a n

d D

e ce

m b

e r,

b a

se d

o n

f o

re ca

st e d

y e a

r 2

0 0 8

i n

co m

e t

a x

e s

D o

N ot

C op

y or

P os

915-523 | Classic Fixtures & Hardware Company

8 BRIEFCASES | HARVARD BUSINESS SCHOOL

Exhibit 4 (Continued - Actual Monthly Inventories)

2008

($ in thousands) Jan Feb Mar Apr May Jun Jul

Raw materials Beginning balance 24,150 24,208 24,246 24,200 24,408 24,516 24,521 + Purchases 18,267 18,112 18,436 18,579 18,135 17,966 17,683 - Transfers to work in progress 18,209 18,074 18,482 18,371 18,027 17,961 17,860

Ending balance 24,208 24,246 24,200 24,408 24,516 24,521 24,344 Work in progress Beginning balance 36,103 36,111 36,040 36,054 36,069 36,080 36,128 + Additions from raw materials 18,209 18,074 18,482 18,371 18,027 17,961 17,860 + Direct labor 11,849 11,827 11,902 11,893 11,931 11,830 11,895 + Manufacturing overhead 21,710 21,651 21,739 22,086 22,029 22,104 22,427 - Transfers to finished goods 51,760 51,623 52,109 52,335 51,976 51,847 52,137

Ending balance 36,111 36,040 36,054 36,069 36,080 36,128 36,173 Finished goods Beginning balance 61,417 75,917 87,161 93,373 91,559 88,680 83,402 + Additions from work in progress 51,760 51,623 52,109 52,335 51,976 51,847 52,137 - Cost of goods sold 37,260 40,379 45,897 54,149 54,855 57,125 57,017

Ending balance 75,917 87,161 93,373 91,559 88,680 83,402 78,522 Total ending inventories 136,236 147,447 153,627 152,036 149,276 144,051 139,039

D o

N ot

C op

y or

P os

Classic Fixtures & Hardware Company | 915-523

HARVARD BUSINESS SCHOOL | BRIEFCASES 9

Exhibit 5 Reported Information for the Home Improvement and New Construction Industries

Net sales ($ in millions) Home Depot Lowe's

3 months ending April 30, 2008 $17,907 $12,009 3 months ending January 31, 2008 $14,607 $9,984 3 months ending October 31, 2007 $18,961 $11,565 3 months ending July 31, 2007 $22,184 $14,167 3 months ending April 30, 2007 $18,545 $12,172 3 months ending January 31, 2007 $17,659 $10,379 3 months ending October 31, 2006 $23,085 $11,211 3 months ending July 31, 2006 $26,026 $13,389 3 months ending April 30, 2006 $21,461 $11,921 3 months ending January 31, 2006 $20,265 $10,406 3 months ending October 31, 2006 $20,744 $10,592 3 months ending July 31, 2006 $22,305 $11,929 3 months ending April 30, 2006 $18,973 $9,913 3 months ending January 31, 2006 $19,489 $10,809

* Sources: Form 10-K filings with the U.S. Securities & Exchange Commission

New privately owned housing units authorized by building permits (not seasonally adjusted)

Calendar 2Q 2008 294.4 Calendar 1Q 2008 231.5 Calendar 4Q 2007 271.1 Calendar 3Q 2007 349.0 Calendar 2Q 2007 412.5 Calendar 1Q 2007 365.6 Calendar 4Q 2006 358.1 Calendar 3Q 2006 445.8 Calendar 2Q 2006 537.2 Calendar 1Q 2006 497.8 Calendar 4Q 2005 490.2 Calendar 3Q 2005 587.2 Calendar 2Q 2005 598.2 Calendar 1Q 2005 479.6

* Source: http://www.census.gov/construction/pdf/bpua.pdf

D o

N ot

C op

y or

P os

BUS 224/Assignment I/Cases/Managerial excellence using ABC.pdf

Activity-Based Costing: A Tool for Manufacturing Excellence

ABC is a strategic weaoon in the Quest for comoetitive oosition.

By Peter B.B. Turney, Ph.D.

This article exammes rne role of actiVity-based costing in the achievement of manufacturing ex- cellence. It describes manufacturing excellence and the product cost in- formation requirements of managers who seek to achieve it. It shows how conventional product costing fails to meet these needs, and dem- onstrates how activity-based cost- ing corrects these deficiencies. It explains how managers in manufac- turing companies can use activity- based costing for strategic, product design, and continuous improve- ment purposes. Finally, the article lays to rest fears that activity-based costing may be too costly and com- plex to be compatible with manu- facturing excellence.

A chieving and sustaining a com-petitive advantage via manufac- turing excellence requires attention to all aspects of manufacturing per- formance. This attention requires that managers have information that helps them choose correct strate- gies, improve product design, and remove waste from operating activi- ties.

Conventional product costing systems provide little information on these sources of competitive advan- tage. Schrader Bellows found that the product costs generated by their conventional system were so inac- curate they encouraged manage- ment to adopt strategies which in- hibited the improvement of manufacturing.' Product designers

Summer 1989

at the Portable Instrument Division of Tektronix reacted to inaccurate cost information by selecting de- signs that increased cost without adding value to the customer. 2 The conventional system at this Division also encouraged management of the allocation and absorption of over- head rather than the elimination of waste.' .

In contrast, activity-based cost- ing is a costing technology that pro- vides information for achieving ex- cellence in manufacturing. (This technology has been named "ABC" despite the use of this term in inven- tory control and Pareto analysis). ABC traces costs to products ac- cording to the activities performea on them. The result is accurate cost information for three purposes: fo- cusing manufacturing strategy, de- signing prodUCts to increase custom- er value, and continuously improving operating activities throughout the manufacturing organization.

A manufacturing company that implements a successful program of continuous improvement sees a simultaneous change in key operating characteristics.

The recent emergence of ABC IS timely because rapid technological change and global competition have increased the need for accurate cost information. At the same time, de- clines in the cost of processing and capturing data have reduced the cost of building new systems.

What is Manufacturing Excellence?

Manufacturing excellence is the deliberate and continuous improve- ment of all activities within a manu- facturing company with the goal of achieving a competitive advantage. This continuous improvement takes place within the framework of a competitive strategy that uses mar- ket, environment, and technical op- portunities to achieve a favorable competitive position in an industry.

Manufacturing excellence re- quires success in three broad types of activity. First, managers must se- lect and implement strategies based on an understanding of the relative profitability of those strategies. Sec- ond, products must be designed to profitably meet the needs of custom- ers identified by the chosen strate- gies, and to facilitate excellent man- ufacturing. Third, managers must strive for continuous improvement in all operating activities. This continu- ous improvement has several objec- tives:

• Eliminate waste. • Reduce leadtimes for:

-Customers -Materials - Tooling and engineering

changes - New product introduction.

• Increase quality. • Reduce cost. • Develop people: Increase skill,

morale, and productivity.

• Improve continuously.'

A manufacturing company that implements a successful program of continuous improvement sees a si- multaneous change in key operating characteristics. Cost will come down, quality will go up, and the gain in flexibility will enhance cus- tomer service. These improvements increase the odds that the company will implement its strategy success- fully.

What do Managers Need from a Product Costing System to Achieve Manufacturing Excellence?

Managers need product cost in- formation to help them achieve man- ufacturing excellence. They need accurate costs for strategic and product design purposes. They re- quire information on operating activi- ties to guide continuous improve- ment in these activities. This must all be provided by a system whose cost does not exceed the benefits prOVided.

Product costs are used by man- agers to make strategic and design decisions. More accu rate product costs reduce the chances that incor- rect decisions will be made. The cost of making incorrect decisions and the need for accurate product costs are determined by the level of competition in the firm's markets. 5

Managers also need activity- level information from the product costing system to guide continuous improvement. Activities are process- es or procedures that cause work. Activity level information allows managers to identify and eliminate waste in these processes and pro- cedures. It also confirms progress at removing waste from operating ac- tivities.'

Managers who are working hard to simplify manufacturing and elimi- nate waste do not wish to introduce a product costing system that is ex- cessively costly to design, imple- ment, and run. This cost should not exceed the perceived benefits of the system. Nor must the system be more complex than is necessary to achieve the required benefits. 7

Conventional Product Costing Systems

Conventional product costing systems assume that individual

products cause cost. They therefore make the individual product item the focus of the cost system design. Conventional systems use cost driv- ers' that are attributes of the prod- uct item such as direct labor hours, machine hours, or material dollars.

Conventional product costing systems may report accurate prod- uct costs where overhead activity is consumed in relation to production volume. Benefits for direct employ- ees may be related to direct labor, for example, and power costs may be related to machine hours.

Product costs may be inaccur- ate, however, where overhead activ- ities are not related to volume. Volume-unrelated activities are com- mon in many manUfacturing set- tings, and include setups and engi- neering changes. There are a number of documented examples of such settings, such as in the screw machine shop of the John Deere Component Works, where conven- tional systems report inaccurate product costs.'

In manufacturing settings where volume-unrelated activities are sig- nificant, conventional product costs do little to enlighten managers' un- derstanding of the relationship be- tween the operating activities that generate the overhead cost and the products. In the absence of proper information, managers tend to rely on across-the-board overhead cuts to control spending.

Such well intentioned efforts are doomed to failure. They do not ad- dress the demand for overhead resources - the activities that keep people busy. Deterioration in the quality of service and pressures on an overburdened staff prompt re- newed spending, and overhead creeps up again.

Conventional systems also con- vey messages that may encourage decisions that conflict with manufac- turing excellence. A direct labor- based overhead rate, for example, may cause design engineers to be- lieve that product design should em- phasize the elimination of direct labor cost. The costing system tells them that direct labor is very expen- sive. Where the direct labor over- head rate is 500 percent, a design change that will remove $1 of direct

labor cost from a product will result in a reported savings of $5 of over- head.'· In reality, not only has the engineering department not gone away, the design change is likely to Increase overhead due to the in- creased demand for engineering change-related activities.

Activity-Based Costing Systems Underlying ABC is the assump-

tion that activities consume re- sources and products consume ac- tivities. Activities include establishing vendor relations, purchasing, receiv- ing, disbursing, setting up a ma- chine, running the machine, reorgan- IZing the production flow, redesign- Ing the product, and taking a cus- tomer order. The performance of these activities triggers the con- sumption of resources that are re- corded as costs in the accounts. The activities are performed in re- sponse to the need to design, pro- duce, market, and distribute prod- ucts."

In manufacturing settings where volume-unrelated activities are significant, conventional product costs do little to enlighten managers' understanding of the relationship between the operating activities that generate the overhead cost and the products.

Each product picks up cost in ABC according to the number of driver units consumed. If the number of times shipped is a driver, for ex- ample, a product will pick up the cost of shipping activities according to the number of times the product is shipped multipiied by the cost per shipment. This cost is divided by the number of product items to get the cost per product item (Fig. 1). This view of the economics of manufac- turing is radically different from the conventional view, and may report more accurate product costs.

Consider the case of a compa- ny that produces two different prod- ucts requiring different levels of at- tention from engineering (Fig. 2). Product A uses a lot of direct labor

Target

How Activity-Based Costing Works: The Shipping Example

Plant shipping cost $100,000

Number of shipments 1000

Cost oer shioment = $100

Product A Product B

Volume 1000 1000

Number of shipments 2 20

Product shipping cost $ 200 $2000

Cost per product item $ 0.20 $ 2.00

Flg.1. • Each product consumes cost according to its specific use of the shipping activity • Product A Is shipped Infrequently In large lots. Relatively little shipping cost is

therefore traced to this product. • Product B requires Just-In-Time (JIT) delivery. The higher shipping cost traced to

this product reflects its frequent shipment. • The cost 01 an Individual shipment is determined by the efficiency with which this

actiVity Is performed. Nate: This example assumes that the resources reqUired for each shipment of Products A and B are the same.

How ABC Can Correct the Inaccuracies of Conventional Costing

Product C Product D Total Production Volume 1000 500

Cost per engineering change $1000 $1000

Number of engineering changes 2 10

Total cost of engineering changes $2000 $10,000 $12,000

Direct labor hours per unit 3 2

Total direct labor hours 3000 1000 4000

Engineering change cost per direct labor hr.($12,000/4000) $3.00

ABC overhead cost ~er unit $2.00 $20.00 (C = $2000/1000 0 = 10,000/500)

Conventional overhead cost per unit $9.00 $6.00 (C = $3.00 x 3 direct labor hours o = $3.00 x 2 direct labor hours)

Fig. 2. • Product A requires relatively little engineering attention. It picks up a lot 01

engineering cost, however, under a conventional system that loads overhead onto direct labor.

• Product B, in contrast, reqUires a lot 01 engineering attention. It receives relatively little engineering cost in the conventional system because it uses little direct labor.

• ABC corrects these errors by tracing engineering costs to the two products based on a driver-engineering changes-that is chosen to reflect the consumption 01 engineering resources. Note: This example assumes that each engineering change consumes the same amount of resources. If this assumption is not true, the design of the ABC system can be modified to reflect these differences.

Summer 1989

but has been in production for some time and most bugs have been elim- inated. Product D, however, is a new product that is designed to re- quire less direct labor. It still has production and quality problems that require a number of engineering changes.

ABC traces the costs of engi- neering change activities via a cost driver, such as the number of engi- neering change orders, to the prod- uct that receives the benefit of this activity. Product B required 10 engi- neering change orders, versus two for Product A, so Product B picks up an amount of cost that reflects its use of engineering time.

Traditional product costing, however, traces engineering cost using direct labor. This volume- related driver traces an equal amount of engineering cost to each direct labor hour. Product A ac- counts for three labor hours per unit, versus two for product B, so product A picks up engineering cost that ex- ceeds its actual consumption of this activity. Product B, with only two di- rect labor hours, receives less engi- neering cost than it deserves.

This miscosting-where one product picks up cost that rightly be- longs to another - is known as cross-subsidy. Cross-subsidy occurs in conventional systems because volume-related cost drivers fail to trace volume-unrelated activities cor- rectly. In contrast, ABC eliminates cross-subsidy by using volume- unrelated cost drivers, such as the number of setups, to trace the cost of volume-unrelated activities to the product.

The process of designing and implementing an ABC system yields a wealth of information on operating activities that can be used by man- agers to eliminate waste. This infor- mation includes an identification of activities performed in the organiza- tion, a determination of the cost of each of these activities, an identifi- cation of where in the organization the activities are performed, and the consumption of these activities by individuai products.

For example, in Fig. 3 the ABC system shows that two activities are performed in the process engineer- ing department: performing setups

#Eng. Chg.* Dept. 2

• Engineering changes

#Setups Dept. 2

The process of designing and implementing an ABC system yields a wealth of information on operating activities that can be used by managers to eliminate waste.

Using ActiVity-Based Costing for Product Design

Using ABC to understand the impact of alternative product designs is the key to using design as a tool of manufacturing excellence. Prod- uct design determines the activities that are consumed by the products.

ABC allows design engineers to understand the impact of different designs on product cost and fleXibili- ty. Product cost can be reduced by

major impacts on the type of activi- ties required and the way they are performed. ABC can model these changes accurately and provide management with the data required for an economic analysis,

Process Engineering

#Eng. Chg.* Dept. 1

#Setups Dept. 1

Products

~& "t'• ABC decomposes each functional area into its component actlvlles. • Activities are grouped together to reflect similarities of location or type. . • The consumption of the activities by the products is measured by cost drivers such

as the number of setups and the number 01 engineering change orders.

company for the additional activities required by the products.

ABC also helps management understand the impact of sourcing decisions. Sourcing decisions often focus on the elimination of direct labor that results from using outside sources but ignore the additional ac- tivities required to coordinate with the vendor. These activities may in- clude qualifying the vendor to make the sub-assembly, shipping compo- nents to the vendor's plant, receiv- ing and processing the ~mplet~d sub-assemblies, monitOring quality and delivery, and processing pur- chase orders and invoices. ABC provides the insights needed to weigh the impact of these activities on the sourcing decision.

ABC also allows managers to understand the impact of new proc- ess technologies. Introducing a new technology such as surface mount equipment, improving quality.to re- duce inspection, and reorganizing the plant layout to create a continu- ous linear flow of product all have

ABC Reveals Information About Operating Activitiesand making engineering changes to products. Each of these two activi- ties is performed in two different de- partments (Departments 1 and 2). In each department the activities are consumed by products according to the demand for setups and engi- neering changes of each product.

Using Activity-Based Costing to Focus Manufacturing Strategy

ABC can radically change the way managers determine the mix of their product line, price the products, identify the location for sourcing components, and assess new tech- nology. It provides a realistic eco- nomic picture of the impact of these decisions on activity consumption.

Consider the case of Schrader Bellows." This manufacturer of pneumatic valves changed its prod- uct mix over time by introducing low- volume specialty products into its line.· Each of these products con- sumed engineering, procurement, quality, setup, and other activities. Introducing one or even a handful of these products did not require the hiring of a new engineer, purchaser, inspector, or setup person. But over time, as new products were added, the demand for these activities in- creased to the point where new staff were required.

The introduction of these low- voiume specialty products was, in part, a response to information re- ported by Schrader Bellows' con- ventional direct labor-based product costing system. This system showed that the low-volume specialty prod- ucts cost about the same as the high-volume standard products. The cost system reported that they were among the most profitable products sold by the division.

A new ABC system, however, showed that these low-volume prod- ucts were more costly than had been previously thought. ABC re- ported that their costs, in most cases, were 100 to 1000 percent greater than the previously reported standard costs. Using this informa- tion, management was able to con- sider a range of alternatives, such as dropping certain products, in- creasing their price, or changing their design, that would simplify manufacturing or compensate the

16 Target

Total Product Overhead $28.71

Product XYZ Summary Bill of Activities

Fig. 4. The summary bill of activities groups e~ch prodUct's activities according to meaningful economic or functional categories: .. • Activities performed in a single functional area-such as receiving-may be

grouped together to show the impact of that department on the cost of each

product. ... th tit d to• Activities may be summarized by economic types of activity a are unre a e organizational structure. Quality-related actiVities, for exa~ple, may be. performed in various parts of the organization. They, may be summarized In the bill of activities, however, to show each product s total cost of quality.

Activity Cost

Receiving $1.87

Procurement 2.19

Raw material inventory 2.99

Finished goods inventory 1.34

Engineering changes 4.75

Rework 2.88

Quality 1.34

Setup 5.21

Manufacturing-Dept. 4.12

Manufacturing-Dept. 2 2.02

away to a site adjacent to the screwmachine manufacturing area, eliminating the cost of moving the parts."

Is Activity-Based Costing Consistent with Manufacturing Excellence?

A company that implements an ABC is adding a new system that requires design, training, and main- tenance resources. An important test of a new system is whether it contributes to the goals of manufac- turing excellence-eliminating waste, and improving quality and flexibility. Otherwise the system adds unnecessary compiexity and becomes a waste itsel!. Robert W. Hall made this point well in his dis- cussion of Shigeo Shingo's seven wastes of manufacturing: "Were he more familiar with Western manufacturing, Shingo might have added an eighth waste: unneces- sary measuring, recording, and managing in an effort to deal with unnecessary complexity. "15

It is my belief-based on the experience of managers using ABC

Kanban was the trigger for a call to the vendor to replenish the parts on the Kanban. Manufacturing pro- posed to track the impact of this change using ABC.

The activity-based product cost structure in ABC also provides im- portant performance information for management. This cost structure - referred to as the bill of activities -describes each product's pattern of activity consumption. The bill may summarize activities consumed by a product into economic or functional groupings such as receiving, pro- curement, engineering changes, and quality (Fig. 4). The bill may also provide detailed information on the activities themselves (Fig. 5). In both cases the bill of activities is a source of information for setting manufac- turing excellence targets for process and design improvement.

In the case of the screw ma- chine shop at John Deere Compo- nent Works, for example, review of the bill of activities of screw machine parts showed that the movement of parts was a costly activity. This in- sight led management to move a . heat treatment facility from one mile

using designs that diminish the de- mand for high-cost activities. Prod- uct cost can be reduced and manu- facturing flexibility improved by designing families of products that use many of the same activities.

Hewlett-Packard's Roseville Network Division, for example, de- veloped an ABC system to guide product design." An early design of the system used the number of in- sertions as a cost driver, but did not distinguish between axial and DIP (dual in-line processor) insertions.. As a result, the design engineers did not distinguish between these two types of components on the basis of insertion cost. A study based on ABC technology, however, showed that axial insertions were about one third the cost of DIP insertions. The ABC system was modified to differ- entiate between axial and DIP inser- tions. The engineers then used this information to guide subsequent product designs.

Using Activity-Based Costing for Continuous Improvement

ABC provides critical informa- tion to support the process of con- tinuous improvement in manufactur- ing. ABC maps the company's activities and describes the cost structure of the products in terms of activity consumption.

Identifying the activities that are performed in each area of the com- pany provides management with in- sights into eliminating activities or improving the efficiency of activity performance. Northern Telecom, for example, used ABC to identify rec- ommended changes in procurement activities and to monitor progress when the changes were implement- ed. Prior to the changes, the buyer received a weekly printout of the production plan and material re- quirements. The buyer visited the stockroom to compare the require- ments with the quantity on hand. I! there was a shortfall, the buyer called the vendor and placed an order.

After studying the cost of this procurement activity as reported by ABC, Northern Telecom replaced the above procedure with a trigger based on Kanban quantities in the assembly area. A red flag on a

Summer 1989 17

$1.34

$2.99

Quality:

Product XYZ Detailed Bill of Activities

Cost

programs have eliminated activities such as incoming inspection and receiving -requires a simple ABC system. In one organization that was well advanced in its manufacturing improvement program, for example, the ABC system used just two product drivers - cycle time and part numbers-to mea- sure the consumption of ac- tivities by the products.

Conclusion ABC is used in a number of

ways to support manufacturing ex- cellence. ABC provides information for strategic decisions, such as product mix and sourcing decisions, that is consistent with the long-run nature of these decisions. ABC al- lows product designers to under- stand the impact of different designs on cost and flexibility and modify their designs accordingly. ABC sup- ports the continuous improvement process by allowing management to gain new insights into activity perfor-

Activities

Raw Material Inventory:

data base like the number of production runs. The ABC designer can also take ad- vantage of design rules that simplify the system without sacrificing the accuracy of product cost. For example, tasks that are performed at the same time, such as changing the tools on a ma- chine and inspecting the first part, can be combined as one activity with one cost driver such as the number of setups."

4. The complexity of an ABC system matches the com- plexity of manufacturing. A complex manufacturing organ- ization will require a system that is sufficiently detailed to capture the patterns of activi- ty performance and con- sumption. A simple manufac- turing organization - such as one where products of simi- lar design are built on a sin- gle line as a family of prod- ucts and/or where manufacturing improvement

# of raw material shipments $1.02

# of purchased part shipments 1.33

# of setups 0.64

# of setups $0.88

# of purchase orders received 0.46

Fig. 5. The detailed bill of activities lists the activities, and the cost of each activity, required to design, produoe, and distribute a product. • Each activity in the bill is described by its cost driver. The cost driver measures the

use of the actiVity by the product. • The bill of activities shows how each product uses activities. and how much that

use costs, in the manufacturing organization. • This example bill shows three raw material inventory activities and two quality

activities. A bill that lists all the activities of a product can be quite extensive if the product is complex.

• Reducing product cost reqUires product or process improvements thai reduce the demands for activities and reduce the resources required by each actiVity.

in a variety of manufacturing situations - that a properly-designed ABC does not add unnecessary complexity. It is a tool for the reduc- tion of waste and the improvement of manufacturing:

1. ABC helps managers under- stand and eliminate waste. ABC provides a road map to the complexity of a manufac- turing organization. It de- scribes and costs the activi- ties being performed. It helps management understand an important source of complexity-the demands placed on the organzation by a diverse range of products. Once managers understand what is keeping the organi- zation busy and where the demands for activities come from, they focus on eliminat- ing both the demand for the activity and possibly the ac- tivity itself.

2. ABC helps prevent product design and marketing from placing unreasonable de- mands on production. ABC is a tool for communicating 10 product design and mar- keting the impact their deci- sions have on production. With the information an ABC provides, the engineers can avoid designs, such as those with a high part count, that create complexity (as mea- sured by ABC) without add- ing features valued by the customer. Marketing can pick strategies that avoid product proliferation which creates complexity unjustified by added customer value.

3. ABC system design avoids unnecessary complexity. The cost of designing, imple- menting, and maintaining an ABC can be reduced by sim- plifying its design. The ABC designer can avoid using data that are not already available within the compa- ny. In some companies, for example, he can take advan- tage of data that already exist in the manufacturing

18 Target

Using Activity.Based Costing for Behavioral Change Some companies use ABC as a behavioral tool to focus attention on one or two critical aspects of manufacturing excellence. The Portable Instru- ment Division of Tektronix, for example, used ABC to drive down the part count and the number of vendors. These reductions were considered critical to accomplishing cost, quality, and flexibility goals of their manu- facturing excellence program.

This division used the number of part numbers as a product driver for procurement, storage, receiving, and part data base maintenance activities. Because each part number received the same cost regardless of volume, the cost per part was much less for high-volume part num- bers than for low-volume part numbers. This situation made it more expensive for the product designer to use a low-volume unique compo- nent than a high-volume common component.

The result was that the design engineers used substantially fewer unique components in their product designs. The part count for the division fell from about 6000 to 1500 in three years, while the number of vendors fell from over 1500 to less than 200 in the same time period. Procurement overhead fell, quality improved, and several products that had previously been produced on separate lines were now produced on the same line.

In another case, Zytec, a manufacturer of power supplies, used cost drivers to focus attention on the need to reduce the elapsed time from the time orders were placed for components to the time the finished product was shipped to the customer. Order leadtime for com- ponents was used as a cost driver to trace the cost of procurement activities to the product. Manufacturing cycle time was used to trace manufacturing overhead to the product. This focus on elapsed time was consistent with a manufacturing strategy that emphasized cost, quality, and flexibility-all three of which the company believed were a function of time.

mance, by focusing attention on the sources of demand for activities and by permitting management to create a behavioral incentive to improve one or more aspects of manufactur- ing.

ABC is a tool for managing complexity in manufacturing. ABC provides activity-based information to help managers understand and eliminate complexity. It is also a communication tool between pro- duction and marketing and product design that helps minimize product changes which create unnecessary complexity.

The benefits of ABC can be achieved without designing a system that is more complex than neces- sary. The ABC designer can use the rules of ABC design to simplify the system without sacrificing the accu- racy of product cost. A well- designed ABC system will also have no more detail than that required by

Summer 1989

the manufacturing environment. An ABC for a simple manufacturing set- ting, for example, will be a simple system.

ABC ... is also a communication tool between production and marketing and product design that helps minimize product changes which create unnecessary complexity.

The experience of the compa- nies described in this article shows that ABC is a strategic weapon in the on-going quest for competitive position in manufacturing. For these companies, ABC is an indispensa- ble, flexible, and cost-effective tool for manufacturing excellence that is tailored to the needs of their com- petitive and manufacturing condI- tions.

'Robin Cooper, "Schrader Bellows," 9-186- 272 (Boston: Harvard Business School), 1986.

'Robin Cooper and Peter B.B. Tumey, "Tek- tronix: The Portable Instrument Division (A), (B), and (C)," 9-188-142/3/4 (Boston: Har- vard Business School), 1988.

'Peter B.B. Turney and Bruce Anderson, "Ac- counting for Continuous Improvement," Sloan Management Review, Winter 1989.

'Robert W. Hall, Attaining Manufacturing Ex- cellence, (Homewood, IL: Dow-Jones Irwin, 1987), p.22.

'Robin Cooper, "The Rise of Activity-Based Costing-Part Two: When Do I Need an Actlvlly-Based Cost System?" Joumai of Cost Management, Fall 1988, Vo1.2, No.3, pp.41-48.

'H. Thomas Johnson, "ActiVity-Based Infor- mation: Accounting for Competitive Excel~ lence," Target, Spring 1989.

'Robin Cooper, "The Rise of Activity-Based Costing-Part Two: When Do I Need an ActiVity-Based Cost System?"

81n this context, a cost driver is a measure of the consumption of activities by the product.

9Robert S. Kaplan, "John Deere Component Works," 9-187-107/8 (Boston: Harvard Busi- ness School), 1986.

1°Dlrect labor overhead rates In excess of 500 percent are not unusual In IOOay's man- ufacturing environment where direct labor has declined and overhead has increased as a percent of manufacturing cost.

11 Much of this section is based on the work of Robin Cooper. See, for example, "The Rise of Activity-Based Costing-Part One: What is an Activity-Based Cost System?" Journal of Cost Management, Summer 1988, Vo1.2, No.2, pp.45-54.

12Robin Cooper, "Schrader Bellows."

13Robin Cooper and Peter B.B. Tumey, "Hewlett Packard: The Roseville Network Division" (Boston: Harvard Business School), 1989.

14Robert S. Kaplan, "John Deere Component Works."

15Robert W. Hall, Attaining Manufacturing Ex- ceiience, pp. 24-25.

"Robin Cooper, "The Rise of Activity-Based Costing Part 3: Determining the Number and Nature of Cost Drivers," Journal of Cost Management, Winter 1989, Vo1.2, No.4, pp.34-46.

Author: Peter B.B. Turney, Ph.D, is the Tektron- ix professor of cost management, Port· land State University, Portland, OR.

BUS 224/Assignment I/Cases/Mangerial decision using ABC for service sector.pdf

www.ccsenet.org/ijbm International Journal of Business and Management Vol. 6, No. 11; November 2011

Published by Canadian Center of Science and Education 3

Activity-Based Costing System in the Service Sector: A Strategic Approach for Enhancing Managerial Decision Making and

Competitiveness

Ashford C. Chea

School of Business, Kentucky Wesleyan College 4721 Covert Avenue, Evansville, IN 47714, USA

Tel: 1-812-471-9341 E-mail: [email protected] Received: June 21, 2011 Accepted: July 4, 2011 Published: November 1, 2011 doi:10.5539/ijbm.v6n11p3 URL: http://dx.doi.org/10.5539/ijbm.v6n11p3 Abstract The author begins the article by outlining a brief historical evolution of activity-based costing (ABC) in the USA preceded by an operating definition of terminologies. Next, he presents the literature review and the methodology employed during the study. He reviews the application of ABC in the service sector, followed by an analysis of the unique attribute of the service sector. Moreover, the researcher briefly profiles several service-oriented firms that have successfully adopted and implemented ABC, and presents his findings from the study. He then addresses the limitations of ABC in the service sectors and offers strategies for dealing with these drawbacks. Finally, the researcher outlines the managerial implications of implementing ABC in the service sector. Keywords: Activity-based costing, Service sector, Managerial decision making, Cost measurement 1. Introduction The concept of activity-based costing (ABC) was introduced in the US, initially in the manufacturing sector during 1970s and 1980s. Robert Cooper and Robert Kaplan brought the ABC concept to light and published the body of knowledge in the Harvard Business Review in 1988. Cooper and Kaplan defined ABC method as an approach to solve the problems of traditional cost management systems; that is, the conventional cost accounting systems are often unable to identify correctly the true costs of processes. Consequently, management and quality professionals are unable to make sound decisions or make decisions based on the misrepresented data. On the other hand, the ABC objectively assigns costs based on the cost-and-effect relationships. And in 1987, Robert Kaplan and W. Burns published in their book Accounting and Management: Field Study Perspective, the ABC body of knowledge with the initial focus on manufacturing where technology and productivity improvement have reduced the direct costs and increased indirect and overhead expenses (Narong, 2009). 2. Definition of Terms An activity is an element of work to be performed to complete a project; it is a process or operation requiring time and associated resources. Activity-based costing is a total quality management tool for cost and performance measurement of activities, resources, and cost objects (i. e., products and services). ABC is also known as the” horizontal” or cross-functional cost view and can provide fact-based insight into the spending and profitability of products, services, customers, districts, distribution lines, and etc. (Narong, 2009). Three guidelines support cost allocations in ABC. 1) Direct-cost tracing to product: The costs of flexible resources are traced to individual products that

exclusively use them. The costs include direct material and direct labor costs. Some of the capacity-related costs are included that are exclusively used for one product.

2) Indirect-cost allocating to products: (a). Multipurpose resource costs –multipurpose resource costs occur when resources are consumed by multiple products. The costs are the overhead costs that need to be allocated to the products. Typically, these costs are collected in an accounting system on a yearly basis; (b). Cost centers—only the three-step allocation process uses cost centers to allocate costs of a group of consumables or indirect resources necessary to operate cost centers. Cost centers include major production machines and human resources; (c). Activity costs (cost pools): The general principle is to use separate activity costs if the cost or productivity of resources is different and if the pattern of demand varies across resources. Each activity cost is homogenous and has a cause-and-effect relationship with the cost driver. A proliferation of multiple products requires more refined activity costs to reflect the complexity of production.

3) Activity cost drivers: Cost drivers should relate to way in which activity costs are consumed. For example, setup cost is assigned to a product consuming a setup activity-based on setup time if setup time drives the costs (Park and Simpson, 2008).

www.ccsenet.org/ijbm International Journal of Business and Management Vol. 6, No. 11; November 2011

ISSN 1833-3850 E-ISSN 1833-8119 4

3. Literature Review 3.1 The Need for ABC Traditional cost accounting, which mainly uses one single cost driver such as direct labor or output volume to allocate the overhead costs, systematically distorts product costs in modern manufacturing and service environments in which overhear costs are a significant portion of product costs. In correct product cost information can lead to poor decisions (Wang, Du, Lei and Lin, 2010). Why is traditional accounting failing quality managers? by Gary Cokins, answers the question that the ABC is the solution to the conventional way of cost reporting. It bases its argument on the fact that the today’s ledger systems support organizational accounting and reporting requirement but not adequate for an internal use or for a process-based decision making. The article also reveals the flaws in the standard costing system as the system is incomplete and unprocessed; misallocates indirect or overhead costs; and structurally deficient to allow decision makers to measure and analyze expenses. To illustrate his reasoning, Cokins provided side by side examples of how costs are captured, summarized and reported via the general ledger and ABC database format. The review of Why is Traditional Accounting Failing Quality Manager? proves that traditional accounting systems provide reports that make managers and quality practitioners happy or sad; however, the ABC methodology educate and makes them smarter in understanding the true cost of processes, products, or services (Narong, 2009). Traditional cost-based measures were developed decade ago, when direct labor costs were valuable and accounted for a major portion of production cost. Standards were developed for tracking and controlling direct labor activity, and indirect costs were allocated across product units. Those measures were appropriate for organizations that mass produced a narrow range of products and incurred mostly variable costs. However, labor now is largely fixed and indirect costs have been a large part of total cost in most organizations. These indirect costs are incurred to acquire resources needed to provide a wide variety of activities, each with different cost drivers. Many of these indirect costs are also committed costs used to acquire capacity to perform these activities. Though management can influence the level of spending for these committed costs in the long run, the amount of capacity acquired and related spending is fixed in the short run. This can lead to either overcapacity and overspending or limited capacity and bottlenecks. Consequently, more robust systems that provide detailed, accurate information about the behavior of these costs, and that assist companies in managing these committed resources are needed. Traditional accounting has a tendency to provide information which though accurate is often late, irrelevant, and misleading. It is also complex to the uninitiated with its double entries, accruals and provisions (Gering, 1999). An alternative managerial philosophy and its associated measurement systems, namely, activity-based costing (ABC), has been offered to overcome some of the failures of standard costing for improving managerial decision making. ABC has been acknowledged to provide cost information for more precise cost allocation (Sheu, Chen and Kovar, 2003). 3.2 Benefits of ABC The costing methodology known as ABC yields cost information that may be significantly different than what is provided when the traditional absorption cost method is used. Perhaps now is the time for the project management profession to consider adopting ABC in evaluating project profitability (Kinsella, 2002). Moreover, ABC analysis enables managers to slice into the business many different ways—by product or group of similar products, by individual customer or client group, or by distribution channel—and gives them a close-up view of whatever slice they are considering. ABC analysis also illuminates exactly what activities are associated with that part of the business and how those activities are linked to the generation of revenues and the consumption of resources. By high-lighting those relationships, ABC helps managers understand precisely where to take actions that will drive profits (Cooper and Kaplan, 1991). Furthermore, managers can use ABC to analyze many other aspects of their company’s operations. They can compare the profits that various customers, product lines, brands, or regions generate. Then they can zero in on the dynamic of the more-or less- profitable ones. For instance, a brand analysis could look at all the expenses associated with sustaining a brand, such as “Snappy Cereal”, which includes a dozen different packages and flavors. Managers can judge the brand’s profitability by matching the revenues earned from all Snappy products against the expenses associated with promoting, adverting, and maintaining the Snappy brand in the marketplace (Cooper and Kaplan, 1991). Finally, ABC is simple. For each process the costs buckets are identified, their cost drivers are discerned and the cost per driver is calculated. Costs are found by counting the drivers. If it costs $5 to invoice a customer and one customer generates a hundred invoices then the associated cost is $500. Another customer might generate ten or a thousand invoices and consequently have a cost structure which is quite different. The main work setting up an ABC program is identifying and calculating the cost buckets and cost drivers. This is the same groundwork required to reengineer a business, including benchmarking (how do we compare?), activity analysis (how can we do better?) and service level analysis (what will the customers pay for?). In its simplest form performance improvement can be seen in terms of time, cost, and quality. The relationship between performance improvement and ABC is noticeable. ABC has a moderate impact on time, a significant impact on quality, and a substantial impact on cost (Gering, 1999).

www.ccsenet.org/ijbm International Journal of Business and Management Vol. 6, No. 11; November 2011

Published by Canadian Center of Science and Education 5

3.3 Critism of ABC Critics of ABC generally fell into two camps. Some argued that ABC was inconsistent with the principles of continuous improvement and total quality management. They wrote that ABC lacked customer focus, was not process-oriented, did not enhance organizational learning, and was top down in approach (i.e., did not involve employees). Other argued that ABC was inconsistent with the theory of constraints. A common argument was that ABC could not reliably measure the short-term impact of decisions on operating costs, inventory and throughput. These criticisms reflected a misunderstanding of the purpose and nature of ABC. Early versions of ABC were designed to reveal strategic insight into sources of profitability. The intention of ABC was neither to provide day-to-day guidance on process quality nor to measure short-term variable costs (Turner, 2005) 3.4 Unique Nature of Service Sector The production system in service organizations is divided into a totally invisible part and a line of visibility. The invisible part consists of such items as systems support, management support and physical support. The visible part is more or less visible to the customer who usually participates in the production process. In the invisible or interactive part, interactions between the service firm’s contact persons and customers take place. The augmented service offer includes the service process and the interaction between the organization and its customers. Because services are activities or processes in which consumption is partly inseparable from production, the service production is a dynamic phenomenon by definition. The service exists as long as the production process goes on. Hence, any model of services, such as the augmented service offering and the creation of such products, must include a dynamic aspect where the basic package facilities’ services and goods and support products have to be planned according to the service concept. A service, both in the elements of the basic package and in the accessibility, interaction and customer participation aspects of service production and delivery, include the desired features, which in turn creates the benefits that customers seek. Therefore, facility—sustaining expenses are dealt with best if they can be treated as an expense of operating the facility for the period and not allocated to products (Hussain and Gunasekaran, 2001). ABC system have recognized that organizational resources are needed both for direct production of goods and services and for indirect or support activities. The goal of ABC is to measure and then price out all the resources used for activities that generate the production of goods and services for customers (Cook, Grove and Coburn, 2000). When analyzing production expenses in service organizations, the demand for support resources arises from product volume and mixes. In a lot of service firms including financial institutions such as banks, some expenses are driven naturally by products, e.g. checking accounts, savings, mortgages, etc. A great deal of the expenses for service functions are caused by differences in customers’ preferences, even though they are using the same service. The analysis starts by examining the expense structure of each operating department and proceeds by determining the factors that create the demands for the functions performed by the department. The objective of analysis is, therefore, to discover the nature of the demand and quantify it. The basic goal of the analysis is to obtain the unit costs for processing transactions from products and customers (Hussain and Gunasekaran, 2001). 4. Methodology This paper relies on the literature review of past and current relevant articles focusing on activity-based costing (ABC). Except where a source was needed specifically for its perspective on broad issues relating to firms’ overall business environment, the author screened papers by “activity-based costing” and by numerous variants of keywords, focusing specifically on activity-based costing in the service sector. Source papers included refereed research studies, empirical reports, and articles from professional journals. Since the literature relating to ABC is voluminous, the author used several decision rules in choosing articles. First, because ABC is changing fast in today’s environment, the author used mostly sources published from 2000-2010, except where papers were needed specifically for their historical perspectives. Second, given the author’s aim to provide a practical understanding of the main issues in ABC in the service sector, he included, in order of priority: refereed empirical research papers, reports, and other relevant literature on current firm ABC practices. To get some perspective on the current state of ABC in, the author begins with a brief historical perspective on ABC. 5. Application of ABC in the Service Sector As a technique, ABC has its roots in the manufacturing sector and most of the literature on ABC emphasizes its use in a manufacturing setting. Yet, it must be acknowledged that significant and growing economic activity takes place in the non-manufacturing sector. It is important to note that ABC principles apply to all types of business. For example, service companies face the same changing environment that has necessitated modifications in cost management practices in manufacturing companies in order for them to remain competitive. Strong competition for existing services together with customers requiring greater service choice will force a compression of profit margins. Since service companies are more people-intensive than manufacturing, there is greater need to focus on the myriad of activities that are performed in order to serve the customer. In a service arena, determining and lowering the “cost to serve” is a critical success factor. The challenge is to make the less expensive service also the preferred service among customers. For example, retail banks can provide basically the same service either through a cash teller or an automated teller machine (ATM). The ATM is significantly

www.ccsenet.org/ijbm International Journal of Business and Management Vol. 6, No. 11; November 2011

ISSN 1833-3850 E-ISSN 1833-8119 6

cheaper for banks, and generally, the preferred service option among customers. For service-oriented companies, there is urgency to use ABC as a growth and profit-enabling tool, through identifying and modifying non-value added activities and improving customer profitability. Although, ABC product costing information may not be acceptable for financial reporting purposes but this (negative) consideration is not relevant in the service sector due to the absence of stock valuation considerations (Clarke and Mullins, 2001). Gone are the days when ABC was just for manufacturers. Nowadays, as mentioned above, it has crept into service industries such as healthcare, banking, and insurance. If a company implements ABC, it will open a lot of eyes. More than just opening eyes, managers will be able to use the information to informed decisions (Baxendale and Dombusch, 2000). During the last two decades, we have witnessed substantial changes in the service sector with new competitors emerging as a result of deregulation which has also given companies greater freedom in setting prices and determining the mix of products offered. Well-managed service firms with a good understanding of their markets, customers and information technologies can become much more profitable in a deregulated, more competitive environment. Even in manufacturing companies, functions such as marketing, selling, distribution, service, research and development, and general administration have become more significant expense categories than in the past (Hussain and Gunasekaran, 2001). In service firms, the most important cost is the labor cost for personnel. Direct labor costs are traceable to the service rendered. In service organizations, the most important cost would be the professional labor involved in producing the services, i.e. the direct labor cost must be traceable to the service rendered. In addition to labor cost, various types of overhead costs will occur in any type of business. In a service firm, the overhead costs usually occur when offering a service. Consequently, they are classified as service overheads and can be compared with factory overheads in a manufacturing firm. Professional labor costs are considered service overheads rather than period cost (Clarke and Mullins, 2001). The fallacy of the standard costing system at many companies, including service firms, is that very few customers’ orders consume the same amount of resources. At a typical service firm, the profit on each sale can vary significantly. Assigning costs accurately to each account would allow the company assesses the profitability of different customers. Making customers pay for what they received is also a fairer arrangement. Few companies recover the exact cost and expenses of serving customers in the sales price charged. In many businesses, profitable accounts subsidize unprofitable ones, and management is none the wiser. In order to track costs more closely, requires the investment in more sophisticated information and accounting system such as the ABC system. First because it would allow management to track the profitability of each customer’s account and, second, because it would allow management to track the performance of outside contractor more closely (Davis and Darling, 1996). 6. Examples of Service –Oriented Firms That Successfully Adopted and Implemented ABC Financial institutions have recently been at the forefront of implementing ABC. Even though the use of ABC has evolved from original user, manufacturing companies, to services companies, the financial sector remains virgin territory. Here it is an even more elusive beast: the new frontier. While the use of ABC within financial institutions poses new and different challenges to ABC Practitioners, little knowledge or information of the experiences of implementing ABC in financial institutions has seeped into the public domain. This paper is aimed to highlight and discuss some issues which are particular to financial institutions, and some which are more generic to the service sector but have not been otherwise highlight. A Large Regional Bank: The use of ABC to effectively allocate resources and to determine prices was the primary objective in the case of a large regional bank. Before ABC, the bank had no clear way to cost services or determine how resources were being consumed by different activities. In addition, since some of the customers were related parties, the bank wished to show that the charges being made to them were effort-and-use-based, i.e., there was a direct correlation between the nature of service provided and the charge for this service. ABC analysis helped the bank to address both these issues—internal pricing and strategic pricing Global Insurance Company: A global insurance company decided to implement ABC for tax purposes—that is, to determine its allocation methodology for external transfer pricing purposes. With increasing scrutiny being the norm in many of the major fiscal jurisdictions, this business wanted to ensure that its charges to its overseas affiliates were accurate and defensible to tax authorities. ABC ensured that the services provided to all overseas affiliates were tracked through the ABC systems, resulting in charges directly related to the economic benefit received by the recipient. The end result was that the Group was able to lower its effective tax rate. Major Investment Bank: The drivers for implementing ABC in the global futures business of a major investment bank were both strategic decision making and internal transfer pricing. The bank had a clear need to determine which products and markets were profitable, and how it should correspondingly shape its business strategy. In this example ABC led to a fairly significant change in its internal transfer pricing and a dramatic improvement in its own internal performance measures. This is because ABC showed that the futures business had undercharged other business units in the bank for the provision of its services thereby reducing its own bottom line figures. ABC allowed more accurate and efficient charges to be made (Rafig and Garg, 2002) Multifoods Distribution Group, a food-service provider in Denver. The report that ABC “kept us from bringing on new customers that we might have lost money on… Our cost to serve is based largely on our transportation

www.ccsenet.org/ijbm International Journal of Business and Management Vol. 6, No. 11; November 2011

Published by Canadian Center of Science and Education 7

costs, so we rank customers in terms of potential profit from zero to 250 miles, 250 miles to 500 miles, and 500 miles to 1,000 miles. Our potential for business growth is greater in rural areas, but we had to be selective because those are also the most remote areas for us to deliver”. Healthspan Transportation Service in the USA reports that, through analyzing ABC data, it was recognized that when the scheduled call service was busy, the emergency room service was often idle. As a result, the emergency room service was used to respond to scheduled calls and greater usage efficiency was achieved with a consequent (positive) impact on profitability. For Northeast Utilities, New England’s largest Electricity Utility Company, activity based measures focus on customer requirements and improving the company’s market responsiveness. Improved information on the costs of maintenance, inspections, hookups, and meter readings gave managers a better idea about the level of quality and reliability customers require and how their costs of delivery of each service compare to that of their competitors. The finance manager estimates that, since the late 1980s, through ABC measurements, the company has eliminated 30% to 40% from its cost structure without an adverse effect on its operations. Fair Oaks Ford, an automotive retailer in Illinois, USA had a pilot study on ABC conducted in the company. It was discovered that there were many areas in which ABC could bring significant improvements in the business. For example, a non-value added activity—waiting at the service and parts counter—was identified as being costly and this was reorganized. Further, performance measurements were developed based on cost drivers for various activities. The dealer is now in a position to determine potential opportunities for productivity improvement by benchmarking their activity performance to industry peers (Clarke and Mullins, 2001). 7. Findings Findings from the author’s research show that the successful implementation of ABC system within a service-oriented firm is a function of the followings: 1. The impetus of the change must come from within the organization. 2. The adoption of ABC must first be bought by operating manager before it is sold to top management. 3. All employees must be made to embrace ABC and be held accountable. 4. Effective sponsorship and how the rationale for ABC adoption is communicated to employees must be given a high priority. Here are the steps used by the firms in this research, which can apply to any organization that wants to develop an ABC system: 1. Form a cross-functional team 2. Identify cost objects (items for which there was a need for cost information) 3. Identify activities (homogenous groups of work such as accounting) 4. Identify cost drivers (the agents that cause costs to be incurred in the activities) 5. Attribute activity costs to cost objects and 6. Use the information (Baxendale and Dombusch, 2000). However, the study shows that a formidable task for most companies that implemented ABC is collecting information for specifying and assigning costs to activities. This phase involves identifying three things: 1. What the company actually does (as opposed to its functional identification) 2. Appropriate assignment bases (resource drivers) to determine the cost of the activities, and 3. Activity drivers to assign the activity costs to cost objects (Bukovinsky, Sprohge and Talbott, 2000). 8. Addressing the Limitations of ABC in the Service Sector ABC is not without its limitations, many of which relate to issues of implementations, such as: the desire to change to an ABC system is often met with reluctance at top-management level; problems are often encountered in identifying appropriate cost pools and related activity cost drivers; ABC implementation is costly and time-consuming. This includes, for example, the costs involved in adapting the internal accounting system with the time involvement of all staff involved in the new accounting systems; ABC systems may be too complex for the needs of the organization. Complexity is brought about by a desire to cater for a vast number of activities, cost drivers, services and cost elements. However, ABC systems that are too complex often fail to meet management requirements. It is therefore important to evaluate the scope of and role for the proposed system, if implementation is to be successful (Clarke and Tracy, 2001). To address the shortcoming of ABC in the service sector, requires a performance-focused ABC system (PFABC) to provide an integrated ABC information system that can be employed 1) for performance control; 2) to solve problems associated with Traditional ABC; and 3) to further extend the implications of conventional ABC. The PFABC is based on several steps including a) identifying major activities; b) Determining actual resources used for each activity; c) determining actual rate of each resource activity; and d)cost determination of each activity. PFABC approaches actual resource determination differently. For example, employees who perform a designated activity determine the kind and amount of the resource actually used for each activity based on its behavior or via the firm’s information systems, particularly the accounting information system. The resources may be time, quantity of direct material, or other appropriate measures, but the resource must reflect a cause-effect relationship with the cost object. This provides great flexibility in choosing the appropriate resource capacity among different effective resources. This also involves a determination of the behavior of the actual resources and committed resources. The approach posits several advantages: 1) It is flexible, because other important activity driven resources such as kilograms, megabytes, or costs may be selected other than time; 2) It is based upon actual data that is usually generated by the firm’s accounting system or other existing information systems. Thus, the data is objective and well documented. The details of required information that are not provided by the existing information systems can be collected directly from the employee work information, eliminating to a great extent the information asymmetry problems existing in the conventional ABC agency

www.ccsenet.org/ijbm International Journal of Business and Management Vol. 6, No. 11; November 2011

ISSN 1833-3850 E-ISSN 1833-8119 8

relations (Namazi, 2009). Moreover, in the drastic competitive environment at present, single ABC cost information has not made enterprise acquire and keep long term competitive advantages and value creation ability. These research emphases of ABC are mainly centralized in the process producing indirect costs in the domains such as production and logistics, but it ignores the distribution process producing the indirect cost in other domain. This is the case when the enterprise evaluates the investment item or the profitability of the new product. It will find that the ABC method could not reflect the capital cost consumed by the investment item or the new product, and the enterprise cannot control the investment risk. Therefore, it is necessary to combine ABC and economic value added (EVA). 9. Integration of ABC and EVA EVA is the economic profit of operating profit after tax minus all capital costs (including debt cost and equity cost). And it is the surplus cost minus all costs, and it is the index to measure the performance of the enterprise, and it could measure the shareholder fortune created by the enterprise. To improve the decision serviceability of the cost information of ABC, ABC should combine with EVA. To bring the principle of EVA into ABC will make the cost management and the performance evaluation system more perfect and complete, and rectify the situation that ABC ignores the capital cost and underestimate the product cost. The combination of ABC and EVA will produce the so-called ABC & EVA integrated system. The ABC module in the system emphasizes the management cost, and the EVA module emphasizes the capital cost, and the combination of both will compose a complete and effective management tool (Hu, 2010). 9.1 Advantages of ABC & EVA Integrated System The integrated management mode of ABC & EVA has the advantages of ABC and EVA, and the introduction of EVA could improve the deficiency that ABC could not completely reflect the capital cost, and it is very important for the management of the enterprise. Comparing with ABC or EVA, the advantages of the integrated mode include the following aspects: 1) the integrated system could distribute the cost and capitals into various activities and activity centers, and the production cost could completely reflect all costs. By introducing EVA in the cost accounting process, the integrated system could more completely reflect the cost information of product; 2) The cost information provided by the integrated system is really “complete cost” which includes not only the management cost, but the capital costs, and it is propitious to make enterprise managers realize that the capital is precious and limited resource, and they will more effectively and reasonably utilize capitals and stop or reduce the wastes of capitals (Hu, 2010). Last but not least is the integration of time-based management into the ABC system to enhance its usefulness. Time-based management (TBM) has made process duration an important tool in performance improvement. Longer processes mean more handovers and more non-value added activities such as counting, checking, and moving. Thus although ABC focuses primarily on cost drivers, time is often used as a proxy for other costs, particularly once an area for improvement has been identified. This is true for bottlenecks where the lead in and out of the bottleneck are seen in terms of utilization and often apportioned based on the bottleneck drivers. TBM is both a marketing tool and a cost saving tool and is often used once ABC has targeted a performance area (Gering, 1999). 10. Discussion In today’s competitive environment, consumers are demanding lower priced and superior quality services while, firms are concentrating on ways to best identify their cost drivers and improve profit. Nowadays, repurchase decisions based solely on brand loyalty are becoming a thing of the past as customers do not hesitate to switch their allegiance to firms that provide excellent quality services at competitive prices. Shopping for new services on the internet has made E-commerce the new way to buy trade or sell goods. In the changing technological environment, firms have come to realize that traditional cost accounting systems do not provide accurate cost information, thus making it decisions about price, service and technology precisely wrong based on cost systems relying on accrual bases. The practice of ABC focuses has gained popularity because of these changing forces. ABC focuses on the activities associated with the costs and assigns costs by using multiple cost drivers (Stapleton et al, 2004). The objective of this paper has been to show how ABC can be used as a tool for determining true costs in the service sector and help firm make better decisions based on more accurate costing information. ABC can assign activity costs to service, or customer that consumes resources in order to measure profitability and provide cost-effective and timely information better than traditional accounting system. ABC enables managers to understand profitability better. Making decisions related to profitability without isolating the factors accounting for profits is like playing poke without looking at one’s cards. In implementing ABC, when determining the cost drivers for each activity, it is important that managers do not get bogged down with too many details that cannot be explained. However, a system that is too general may not be accurate enough. Customers, whether internal or external, need to be prepared for the changes to come. The firm should educate customers to prepare them before starting the implementation process. In implementing ABC, the firm should set-up a balanced team that gets input from all parties involved: finance staff, information technology staff, human resources, so forth. The firm will be able to get faster buy-in from upper management if managers can quickly points to cost savings. ABC implementation must have the support of all levels in a firm.

www.ccsenet.org/ijbm International Journal of Business and Management Vol. 6, No. 11; November 2011

Published by Canadian Center of Science and Education 9

ABC requires a new way of thinking from all the firm’s functions. For optimal success, the firm should establish a reasonable time frame. In most service industries, six to twelve months is aggressive but reasonable (Stapleton et al, 2004). When applying ABC to service organizations, one must distinguish the different services that the organization produces. In firm producing professional services, it is probably easier to implement ABC, as the costs are not so difficult to trace to different activities. In an accounting firm, the customers are limited, and the accountants and support people can quite easily keep record of the amount of time and material they use when dealing with a specific customer. Other professional services include consulting services, education services or legal services. For example, a consulting firm providing educational services which gives courses in service marketing will have more or less the same cost for giving the course irrespective of how many persons are attending. Unit level cost will probably be rather low, consisting of copies and similar materials distributed during the course. Most of the costs can be traced to batch-level costs, i.e. cost for teachers and rents. Cost for planning, marketing and other similar activities for a specific course can be traced to product level. Costs at the facility level can, for example, be general administration and support (Hussain and Gunasekaran, 2001). Implementing an accounting transformation like ABC in the service sector only makes sense if it improves the ability of the organization to function. The impetus for change must come from within the organization. Within an organization, operating managers stand to benefit the most from ABC. If the costs of major activities involved in a manager’s operations are at the batch or product level, then the cost estimates provided to these managers will often be significantly different, and more accurate, when developed under ABC. This means that to sell ABC to top management, it must first be sold to the operating managers, who will benefit the most. To sell it to them, one must understand the levers they can adjust and how those levers change costs (Lere, 2002). Moreover, for ABC to be successful and to produce any meaningful results, employees must be made to embrace ABC and be held accountable. Effective sponsorship and how the rationale for ABC adoption is communicated to employees are important. If this does not occur, ABC will be nothing but a house built on sand (Rafig and Garg, 2002). 11. Managerial Implications Knowledge of the linkage between ABC and firm performance, as well as the organizational circumstances under which ABC can provide performance enhancements to companies, are essential inputs to the investment and operational decisions that companies must make before approving this important resource allocation decision. Many companies have adopted ABC, and researchers have examined important issues related to the financial impact of this organizational innovation (Maiga and Jacobs, 2008). The central idea of ABC is to classify and separate activity costs from an accounting system and allocate the costs to products by measuring the cost drivers of the costs. The bottom line is that all indirect costs accumulated in an accounting system should be appropriately allocated to products consuming those indirect costs to prevent cost distortion (Park and Simpson, 2008). There is no standard for ABC. As a result, practitioners may be familiar with different variations of ABC. Any costing approach should apply common sense. There will be environments with either low product diversity or a unique production schedule where cost measurement would be different (Vercio and Shoemaker, 2007). 12. Concluding Remarks As shown in this paper, ABC is not only appropriate for use in a manufacturing environment; it is also most appropriate for service organizations such as financial institutions, the healthcare industry, and government organizations. In fact, some banking and financial institutions have been applying the concept for years under other names. One of them is unit costing, which is used to calculate the cost of banking services by determining the cost and consumption of each unit of output of functions required to deliver the service. ABC in very basic terms may provide very good payback for businesses. Some of the benefits that relate directly to the financial services industry are: 1) identification of the most profitable customers; 2) More accurate product and service pricing; 3) Increase product profitability; 4) Well-organized process costs (Kocakulah, Bartlett and Albin, 2009). References Baxendale, S. J., and Dombusch, V. (2000). Activity-based costing for a hospice. Strategic Finance, 81(9), 64-71. Bukovinsky, D., Sprohge, H., and Talbott, J. (2000). Activity-based costing for sales and administrative costs: A case study. The CPA Journal, 70(4), 70-72 Clarke, P., and Mullins, T. (2001). Activity based costing in the non-manufacturing sector in Ireland: A preliminary investigation. Irish Journal of Management, 22(2), 1-18. Cook, T. J., Grove, H. D., and Coburn, S. (2000). ABC process-based capital budgeting. Journal of Managerial Issues, 12(3), 305-324. Cooper, R., and Kaplan, R. S. (1991, May-June). Profit priorities from activity-based costing. Harvard Business Review, 130-137. Davis, T. R. V and Darling, B. L. (1996). ABC in a virtual corporation. Management Accounting, 78(4), 18-24.

www.ccsenet.org/ijbm International Journal of Business and Management Vol. 6, No. 11; November 2011

ISSN 1833-3850 E-ISSN 1833-8119 10

Gering, M. (1999). Activity based costing and performance improvement. Management Accounting, 77(3), 24-26. Hu, H. (2010). Primary research of the advantages and the cost control of the ABC & EVA integrated system. International Business Research, 3(3), 141-144. Hussain, M. M., and Gunasekaran, A. (2001). Activity-based cost management in financial services industry. Managing Service Quality, 11(3), 213-224. http://dx.doi.org/10.1108/09604520110391324 Kantor, J., and Maital, S. (1999). Measuring efficiency by product group: Integrating DEA with activity-based accounting in a large Mideast bank. Interfaces Linthicum, 29(3), 27-37. http://dx.doi.org/10.1287/inte.29.3.27 Kinsella, S. (2002). Activity-based costing: Does it warrant inclusion in a guide to the project management body of knowledge (PMBOK Guide)? Project Management Journal, 33(2), 49-56. Kocakulah, M. C., Bartlett, J., and Albin, M. (2009). ABC for calculating mortgage loan servicing expenses. Cost Management, 23(4), 36-44. Lere, J. C. (2002, March). Selling activity-based costing. The CPA Journal, 1-4. Maiga, A. S., and Jacobs, F. A. (2008). Extent of ABC use and its consequences. Contemporary Accounting Research, 25(2), 533-66. http://dx.doi.org/10.1506/car.25.2.9 Namazi, M. (2009). Performance-focused ABC: A third generation of activity-based costing system. Cost Management, 23(5), 34-47. Narong, D. K. (2009). Activity-based costing and management solutions to traditional shortcomings of cost accounting. Cost Engineering, 51(8), 11-18. Park, J., and Simpson, T. W. (2008). Toward an activity-based costing system for product families and product platforms in the early stages of development. International Journal of Production Research, 46(1), 103-105. http://dx.doi.org/10.1080/00207540600825240 Rafiq, A., and Garg, A. (2002). Activity based costing and financial institutions: Old wine in new bottles or corporate panacea? The Journal of Bank Cost & Management Accounting, 15(2), 12-30. Sheu, C., Chen, M., and Kovar, S. (2003). Integrating ABC and TOC for better manufacturing decision making. Integrated Manufacturing Systems, 14(5), 433-441. http://dx.doi.org/10.1108/09576060310477834 Stapleton, D., Pati, S., Beach, E., & Julmanichoti, P. (2004). Activity-based costing for logistics and marketing. Business Process Management Journal, 10(5), 584-591. http://dx.doi.org/10.1108/14637150410559243 Turner, P. B. B. (2005). Common cents: The activity-based costing and activity-based management performance breakthrough. New York: McGraw Hill. Vercio, A., and Shoemaker, B. (2007, August). ABCs of batch processing: Assign the batch cost to the product that required the batch activity? Maybe not! Journal of Accountancy, 1-5. Wang, P., Du, F., Lei, D., and Lin, T. W. (2010). The choice of cost drivers in activity-based costing: Application at a Chinese oil well cementing company. International Journal of Management, 27(2), 367-373.

BUS 224/ILO/Intended Learning Outcomes.docx

Knowledge

1.1 Recognize key processes and procedures in cost Accounting such as accountant’s

role in the Organization, different cost terms and their purposes, master budget,

flexible budgets; and direct cost variance.

1.2 State the different process involved in inventory costing, capacity analysis,

allocation of support department costs and common costs, cost allocation,

process costing, inventory management, jit and simplified costing methods

that are necessary for the professional environment

Cognitive Skills

2.1 Analyze the cost accounting concepts and practices in various business

situations.

2.2 Calculate different concepts of costing, cost allocation, budgeting, Breakeven,

and inventory management.

Interpersonal Skills & Responsibility

3.1 Evaluate the Cost benefit analysis for business development.

Communication, Information Technology, Numerical

4.1 Evaluate costing and budgeting and report and present it professionally

BUS 224/PPT/Chapter 1.ppt

The Manager and Management Accounting

Distinguish financial accounting from management accounting

Understand how management accountants help firms make strategic decisions

Describe the set of business functions in the value chain and identify the dimensions of performance that customers are expecting of companies

Managers at companies large and small must understand how revenues and costs behave or they risk losing control of the performance of their firms.

Our first 3 of 7 learning objectives are:

1. Distinguish financial accounting from management accounting

2. Understand how management accountants help firms make strategic decisions

3. Describe the set of business functions in the value chain and identify the dimensions of performance that customers are expecting of companies

Explain the five-step decision-making process and its role in management accounting

Describe three guidelines management accountants follow in supporting managers

Understand how management accounting fits into an organization’s structure

Understand what professional ethics mean to management accountants

Managers use cost accounting information to make decisions about research and development, budgeting, production planning, pricing, and the products or services to offer customers.

The remaining learning objectives for this chapter are:

4. Explain the five-step decision-making process and its role in management accounting

5. Describe three guidelines management accountants follow in supporting managers

6. Understand how management accounting fits into an organization’s structure

7. Understand what professional ethics mean to management accountants

Management accounting—measures, analyzes, and reports financial and nonfinancial information to help managers make decisions to fulfill organizational goals. Management accounting need not be GAAP compliant.

Financial accounting—focuses on reporting to external users including investors, creditors, banks, suppliers, and governmental agencies. Financial statements must be based on GAAP.

Accounting systems are used to record economic events and transactions such as sales and the purchases of materials and then process the data into a format that is helpful for managers and others.

Management accounting is the process of measuring, analyzing and reporting financial and nonfinancial information that helps managers make decisions.

Financial accounting has a focus on the financial information that is disseminated to external parties such as investors, government agencies, banks and suppliers.

Cost accounting – measures, analyzes and reports financial and nonfinancial information related to the costs of acquiring or using resources in an organization.

Today, most accounting professionals take the position that cost information is part of management accounting; therefore, the distinction between the two is not clear-cut and in this book, we often use the terms interchangeably.

Cost accounting provides information for both management and financial accounting professionals has its focus on the costs of acquiring or using resources in the organization.

In this slide, a graphical representation highlighting the major differences between management and financial accounting is presented. The categories compared are the:

Purpose of the information, Primary users, Focus and emphasis, Rules of measurement and reporting (for example, Financial Accounting must follow GAAP whereas management accounting information is based on a cost-benefit analysis.), Time span and type of reports and Behavioral implications. This is Exhibit 1-1 page 4.

Strategy specifies how an organization matches its own capabilities with the opportunities in the marketplace.

There are two broad strategies: cost leadership or product differentiation

Strategic cost management—describes cost management that specifically focuses on strategic issues.

Deciding between the two broad strategies of cost leadership or product differentiation is a critical part of what managers do. Management accountants work closely with managers in various departments to formulate strategies by providing information about the sources of competitive advantage, such as (1) their company’s cost, productivity or efficiency advantage relative to competitors or (2) the premium prices a company can charge relative to the costs of adding features that make its products or services distinctive.

Management accounting helps answer important questions such as:

Who are our most important customers, and how can we be competitive and deliver value to them?
What substitute products exist in the marketplace, and how do they differ from our own?
What is our most critical capability?
Will adequate cash be available to fund the strategy or will additional funds need to be raised?

Management accounting information helps managers formulate strategy by answering questions such as the following:

Who are our most important customers, and how can we be competitive and deliver value to them?

What substitute products exist in the marketplace, and how do they differ from our own?

What is our most critical capability?

Will adequate cash be available to fund the strategy or will additional funds need to be raised?

Creating value is an important part of planning and implementing strategy.
Value is the usefulness a customer gains from a company’s product or service. The entire customer experience determines the value a customer derives from a product.

Customers demand much more than just a fair price – they expect quality products delivered in a timely manner. That experience is the VALUE derived from purchasing a particular product or service.

The Value chain is the sequence of business functions in which a product is made progressively more useful to customers.
The Value chain consists of:

Research & development

Design of Products and Processes

Production

Marketing

Distribution

Customer service

The Value chain is the sequence of business functions in which a product is made progressively more useful to customers.

The Value chain consists of:

Research & development (generating and experimenting with ideas related to new products, services or processes)
Design of Products and Processes (detailed planning, engineering and testing of products and processes)
Production (procuring, transporting and storing, coordinating and assembling resources to produce a product or deliver a service)
Marketing (promoting and selling products or services)
Distribution (processing orders and shipping products or services to customers)
Customer service (providing after-sales service to customers)

Here we have a pictorial view of the value chain. In addition to each of our functions previously discussed, you see “administration” as an additional function. This includes accounting, human resources, information technology and supports the six primary business functions.

Management accounting provides information to inform each of these functions in the value chain.

Part of management accounting emphasizes integrating and coordinating activities across all companies in the supply chain to improve their performance and reduce costs.

Production and Distribution are the parts of the value chain associated with producing and delivering a product or service.
These two functions together are known as the Supply-Chain
The supply chain describes the flow of goods, services and information from the initial sources of materials, services, and information to their delivery regardless of whether the activities occur in one organization or in multiple organizations.

Production and Distribution are the parts of the value chain associated with producing and delivering a product or service.

These two functions together are known as the Supply-Chain

The supply chain describes the flow of goods, services and information from the initial sources of materials and services to their delivery regardless of whether the activities occur in one organization or in multiple organizations.

To increase efficiency in these areas, in other words to increase performance and reduce costs, suppliers may be asked to deliver small quantities of materials frequently instead of one larger shipment.

Customers want companies to use the value chain and supply chain to deliver ever-improving levels of performance when it comes to several (or even all) of the following:
Cost and efficiency
Quality
Time
Innovation
Sustainability

The key success factors to improve performance are shown here in this slide:

Cost and efficiency-understanding the activities that cause costs to arise and managing them allows managers to react to the continuous pressure to reduce costs

Quality-customers expect high levels of quality

Time-two important dimensions of time are new-product development and customer-response time

Innovation-a constant flow of innovative products or services is the basis for the ongoing success of a company.

Sustainability-the development and implementation of strategies to achieve long-term financial, social and environmental goals.

Identify the problem and uncertainties.

Obtain information.

Make predictions about the future.

Make decisions by choosing between alternatives.

Implement the decision, evaluate performance, and learn.

Here are the five steps in the decision making process in planning and control. The first four of these steps fall under Planning; step five is the Control.

Identify the problem and uncertainties.
Obtain information.
Make predictions about the future.
Make decisions by choosing between alternatives.
Implement the decision, evaluate performance, and learn.

Planning selects goals and strategies, predicts results, decides how to attain goals, and communicates this to the organization.
Budget—the most important planning tool-is the quantitative expression of a plan of activity by management and is an aid to coordinating what needs to be done to execute that plan.
Control takes actions that implement the planning decision, evaluates performance, and provides feedback and learning to the organization.

Of the five steps in decision making, the first four are planning and the fifth is control. The most important planning tool when implementing strategy is a budget.

Planning selects goals, predicts results, decides how to attain goals and communicates this to the organization.

Control takes actions that implement the planning decision, evaluates performance and provides feedback to the organization.

Three guidelines help management accountants provide the most value to the strategic and operational decision- making of their companies:

Cost–benefit approach: benefits of an action/purchase generally must exceed costs as a basic decision rule.
Behavioral and technical considerations: people are involved in decisions, not just dollars and cents.
Different Costs for Different Purposes: Managers use alternative ways to compute costs in different decision-making situations.

The guidelines shown here help management accountants provide the most value to the strategic and operational decision-making of their companies.

Cost–benefit approach: benefits of an action/purchase generally must exceed costs as a basic decision rule.

Behavioral and technical considerations: people are involved in decisions, not just dollars and cents.

Different Costs for Different Purposes: Managers use alternative ways to compute costs in different decision-making situations.

The Chief Financial Officer and the Controller

Chief financial officer (CFO)—(also called the vice-president of finance or finance director)—the executive responsible for overseeing the financial operations of an organization.

Controller—(also called the chief accounting officer)—the financial executive primarily responsible for management accounting and financial accounting.

The organizational structure depicted here shows the details of the CFO (Chief Financial Officer) position who generally reports to the Chief Executive Officer.

The CFO is sometimes also called the Finance Director and is the executive responsible for overseeing the financial operations of an organization. Exhibit 1-6 page 15.

Line and Staff Relationships

Organizations distinguish between line management and staff management:

Line management—Managers who are directly responsible for attaining the goals of the organization.

Staff management—Staff who provide advice and assistance to line management.

Accountants have special obligations regarding ethics, given that they are responsible for the integrity of the financial information provided to internal and external parties.
The four standards of ethical conduct for management accountants as advanced by the Institute of Management Accountants are:
Competence
Confidentiality
Integrity
Objectivity

There are four standards of ethical conduct for management accountants as advanced by the Institute of Management Accountants. They are:

Competence

Confidentiality

Integrity

Objectivity

Ethics are the foundation of a well-functioning economy. Accountants have special ethical obligations given that they are responsible for the integrity of the financial information provided to internal and external parties.

The Sarbanes-Oxley legislation was passed in 2002 in response to a series of corporate scandals. The act focuses on improving:

Internal controls

Corporate governance

Monitoring of managers

Disclosure practices of public companies

As part of the SOX act, CEOs and CFOs must certify that the financial statements of their firms fairly represent the results of their operations.

The act focuses on improving:

Internal controls

Corporate governance

Monitoring of managers

Disclosure practices of public companies

BUS 224/PPT/Chapter 15.ppt

Allocation of

Support Department Costs,

Common Costs,

and Revenues

Distinguish the single-rate method from the dual-rate method

Understand how the choice between allocation based on budgeted and actual rates and between budgeted and actual usage can affect the incentives of division managers

Allocate multiple supporting-department costs using the direct method, the step-down method and the reciprocal method

15-*

In this chapter, we’ll be exploring issues surrounding the allocation of support department costs, common costs and revenues. Here are the first 3 of our 6 learning objectives:

Distinguish the single-rate method from the dual-rate method
Understand how the choice between allocation based on budgeted and actual rates and between budgeted and actual usage can affect the incentives of division managers
Allocate multiple supporting-department costs using the direct method, the step-down method and the incremental method

Allocate common costs using the stand-alone method and the incremental method

Explain the importance of explicit agreement between contracting parties when the reimbursement amount is based on costs incurred

Understand how bundling of products causes revenue allocation issues and the methods managers use to allocate revenues

15-*

Here are learning objectives 4-6:

Allocate common costs using the stand-alone method and the incremental method
Explain the importance of explicit agreement between contracting parties when the reimbursement amount is based on costs incurred
Understand how bundling of products causes revenue allocation issues and the methods managers use to allocate revenues

How a company allocates its overhead and internal support costs – costs related to marketing, advertising and other internal services – among its various production departments or projects can have a big impact on how profitable those departments or projects are.
Operating (production) department—directly adds value to a product or service.
Support (service) department—provides the services that assist other internal departments (operating departments and other support departments) in the company.

15-*

How a company allocates its overhead and internal support costs – costs related to marketing, advertising and other internal services – among its various production departments or projects can have a big impact on how profitable those departments or projects are.

Operating (production) department—directly adds value to a product or service

Support (service) department—provides the services that assist other internal departments (operating departments and other support departments) in the company

Managers face two questions when allocating the costs of a support department to operating departments or divisions:

Should fixed costs of a support departments be allocated to operating divisions?

If fixed costs are allocated, should variable and fixed costs of the support department be allocated in the same way?

15-*

Managers face two questions when allocating the costs of a support department to operating departments or divisions:

Should fixed costs of a support departments be allocated to operating divisions?
If fixed costs are allocated, should variable and fixed costs of the support department be allocated in the same way?

With regard to the first question, most companies believe that fixed costs of support departments should be allocated because the support departments need to incur these fixed costs to provide operating divisions with the services they require.

Single-rate method—does not distinguish between fixed and variable costs. It allocates costs in each cost pool using the same rate per unit of a single allocation base.
A support department would be an example of a cost-pool.

15-*

Single-rate method—does not distinguish between fixed and variable costs. It allocates costs in each cost pool using the same rate per unit of a single allocation base.

A support department would be an example of a cost-pool

Dual-rate method—partitions the cost of each support department into two pools, a variable-cost pool and a fixed-cost pool, and
allocates each pool using a different cost-allocation base.

15-*

Dual-rate method—partitions the cost of each support department into two pools, a variable-cost pool and a fixed-cost pool, and

allocates each pool using a different cost-allocation base.

Under either method, allocation of support costs can be based on one of the three following scenarios:

Budgeted overhead rate and budgeted hours

Budgeted overhead rate and actual hours

Actual overhead rate and actual hours.

When using either method, managers can allocate support-department costs to operating divisions based on either a budgeted rate or the eventual actual cost rate.
The latter approach is neither preferred nor widely used; we will illustrate using budgeted rates.

15-*

Under either method, allocation of support costs can be based on one of the three following scenarios:

Budgeted overhead rate and budgeted hours
Budgeted overhead rate and actual hours
Actual overhead rate and actual hours

When using either method, managers can allocate support-department costs to operating divisions based on either a budgeted rate or the eventual actual cost rate.

The latter approach is neither preferred nor widely used; we will illustrate using budgeted rates

Advantage #1: Less costly to implement.

Advantage #2: Offers user departments some operational control over the charges they bear.

Disadvantage #1: May lead operating department managers to make sub-optimal decisions that are in their own best interest but may be inefficient for the organization as a whole.

15-*

Advantages and Disadvantages: Single-rate method

Advantage #1: Less costly to implement

Advantage #2: Offers user departments some operational control over the charges they bear

Disadvantage #1: May lead operating department managers to make sub-optimal decisions that are in their own best interest but may be inefficient for the organization as a whole

Advantage #1: Guides department managers to make decisions that benefit both the organization as a whole and each department.

Advantage #2: Allocating fixed costs based on budgeted usage helps user departments with both short-run and long-run planning because user departments know the costs allocated to them in advance.

15-*

Advantages and Disadvantages: Dual-rate method

Advantage #1: Guides department managers to make decisions that benefit both the organization as a whole and each department

Advantage #2: Allocating fixed costs based on budgeted usage helps user departments with both short-run and long-run planning because user departments know the costs allocated to them in advance.

Disadvantage #1: Requires managers to distinguish variable costs from fixed costs, which is often a challenging task.

Disadvantage #2: Does not indicate to operating managers the cost of fixed support department resources used because fixed costs are allocated to operating departments based on budgeted rather than actual usage.

Disadvantage #3: Allocating fixed costs on the basis of budgeted long-run usage may tempt some managers to under-estimate their planned usage.

15-*

Advantages and Disadvantages: Dual-Rate Method, Concluded

Disadvantage #1: Requires managers to distinguish variable costs from fixed costs, which is often a challenging task

Disadvantage #3: Allocating fixed costs on the basis of budgeted long-run usage may tempt some managers to under-estimate their planned usage.

BUS 224/PPT/Chapter 16.ppt

Cost Allocation:

Joint Products and Byproducts

Identify the split-off point in a joint-cost situation and distinguish joint products from byproducts

Explain why joint costs are allocated to individual products

Allocate joint costs using four methods

Identify situations where the sales value at splitoff method is preferred when allocating joint costs

16-*

In this chapter, we’ll study the allocation of costs for joint products and byproducts. Here are the first 4 of our 6 learning objectives.

Identify the split-off point in a joint-cost situation and distinguish joint products from byproducts.
Explain why joint costs are allocated to individual products
Allocate joint costs using four methods
Identify situations where the sales value at splitoff method is preferred when allocating joint costs

Explain why joint costs are irrelevant in a sell-or-process further decision

Account for byproducts using two methods

16-*

Here are the final two of our 6 learning objectives.

Explain why joint costs are irrelevant in a sell-or-process further decision
Account for byproducts using two methods

Joint costs—the costs of a production process that yields multiple products simultaneously.
Splitoff point—the juncture in a joint production process where two or more products become separately identifiable.
Separable costs—all costs incurred beyond the splitoff point that are assignable to each of the specific products identified at the splitoff point.

16-*

Joint costs—the costs of a production process that yields multiple products simultaneously

Splitoff point—the juncture in a joint production process where two or more products become separately identifiable

Separable costs—all costs incurred beyond the splitoff point that are assignable to each of the specific products identified at the splitoff point

Categories of joint process outputs:

Outputs with a positive sales value

Outputs with a zero sales value.

Product—any output with a positive sales value, or an output that enables a firm to avoid incurring costs:
Sales value can be high or low.

16-*

Categories of joint process outputs:

Outputs with a positive sales value
Outputs with a zero sales value

Product—any output with a positive sales value, or an output that enables a firm to avoid incurring costs

Sales value can be high or low

Main product—output of a joint production process that yields one product with a high sales value compared to the sales values of the other outputs.
Joint products—outputs of a joint production process that yields two or more products with a high sales value compared to the sales values of any other outputs.
Byproducts—outputs of a joint production process that have low sales values compared to the sales values of the other outputs.

16-*

Here are a few last applicable terms:

Main product—output of a joint production process that yields one product with a high sales value compared to the sales values of the other outputs

Joint products—outputs of a joint production process that yields two or more products with a high sales value compared to the sales values of any other outputs

Byproducts—outputs of a joint production process that have low sales values compared to the sales values of the other outputs

16-*

Here you see some examples of joint cost situations:

Distinctions among main products, joint products and byproducts are not so clear-cut in practice. Companies use different thresholds for determining whether the relative sales value of a product is high enough for it to be considered a joint product. Exhibit 16-1 page 634

Before a manager is able to allocate joint costs, he or she must first look at the context for doing so. Joint costs must be allocated to individual products or services for several purposes, including:

Computation of inventoriable costs and cost of goods sold for financial accounting and tax reporting.
Reimbursing companies that have some products reimbursed under cost-plus contracts.
Regulating the rates or prices of one or more of the jointly produced products.
Litigation or insurance settlement situations

16-*

Computation of inventoriable costs and cost of goods sold for financial accounting and tax reporting

Reimbursing companies that have some products reimbursed under cost-plus contracts

Regulating the rates or prices of one or more of the jointly produced products

Litigation or insurance settlement situations

Market-based—allocate using market-derived data (dollars):

Sales value at splitoff

Net realizable value (NRV)

Constant gross-margin percentage NRV.

Physical measures—allocate using tangible attributes of the products, such as pounds, gallons, barrels, and so on.

16-*

We have two approaches to allocating joint costs:

Market-based—allocate using market-derived data (dollars):
Sales value at splitoff
Net realizable value (NRV)
Constant gross-margin percentage NRV
Physical measures—allocate using tangible attributes of the products, such as pounds, gallons, barrels, and so on

In preceding chapters, we used the cause-and-effect and benefits-received criteria for guiding cost-allocation decisions. Joint costs do not have a cause-and-effect relationship with individual products because the production process simultaneously yields multiple products. Using the benefits-received criterion leads to a preference for methods under approach 1 because revenues are, in general, a better indicator of benefits received than physical measures.

16-*

Here is a pictorial view of joint costs. In this case, we are looking at the production of raw milk into cream and liquid skim. Exhibit 16-2 page 637

16-*

We’ll use information from this slide in our joint cost examples. From page 637

The sales value at splitoff method allocates joint costs to joint products produced during the accounting period on the basis of the relative total sales value at the splitoff point.
This method uses the sales value of the entire production of the accounting period, not just the quantity sold.
The sales value at splitoff method follows the benefits-received criterion of cost allocation.

16-*

The sales value at splitoff method allocates joint costs to joint products produced during the accounting period on the basis of the relative total sales value at the splitoff point.

This method uses the sales value of the entire production of the accounting period, not just the quantity sold.

The sales value at splitoff method follows the benefits-received criterion of cost allocation

16-*

In this example, we use the sales value of total production at splitoff to determine that cream is 40% and liquid skim is 60%. Those percentages are then used to allocate the joint costs. (row 4 for the weighting and row 5 for the allocation) Exhibit 16-3 page 638

The physical-measure method allocates joint costs to joint products produced during the accounting period on the basis of a comparable physical measure, such as the relative weight, quantity or volume at the splitoff point.

16-*

The physical-measure method allocates joint costs to joint products produced during the accounting period on the basis of a comparable physical measure, such as the relative weight, quantity or volume at the splitoff point.

16-*

In this example, still using the cream and liquid skim products, we see that the cream accounts for 25% of the gallons while liquid skim accounts for 75%. These are quite different from the allocation percents we used under the sales value at split off method. Exhibit 16-4 page 639

Allocates joint costs to joint products produced during the accounting period on the basis of relative NRV.
NRV = Final Sales Value – Separable Costs.
In many cases, products are processed beyond the splitoff point to bring them to a marketable form or to increase their value above their selling price at the splitoff point.

16-*

Allocates joint costs to joint products produced during the accounting period on the basis of relative NRV

NRV = Final Sales Value – Separable Costs

In many cases, products are processed beyond the splitoff point to bring them to a marketable form or to increase their value above their selling price at the splitoff point.

The NRV method is typically used in preference to the sales value at splitoff method only when selling prices for one or more products at splitoff do not exist.

16-*

In this slide, we see an overview of the net realizable value method. Note how the costs of further processing (the separable costs) are taken into account with this method.

16-*

In the NRV method, we first determine the selling price for the goods after they are processed further. From page 640

16-*

Next, we use the selling price information to calculate final sales value, deduct separable costs and determine the Net realizable value at splitoff. This is what we weight to allocate joint costs.

Exhibit 16-6 page 641

The constant gross-margin percentage NRV method allocates joint costs to joint products produced during the accounting period in such a way that each individual product achieves an identical gross-margin percentage. The method works backward in that the overall gross margin is computed first.
Joint costs are calculated as a residual amount by subtracting the separable costs and gross margin from the final sales value.

16-*

The constant gross-margin percentage NRV method allocates joint costs to joint products produced during the accounting period in such a way that each individual product achieves an identical gross-margin percentage. The method works backward in that the overall gross margin is computed first.

Joint costs are calculated as a residual amount by subtracting the separable costs and gross margin from the final sales value.

The constant gross-margin percentage NRV method can be broken down into 3 steps:

Compute the overall gross margin percentage

Compute the total production costs for each product

Compute the allocated joint costs.

16-*

The constant gross-margin percentage NRV method can be broken down into 3 steps:

Compute the overall gross margin percentage
Compute the total production costs for each product
Compute the allocated joint costs

If selling price at splitoff is available, the sales value at splitoff method is preferred even if further processing is done. Reasons include:
Best measure of benefits received
Independent of further processing decisions
Common allocation basis (revenue)
Simplicity
If selling prices are not available, the NRV method is the best alternative
Despite this, some firms choose not to allocate joint costs at all.

16-*

When choosing an allocation method, consider the following:

If selling price at splitoff is available, the sales value at splitoff method is preferred even if further processing is done. Reasons include:

Best measure of benefits received

Independent of further processing decisions

Common allocation basis (revenue)

Simplicity

If selling prices are not available, the NRV method is the best alternative

Despite this, some firms choose not to allocate joint costs at all.

Two methods for accounting for byproducts
Production method—recognizes byproduct inventory as it is created, and sales and costs at the time of sale.
Sales method—recognizes no byproduct inventory, and recognizes only sales at the time of sales: byproduct costs are not tracked separately.

16-*

Two methods for accounting for byproducts

Production method—recognizes byproduct inventory as it is created, and sales and costs at the time of sale

Sales method—recognizes no byproduct inventory, and recognizes only sales at the time of sales: byproduct costs are not tracked separately

The total sales values of byproducts are usually low, but the byproducts in a joint production process can affect the allocation of joint costs.

16-*

Here we see a pictorial view of how byproducts, in this case wood chips, come about. Exhibit 16-6 page 646

The production method is consistent with the matching principle and is the preferred method.
The production method recognizes the byproduct inventory in the accounting period in which it is produced and simultaneously reduces the cost of manufacturing the main or joint products, thereby better matching the revenues and expenses from selling the main product.
Sales method is simpler but allows a firm to “manage” reported earnings by timing the sale of byproducts.

16-*

How do we select the method to use to account for byproducts? Keep in mind the following:

The production method is consistent with the matching principle and is the preferred method.

The production method recognizes the byproduct inventory in the accounting period in which it is produced and simultaneously reduces the cost of manufacturing the main or joint products, thereby better matching the revenues and expenses from selling the main product.

Sales method is simpler but allows a firm to “manage” reported earnings by timing the sale of byproducts.

BUS 224/PPT/Chapter 17.ppt

Process Costing

Identify the situation in which process-costing systems are appropriate

Understand the basic concepts of process-costing and compute average unit costs

Describe the five steps in process costing and calculate equivalent units

Use the weighted-average method and first-in, first-out (FIFO) method of process costing

17-*

Previously, we’ve studied job costing. In chapter 17, we will study process costing. In this chapter, we have 6 learning objectives. Presented here are the first 4:

Identify the situation in which process-costing systems are appropriate
Understand the basic concepts of process-costing and compute average unit costs
Describe the five steps in process costing and calculate equivalent units
Use the weighted-average method and first-in, first-out (FIFO) method of process costing

Apply process-costing methods to situations with transferred-in costs

Understand the need for hybrid-costing systems such as operation-costing

17-*

Here are the final 2 of our 6 learning objectives for the chapter:

Apply process-costing methods to situations with transferred-in costs
Understand the need for hybrid-costing systems such as operation-costing

Job-Costing Systems

Distinct, identifiable

units of a product

or service

Examples:

Custom-made

machines,

houses

Process-Costing

Systems

Masses of identical

or similar units of a

product or service

Examples:

Food,

chemical processing

17-*

Here we have a comparison of job-costing and process-costing systems.

Job costing systems are used for distinct, identifiable units of a product or service while process costing is used for masses of identical or similar units of a product or service.

From page 665

Process costing is a system where the unit cost of a product or service is obtained by assigning total costs to many identical or similar units of output.
Unit costs are computed by dividing total costs incurred by the number of units of output from the production process.
Each unit receives the same or similar amounts of direct materials costs, direct labor costs, and manufacturing overhead.

17-*

Process costing is a system where the unit cost of a product or service is obtained by assigning total costs to many identical or similar units of output.

Unit costs are computed by dividing total costs incurred by the number of units of output from the production process.

Each unit receives the same or similar amounts of direct materials costs, direct labor costs, and manufacturing overhead.

In a job-costing system, individual jobs use different quantities of resources, so it would be incorrect to cost each job at the same average production cost.
In contrast, when identical or similar units of products or services are mass-produced, process costing is used to calculate an average production cost for all units produced.

17-*

A little more information about job-vs-process-costing:

In a job-costing system, individual jobs use different quantities of resources, so it would be incorrect to cost each job at the same average production cost.

In contrast, when identical or similar units of products or services are mass-produced, process costing is used to calculate an average production cost for all units produced.

Process-costing systems separate costs into cost categories according to when costs are introduced into the process.
1. Direct materials are usually added at the beginning of the production process, or at the start of work in a subsequent department down the assembly line.
2. Conversion costs are generally added equally along the production process.

17-*

Process-costing systems separate costs into cost categories according to when costs are introduced into the process.

1. Direct materials are usually added at the beginning of the production process, or at the start of work in a subsequent department down the assembly line.

2. Conversion costs are generally added equally along the production process.

In situations where this is not the case, additional categories of either direct materials or conversion costs would need to be added.

Let’s look at the process-costing process three ways:

No beginning or ending work-in-process inventories.

No beginning work-in-process inventory and some ending work-in-process inventory.

Both beginning and ending work-in-process inventories are present.

17-*

Let’s look at the process-costing process three ways:

No beginning or ending work-in-process inventories
No beginning work-in-process inventory and some ending work-in-process inventory
Both beginning and ending work-in-process inventories are present

When using process costing without any beginning or ending work-in-process inventory, all costs that were introduced to the process during the period will be assigned to the finished units leaving work-in-process inventory at the end of the period.

17-*

Summarize the flow of physical units of output.

Compute output in terms of equivalent units.

Summarize total costs to account for.

Compute cost per equivalent unit.

Assign total costs to units completed and to units in ending work-in-process.

17-*

We use a five-step process to allocate costs under process-costing:

Summarize the flow of physical units of output.
Compute output in terms of equivalent units.
Summarize total costs to account for.
Compute cost per equivalent unit.
Assign total costs to units completed and to units in ending work-in-process.

A derived amount of output units that:

Takes the quantity of each input in units completed and in unfinished units of work in process and

Converts the quantity of input into the amount of completed output units that could be produced with that quantity of input.

Are calculated separately for each input. (direct materials and conversion cost)
When calculating equivalent units in step 2, focus on quantities and disregard dollar amounts until after the equivalent units are computed.

17-*

The first step is simply to summarize the flow of physical units.

The second step requires that we determine the equivalent units.

If, for example, I expended all my effort to complete one unit, I would have 1 unit. On the other hand, if instead I expended all my effort to produce two units each of which were 50% complete, I would have the EQUIVALENT of 1 unit.

Equivalent units:

Are a derived amount of output units that:

Takes the quantity of each input in units completed and in unfinished units of work in process and
Converts the quantity of input into the amount of completed output units that could be produced with that quantity of input

Are calculated separately for each input (direct materials and conversion cost)

When calculating equivalent units in step 2, focus on quantities and disregard dollar amounts until after the equivalent units are computed

17-*

In this example, we have no beginning work-in-process but do have ending work-in-process.

The focus for these steps, as we said, is on units. Since the units are 100% complete as to materials, we have 225 equivalent units for DM; since the units are only 60% complete as to conversion costs, we have 135 equivalent units for conversion costs. This is calculated by taking 225 x 60%.

Please note that if the percentage of completion is estimated incorrectly, that will translate into an incorrect unit cost. Exhibit 17-1 page 669

17-*

The costs added during the period are the only costs in the process because in this example, we do not have beginning work-in-process. Of the $50,600, steps 3, 4 and 5 allow us to determine how much of that cost was completed and will be transferred out and how much should remain in work-in-process.

Notice that the costs for DM and CC are divided by the equivalent units for DM and CC to obtain the cost per equivalent unit. That unit cost is used in step 5 to assign the costs.

Exhibit 17-2 page 670

17-*

In this illustration of the cost flows for process costing, we see how the values move from account to account. Each of the transactions shown must be journalized, then posted just as any other transaction would be.

Exhibit 17-3 page 671

Process costing can be accomplished using the weighted-average method or the FIFO method. We’ll look first at weighted-average.
Calculates cost per equivalent unit of all work done to date. (regardless of the accounting period in which it was done)
Assigns this cost to equivalent units completed and transferred out of the process, and to equivalent units in ending work-in-process inventory.

17-*

Process costing can be accomplished using the weighted-average method or the FIFO method. We’ll look first at weighted-average

Calculates cost per equivalent unit of all work done to date (regardless of the accounting period in which it was done)

Assigns this cost to equivalent units completed and transferred out of the process, and to equivalent units in ending work-in-process inventory.

The Weighted-average cost is the total of all costs entering the work-in-process account divided by the total equivalent units of work done to date.
The beginning balance of the work-in-process account (work done in a prior period) is blended in with current period costs.
Let’s look at Case 3 (with both beginning and ending work-in-process inventory using the Weighted Average method.)

17-*

The Weighted-average cost is the total of all costs in the work-in-process account divided by the total equivalent units of work done to date.

The beginning balance of the work-in-process account (work done in a prior period) is blended in with current period costs.

Let’s look at Case 3 (with both beginning and ending work-in-process inventory using the Weighted Average method.)

17-*

In this table, we are completing steps 1 and 2 where the company has both beginning and ending work-in-process inventory. Please note that we are added existing WIP units to new units started during the period giving us a total, in this example, of 500 units to account for. Exhibit 17-4 page 673

17-*

Still using case 3, we complete steps 3, 4 and 5. Note that in step 3 we now have costs that we started the period with in addition to those that were added in during the period.

Exhibit 17-5 page 674

Two critical figures arise out of step 5 of the cost allocation process:

The amount of the journal entry transferring the allocated cost of units completed and sent from work-in-process inventory to finished goods inventory

The ending balance of the work-in-process inventory account that will appear on the balance sheet.

17-*

Two critical figures arise out of step 5 of the cost allocation process:

The amount of the journal entry transferring the allocated cost of units completed and sent from work-in-process inventory to finished goods inventory
The ending balance of the work-in-process inventory account that will appear on the balance sheet

Assigns the cost of the previous accounting period’s equivalent units in beginning work-in-process inventory to the first units completed and transferred out of the process.
Assigns the cost of equivalent units worked on during the current period first to complete beginning inventory, next to started and completed new units, and finally to units in ending work-in-process inventory.

17-*

Recall we mentioned that process costing can be accomplished using either the weighted-average method or the FIFO (first-in, first-out) method. We’ll look now at the FIFO (First-in, First-out) method.

Assigns the cost of the previous accounting period’s equivalent units in beginning work-in-process inventory to the first units completed and transferred out of the process

Assigns the cost of equivalent units worked on during the current period first to complete beginning inventory, next to started and completed new units, and lastly to units in ending work-in-process inventory

A distinctive feature of FIFO process-costing method is that work done on beginning inventory is kept separate from work done in the current period.
There is no blending of costs as we saw with the weighted-average method.

17-*

A distinctive feature of FIFO process-costing method is that work done on beginning inventory is kept separate from work done in the current period.

There is no blending of costs as we saw with the weighted-average method.

FIFO assumes that all the higher-cost units (from our example) from the previous period in beginning wip are the first to be completed and transferred out and that ending wip consists of only the lower-cost current-period units.
The weighted-average method smooths out the cost per equivalent unit by assuming that more lower-cost units are transferred out and some higher-cost remain in ending wip.

17-*

Some information that can be used to compare the two methods are:

FIFO assumes that all the higher-cost units (from our example) from the previous period in beginning wip are the first to be completed and transferred out and that ending wip consists of only the lower-cost current-period units

The weighted-average method smooths out the cost per equivalent unit by assuming that more lower-cost units are transferred out and some higher-cost remain in ending wip

Managers use information from process-costing systems to make pricing and product-mix decisions and understand how well a firm’s processes are performing.
FIFO provides managers with information about changes in the costs per unit from one period to the next.
In a period of rising prices, the weighted-average method will decrease taxes because cost of goods sold will be higher and operating income lower.

17-*

Managers use information from process-costing systems to make pricing and product-mix decisions and understand how well a firm’s processes are performing.

FIFO provides managers with information about changes in the costs per unit from one period to the next.

In a period of rising prices, the weighted-average method will decrease taxes because cost of goods sold will be higher and operating income lower.

Product-costing systems do not always fall neatly into either job-costing or process-costing categories.
A Hybrid-costing system blends characteristics from both job-costing and process-costing systems.
Many actual production systems are in fact hybrids.
Examples include manufacturers of televisions, dishwashers, and washing machines, and shoes who tend to use hybrid-costing systems.

17-*

Product-costing systems do not always fall neatly into either job-costing or process-costing categories.

A Hybrid-costing system blends characteristics from both job-costing and process-costing systems.

Many actual production systems are in fact hybrids.

Examples include manufacturers of televisions, dishwashers, and washing machines, and shoes who tend to use hybrid-costing systems.

The hybrid-costing systems use process costing to account for the conversion costs and job costing for the material and customizable components.
One specific type of hybrid-costing system is known as the Operation-Costing System

17-*

The hybrid-costing systems use process costing to account for the conversion costs and job costing for the material and customizable components.

One specific type of hybrid-costing system is known as the Operation-Costing System

An operation is a standardized method or technique that is performed repetitively resulting in different finished goods.
An operation-costing system is a hybrid-costing system applied to batches of similar, but not identical, products.
Within each operation, all product units are treated exactly alike, using identical amounts of the operation’s resources.
Managers find operation costing useful in cost management because operation costing focuses on control of physical processes or operations of a given production system.

17-*

With regard to the particular type of hybrid-costing system called an Operation-Costing System,

An operation is a standardized method or technique that is performed repetitively resulting in different finished goods.

An operation-costing system is a hybrid-costing system applied to batches of similar, but not identical, products.

Within each operation, all product units are treated exactly alike, using identical amounts of the operation’s resources.

Managers find operation costing useful in cost management because operation costing focuses on control of physical processes of a given production system.

BUS 224/PPT/Chapter 2.ppt

An Introduction to Cost Terms and Purposes

Define and illustrate a cost object

Distinguish between direct costs and indirect costs

Explain variable costs and fixed costs

Interpret unit costs cautiously

Distinguish inventoriable costs period costs

Explain why product costs are computed in different ways for different purposes

Describe a framework for cost accounting and cost management

What does the word cost mean to you?

In this chapter, we’ll distinguish among various types of costs and will explore the following objectives:

1. Define and illustrate a cost object

2. Distinguish between direct costs and indirect costs

3. Explain variable costs and fixed costs

4. Interpret unit costs cautiously

5. Distinguish inventoriable costs period costs

6. Illustrate the flow of inventoriable and period costs

Cost—a sacrificed or forgone resource to achieve a specific objective.
Actual cost—a cost that has occurred.
Budgeted cost—a predicted cost.
Cost object—anything for which a cost measurement is desired.

Cost—a sacrificed resource to achieve a specific objective

Actual cost—a cost that has occurred

Budgeted cost—a predicted cost

Cost object—anything for which a cost measurement is desired

Managers use cost information in two main ways: when MAKING decisions and when IMPLEMENTING decisions

Cost Object	Illustration
Product	A BMW X6 sports activity vehicle
Service	Telephone hotline providing information and assistance to BMW dealers
Project	R&D project on DVD system enhancement in BMW cars
Customer	Herb Chambers Motors, a dealer that purchases a broad range of BMW vehicles
Activity	Setting up machines for production or maintaining production equipment
Department	Environmental, Health and Safety department

When we are thinking of the cost of something, it is a particular something: a car, a piano, a new outfit. That THING about which we want to know the cost is called a cost object.

In this slide, we have some examples of different things about which we may want to know the costs. Exhibit 2-1 page 30.

Cost accumulation—the collection of cost data in an organized way by means of an accounting system.

Cost assignment—a general term that encompasses the gathering of accumulated costs to a cost object in two ways:
Tracing accumulated costs with a direct relationship to the cost object and
Allocating accumulated costs with an indirect relationship to a cost object.

Here, we have some additional terminology:

Cost accumulation—a collection of cost data in an organized way by means of an accounting system

Cost assignment—a general term that encompasses the gathering of accumulated costs to a cost object in two ways:

Tracing accumulated costs with a direct relationship to the cost object and

Allocating accumulated costs with an indirect relationship to a cost object

Direct costs can be conveniently and economically traced (tracked) to a cost object.

Indirect costs cannot be conveniently or economically traced (tracked) to a cost object. Instead of being traced, these costs are allocated to a cost object in a rational and systematic manner.

One way that we differentiate between different kinds of costs is to identify them as direct or indirect.

Direct costs can be conveniently and economically traced (tracked) to a cost object.

Indirect costs cannot be conveniently or economically traced (tracked) to a cost object. Instead of being traced, these costs are allocated to a cost object in a rational and systematic manner.

The salary of a plant administrator at BMW, as an example, is an indirect cost of a particular automobile because unlike the steel or tires used, it is virtually impossible to trace plant administration to a particular car line.

Going back to our X6 BMW example, we see here an illustration of how costs for that line would be collected to the cost object.

If the BMW X6 is our cost object, the direct costs can be traced but the indirect costs must be allocated. Added together, we’ll obtain total costs for the cost object.

Exhibit 2-2 page 30.

Direct Costs
Parts (steel or tires for a car, as an exampe)
Assembly line wages
Indirect Costs
Electricity
Rent
Property taxes
Plant administration expenses

To gain a better understanding of the types of items that fit into each type of cost (direct or indirect), we present some examples:

Direct Costs

Parts (steel or tires for a car, as an exampe)

Assembly line wages

Indirect Costs

Electricity

Rent

Property taxes

One way to think about this is that association between the direct costs and the specific request for those items in the production process. We need 4 tires and x lbs of steel for each car, but we don’t requisition some number of hours of administration time or rent for each car or for the line.

Managers are generally more confident about the accuracy of the direct costs of cost objects.

The materiality of the cost in question.
The available information-gathering technology.
Design of operations.

NOTE: a specific cost may be both a direct cost of one cost object and an indirect cost of another cost object.

A few factors affect the direct/indirect cost classification:

The materiality of the cost in question (the smaller the cost, the less likely it will be efficient to trace the cost)

The available information-gathering technology (technology allows us to treat more and more costs as direct)

Design of operations (if parts of a facility are dedicated to a particular cost object, we are generally able to classify more costs as direct)

A specific cost may be a direct cost for one cost object and an indirect cost for another.

Variable costs—change in total in proportion to changes in the related level of activity or volume of output produced.
Fixed costs—remain unchanged in total, for a given time period, despite changes in the related level of activity or volume of output produced.
Costs are fixed or variable only with respect to a specific activity or a given time period.

Cost behavior defines how costs change. That will be in total, with a change of activity (variable costs) or per unit, with a change of activity (fixed costs).

Another way to look at it is this way:

Variable costs are constant on a per-unit basis. If a product takes 5 pounds of materials each, it stays the same per unit regardless if one, ten, or a thousand units are produced.

Fixed costs change inversely with the level of production. As more units are produced, the same fixed cost is spread over more and more units, reducing the cost per unit.

Costs are defined as variable or fixed for a specific activity and for a given time period.

Variable costs are constant on a per-unit basis. If a product takes 5 pounds of materials each, it stays the same per unit regardless if one, ten, or a thousand units are produced.

Fixed costs per unit change inversely with the level of production. As more units are produced, the same fixed cost is spread over more and more units, reducing the cost per unit.

When considering variable and fixed costs, it is very important to know if you are looking at the cost IN TOTAL or PER UNIT.

Variable costs—change in total in proportion to changes in the related level of activity or volume of output produced

Fixed costs—remain unchanged in total, for a given time period, despite changes in the related level of activity or volume of output produced

Total Dollars	Cost per Unit
Variable Costs	Change in proportion with output More output = more cost	Unchanged in relation to output
Fixed Costs	Unchanged in relation to output	Change inversely with output More output = lower cost per unit

In these charts, we see the graphs for variable and fixed costs using the number of steering wheels for the BMW X6.

Panel A shows a graph of the total variable cost of steering wheels. The cost begins at zero because if we make no X6s, we’ll incur no cost for the steering wheels.

Fixed Costs are presented in Panel B where we have a line across at the $2,000,000 mark. The Annual total fixed supervision costs for the X6 are that amount and will be that amount whether we assemble zero, 20,000, 40,000 or 60,000 cars. Exhibit 2-3 page 32.

Cost driver—a variable, such as the level of activity or volume, that causally affects costs over a given time span.
Relevant range—the band or range of normal activity level (or volume) in which there is a specific relationship between the level of activity (or volume) and the cost in question.
For example, fixed costs are considered fixed only within the relevant range.

We have a few additional concepts to review:

Cost driver—a variable, such as the level of activity or volume, that causally affects costs over a given time span

Relevant range—the band or range of normal activity level (or volume) in which there is a specific relationship between the level of activity (or volume) and the cost in question

The idea of the relevant range is that at some point of increased production or assembly, fixed costs will likely increase. For example, if you run out of capacity and need to enlarge the facility, there will be additional costs involved.

Costs may be classified as:
Direct/Indirect, and
Variable/Fixed
These multiple classifications give rise to important cost combinations:
Direct and variable
Direct and fixed
Indirect and variable
Indirect and fixed

We have introduced two major classifications of costs: direct and indirect; variable and fixed.

As a result, we can have the following combinations of costs:

Direct and variable

Direct and fixed

Indirect and variable

Indirect and fixed

Unit cost:

Cost computed by dividing total cost by the number of units. Also called average cost.
Unit costs should be used cautiously. Because unit costs change with a different level of output or volume, it may be more prudent to base decisions on a total cost basis.
Unit costs that include fixed costs should always reference a given level of output or activity.
Unit costs are also called average costs.
Managers should think in terms of total costs rather than unit costs for many decisions.

We’ve been discussing how variable costs and fixed costs differ in terms of their unit costs. For this reason, unit costs should be used cautiously. Because unit costs change with a different level of output or volume, it may be more prudent to base decisions on a total dollar basis.

Once again using the BMW X6 as an example, we see here examples of the various combinations that can occur for direct/indirect and variable/fixed costs.

Exhibit 2-5 page 36.

Manufacturing-sector companies purchase materials and components and convert them into finished products.
Merchandising-sector companies purchase and then sell tangible products without changing their basic form.
Service-sector companies provide services (intangible products) like legal advice or audits.

Cost accounting is used for all types of firms including:

Manufacturing-sector companies purchase materials and components and convert them into finished products.

Merchandising-sector companies purchase and then sell tangible products without changing their basic form.

Service-sector companies provide services (intangible products) like legal advice or audits.

Direct materials—resources in-stock and available for use
Work-in-process (or progress)—products started but not yet completed, often abbreviated as WIP
Finished goods—products completed and ready for sale

Note: Merchandising-sector companies hold only one type of inventory: merchandise inventory

Manufacturing-sector companies purchase materials and components and convert them into finished goods. These companies typically have one or more of the following three types of inventory:

Direct materials—resources in-stock and available for use

Work-in-process (or progress)—products started but not yet completed, often abbreviated as WIP

Finished goods—products completed and ready for sale

Note: Merchandising-sector companies hold only one type of inventory: merchandise inventory

Also known as inventoriable costs
Direct materials—acquisition costs of all materials that will become part of the cost object.
Direct labor—compensation of all manufacturing labor that can be traced to the cost object.
Indirect manufacturing—factory costs that are not traceable to the product in an economically feasible way. Examples include lubricants, indirect manufacturing labor, utilities, and supplies.

Three terms are commonly used when describing manufacturing costs. These terms build on the direct versus indirect cost distinctions we discussed earlier.

Direct materials—acquisition costs of all materials that will become part of the cost object.

Direct labor—compensation of all manufacturing labor that can be traced to the cost object.

Indirect manufacturing—factory costs that are not traceable to the product in an economically feasible way. Examples include lubricants, indirect manufacturing labor, utilities, and supplies.

These costs are also known as inventoriable costs.

Inventoriable costs:

All costs of a product that are considered as assets in the balance sheet when they are incurred and that become cost of goods sold only when the product is sold.

Period costs:

All costs in the income statement other than cost of goods sold. These have no future value and are expensed in the period incurred.

Accounting Distinction Between Costs

The Cost of Goods Manufactured and the Cost of Goods Sold section of the Income Statement are accounting representations of the actual flow of costs through a production system.
Note how inventoriable costs to through the balance sheet accounts of work-in-process and finished goods inventory before entering the cost of goods sold in the income statement.

Here, we begin our conversation about the flow of costs. Costs will flow from the balance sheet to the income statement or will originate on the income statement.

Let’s take a closer look.

Here, we see Exhibit 2-7 page 41, representing the flow of costs through the balance sheet accounts (for inventoriable costs only) and into the income statement for both inventoriable and period costs.

To report the flow of costs just illustrated on the income statement, we calculate cost of goods sold as follows:

Beginning Finished Goods Inventory

PLUS Cost of Goods Manufactured (see next slide)

EQUALS Cost of Goods available for sale

SUBTRACT Ending Finished Goods Inventory

EQUALS Cost of Goods Sold

If you subtract Cost of Goods Sold from Net Revenues, you get Gross Margin.

Exhibit 2-8 page 42.

From Gross Margin we subtract period costs to obtain Operating Income

From our first panel on the Multiple-Step Income Statement, we used a figure called Cost of Goods Manufactured.

Step one is to calculate cost of direct materials used by adding beginning direct materials to purchases, then subtracting out ending direct materials inventory

Step 2 is to calculate the total manufacturing costs incurred which includes the cost of direct materials used plus direct manufacturing labor plus manufacturing overhead.

Finally in step 3, to Beginning Work in Process inventory, we add the manufacturing costs incurred calculated in step 2. That gives us the total manufacturing costs to account for. In other words, these costs will either remain in Work in Process or they will be transferred to Finished Goods.

Continuing step 3, subtracting ending work in process from total manufacturing costs to account for, we get the Cost of Goods Manufactured that we used in the last slide.

Prime cost is a term referring to all direct manufacturing costs (materials and labor).

Conversion cost is a term referring to direct labor and indirect manufacturing costs.

Overtime labor costs are considered part of indirect overhead costs.

Two additional terms we use to describe cost classifications in manufacturing costing systems are:

Prime costs -- a term referring to all direct manufacturing costs (materials and labor).

Conversion costs -- a term referring to direct labor and indirect manufacturing costs.

Because there are alternative ways for management to define and classify costs, judgment is required.

Managers, accountants, suppliers and others should agree on the classifications and meanings of the cost terms introduced in this chapter and throughout the book.

Pricing and product-mix decisions—decisions about pricing and maximizing profits
Contracting with government agencies—very specific definitions of allowable costs for “cost plus profit” contracts
Preparing external-use financial statements—GAAP-driven product costs only

Many cost terms used by organizations have ambiguous meanings. Consider the term product cost as an example. A product cost is the sum of the costs assigned to a product for a specific purpose. Some different purposes might include:

Pricing and product-mix decisions—decisions about pricing and maximizing profits

Contracting with government agencies—very specific definitions of allowable costs for “cost plus profit” contracts

Preparing external-use financial statements—GAAP-driven product costs only

These different purposes can result in different measures of product costs. You can see a pictorial view of this concept on the next slide.

Pricing and product-mix decisions—decisions about pricing and maximizing profits

Contracting with government agencies—very specific definitions of allowable costs for “cost plus profit” contracts

Preparing external-use financial statements—GAAP-driven product costs only

These different purposes can result in different measures of product costs.

Exhibit 2-11 page 48.

The following three features of cost accounting and cost management can be used for a wide range of applications (for helping managers make decisions):

Calculating the cost of products, services, and other cost objects

Obtaining information for planning and control, and performance evaluation

Analyzing the relevant information for making decisions

This framework for cost accounting and cost management can help managers make decisions:

Calculating the cost of products, services, and other cost objects
Obtaining information for planning and control, and performance evaluation
Analyzing the relevant information for making decisions

BUS 224/PPT/Chapter 20.ppt

Inventory Management,

Just-in-Time,

and Simplified Costing Methods

Identify six categories of costs associated with goods for sale

Balance ordering costs with carrying costs using the economic-order-quantity (EOQ) decision model

Identify the effect of errors that can arise when using the EOQ decision model and ways to reduce conflicts between the EOQ model and models used for performance evaluation

20-*

In chapter 20, we’ll discuss various issues about inventory management including just-in-time purchasing and simplified costing methods. Here are the first 3 of our 8 learning objectives.

Identify six categories of costs associated with goods for sale
Balance ordering costs with carrying costs using the economic-order-quantity (EOQ) decision model
Identify the effect of errors that can arise when using the EOQ decision model and ways to reduce conflicts between the EOQ model and models used for performance evaluation

Describe why companies are using just-in-time (JIT) purchasing

Distinguish materials requirements planning (MRP) systems from just-in-time (JIT) systems for manufacturing

Identify the features and benefits of a just-in-time production system

20-*

Here you’ll see learning objectives #4 through #6:

Describe why companies are using just-in-time (JIT) purchasing
Distinguish materials requirements planning (MRP) systems from just-in-time (JIT) systems for manufacturing
Identify the features and benefits of a just-in-time production system

Inventory management includes planning, coordinating, and controlling activities related to the flow of inventory into, through, and out of an organization.

20-*

Inventory management in organizations includes planning, coordinating, and controlling activities related to the flow of inventory into, through, and out of an organization.

Managing inventories to increase net income requires effectively managing costs that fall into these six categories:

Purchasing costs.

Ordering costs.

Carrying costs.

Stockout costs.

Quality costs.

Shrinkage costs.

20-*

Managing inventories to increase net income requires effectively managing costs that fall into these six categories:

Purchasing costs
Ordering costs
Carrying costs
Stockout costs
Quality costs
Shrinkage costs

Purchasing costs—the cost of goods acquired from suppliers, including incoming freight costs. Usually this is the largest cost category of goods in inventory.

Ordering costs—the costs of preparing and issuing purchase orders, receiving and inspecting the items included in the orders, and matching invoices received, purchase orders, and delivery records to make payments.

20-*

Let’s look at the details of the costs associated with goods for sale:

Purchasing costs—the cost of goods acquired from suppliers, including incoming freight costs. Usually this is the largest cost category of goods in inventory.
Ordering costs—the costs of preparing and issuing purchase orders, receiving and inspecting the items included in the orders, and matching invoices received, purchase orders, and delivery records to make payments.

Carrying costs—the costs that arise while goods are being held in inventory. These costs include the opportunity cost of the investment tied up in inventory, and costs associated with storage.

Stockout costs—the costs that arise when a company runs out of a particular item for which there is customer demand (stockout). The company must act quickly to meet the demand or suffer the costs of not meeting it.

20-*

Carrying costs—the costs that arise while goods are being held in inventory. These costs include the opportunity cost of the investment tied up in inventory, and costs associated with storage.
Stockout costs—the costs that arise when a company runs out of a particular item for which there is customer demand (stockout). The company must act quickly to meet the demand or suffer the costs of not meeting it.

Costs of Quality – the costs incurred to prevent and appraise, or the costs arising as a result of, quality issues. Recall from chapter 19, there are four categories of quality costs:

Prevention.

Appraisal.

Internal failure.

External failure.

Shrinkage costs—costs that result from theft by outsiders, embezzlement by employees, misclassifications and clerical errors. Shrinkage is measured by the difference between the cost of inventory on the books vs the cost of the physical count.

20-*

Costs of Quality – the costs incurred to prevent, or the costs arising as a result of, quality issues. Recall from chapter 19, there are four categories of quality costs:
Prevention
Appraisal
Internal failure
External failure
Shrinkage costs—costs that result from theft by outsiders, embezzlement by employees, misclassifications and clerical errors. Shrinkage is measured by the difference between the cost of inventory on the books vs the cost of the physical count.

The first decision in managing goods for sale is how much to order of a given product.
Economic order quality (EOQ) is a decision model that calculates the optimal quantity of inventory to order under a given set of assumptions.

20-*

The first decision in managing goods for sale is how much to order of a given product.

Economic order quality (EOQ) is a decision model that calculates the optimal quantity of inventory to order under a given set of assumptions.

There are only ordering and carrying costs.
The same quantity is ordered at each reorder point.
Demand, purchase-order lead time, ordering costs, and carrying costs are known with certainty.
Purchasing costs per unit are unaffected by the quantity ordered. (Therefore, purchasing costs are irrelevant.)
No stockouts occur.
Managers consider the costs of quality and shrinkage costs only to the extent that these costs affect ordering or carrying costs.

20-*

The EOQ is a decision model that, under a given set of assumptions, calculates the optimal quantity of inventory to order. Here are those assumptions:

There are only ordering and carrying costs.

The same quantity is ordered at each reorder point.

Demand, purchase-order lead time, ordering costs, and carrying costs are known with certainty.

Purchasing costs per unit are unaffected by the quantity ordered. (Therefore, purchasing costs are irrelevant.)

No stockouts occur.

Managers consider the costs of quality and shrinkage costs only to the extent that these costs affect ordering or carrying costs.

D = Demand in units for specified period

P = Relevant ordering costs per purchase order

C = Relevant carrying costs of one unit in stock for the time period used for D

20-*

The EOQ Formula = the square root of (2 x Demand in units for a specified period (often one year) X Relevant ordering costs per purchase order) divided by the relevant carrying cost of one unit in stock for the time period used for D

The formula indicates that EOQ increases with higher demand and/or higher ordering costs and decreases with higher carrying costs. From page 767.

20-*

In this chart, you can see the relationship between the data points used in our EOQ formula. Exhibit 20-1 page 768

The second decision in managing goods for sale is when to order a given product.
Reorder point—the quantity level of inventory on hand that triggers a new purchase order.

20-*

Once we know how much to order, the next decision is when. The reorder point is the quantity level of inventory on hand that triggers a new purchase order. It is the point of inventory quantity on hand below which we don’t want to fall.

The formula is the number of units sold per unit of time X the purchase order lead time. From page 769.

Sheet1


EOQ	=
EOQ	=	√	2DP
			C

Sheet2


Reorder	=	Number of units sold	X	Purchase Order
Point		per unit of time		Lead Time

Sheet3

20-*

In this chart, we can see how the assumption of certainty for the demand and lead time affect our reorder point. Exhibit 20-2 page 769

Safety stock is inventory held at all times regardless of the quantity of inventory ordered using the EOQ model.
Safety stock is a buffer against unexpected increases in demand, uncertainty about lead time, and unavailability of stock from suppliers.
Managers use a frequency distribution based on prior daily or weekly levels of demand to compute safety-stock levels.

20-*

Safety stock is inventory held at all times regardless of the quantity of inventory ordered using the EOQ model.

Safety stock is a buffer against unexpected increases in demand, uncertainty about lead time, and unavailability of stock from suppliers.

Managers use a frequency distribution based on prior daily or weekly levels of demand to compute safety-stock levels.

The relevant costs are categorized as follows:

Carrying costs – see next slide
Stockout costs – the cost of expediting an order from a supplier
Ordering costs – those ordering costs that change with the number of orders placed

20-*

The relevant costs are categorized as follows:

Carrying costs – see next slide

Stockout costs – the cost of expediting an order from a supplier

Ordering costs – those ordering costs that change with the number of orders placed

Relevant inventory carrying costs consist of relevant incremental costs and the relevant opportunity cost of capital.
Relevant incremental costs—those costs of the purchasing firm that change with the quantity of inventory held.

20-*

Relevant inventory carrying costs consist of relevant incremental costs and the relevant opportunity cost of capital.

Relevant incremental costs—those costs of the purchasing firm that change with the quantity of inventory held.

Relevant opportunity cost of capital—the return foregone by investing capital in inventory rather than elsewhere.
It is calculated as the required rate of return multiplied by the per-unit costs of acquiring inventory, such as the purchase price of units, incoming freight, and incoming inspection.
Opportunity costs are also computed on investments if these investments are affected by changes in inventory levels.

20-*

Relevant opportunity cost of capital—the return foregone by investing capital in inventory rather than elsewhere.

It is calculated as the required rate of return multiplied by the per-unit costs of acquiring inventory, such as the purchase price of units, incoming freight, and incoming inspection.

Opportunity costs are also computed on investments if these investments are affected by changes in inventory levels.

Three steps in determining the cost of a prediction error:

Compute the monetary outcome from the best action that could be taken, given the actual amount of the cost per purchase order.

Compute the monetary outcome from the best action based on the incorrect amount of the predicted cost per purchase order.

Compute the difference between steps 1 and 2.

20-*

Three steps in determining the cost of a prediction error:

Compute the monetary outcome from the best action that could be taken, given the actual amount of the cost per purchase order.
Compute the monetary outcome from the best action based on the incorrect amount of the predicted cost per purchase order.
Compute the difference between steps 1 and 2.

Just-in-time (JIT) purchasing, a method of managing purchases so the materials or goods are delivered just as needed for production or sales.
JIT purchasing is not guided solely by the EOQ model because that model only emphasizes the tradeoff between relevant carrying and ordering costs.

20-*

Just-in-time (JIT) purchasing, a method of managing purchases so the materials or goods are delivered just as needed for production or sales.

JIT purchasing is not guided solely by the EOQ model because that model only emphasizes the tradeoff between relevant carrying and ordering costs.

JIT reduces the cost of placing a purchase order because:
Long-term purchasing agreements define price and quality terms. Individual purchase orders covered by those agreements require no additional negotiation regarding price or quality.
Companies are using electronic links to place purchase orders at a small fraction of traditional methods (phone or mail).
Companies are using purchase-order cards (similar to consumer credit cards).

20-*

JIT reduces the cost of placing a purchase order because:

Long-term purchasing agreements define price and quality terms. Individual purchase orders covered by those agreements require no additional negotiation regarding price or quality.

Companies are using electronic links to place purchase orders at a small fraction of traditional methods (phone or mail).

Companies are using purchase-order cards (similar to consumer credit cards)

To determine outputs at each stage of production, MRP uses:

The demand forecasts for final products.

A bill of materials detailing the materials, components, and subassemblies for each final product.

Information about a company’s inventories of materials, components, and products.

20-*

To determine outputs at each stage of production, MRP uses:

The demand forecasts for final products
A bill of materials detailing the materials, components, and subassemblies for each final product
Information about a company’s inventories of materials, components, and products.

Taking into account the lead time required to purchase materials and to manufacture components and finished products, a master production schedule specifies the quantity and timing of each item to be produced.
Once production starts as scheduled, the output of each department is pushed through the production line.
Maintaining accurate inventory records and costs is critical in an MRP system.

20-*

Let’s discuss the MRP process:

Taking into account the lead time required to purchase materials and to manufacture components and finished products, a master production schedule specifies the quantity and timing of each item to be produced.

Once production starts as scheduled, the output of each department is pushed through the production line

Maintaining accurate inventory records and costs is critical in an MRP system

JIT (lean) production is a “demand-pull” manufacturing system that manufactures each component in a production line as soon as, and only when, needed by the next step in the production line.
Demand triggers each step of the production process, starting with customer demand for a finished product and working all the way back to the demand for direct materials at the beginning of the process.

20-*

JIT (lean) production is a “demand-pull” manufacturing system that manufactures each component in a production line as soon as, and only when, needed by the next step in the production line.

Demand triggers each step of the production process, starting with customer demand for a finished product and working all the way back to the demand for direct materials at the beginning of the process.

JIT production systems result in close coordination among work-stations.
Smooths the flow of goods.
Achieves low quantities of inventory.
JIT aims to simultaneously:
Meet customer demand in a timely manner.
Produce high quality products.
Generate the lowest possible costs.

20-*

JIT production systems result in close coordination among work-stations

Smooths the flow of goods

Achieves low quantities of inventory

JIT aims to simultaneously:

Meet customer demand in a timely manner

Produce high quality products

Generate the lowest possible costs

Production is organized in manufacturing cells, which are work areas with different types of equipment grouped together to make related products.
Workers are hired and trained to be multi-skilled (cross-trained).
Defects are aggressively eliminated.
Setup time and manufacturing cycle time are reduced.
Suppliers are selected on the basis of their ability to deliver quality materials in a timely manner.

20-*

Some features of a JIT production system include:

Production is organized in manufacturing cells, which are work areas with different types of equipment grouped together to make related products

Workers are hired and trained to be multi-skilled (cross-trained).

Defects are aggressively eliminated.

Setup time and manufacturing cycle time are reduced.

Suppliers are selected on the basis of their ability to deliver quality materials in a timely manner.

Lower overhead costs
Lower inventory levels, lower carrying costs
Heightened emphasis on improving quality by eliminating the specific causes of rework, scrap, and waste
Lower manufacturing cycle times

20-*

Some of the costs and benefits of JIT production include:

Lower overhead costs

Lower inventory levels, lower carrying costs

Heightened emphasis on improving quality by eliminating the specific causes of rework, scrap, and waste

Lower manufacturing cycle times

ERP systems are frequently used in conjunction with JIT production.

An ERP system is an integrated set of software modules covering a company’s accounting, distribution, manufacturing, purchasing, human resources and other functions.
Real-time information is collected in a single database and simultaneously fed into all of the software applications, giving personnel greater visibility into the company’s end-to-end business processes.
Companies believe that an ERP system is essential to support JIT initiatives because of the effect it has on lead time.

20-*

ERP systems are frequently used in conjunction with JIT production.

An ERP system is an integrated set of software modules covering a company’s accounting, distribution, manufacturing, purchasing, human resources and other functions.

Real-time information is collected in a single database and simultaneously fed into all of the software applications, giving personnel greater visibility into the company’s end-to-end business processes.

Companies believe that an ERP system is essential to support JIT initiatives because of the effect it has on lead time.

The challenge, when implementing ERP systems, is to strike the proper balance between the lower cost and reliability of standardized systems and the strategic benefits that accrue from customization.

20-*

The challenge, when implementing ERP systems, is to strike the proper balance between the lower cost and reliability of standardized systems and the strategic benefits that accrue from customization.

Financial performance measures such as inventory turnover ratio, which is expected to increase.
Nonfinancial performance measures of time, inventory, and quality such as:
Number of days of inventory on hand: expected to decrease.
Units produced per hour: expected to increase
% of scrapped/rework over total units started: expected to decrease.
Manufacturing cycle time: expected to decrease.
Setup time: expected to decrease.

20-*

Some of the performance measures and control in JIT include:

Financial performance measures such as inventory turnover ratio, which is expected to increase

Nonfinancial performance measures of time, inventory, and quality such as:

Number of days of inventory on hand: expected to decrease.

Units produced per hour: expected to increase.

% of scrapped/rework over total units started: expected to decrease.

Manufacturing cycle time: expected to decrease.

Setup time: expected to decrease.

Traditional normal or standard-costing systems use sequential tracking in which the recording of the journal entries occurs in the same order as actual purchases and progress in production.

As a reminder, the 4 stages are:

Purchase of Direct Materials & Incurring of Conversion costs*

Production resulting in WIP

Completion of Good finished units of product*

Sales of finished goods*

* Indicates a trigger point for journal entries

20-*

Traditional normal or standard-costing systems use sequential tracking in which the recording of the journal entries occurs in the same order as actual purchases and progress in production.

As a reminder, the 4 stages are:

Purchase of Direct Materials & Incurring of Conversion costs*

Production resulting in WIP

Completion of Good finished units of product*

Sales of finished goods*

Indicates a trigger point for journal entries
From page 781.

Backflush costing omits recording some of the journal entries relating to the stages from the purchase of direct materials to the sale of finished goods.
Because some stages are omitted, the journal entries for a subsequent stage use normal or standard costs to work backward to “flush out” the costs in the cycle for which journal entries were not made.

20-*

Backflush costing omits recording some or all of the journal entries relating to the stages from the purchase of direct materials to the sale of finished goods.

Because some stages are omitted, the journal entries for a subsequent stage use normal or standard costs to work backward to “flush out” the costs in the cycle for which journal entries were not made.

This is in contrast to the traditional normal and standard costing systems which use sequential tracking: recording journal entries at each trigger point in the production process.

Backflush costing does not necessarily comply with GAAP.
However, inventory levels may be immaterial, negating the necessity for compliance.
Backflush costing does not leave a good audit trail—the ability of the accounting system to pinpoint the uses of resources at each step of the production process.

20-*

Backflush costing does not necessarily comply with GAAP.

However, inventory levels may be immaterial, negating the necessity for compliance.

Backflush costing does not leave a good audit trail—the ability of the accounting system to pinpoint the uses of resources at each step of the production process.

Another simplified product costing system that can be used with JIT systems is lean accounting.
When a company utilizes JIT production, it has to focus on the entire value chain of business functions in order to reduce inventories, lead times and waste.
The improvements that result have led some companies with JIT systems to develop organizations structures and costing systems that focus on value streams.

20-*

Another simplified product costing system that can be used with JIT systems is lean accounting

When a company utilizes JIT production, it has to focus on the entire value chain of business functions in order to reduce inventories, lead times and waste.

The improvements that result have led some companies with JIT systems to develop organizations structures and costing systems that focus on value streams.

Value streams are all the value-added activities needed to design, manufacture, and deliver a given product or product line to customers.
Lean accounting is a costing method that focuses on value streams, as distinguished from individual products or departments, thereby eliminating waste in the accounting process.
Tracing more costs as direct costs to value streams is possible because companies using lean accounting often dedicate resources to individual value streams.

20-*

Value streams are all the value-added activities needed to design, manufacture, and deliver a given product or product line to customers.

Lean accounting is a costing method that focuses on value streams, as distinguished from individual products or departments, thereby eliminating waste in the accounting process.

Tracing more costs as direct costs to value streams is possible because companies using lean accounting often dedicate resources to individual value streams.

Lean accounting is much simpler than traditional product costing because calculating actual product costs by value streams requires less overhead allocation.
Critics of lean accounting charge that it does not compute the costs of individual products, which makes it less useful for making decisions.
Critics of lean accounting charge that it excludes certain support costs and unused capacity costs.
A final criticism is that, like backflush costing, it does not correctly account for inventories under GAAP.

20-*

Lean accounting is much simpler than traditional product costing because calculating actual product costs by value streams requires less overhead allocation.

Critics of lean accounting charge that it does not compute the costs of individual products, which makes it less useful for making decisions.

Critics of lean accounting charge that it excludes certain support costs and unused capacity costs.

A final criticism is that, like backflush costing, it does not correctly account for inventories under GAAP.

ReorderNumber of units sold Purchase Order

Pointper unit of time Lead Time

BUS 224/PPT/Chapter 6.ppt

Master Budget

and

Responsibility Accounting

Describe the master budget and explain its benefits

Describe the advantages of budgets

Prepare the operating budget and its supporting schedules

Use computer-based financial planning models for sensitivity analysis

Describe responsibility centers and responsibility accounting

6-*

In Chapter 6, we will explore the budget process.

On this slide are the first five of our 7 learning objectives:

Describe the master budget and explain its benefits
Describe the advantages of budgets
Prepare the operating budget and its supporting schedules
Use computer-based financial planning models for sensitivity analysis
Describe responsibility centers and responsibility accounting

Recognize the human aspects of budgeting

Appreciate the special challenges of budgeting in multinational companies

6-*

Here are the last two of our seven learning objectives about budgeting.

Recognize the human aspects of budgeting
Appreciate the special challenges of budgeting in multinational companies

A budget is the quantitative expression of a proposed plan of action by management for a specified period.
A budget is an aid to coordinating what needs to be done to implement that plan.

A budget generally includes both the plan’s financial and nonfinancial aspects and serves as a blueprint for the company to follow in an upcoming period.

6-*

A budget is the quantitative expression of a proposed plan of action by management for a specified period, and

Also works as an aid to coordinating what needs to be done to implement that plan

Communicate directions and goals to different departments of a company to help them coordinate the actions they must pursue to satisfy customers and succeed in the marketplace.
Judge performance by measuring financial results against planned objectives, activities, and timelines to learn about potential problems.
Motivate employees to achieve their goals.

6-*

Budgets serve many purposes for firms including those seen here:

Communicate directions and goals to different departments of a company to help them coordinate the actions they must pursue to satisfy customers and succeed in the marketplace

Judge performance by measuring financial results against planned objectives, activities, and timelines to learn about potential problems

Motivate employees to achieve their goals.

To develop successful strategies, managers must consider questions such as the following:

What are our objectives?

How do we create value for our customers while distinguishing ourselves from our competitors?

Are the markets for our products local, regional, national or global?

What trends affect our markets?

What organizational and financial structures serve us best?

What are risks and opportunities of alternative strategies and what are our contingency plans if our preferred plan fails?

6-*

As managers work to develop successful strategies, they must consider various questions including the risks and opportunities of alternative strategies, contingency plans if the preferred plan fails, how the economy, industry and competitors affect the business as well as, and in addition to, the questions shown here:

To develop successful strategies, managers must consider questions such as the following:

What are our objectives?
How do we create value for our customers while distinguishing ourselves from our competitors?
Are the markets for our products local, regional, national or global?
What trends affect our markets?
What organizational and financial structures serve us best?

Before the start of a fiscal year, managers at all levels take into account past performance, market feedback, anticipated future changes and other indicators to initiate plans for the next period.

Senior managers give subordinate managers a frame of reference against which they will compare actual results.

Managers and management accountants investigate any deviations from the plan.

6-*

Well managed companies usually cycle through these steps during the course of a fiscal year:

Before the start of a fiscal year, managers at all levels take into account past performance, market feedback, anticipated future changes and other indicators to initiate plans for the next period.
Senior managers give subordinate managers a frame of reference against which they will compare actual results.
Managers and management accountants investigate, during the course of the year, changes.

The master budget is at the core of the budgeting process. It expresses management’s operating and financial plans for a specified period:

Operating decisions deal with how to best use the limited resources of an organization. (the operating budget)
Financial decisions deal with how to obtain the funds to acquire those resources. (the financial budget)

6-*

The working document at the core of the budget-related process is known as the master budget. It expresses management’s operating and financial plans for a specified period and includes a set of budgeted financial statements.

Promotes coordination and communication among subunits within the company.
Provides a framework for judging performance and facilitating learning.
Motivates managers and other employees.

6-*

Among the advantages of budgets are that it:

Promotes coordination and communication among subunits within the company

Provides a framework for judging performance and facilitating learning - as an example, budgets enable a company’s managers to measure actual performance against predicted performance. This information, then, can be used to guide future activity.

Motivates managers and other employees

Top managers want lower-level managers to participate in the budgeting process because they have more specialized knowledge of day-to-day management, however…
The budgeting process is time-consuming, and
Upper-level management’s support is crucial

6-*

Of course, challenges are also associated with budgets and the budget process.

The budget process is time-consuming, requires lower-level managers “buy-in” and upper-level management support.

The timeline for a budget is dependent on the motive for creating the budget.

The most frequently used budget period is 1 year.

Businesses may also use a rolling budget. This budget is always available for a specified future period, by continually adding a month, quarter, or year to the period just ended.

6-*

The motive for creating a budget should guide a manager in choosing the period for the budget.

As an example, if the purpose for the budget is cash-flow, you may look at a 6-month horizon whereas if you are looking at profitability of a new product line, you may need to look 3-years into the future.

Identify the problem and uncertainties

Obtain information

Make predictions about the future

Make decisions by choosing among alternatives

Implement the decision, evaluate performance and learn

6-*

A company will go through the five-step decision-making process that was introduced in Chapter 1 and is shown here.

Identify the problem and uncertainties
Obtain information
Make predictions about the future
Make decisions by choosing among alternatives
Implement the decision, evaluate performance and learn

Prepare the revenues budget (schedule 1; the starting point) Page 213

Prepare the production budget (schedule 2; in units). Page 214

Prepare the direct materials usage budget and direct materials purchases budget (schedule 3A and 3B) Pages 214 and 215

Prepare the direct manufacturing labor budget (schedule 4) Page 215

6-*

The revenue budget is usually based on expected demand because demand for a company’s products is invariably the limiting factor for achieving profit goals.

The logical next step is to plan the production so that the product is available when customers need it.

The number of units to be produced is the key to computing the usage of direct materials in both quantity and dollars. This will be based on quantity required for each unit to be produced from the production budget

To create the budget for direct manufacturing labor costs, managers estimate wage rates, production methods, process and efficiency improvements and hiring plans.

Prepare the manufacturing overhead costs budget (schedule 5) Page 216

Prepare the ending inventories budget (schedule 6A, units; schedule 6B, dollars) Pages 217

Prepare the cost of goods sold budget (schedule 7) Page 217

Prepare the operating expense (period cost) budget (schedule 8) Page 218

Prepare the budgeted income statement Exhibit 6-3 page 218

6-*

The next schedule to be created (schedule #5) is the manufacturing overhead costs budget. Managing overhead costs is both challenging and important because of the required understanding of the activities required for production and the cost driver of those activities.

Inventories are essential for proper customer service and play an important role in the determination of the budget. The production budget already included a determination of the target ending finished goods inventory.

Cost of Goods Sold are calculated by adding additional production costs to beginning finished goods inventory and subtracting ending finished goods inventory.

Non-manufacturing costs are included in the operating expense budget.

Formats differ for the budgeting income statement but generally, information from schedules 1, 7 and 8 are used to generate the budgeted income statement.

Based on the operating budgets:

Prepare the capital expenditures budget.

Prepare the cash budget.

Prepare the budgeted balance sheet.

Prepare the budgeted statement of cash flows.

6-*

Once the schedules just discussed and the budgeted income statement are complete, additional schedules need to be created to complete the budgeted balance sheet and the financial section of the master budget.

Prepare the capital expenditures budget.
Prepare the cash budget.
Prepare the budgeted balance sheet.
Prepare the budgeted statement of cash flows.

6-*

This illustration shows the relationship between the schedules that we discussed for both the operating and financial sections of the master budget.

As is clearly demonstrated, the revenues budget begins the process and informs virtually all of the schedules that come later. Exhibit 6-2 page 204

Financial planning models may be employed to conduct sensitivity (“what-if”) analysis to assist in the budgetary process.

A “what-if” analysis or sensitivity analysis is a technique that examines how a result will change if the original predicted data or underlying assumption change.

6-*

Financial planning models are mathematical representations of the relationships among operating activities, financing activities and other factors that affect the master budget.

Sensitivity analysis is used to assist managers in planning and budgeting.

Sensitivity analysis is a “what if” technique that illustrates the impact of changes from the predicted data.

Two scenarios are being considered for Stylistic Furniture’s (the company from the textbook) budget.

6-*

As we learn from the table shown here, the master budget assumes a particular mix of product sales, selling price, material cost with the resulting budgeted operating income. In scenario #1, a what-if look at an alternative, the price has been reduced with no offsetting decrease in direct material cost or increase in units sold. This results in a 22% decrease in budgeted operating income. In scenario #2, we instead are looking at an increase in direct material costs, resulting in an 8% decrease in budgeted operating income.

This kind of “advance notice” gives managers an idea of where they should focus efforts to ensure meeting the budgeted operating income. Exhibit 6-4 page 214

Responsibility center—a part, segment, or subunit of an organization whose manager is accountable for a specified set of activities.
Responsibility accounting—a system that measures the plans, budgets, actions, and actual results of each responsibility center.
Generally, we consider 4 levels of responsibility center.

6-*

To attain the goals described in the master budget, top managers must coordinate the efforts of all the firm’s employees. Consequently, the way a firm is structured shapes how the coordination occurs.

Here we see the definition of a responsibility center and responsibility accounting:

Responsibility center—a part, segment, or subunit of an organization whose manager is accountable for a specified set of activities.

Responsibility accounting—a system that measures the plans, budgets, actions, and actual results of each responsibility center

Cost—accountable for costs only

Revenue—accountable for revenues only

Profit—accountable for revenues and costs

Investment—accountable for investments, revenues, and costs

6-*

There are 4 types of responsibility center:

Cost—accountable for costs only
Revenue—accountable for revenues only
Profit—accountable for revenues and costs
Investment—accountable for investments, revenues, and costs

Budgets offer feedback in the form of variances: actual results deviate from budgeted targets.
Variances provide managers with:
Early warning of problems
A basis for performance evaluation
A basis for strategy evaluation

6-*

Budgets offer feedback in the form of variances and provide managers with early warning of problems. They can also be the basis for performance evaluations and are a basis for strategy evaluation.

Controllability is the degree of influence that a manager has over costs, revenues, or related items for which he or she is being held responsible.
Responsibility accounting helps managers to first focus on whom they should ask to obtain information and not on whom they should blame.
Responsibility accounting focuses on gaining information and knowledge, not only on control.
The fundamental purpose of responsibility accounting is to enable future improvement.

6-*

Managers should avoid thinking about controllability only in the context of performance evaluation.

Responsibility accounting helps managers to first focus on whom they should ask to obtain information and not on whom they should blame.

The fundamental purpose of responsibility accounting is to enable future improvement.

Budgetary slack is the practice of underestimating budgeted revenues or overestimating budgeted costs to make budgeted targets easier to achieve.

Stretch targets are targets that are challenging but achievable to focus effort on achieving the targets.

Kaizen Budgeting is a practice whereby each budget process incorporates continuous improvement from past results.

6-*

Budgetary slack is a concern for firms when using budgets for performance evaluation. There are many techniques to avoid or minimize this negative aspect including the use of stretch targets and Kaizen budgeting.

International companies face significant exchange rate uncertainty rendering budgets for traditional purposes of evaluating a firm’s performance moot but still very useful as a tool to help manager’s adapt plans and coordinate actions when conditions are volatile.

6-*

Do managers of multinational companies find budgeting to be a helpful tool? A natural question when you consider the volatility of exchange rates, among other conditions.

The answer is yes though the use of the budget is often modified to accommodate that volatility.

BUS 224/PPT/Chapter 7.ppt

Flexible Budgets,

Direct-Cost Variances,

and

Management Control

We learned in Chapter 6 how budgets help managers with their planning function. In Chapter 7, we’ll take a look at flexible budgets and variances.

Understand static budgets and static-budget variances

Examine the concept of a flexible budget and learn how to develop it

Calculate flexible-budget variances and sales-volume variances

Explain why standard costs are often used in variance analysis

7-*

We have 7 learning objectives in our chapter on flexible budgets. The first 4 are shown here:

Understand static budgets and static-budget variances
Examine the concept of a flexible budget and learn how to develop it
Calculate flexible-budget variances and sales-volume variances
Explain why standard costs are often used in variance analysis

Compute price variances and efficiency variances for direct-cost categories.

Understand how managers use variances

Describe benchmarking and explain its role in cost management

7-*

The final 3 learning objectives for chapter 7 are:

Compute price variances and efficiency variances for direct-cost categories.
Understand how managers use variances
Describe benchmarking and explain its role in cost management

Variance—difference between actual results and expected (budgeted) performance.
Management by exception—the practice of focusing attention on areas not operating as expected (budgeted).
Static (master) budget is based on the output planned at the start of the budget period.

7-*

A variance is the difference between actual results and expected performance. The expected performance is also called budgeted performance.

Management by exception is a practice whereby managers focus more closely on areas that are not operating as expected and less closely on areas that are.

The static budget is another name for the master budget. It is based on the level of output planned at the start of the budget period. It is called a static budget because the budget for the period is developed around a single (static) planned output level.

Static-budget variance—the difference between the actual result and the corresponding static budget amount
Favorable variance (F)—has the effect of increasing operating income relative to the budget amount
Unfavorable variance (U)—has the effect of decreasing operating income relative to the budget amount

7-*

The static-budget variance is the difference between the actual result and the corresponding budgeted amount in the static budget.

Favorable variances are denoted with an F. Variances are favorable when actual revenues exceed budgeted revenues and when actual costs are less than budgeted costs.

Variances may start out “at the top” with a Level 0 analysis.
This is the highest level of analysis, a super-macro view of operating results.
The Level 0 analysis is nothing more than the difference between actual and static-budget operating income.

7-*

Variances can be calculated at multiple levels and those levels are identified with level numbers. The most broad variance is a level 0 and is a very macro-view showing the difference between actual and static-budget operating income.

Further analysis decomposes (breaks down) the Level 0 analysis into progressively smaller and smaller components.
Answers: “How much were we off?”
Levels 1, 2, and 3 examine the Level 0 variance into progressively more-detailed levels of analysis.
Answers: “Where and why were we off?”

7-*

Variances are broken down further into smaller and smaller components to help managers understand more and more about what happened in the business.

Further analysis decomposes (breaks down) the Level 0 analysis into progressively smaller and smaller components.

Answers: “How much were we off?”

Levels 1, 2, and 3 examine the Level 0 variance into progressively more-detailed levels of analysis.

Answers: “Where and why were we off?”

Level 0 tells the user very little other than how much operating income was off from budget.
Level 0 answers the question: “How much were we off in total?”
Level 1 gives the user a little more information: it shows which line-items led to the total Level 0 variance.
Level 1 answers the question: “Where were we off?”

7-*

As previously stated, level 1 can provide information on WHERE we were off from target instead of just HOW MUCH we were off, which is what level 0 provides.

7-*

A level 1 analysis, illustrated here, takes the static-budget variance (level 0) and breaks it down by line item. As a result, in addition to knowing that we fell short in operating income, we now know how we got there. Column 1 presents the actual results, column 3 the static budget and in column 2 are the level 1 variances: the difference between the static budget and the actual results. Exhibit 7-1 page 251

Flexible budget—shifts budgeted revenues and costs up and down based on actual operating results (activities)
Represents a blending of actual activities and budgeted dollar amounts
Will allow for preparation of Level 2 and 3 variances
Answers the question: “Why were we off?”

7-*

Variance analysis levels 2 and 3 answer the question WHY were we off? With level 2 and 3 variances, we can get quite specific about what went wrong in our operations that caused the shortfall in operating income.

7-*

Here is an example of a Level 2 analysis. In the first column, the actual results are reported. The third column reports the FLEXIBLE BUDGET and the 5th column reports the STATIC BUDGET.

The second column provides the variances between our actual results and the flexible budget. These variances are the flexible-budget variances. They help us to understand what results we should have had for the level of volume compared to what was actually obtained.

The fourth column provides the difference between the static and the flexible budget. This is called the sales-volume variance because it tells us how much we gained or lost as a result of a volume difference between what was originally anticipated and what we actually achieved.

The flexible budget uses budgeted per unit data applied to ACTUAL units. It represents what our budget would have been had we budgeted correctly for volume. Exhibit 7-2 page 253

Some possible reasons we might incur an unfavorable Sales-Volume Variance include:

Failure to execute the sales plan

Weaker than anticipated demand

Aggressive competitors taking market share

Unanticipated market preference away from the product

Quality problems

7-*

Some reasons we may incur unfavorable sales-volume variances include:

Failure to meet the sales plan
Weaker than anticipated demand
Aggressive competitors taking market share
Unanticipated market preference away from the product
Quality problems

All product costs can have Level 3 variances. Direct materials and direct labor will be handled next. Overhead variances are discussed in detail in a later chapter.
Direct materials and direct labor both have price and efficiency variances, and their formulae are the same.

7-*

The level 2 variances are great – they certainly break down our successes and shortfalls in more detail than level 1. However, as you’ll see, level 3 variances are even better because they separate what we call Price and Efficiency variances.

Direct materials and direct labor both have price and efficiency variances, and their formulae are the same.

Let’s take a look:

Price variance formula:

Efficiency variance formula:

7-*

The formulas to calculate the price and efficiency variances are shown here. These formulas work equally well for direct material and direct labor but will not work for overhead.

The formula for PRICE VARIANCE is: (Actual Price – Budgeted Price) X Actual Quantity

The formula for EFFICIENCY VARIANCE is: (Actual Quantity – Budgeted Quantity) X Budgeted Price

The Actual Quantity of Input used can be yards or pounds of material or direct labor or machine hours.

The Budgeted Quantity of Input Allowed for Actual Output means that we’ll take the quantity expected to be used per output (4 lbs of steel per item) X the actual quantity.

As an example, if we made 10 units and each required 4.4 lbs of plastic, we would expect to have used 44 lbs of plastic. If we ACTUALLY used 48 lbs of plastic, that element of the formula would be (48 – 44).

Level 1


		Static-Budget
	Actual Results	Variances		Static Budget
Units Sold	100	10	F	90
Revenues	$ 3,500	$ 800	F	$ 2,700
Variable Costs:
Direct Materials	700	160	U	540
Direct Labor	1,000	100	U	900
Variable Factory Overhead	500	(40)	F	540
Contribution Margin	1,300	580	F	720
Fixed Costs	600	(100)	F	700
Operating Income	$ 700	$ 680	F	$ 20

Operating Indicators


	Actual	Static
Indicator	Results	Budget
Units Sold	100	90
Selling Price	$ 35	$ 30
Direct Material Cost per Unit	$ 7	$ 6
Direct Labor Cost per Unit	$ 10	$ 10
Variable Manufacturing Overhead per Unit	$ 5	$ 6
Fixed Costs	$ 600	$ 700

Level 3

Budgeted Quantity of Input

Allowed for Actual Output

Of Input

Level 2


		Flexible-Budget			Sales-Volume
	Actual Results	Variances		Flexible Budget	Variances		Static Budget
Units Sold	100	- 0	N/A	100	10	F	90
Revenues	$ 3,500	$ 500	F	$ 3,000	$ 300	F	$ 2,700
Variable Costs:
Direct Materials	700	100	U	600	60	U	540
Direct Labor	1,000	- 0	N/A	1,000	100	U	900
Variable Factory Overhead	500	(100)	F	600	60	U	540
Contribution Margin	1,300	500	F	800	80	F	720
Fixed Costs	600	(100)	F	700	- 0	N/A	700
Operating Income	$ 700	$ 600	F	$ 100	$ 80	F	$ 20

Level 1


		Static-Budget
	Actual Results	Variances		Static Budget
Units Sold	100	10	F	90
Revenues	$ 3,500	$ 800	F	$ 2,700
Variable Costs:
Direct Materials	700	160	U	540
Direct Labor	1,000	100	U	900
Variable Factory Overhead	500	(40)	F	540
Contribution Margin	1,300	580	F	720
Fixed Costs	600	(100)	F	700
Operating Income	$ 700	$ 680	F	$ 20

Operating Indicators


	Actual	Static
Indicator	Results	Budget
Units Sold	100	90
Selling Price	$ 35	$ 30
Direct Material Cost per Unit	$ 7	$ 6
Direct Labor Cost per Unit	$ 10	$ 10
Variable Manufacturing Overhead per Unit	$ 5	$ 6
Fixed Costs	$ 600	$ 700

Level 3

Budgeted Quantity of Input

Allowed for Actual Output

Of Input

Level 2


		Flexible-Budget			Sales-Volume
	Actual Results	Variances		Flexible Budget	Variances		Static Budget
Units Sold	100	- 0	N/A	100	10	F	90
Revenues	$ 3,500	$ 500	F	$ 3,000	$ 300	F	$ 2,700
Variable Costs:
Direct Materials	700	100	U	600	60	U	540
Direct Labor	1,000	- 0	N/A	1,000	100	U	900
Variable Factory Overhead	500	(100)	F	600	60	U	540
Contribution Margin	1,300	500	F	800	80	F	720
Fixed Costs	600	(100)	F	700	- 0	N/A	700
Operating Income	$ 700	$ 600	F	$ 100	$ 80	F	$ 20

7-*

Level 3 analysis looks at the flexible budget variances (the variance between the flexible budget and the actual results) and explains it in more detail.

For example, on a previous slide, we saw that direct materials was unfavorable by $21,600. That means that we spent $21,600 more for the materials than we should have.

This level 3 analysis tells us how much of that amount was based on price (we paid more or less for the material than we expected to) and how much of the amount was based on usage or efficiency. You can see that the situation is even worse than it appears. We spent $66,000 more than we expected to on usage which was offset quite a bit by the $44,400 favorable purchase price variance.

These variances provide infinitely important information to management to help them improve operations in the future. Exhibit 7-3 page 260

7-*

The slide almost looks like an organization chart, but it isn’t. It is a summary of the variances we’ve just discussed. At the top is our level 1 variance (remember, level 0 is the static-budget variance for operating income and level 1 is that variance broken down by line item).

Level two identifies the variances between the flexible budget and actual operating income by line item and in total. Exhibit 7-4 page 261

Level three variances target one of the level 2 line item variances and breaks it down into more detail.

Budgeted input prices and budgeted input quantities can be obtained from a number of sources including actual input data from past periods, data from other companies that have similar processes and standards developed by the firm itself.

A standard is a carefully determined price, cost or quantity that is used as a benchmark for judging performance.

7-*

A standard is a carefully determined price, cost or quantity that is used as a benchmark for judging performance.

Of course each of these has its own advantages and disadvantages.

Sometimes the terms budget and standard are confused. Budget is the broader term but when standards are used to obtain budgeted input quantities and prices, the terms are used interchangeably.

Each variance may be journalized.
Each variance has its own account.
Favorable variances are credits; unfavorable variances are debits.
Variance accounts are generally closed into cost of goods sold at the end of the period, if immaterial.

7-*

Variances are journalized into individual variance accounts. Favorable variances are credits and unfavorable variances are debits.

If immaterial, variances are closed into cost of goods sold at the end of the period.

Targets or standards are established for direct material and direct labor.
The standard costs are recorded in the accounting system.
Actual price and usage amounts are compared to the standard and variances are recorded.

7-*

In Chapter 4, we looked at journal entries when normal costing is used.

When standard costing is used, variances are recorded a bit differently. As an example, since the purchased material will be recorded at STANDARD, the price variance will be recorded upon purchase rather than when used.

Price and efficiency variances provide feedback to initiate corrective actions.
Standards are used to control costs.
Managers use variance analysis to evaluate performance after decisions are implemented.
Part of a continuous improvement program.

7-*

Standard costing provides valuable information that is used for the management and control of materials, labor and other activities related to production.

Managers must not interpret variances in isolation of each other; when used correctly, variance analysis provides information helpful for future improvement.

Benchmarking is the continuous process of comparing the levels of performance in producing products and services against the best levels of performance in competing companies.
Variances can be extended to include comparison to other entities.

7-*

Management accountants are more valuable to managers when they use benchmarking data to provide insight into WHY costs or revenues differ across companies or within plants of the same company, as distinguished from simply reporting the magnitude of the differences.

7-*

In this chart, we can see various measures between United and other airlines. Airlines use Available Seat Miles (ASM) to answer questions such as how plane size and type affect the cost per ASM. Exhibit 7-5 page 268

PriceActual PriceBudgeted PriceActual Quantity

VarianceOf InputOf InputOf Input

{

}

EfficiencyActual QuantityBudgeted Quantity of Input Budgeted Price

VarianceOf Input UsedAllowed for Actual Output Of Input

{

}

BUS 224/PPT/Chapter 9.ppt

Inventory Costing

and

Capacity Analysis

Identify what distinguishes variable costing from absorption costing

Compute income under variable costing and absorption costing and explain the difference in income

Understand how absorption costing can provide undesirable incentives for managers to build up inventory

Differentiate throughput costing from variable costing and absorption costing

9-*

In chapter 9, we’ll be studying inventory costing and capacity analysis concepts. Here are the first 4 of our 7 learning objectives:

Identify what distinguishes variable costing from absorption costing
Compute income under variable costing and absorption costing and explain the difference in income
Understand how absorption costing can provide undesirable incentives for managers to build up inventory
Differentiate throughput costing from variable costing and absorption costing

Describe the various capacity concepts that firms can use in absorption costing

Examine the key factors managers use to choose a capacity level to compute the budgeted fixed manufacturing cost rate

Understand other issues that play an important role in capacity planning and control

9-*

Here are the final 3 learning objectives:

Describe the various capacity concepts that firms can use in absorption costing
Examine the key factors managers use to choose a capacity level to compute the budgeted fixed manufacturing cost rate
Understand other issues that play an important role in capacity planning and control

The inventory costing system that is chosen determines which manufacturing costs are treated as inventoriable costs.

The denominator-level capacity choice focuses on the cost allocation base used to set budgeted fixed manufacturing cost rates.

9-*

Our two major topics in this chapter include inventory costing options and capacity level issues. We’ll take a brief look at both and we’ll then look more closely first at Inventory costing options.

The inventory costing system that is chosen determines which manufacturing costs are treated as inventoriable costs.

The denominator level capacity choice focuses on the cost allocation base used to set budgeted fixed manufacturing cost rates.

Variable costing—a method of inventory costing in which all variable manufacturing costs (direct and indirect) are included as inventoriable costs. (Also known as direct costing)
Absorption costing—a method of inventory costing in which all variable and fixed manufacturing costs are included as inventoriable costs. You can say that inventory “absorbs” all manufacturing costs.
Throughput costing—only direct materials are capitalized; all other costs are expensed.

9-*

There are three inventory costing choices. They are:

Variable costing—a method of inventory costing in which all variable manufacturing costs (direct and indirect) are included as inventoriable costs. (Also known as direct costing though that is somewhat imprecise since the method includes variable manufacturing overhead as an inventoriable cost.)

Absorption costing—a method of inventory costing in which all variable and fixed manufacturing costs are included as inventoriable costs. You can say that inventory “absorbs” all manufacturing costs.

Throughput costing—only direct materials are capitalized; all other costs are expensed.

Operating income will differ between absorption and variable costing.
The amount of the difference represents the amount of fixed manufacturing costs capitalized as inventory under absorption costing and expensed as a period cost under variable costing.
If inventory levels change, operating income will differ between the two methods because of the difference in accounting for fixed manufacturing costs.

9-*

If inventory levels change, operating income will differ between the two methods because of the difference in accounting for fixed manufacturing costs.

The amount of the difference represents the amount of fixed manufacturing costs capitalized as inventory under absorption costing, and expensed as a period costs under variable costing.

9-*

This Exhibit highlights the differences between the two methods. Panel A calculates operating income under variable costing and panel B under absorption costing.

The variable costing format uses the contribution margin format introduced in chapter 3 while the absorption-costing income statement uses the gross margin format introduced in chapter 2.

The distinction between variable costs and fixed costs is central to variable costing and is highlighted in the contribution margin format.

Similarly, the distinction between manufacturing and nonmanufacturing costs is central to absorption costing and it is highlighted by the gross-margin format. Exhibit 9-1 page 332

9-*

In this exhibit, we have two years of income statements under each costing system. Panel A again showing Variable costing and Panel B Absorption costing. The values you see for 2014 are the same as the previous slide.

There is a similarity between these two years but note the following in 2015:

Fixed cost rate of $135 is based on a budgeted denominator capacity level of 8,000
In 2015, production was only 5,000 creating a production volume variance of $135 x 3000 or $405,000
Under variable costing, fixed costs are expensed as incurred and no production volume variance exists.
Exhibit 9-2 page 334

9-*

Here we have a summary of the comparative income effects between the two costing systems including explanatory comments. Exhibit 9-3 page 337

Absorption costing is the required inventory method for external financial reporting in most countries. Also preferred because:

It is cost-effective and less confusing.
It can help prevent managers from taking actions that make their performance measure look good but that hurt the income they report to shareholders.
It measures the cost of all manufacturing resources (variable or fixed) necessary to produce inventory.

9-*

Absorption costing is the required inventory method for external financial reporting in most countries. Also preferred because:

It is cost-effective and less confusing
It can help prevent managers from taking actions that make their performance measure look good
It measures the cost of all manufacturing resources (variable or fixed) necessary to produce inventory

One unfavorable attribute of absorption costing is that it enables managers to increase margins and, therefore, operating income, by producing more ending inventory.
Producing for inventory can be justified when rapid growth is forecasted, but should not be undertaken simply to boost profits.
To reduce an undesirable buildup of inventory, companies can use variable costing for internal reporting purposes including performance measurement.

9-*

One unfavorable attribute of absorption costing is that it enables managers to increase margins and, therefore, operating income, by producing more ending inventory.
Producing for inventory can be justified when rapid growth is forecasted, but should not be undertaken simply to boost profits.
To reduce an undesirable buildup of inventory, companies can use variable costing for internal reporting purposes including performance measurement.

To reduce the undesirable effects of absorption costing, management can:

Focus on careful budgeting and inventory planning.
Incorporate an internal carrying charge for inventory
Change (lengthen) the period used to evaluate performance.
Include nonfinancial as well as financial variables in the measures to evaluate performance. (compare ratio of ending/beginning inventory to ratio of units produced/sold)

9-*

To reduce the undesirable effects of absorption costing, management can:

Focus on careful budgeting and inventory planning

Incorporate an internal carrying charge for inventory

Change (lengthen) the period used to evaluate performance

Include nonfinancial as well as financial variables in the measures to evaluate performance (compare ratio of ending/beginning inventory to ratio of units produced/sold)

Throughput costing (super-variable costing) is a method of inventory costing in which only direct material costs are included as inventory costs. All other product costs are treated as period expenses.
Throughput margin equals revenues minus all direct material cost of the goods sold.

9-*

Some managers believe that even variable costing promotes an excessive amount of costs being inventoried.

Throughput costing (super-variable costing) is a method of inventory costing in which only direct material costs are included as inventory costs. All other product costs are treated as period expenses.

Throughput margin equals revenues minus all direct material cost of the goods sold

9-*

Here we see an income statement using throughput costing.

As is shown, only direct materials are subtracted from revenues to calculate throughput margin. All other costs (variable or fixed) are subtracted to obtain operating income. Exhibit 9-5 page 341

9-*

In this slide, we have a comparison of variable and absorption costing as would be calculated under the actual costing, normal costing or standard costing systems.

As a result, we have a combination of six alternative inventory-costing systems.

Accountants, and others, disagree about which costs should be expensed and which inventoried.

For external reporting to shareholders, companies around the globe tend to follow the generally accepted accounting principle that all manufacturing costs are inventoriable. Exhibit 9-6 page 342

We have concluded the discussion of inventory costing and will begin capacity analysis.

Given a firm’s level of spending on fixed manufacturing costs, what capacity level should managers and accountants use to compute the fixed manufacturing cost per unit?

9-*

We have concluded the discussion of inventory costing and will begin capacity analysis.

Recall from an earlier slide that the key question regarding capacity concepts is: Given a firm’s level of spending on fixed manufacturing costs, what capacity level should managers and accountants use to compute the fixed manufacturing cost per unit?

Spending on fixed manufacturing costs enables firms to obtain the scale or capacity needed to satisfy the expected market demand from customers. Determining the “right” amount of spending, or the appropriate level of capacity, is one of the most strategic and most difficult decisions managers face.

9-*

The key question regarding denominator level capacity is this:

Given a firm’s level of spending on fixed manufacturing costs, what capacity level should managers and accountants use to compute the fixed manufacturing cost per unit?

Too much capacity means firms will incur the cost of unused capacity; having too little means that demand from some customers may be unfulfilled.

9-*

Too much capacity means firms will incur the cost of unused capacity; having too little means that demand from some customers may be unfulfilled.

The choice of the capacity level used to allocate budgeted fixed manufacturing costs to products can greatly affect operating income.
Four different capacity levels can be used as the denominator to compute the budgeted fixed manufacturing cost rate:
Theoretical capacity
Practical capacity
Normal capacity utilization
Master-budget capacity utilization

9-*

The choice of the capacity level used to allocate budgeted fixed manufacturing costs to products can greatly affect operating income.

Four different capacity levels can be used as the denominator to compute the budgeted fixed manufacturing cost rate:

Theoretical capacity

Practical capacity

Normal capacity utilization

Master-budget capacity utilization

Theoretical capacity is the level of capacity based on producing at full efficiency all the time.
It is theoretical in the sense that it does not allow for any slowdowns due to plant maintenance, shutdown periods or interruptions because of downtime.
In the real world, theoretical capacity levels are unattainable but they represent the ideal goal of capacity utilization a company can aspire to.

9-*

Theoretical capacity is the level of capacity based on producing at full efficiency all the time.

It is theoretical in the sense that it does not allow for any slowdowns due to plant maintenance, shutdown periods or interruptions because of downtime.

In the real world, theoretical capacity levels are unattainable but they represent the ideal goal of capacity utilization a company can aspire to.

Practical capacity is the level of capacity that reduces theoretical capacity by considering unavoidable operating interruptions like maintenance and holiday shutdowns.

Engineering and human resource factors are important when estimating theoretical or practical capacity.

9-*

Practical capacity is the level of capacity that reduces theoretical capacity by considering unavoidable operating interruptions like maintenance and holiday shutdowns.

Engineering and human resource factors are important when estimating theoretical or practical capacity.

Both theoretical and practical capacity measure capacity levels in terms of what a plant can supply.

Normal Capacity Utilization and Master-Budget Capacity Utilization, in contrast, measure capacity levels in terms of demand for the output of the plant.

It is possible and even likely that budgeted demand will be below production capacity levels.

9-*

Capacity can be measured in terms of output capable of being supplied or in terms of demand on the product.

Both theoretical and practical capacity measure capacity levels in terms of what a plant can supply.

Normal Capacity Utilization and Master-Budget Capacity Utilization, in contrast, measure capacity levels in terms of demand for the output of the plant.

Normal capacity utilization is the level of capacity utilization that satisfies average customer demand over a period that is long enough to consider seasonal, cyclical and trend factors.
Master-budget capacity utilization is the level of capacity utilization that managers expect for the current budget period which is typically one year.

9-*

Turning now to the next two types of capacity:

Normal capacity utilization is the level of capacity utilization that satisfies average customer demand over a period that is long enough to consider seasonal, cyclical and trend factors.

Master-budget capacity utilization is the level of capacity utilization that managers expect for the current budget period which is typically one year.

These two capacity-utilization levels can differ significantly in industries that face cyclical demand patterns.

The choice of capacity level can have a huge impact on budgeted fixed manufacturing cost per unit as shown here:

9-*

As you can see on this chart, choosing between the capacity levels for the denominator in the calculation of the budgeted fixed manufacturing cost rate has a tremendous impact on the overall fixed manufacturing cost per unit – in this example, from $60 per unit to $135 per unit.

Remember too, that you’ll be adding this cost per unit to the variable manufacturing cost per unit to obtain total budgeted manufacturing cost per unit. How should a company choose the capacity level to use?

From page 345.

The choice of denominator-level capacity to use may differ based on the purpose for which the choice is being made. Some of those purposes include:

Product costing and capacity management

Pricing

Performance evaluation

External reporting

Tax requirements

9-*

Having discussed the various capacity levels, we now turn to a discussion of how to choose the appropriate level for a particular purpose. We’ll review the process for 5 different purposes, including:

Product costing and capacity management
Pricing
Performance evaluation
External reporting
Tax requirements

For product costing and capacity management, using practical capacity as the denominator level sets the cost of capacity at the cost of supplying the capacity, regardless of demand for the capacity.
Highlighting the cost of capacity acquired but not used directs managers’ attention toward managing unused capacity.
In contrast, using either of the capacity levels based on demand hides the amount of unused capacity.

9-*

For product costing and capacity management, using practical capacity as the denominator level sets the cost of capacity at the cost of supplying the capacity, regardless of demand for the capacity.

Highlighting the cost of capacity acquired but not used directs managers’ attention toward managing unused capacity.

In contrast, using either of the capacity levels based on demand hides the amount of unused capacity.

To understand the best choice for pricing decisions, let’s look first at the downward demand spiral for a company. It is the continuing reduction in the demand for its products that occurs when competitor prices are not met, demand drops further and the fixed costs are spread over fewer units, resulting in greater and greater costs per unit.
Practical capacity, by contrast, is a more stable measure. It calculates the fixed cost rate based on capacity available rather than capacity used to meet demand.

9-*

The downward demand spiral for a company is important to understand before determining the best capacity level for pricing decisions. It is the continuing reduction in the demand for its products that occurs when competitor prices are not met, demand drops further and the fixed costs are spread over fewer units, resulting in greater and greater costs per unit.

Practical capacity, by contrast, is a more stable measure. It calculates the fixed cost rate based on capacity available rather than capacity used to meet demand.

Unused capacity adds costs to products.
Mid-level managers have no control over those costs but do have control over prices.
Should the marketing managers be held accountable for the manufacturing overhead costs unrelated to their potential customer base? (practical capacity vs master-budget capacity utilization)
Where there are large differences between practical capacity and master-budget capacity utilization, that difference is often classified as planned unused capacity.

9-*

For performance evaluations, it is often best to use master-budget capacity utilization since that most closely holds managers accountable for what they have control over.

In this case, where there are large differences between practical capacity and master-budget capacity utilization, that difference is often classified as planned unused capacity and is shown as a separate cost on the financial statements.

The magnitude of the favorable/unfavorable production-volume variance under absorption costing is affected by the choice of the denominator level used to calculate the budgeted fixed manufacturing cost per unit.
Recall from Chapter 4 that the production-volume variance can be disposed of three ways:
Adjusted allocation-rate approach (recalculate at year end)
Proration approach (spread to Work-In-Process, Finished Goods and Cost of Goods Sold)
Write-off to Cost of Goods Sold.

9-*

The production-volume variance will be affected by the choice of denominator level used to calculate the budgeted fixed manufacturing cost per unit. Recall from Chapter 4 that the production volume variance can be disposed of three ways:

Adjusted allocation-rate approach (recalculate at year end)

Proration approach (spread to Work-In-Process, Finished Goods and Cost of Goods Sold)

Write-off to Cost of Goods Sold

The objective in choosing the method to dispose of the production-volume variance is to write-off the portion of the variance that represents the cost of capacity not used to support the production of output during the period.

That objective is also helpful in determining which capacity should be used to develop the budgeted fixed manufacturing cost per unit.

9-*

The objective to choosing the method to write-off the production-volume variance is to write-off the portion of that variance that represents the cost of capacity not used during the period to support production of output. That objective should also influence the capacity that is used to develop the budgeted fixed manufacturing cost per unit.

The IRS permits the use of practical capacity to calculate budgeted fixed manufacturing costs per unit AND allows for the write-off of the production-volume variance generated this way.
The tax benefit can be significant

9-*

The IRS permits the use of practical capacity to calculate budgeted fixed manufacturing costs per unit AND allows for the write-off of the production-volume variance generated this way.

The tax benefit can be significant.

A few other factors should be taken into account when planning capacity levels and in deciding how best to control and assign capacity costs. They are:

Difficulty of obtaining demand-side denominator-level concepts

Difficulty of forecasting fixed manufacturing costs

Capacity issues for nonmanufacturing parts of the value chain

In ABC Costing, a capacity level must be chosen for each cost driver

9-*

A few other factors should be taken into account when planning capacity levels and in deciding how best to control and assign capacity costs. They are:

Difficulty of obtaining demand-side denominator-level concepts
Difficulty of forecasting fixed manufacturing costs
Capacity issues for nonmanufacturing parts of the value chain
In ABC Costing, a capacity level must be chosen for each cost driver

9-*

9-16 (30 min.) Variable and absorption costing, explaining operating -income differences.

1. Key inputs for income statement computations are

April May

Beginning inventory

Production

Goods available for sale

Units sold

Ending inventory

500

350

150

400

550

520

The budgeted fixed cost per unit and budgeted total manufacturing cost per unit under absorption

costing are

April May

(a) Budgeted fixed manufacturing costs

(b) Budgeted production

(d) Budgeted variable manufacturing cost per unit

(e) = (c) + (d) Budgeted total manufacturing cost per unit

$2,000,000

500

$4,000

$10,000

$14,000

$2,000,000

500

$4,000

$10,000

$14,000

(a) Variable costing

April 2014 May 2014

Revenues

$8,400,000 $12,480,000

Variable costs

Beginning inventory $ 0 $1,500,000

Variable manufacturing costs

5,000,000 4,000,000

Cost of goods available for sale 5,000,000 5,500,000

Deduct ending inventory

(1,500,000) (300,000)

Variable cost of goods sold 3,500,000 5,200,000

Variable operating costs

1,050,000 1,560,000

Total variable costs 4,550,000 6,760,000

Contribution margin 3,850,000 5,720,000

Fixed costs

Fixed manufacturing costs 2,000,000 2,000,000

Fixed operating costs 600,000 600,000

Total fixed costs 2,600,000 2,600,000

Operating income $1,250,000 $3,120,000

$24,000 × 350; $24,000 × 520

$10,000 × 150; $10,000 × 30

$10,000 × 500; $10,000 × 400

$3,000 × 350; $3,000 × 520

(b) Absorption costing

April 2014 May 2014

Revenues

$8,400,000

$12,480,00

Cost of goods sold

Beginning inventory $ 0 $2,100,000

Variable manufacturing costs

5,000,000 4,000,000

Allocated fixed manufacturing

costs

2,000,000 1,600,000

Cost of goods available for sale 7,000,000 7,700,000

Deduct ending inventory

(2,100,000) (420,000)

Adjustment for prod.-vol.

variance

400,000

Cost of goods sold 4,900,000

7,680,000

Gross margin 3,500,000 4,800,000

Operating costs

Variable operating costs

1,050,000 1,560,000

Fixed operating costs 600,000 600,000

Total operating costs 1,650,000

2,160,000

Operating income $1,850,000

2,640,000

$24,000 × 350; $24,000 × 520

$14,000 × 150; $14,000 × 30

$10,000 × 500; $10,000 × 400

$2,000,000 – $2,000,000; $2,000,000 – $1,600,000

$4,000 × 500; $4,000 × 400

$3,000 × 350; $3,000 × 520

Absorption-costingoperating income

–

Variable-costingoperating income

Fixed manufacturing costsin ending inventory

–

Fixed manufacturing costsin beginning inventory

April:

$1,850,000 – $1,250,000 = ($4,000 × 150) – ($0)

$600,000 = $600,000

May:

$2,640,000 – $3,120,000 = ($4,000 × 30) – ($4,000 × 150)

– $480,000 = $120,000 – $600,000

– $480,000 = – $480,000

The difference between absorption and variable costing is due solely to moving fixed

manufacturing costs into inventories as inventories increase (as in April) and out of inventories as

they decrease (as in May).

9-17 (20 min.) Throughput costing (continuation of Exercise 9 -16).

April 2014 May 2014

Revenues

$8,400,000

$12,480,00

Direct material cost of goods sold

Beginning inventory

Direct materials in goods

manufactured

$ 0

3,350,000

$1,005,000

2,680,000

Cost of goods available for

sale

Deduct ending inventory

3,350,000

(1,005,000)

3,685,000

(201,000)

Total direct material cost of goods sold

Throughput margin

Other costs

2,345,000

6,055,000

3,484,000

8,996,000

Manufacturing costs 3,650,000

3,320,000

Other operating costs 1,650,000

2,160,000

Total other costs

Operating income

5,300,000

$ 755,000

5,480,000

3,516,000

$24,000 × 350; $24,000 × 520

($3,300 × 400) + $2,000,000

$6,700 × 500; $6,700 × 400

($3,000 × 350) + $600,000

$6,700 × 150; $6,700 × 30

($3,000 × 520) + $600,000

($3,300 × 500) + $2,000,000

2. Operating income under:

April May

Variable costing

Absorption costing

Throughput costing

$1,250,000

1,850,000

755,000

$3,120,000

2,640,000

3,516,000

In April, throughput costing has the lowest operating income, whereas in May throughput costing

has the highest operating income. Throughput costing puts greater emphasis on sales as the source

of operating income than does either absorption or variable costing .

3. Throughput costing puts a penalty on production without a corresponding sale in the same

period. Costs other than direct materials that are variable with respect to production are expensed

in the period of incurrence, whereas under variable costing they would be capitalized. As a result,

throughput costing provides less incentive to produce for inventory than either variable costing or

absorption costing.

BUS 224/syllabus/BUS 224 - Syllabus - 382.docx

Royal Commission for Jubail and Yanbu

FX-ACA-057

Issue 0 Rev. 0

April 21, 2015

Jubail University College

Academic Affairs Department

Department of Business Administration

COURSE SYLLABUS SEMESTER 382

Course Code & Number:

BUS 224

Course Title:

Cost Accounting

Prerequisite:

Accounting 2 [BUS 222]

Section Number(s):

201, 202 & 203

Instructor:

Dr. Abirami Devi Sivakumar

Office Location:

Room 422

Office Hours:

Day	Periods
Sun	4,5,6,7,8
Mon	3
Tue	3
Wed	3,4,5,8
Thurs	1,2,4,5,7

Class Hours:

Day	201	202	203
Sun	1,2
Mon		1,2	4,5
Tue
Wed	7		6
Thurs		3

Instructor’s Office Phone:

03-3459000 Extension: 3642

Instructor’s Email:

[email protected]

Course Description	One of the branches of Accounting, Cost Accounting deals with finding, deciding and analyzing the cost aspect of the business. It forms a decision making tool for the management to take all types of decision in production, Operation, Financing, Staffing and other functional area of management which needs to consider the cost. This course deals in the theoretical understanding of the concepts and logical application of cost accounting methods in business decisions. In addition, the students should appreciate and enjoy this course as an independent subject having its own body of knowledge.
Course Objectives	Upon successful completion of this course, students will be able to make professional and independent costing and pricing decisions related to manufacturing, merchandising, and service organizations’ activities. They will develop analytical skills that enable them to solve managerial problems independently and apply the conceptual tools to concrete cost management challenges.
Methods of Instruction	Lecture and Presentation, Case Study, Industrial Visit and Student Individual and Team Projects.
Required Textbooks	Cost Accounting : A Managerial Emphasis; Horngren, Datar & Foster; 15th Edition, 2015; Prentice Hall; ISBN 13:978-1-292-01822-5
Proposed Websites	www.pearsonhighered.com
Grading Scheme	Quizzes 20% Assignments 20% Mid Term Examination 20% Final Examination 40% Total 100%

Course Outline
Week	Topics & Activities	Notes
1 -2	The Manager and Management Accounting: Introduction to the course, Management Accounting, Financial Accounting and Cost Accounting, Value chain analysis, Supply chain analysis, key success factors, Cost Benefit Approach, Line And Staff Relationship, Professional Ethics	Chapter 1
3	An Introduction to Cost Terms and Purposes: Costs and Cost terminology, Direct cost Indirect cost, Variable cost and Fixed cost, Cost Drivers, Relevant Range, Total cost and Unit cost, Inventoriable cost, Period cost, Prime Cost, Conversion cost, Overtime Premium And Idle Costs.	Chapter 2
4-5	Master Budget and Responsibility Accounting: Strategic Plans and Operating Plans, Budgeting Cycle and Master Budgets, Advantages and Challenges of Budgeting, Steps in developing Budgets, Kaizen Budgeting Quiz 1 (WEEK 4)	Chapter 6
6-7	Flexible Budgets, Direct Cost Variance and Management Control: Use of Variances, Static Budget and Flexible Budgets, Variances. Sales Volume Variance, Flexible Budget Variance, Price Variances and Efficiency Variances for Direct Costs inputs.	Chapter 7
8	Mid Term Examination (20 %)
9	Inventory Costing and Capacity Analysis: Variable Costing and Absorption Costing, Undesirable Buildup of Inventory	Chapter 9
10-11	Allocation of Support Department Costs and Common Costs and Revenues: Allocating Cost of a support Department to Operating Department, Single Rate and Dual Rate methods, Demand based and supply based Allocations. Quiz 2	Chapter 15
12-13	Cost Allocation: Joint Products and Byproducts: Joint Costs, approaches to allocating Joint Costs, Sales Value at Split off Method, Physical Measure Method, Net Realizable Value (NRV) Method, Not allocating joint cost, Accounting for byproducts, production method, sales method Quiz2 (WEEK 12)	Chapter 16
13	Process Costing: Calculation of product cost with or without ending inventory, Weighted Average method, and FIFO method. Hybrid Costing System, Operation Costing System.	Chapter 17
14	Inventory Management, JIT and Simplified Costing Methods: Inventory management in retail Organizations, Costs associated with Goods for Sales, EOQ Decision Models, Safety Stock, JIT and MRP and ERP, Backflush Costing, Lean Accounting.	Chapter 20
15	Revision
16-17	FINAL EXAMINATION (40 %)

Jubail University College Policies

Attendance

1. Attending at punctual time: Present otherwise the student is absent.

2. Late attendance 0 < 5 minutes: is late

3. Late ≥ 5 minutes: is absent

Notes:

(i) Every 3 late are counted as 1 absent

(ii) Every × total semester contact hours + 1 is DN

Grading

1. Quality point: is the result of multiplying the credit hours by the grading points.

2. Semester GPA: is the result of dividing total quality points achieved in all courses at that semester by total graded credit hours of all courses in that semester.

3. Cumulative GPA in a semester: is the sum of total quality points achieved in all courses up to that semester divided by the total credit hours graded for all courses up to that semester

Plagiarism & Cheating

1. Cheating is a serious offence and will be punished by the JUC.

2. Talking, looking at your colleagues’ exam papers or any other suspicious act is considered cheating during exam.

3. Student will fail the subject if caught cheating.