Answer question

Cases for Management Decision-Making

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Case Overview

This case is the fi rst in a series of four cases that presents a business situation in which a traditional retailer decides to employ Internet technology to expand its sales opportunities. It requires the student to employ traditional job order cost- ing techniques and then requests an evaluation of the result- ing product costs. (Related to Chapter 15, Job Order Costing.)

This case focuses on decision-making benefi ts of activity- based costing relative to the traditional approach. It also offers an opportunity to discuss the cost/benefit trade-off between simple ABC systems versus refined systems, and the potential benefit of using capacity rather than expected sales when allocating fixed overhead costs. (Related to Chapter 17, Activity-Based Costing.)

This case illustrates the importance of proper transfer pric- ing for decision-making as well as performance evaluation. The student is required to evaluate profi tability using two different transfer pricing approaches and comment on the terms of the proposed transfer pricing agreement. (Related to Chapter 21, Pricing.)

This case is set in an environment in which the company is searching for new opportunities for growth. It requires evalu- ation of a proposal based on initial estimates as well as sen- sitivity analysis. It also requires evaluation of the underlying assumptions used in the analysis. (Related to Chapter 25, Planning for Capital Investments.)

This comprehensive case is designed to be used as a cap- stone activity at the end of the course. It deals with a not-for- profi t service company. The case involves many managerial accounting issues that would be common for a start-up busi-ness. (Related to Chapter 18, Cost-Volume-Profit; Chapter 20, Incremental Analysis; and Chapter 22, Budgetary Planning.)

This case focuses on setting up a new business. In planning for this new business, the preparation of budgets is empha- sized. In addition, an understanding of cost-volume-profit relationships is required. (Related to Chapter 18, Cost-Volume- Profit, and Chapter 22, Budgetary Planning.)

This comprehensive case involves fi nding the cost for a given product. In addition, it explores cost-volume-profi t relationships. It requires the preparation of a set of budgets. (Related to Chapter 14, Managerial Accounting; Chapter 18, Cost-Volume-Profit; Chapter 22, Budgetary Planning; Chapter 23, Budgetary Control and Responsibility Accounting; Chapter 24, Standard Costs and Balanced Scorecard; and Chapter 25, Planning for Capital Investments.)

CA-2

Suggested Uses of Cases

CASE 1 Greetings Inc.: Job Order Costing

CASE 2 Greetings Inc.: Activity-Based Costing

CASE 3 Greetings Inc.: Transfer Pricing Issues

CASE 4 Greetings Inc.: Capital Budgeting

CASE 5 Auburn Circular Club Pro Rodeo Roundup

CASE 6 Sweats Galore, Inc.

CASE 7 Armstrong Helmet Company

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Case 1

Greet ings Inc.

Greetings Inc.: Job Order Costing

Developed by Thomas L. Zeller, Loyola University Chicago, and Paul D. Kimmel, University of Wisconsin–Milwaukee

The Business Situation

Greetings Inc. has operated for many years as a nationally recognized retailer of greeting cards and small gift items. It has 1,500 stores throughout the United States located in high-traffi c malls.

As the stock price of many other companies soared, Greetings’ stock price remained fl at. As a result of a heated 2013 shareholders’ meeting, the president of Greetings, Robert Burns, came under pressure from shareholders to grow Greet- ings’ stock value. As a consequence of this pressure, in 2014 Mr. Burns called for a formal analysis of the company’s options with regard to business opportunities.

Location was the fi rst issue considered in the analysis. Greetings stores are located in high-traffi c malls where rental costs are high. The additional rental cost was justifi ed, however, by the revenue that resulted from these highly visible locations. In recent years, though, the intense competition from other stores in the mall selling similar merchandise has become a disadvantage of the mall loca- tions.

Mr. Burns felt that to increase revenue in the mall locations, Greetings would need to attract new customers and sell more goods to repeat customers. In order to do this, the company would need to add a new product line. However, to keep costs down, the product line should be one that would not require much addition- al store space. In order to improve earnings, rather than just increase revenues, Greetings would have to carefully manage the costs of this new product line.

After careful consideration of many possible products, the company’s man- agement found a product that seemed to be a very good strategic fi t for its exist- ing products: high-quality unframed and framed prints. The critical element of this plan was that customers would pick out prints by viewing them on wide- screen computer monitors in each store. Orders would be processed and shipped from a central location. Thus, store size would not have to increase at all. To offer these products, Greetings established a new e-business unit called Wall Décor. Wall Décor is a “profi t center”; that is, the manager of the new business unit is responsible for decisions affecting both revenues and costs.

Wall Décor was designed to distribute unframed and framed print items to each Greetings store on a just-in-time (JIT) basis. The system works as fol- lows: The Wall Décor website allows customers to choose from several hundred prints. The print can be purchased in various forms: unframed, framed with a steel frame and no matting, or framed with a wood frame and matting. When a

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CA-4 case 1 Cases for Management Decision-MakingGreet ings customer purchases an unframed print, it is packaged and shipped the same day from Wall Décor. When a customer purchases a framed print, the print is framed at Wall Décor and shipped within 48 hours.

Each Greetings store has a computer linked to Wall Décor’s Web server so Greetings’ customers can browse the many options to make a selection. Once a selection is made, the customer can complete the order immediately. Store em- ployees are trained to help customers use the website to shop and to complete their purchases. The advantage to this approach is that each Greetings store, through the Wall Décor website, can offer a wide variety of prints, yet the indi- vidual Greetings stores do not have to hold any inventory of prints or framing materials. About the only cost to the individual store is the computer and high- speed line connection to Wall Décor. The advantage to the customer is the wide variety of unframed and framed print items that can be conveniently purchased and delivered to the home or business, or to a third party as a gift.

Wall Décor uses a traditional job order costing system. Operation of Wall Décor would be substantially less complicated, and overhead costs would be substantially less, if it sold only unframed prints. Unframed prints require no additional processing, and they can be easily shipped in simple protective tubes. Framing and matting requires the company to have multiple matting colors and frame styles, which requires considerable warehouse space. It also requires skilled employees to assemble the products and more expensive packaging procedures.

Manufacturing overhead is allocated to each unframed or framed print, based on the cost of the print. This overhead allocation approach is based on the as- sumption that more expensive prints will usually be framed and therefore more overhead costs should be assigned to these items. The predetermined overhead rate is the total expected manufacturing overhead divided by the total expected cost of prints. This method of allocation appeared reasonable to the account- ing team and distribution fl oor manager. Direct labor costs for unframed prints consist of picking the prints off the shelf and packaging them for shipment. For framed prints, direct labor costs consist of picking the prints, framing, matting, and packaging.

The information in Illustration CA 1-1 for unframed and framed prints was collected by the accounting and production teams. The manufacturing overhead budget is presented in Illustration CA 1-2.

Illustration CA 1-1 Information about prints and framed items for Wall Décor

Unframed Steel-Framed Print, Wood-Framed Print, Print No Matting with Matting

Volume—expected units 80,000 15,000 7,000 sold

Cost Elements

Direct materials Print (expected average $12 $16 $20

cost for each of the three categories)

Frame and glass $4 $6 Matting $4 Direct labor

Picking time 10 minutes 10 minutes 10 minutes Picking labor rate/hour $12 $12 $12 Matting and framing time 20 minutes 30 minutes Matting and framing

rate/hour $21 $21

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Instructions Use the information in the case and your reading from Chapters 14 and 15 of the text to answer each of the following questions.

1. Defi ne and explain the meaning of a predetermined manufacturing overhead rate that is applied in a job order costing system.

2. What are the advantages and disadvantages of using the cost of each print as a manu- facturing overhead cost driver?

3. Using the information in Illustrations CA 1-1 and CA 1-2, compute and interpret the predetermined manufacturing overhead rate for Wall Décor.

4. Compute the product cost for the following three items. (a) Lance Armstrong unframed print (base cost of print $12). (b) John Elway print in steel frame, no mat (base cost of print $16). (c) Lambeau Field print in wood frame with mat (base cost of print $20).

5. (a) How much of the total overhead cost is expected to be allocated to unframed prints? (b) How much of the total overhead cost is expected to be allocated to steel-framed

prints? (c) How much of the total overhead cost is expected to be allocated to wood-framed

prints? (d) What percentage of the total overhead cost is expected to be allocated to unframed

prints?

6. Do you think the amount of overhead allocated to the three product categories is rea- sonable? Relate your response to this question to your fi ndings in previous questions.

7. Anticipate business problems that may result from allocating manufacturing overhead based on the cost of the prints.

Illustration CA 1-2 Manufacturing overhead budget for Wall Décor

Manufacturing Overhead Budget

Supervisory salaries $100,000 Factory rent 130,200 Equipment rent (framing and matting equipment) 50,000 Utilities 20,000 Insurance 10,000 Information technology 50,000 Building maintenance 11,000 Equipment maintenance 4,000

Budgeted total manufacturing overhead costs $375,200

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Case 2

Greet ings Inc.

Greetings Inc.: Activity-Based Costing

Developed by Thomas L. Zeller, Loyola University Chicago, and Paul D. Kimmel, University of Wisconsin–Milwaukee

The Business Situation

Mr. Burns, president of Greetings Inc., created the Wall Décor unit of Greetings three years ago to increase the company’s revenue and profi ts. Unfortunately, even though Wall Décor’s revenues have grown quickly, Greetings appears to be losing money on Wall Décor. Mr. Burns has hired you to provide consulting services to Wall Décor’s management. Your assignment is to make Wall Décor a profi table business unit.

Your fi rst step is to talk with the Wall Décor work force. From your conver- sations with store managers you learn that the individual Greetings stores are very happy with the Wall Décor arrangement. The stores are generating additional sales revenue from the sale of unframed and framed prints. They are especially enthusiastic about this revenue source because the online nature of the product enables them to generate revenue without the additional cost of carrying inven- tory. Wall Décor sells unframed and framed prints to each store at product cost plus 20%. A 20% markup on products is a standard policy of all Greetings inter- company transactions. Each store is allowed to add an additional markup to the unframed and framed print items according to market pressures. That is, the sell- ing price charged by each store for unframed and framed prints is determined by each store manager. This policy ensures competitive pricing in the respective store locations, an important business issue because of the intense mall competition.

While the store managers are generally happy with the Wall Décor products, they have noted a signifi cant difference in the sales performance of the unframed prints and the framed prints. They fi nd it diffi cult to sell unframed prints at a competitive price. The price competition in the malls is very intense. On average, stores fi nd that the profi ts on unframed prints are very low because the cost for unframed prints charged by Wall Décor to the Greetings stores is only slightly below what competing stores charge their customers for unframed prints. As a result, the profi t margin on unframed prints is very low, and the overall profi t earned is small, even with the large volume of prints sold. In contrast, stores make a very good profi t on framed prints and still beat the nearest competitor’s price by about 15%. That is, the mall competitors cannot meet at a competi- tive price the quality of framed prints provided by the Greetings stores. As a re- sult, store managers advertise the lowest prices in town for high-quality framed prints. One store manager referred to Wall Décor’s computer on the counter as a “cash machine” for framed prints and a “lemonade stand” for unframed prints.

In a conversation with the production manager, you learned that she believes that the relative profi tability of framed and unframed prints is distorted because

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of improper product costing. She feels that the costs provided by the company’s traditional job order costing system are inaccurate. From the very beginning, she has carefully managed production and distribution costs. She explains, “Wall Décor is essentially giving away expensive framed prints, and it appears that it is charging the stores too much for unframed prints.” In her offi ce she shows you her own product costing system, which supports her point of view.

Your tour of the information technology (IT) department provided additional insight as to why Wall Décor is having fi nancial problems. You discovered that to keep the website running requires separate computer servers and several infor- mation technology professionals. Two separate activities are occurring in the technology area. First, purchasing professionals and IT professionals spend many hours managing thousands of prints and frame and matting materials. Their tasks include selecting the prints and the types of framing material to sell. They also must upload, manage, and download prints and framing material onto and off of the website. The IT staff tells you much of their time is spent with framing and matting material. Only a highly skilled IT professional can properly scan a print and load it up to the site so that it graphically represents what the print will look like when properly matted and framed.

In addition, you discover that a different team of IT professionals is dedicated to optimizing the operating performance of the website. These costs are classifi ed as manufacturing overhead because a substantial amount of work is required to keep the site integrated with purchasing and production and to safeguard Wall Décor’s assets online. Most time-consuming is the effort to develop and maintain the site so that customers can view the prints as they would appear either un- framed or framed and matted.

A discussion with the IT professionals suggests that the time spent develop- ing and maintaining the site for the unframed prints is considerably less than that required for the framed prints and in particular for the framed and matted prints. Developing and maintaining a site that can display the unframed prints is relatively straightforward. It becomes more complicated when the site must allow the customer to view every possible combination of print with every type of steel frame, and immensely more complicated when one considers all of the possible wood frames and different matting colors. Obviously, a very substantial portion of the IT professionals’ time and resources is required to present the over 1,000 different framing and matting options.

Based on your preliminary fi ndings, you have decided that the company’s ability to measure and evaluate the profi tability of individual products would be improved if the company employed an activity-based costing (ABC) system. As a fi rst step in this effort, you compiled a list of costs, activities, and values. Your work consisted of taking the original manufacturing overhead cost ($375,200, provided in Case 1) and allocating the costs to activities. You identifi ed four activities: picking prints; inventory selection and management (includes general management and overhead); website optimization; and framing and matting cost (includes equipment, insurance, rent, and supervisor’s salary).

The fi rst activity is picking prints. The estimated overhead related to this activity is $30,600. The cost driver for this activity is the number of prints. It is expected that the total number of prints will be 102,000. This is the sum of 80,000 unframed, 15,000 steel-framed, and 7,000 wood-framed.

Illustration CA 2-1 Information for activity 1Estimated Expected Use of

Activity Cost Driver Overhead Cost Driver

Picking prints Number of prints $30,600 (80,000 � 15,000 � 7,000) � 102,000 prints

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The second activity is inventory selection and management. The estimated overhead related to this activity is $91,700. The cost driver for this activity is the number of components per print item. An unframed print has one component, a steel-framed print has two components (the print and the frame), and a wood- framed print has three components (the print, the mat, and the frame). The total number of components is expected to be 131,000.

Illustration CA 2-2 Information for activity 2 Estimated Expected Use of

Activity Cost Driver Overhead Cost Driver

Inventory Number of $91,700 Prints: 80,000 components selection and components: Print and frame: 15,000 3 2 5

management Print (1) 30,000 components Print and frame (2) Print, mat, and frame: Print, mat, and frame (3) 7,000 3 3 5 21,000

components Total 5 131,000 components

Illustration CA 2-3 Information for activity 3 Estimated Expected Use of

Activity Cost Driver Overhead Cost Driver

Website optimization:

Unframed Number of prints $ 25,800 Unframed prints: at capacity 100,000 print

capacity Framed Number of prints $103,200 Framed and/or

at capacity matted prints: 25,000 print capacity (16,000

steel; 9,000 wood)

The third activity is website optimization. The total overhead cost related to website optimization is expected to be $129,000. It was diffi cult to identify a cost driver that directly related website optimization to the products. In order to re- fl ect the fact that the majority of the time spent on this activity related to framed prints, you fi rst split the cost of website optimization between unframed prints and framed prints. Based on your discussion with the IT professionals, you deter- mined that they spend roughly one-fi fth of their time developing and maintain- ing the site for unframed prints, and the other four-fi fths of their time on framed prints, even though the number of framed prints sold is substantially less than the number of unframed prints. As a consequence, you allocated $25,800 of the over- head costs related to website optimization to unframed prints and $103,200 to framed prints. You contemplated having three categories (unframed, steel-framed, and wood-framed with matting), but chose not to add this additional refi nement.

Once the $129,000 of the third activity was allocated across the two broad product categories, the number of prints at operating capacity was used as the cost driver. Note that operating capacity was used instead of expected units sold. The overhead costs related to website optimization are relatively fi xed because the employees are salaried. If a fi xed cost is allocated using a value that varies from period to period (like expected sales), then the cost per unit will vary from period to period. When allocating fi xed costs it is better to use a base that does not vary as much, such as operating capacity. The advantage of using operating capacity as the base is that it keeps the fi xed costs per unit stable over time.

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The fi nal activity is framing and matting. The expected overhead costs related to framing and matting are $123,900. None of this overhead cost should be allo- cated to unframed prints. The costs related to framing and matting are relatively fi xed because the costs relate to equipment and other costs that do not vary with sales volume. As a consequence, like website optimization, you chose to base the cost driver on levels at operating capacity, rather than at the expected sales level. The cost driver is the number of components. Steel-framed prints have two com- ponents (the print and frame), and wood-framed prints have three components (the print, mat, and frame). The total components at operating capacity would be steel frame 32,000 (or 16,000 3 2) and wood frame 27,000 (or 9,000 3 3,000).

Illustration CA 2-4 Information for activity 4Estimated Expected Use of

Activity Cost Driver Overhead Cost Driver

Framing and Number of $123,900 Print and frame: 16,000 3 2 5 matting cost components 32,000 components at capacity (equipment, at capacity Print, mat, and frame: 9,000 3 insurance, rent, 3 5 27,000 components at and supervisory capacity

labor) Total 5 59,000 components

To summarize, the overhead costs and cost drivers used for each product are expected to be:

Illustration CA 2-5 Summary of overhead costs and cost drivers

Steel- Wood- Framed, Framed,

Cost No with Overhead Activity Driver Unframed Matting Matting Total Cost

1. Picking Number of prints prints 80,000 15,000 7,000 102,000 $ 30,600

2. Inventory Number of selection and components management 80,000 30,000 21,000 131,000 91,700

3. Website Number of 100,000 100,000 25,800 optimization prints at

capacity 16,000 9,000 25,000 103,200

4. Framing and Number of matting components

at capacity na 32,000 27,000 59,000 123,900

$375,200

Instructions Answer the following questions.

1. Identify two reasons why an activity-based costing system may be appropriate for Wall Décor.

2. Compute the activity-based overhead rates for each of the four activities.

3. Compute the product cost for the following three items using ABC. (Review Case 1 for additional information that you will need to answer this question.) (a) Lance Armstrong unframed print (base cost of print $12). (b) John Elway print in steel frame, no mat (base cost of print $16). (c) Lambeau Field print in wood frame with mat (base cost of print $20).

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4. In Case 1 for Greetings, the overhead allocations using a traditional volume- based approach were $3.36 for Lance Armstrong, $4.48 for John Elway, and $5.60 for Lambeau Field. The total product costs from Case 1 were Lance Armstrong $17.36, John Elway $33.48, and Lambeau Field $48.10. The overhead allocation rate for unframed prints, such as the unframed Lance Armstrong print in question 3, decreased under ABC compared to the amount of overhead that was allocated under the tradi- tional approach in Case 1. Why is this the case? What are the potential implications for the company?

5. Explain why the overhead cost related to website optimization was fi rst divided into two categories (unframed prints and framed prints) and then allocated based on number of prints.

6. When allocating the cost of website optimization, the decision was made to initially a llocate the cost across two categories (unframed prints and framed prints) rather than three cat- egories (unframed prints, steel-framed prints, and wood-framed prints with matting). Dis- cuss the pros and cons of splitting the cost between two categories rather than three.

7. Discuss the implications of using operating capacity as the cost driver rather than the expected units sold when allocating fi xed overhead costs.

8. (a) Allocate the overhead to the three product categories (unframed prints, steel- framed prints, and wood-framed prints with matting), assuming that the estimate of the expected units sold is correct and the actual amount of overhead incurred equaled the estimated amount of $375,200.

(b) Calculate the total amount of overhead allocated. Explain why the total overhead of $375,200 was not allocated, even though the estimate of sales was correct. What are the implications of this for management?

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Case 3

Greet ings Inc.

Greetings Inc.: Transfer Pricing Issues

Developed by Thomas L. Zeller, Loyola University Chicago, and Paul D. Kimmel, University of Wisconsin–Milwaukee

The Business Situation

Two years ago, prior to a major capital-budgeting decision (see Case 4), Robert Burns, the president of Greetings Inc., faced a challenging transfer pricing issue. He knew that Greetings store managers had heard about the ABC study (see Case 2) and that they knew a price increase for framed items would soon be on the way. In an effort to dissuade him from increasing the transfer price for framed prints, several store managers e-mailed him with detailed analyses show- ing how framed-print sales had given stores a strong competitive position and had increased revenues and profi ts. The store managers mentioned, however, that while they were opposed to an increase in the cost of framed prints, they were looking forward to a price decrease for unframed prints.

Management at Wall Décor was very interested in changing the transfer pric- ing strategy. You had reported to them that setting the transfer price based on the product costs calculated by using traditional overhead allocation measures had been a major contributing factor to its non-optimal performance.

Here is a brief recap of what happened during your presentation to Mr. Burns and the Wall Décor managers. Mr. Burns smiled during your presentation and graciously acknowledged your excellent activity-based costing (ABC) study and analysis. He even nodded with approval as you offered the following suggestions.

1. Wall Décor should decrease the transfer price for high-volume, simple print items.

2. Wall Décor should increase the transfer price for low-volume, complex framed print items.

3. Your analysis points to a transfer price that maintains the 20% markup over cost.

4. Adoption of these changes will provide Wall Décor with an 11% return on invest- ment (ROI), beating the required 10% expected by Greetings’ board of directors.

5. Despite the objections of the store managers, the Greetings stores must accept the price changes.

Finishing your presentation, you asked the executive audience, “What questions do you have?” Mr. Burns responded as follows.

“Your analysis appears sound. However, it focuses almost exclusively on Wall Décor. It appears to tell us little about how to move forward and benefi t the entire company, especially the Greetings retail stores. Let me explain.

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I am concerned about how individual store customers will react to the price changes, assuming the price increase of framed-print items is passed along to the customer. Store managers will welcome a decrease in the transfer price of unframed prints. They have complained about the high cost of prints from the beginning. With a decrease in print cost, store managers will be able to compete against mall stores for print items at a competitive selling price. In addition, the increase in store traffi c for prints should increase the sales revenue for related items, such as cards, wrapping paper, and more. These are all low-margin items, but with increased sales volume of prints and related products, revenues and profi ts should grow for each store.

Furthermore, store managers will be upset with the increase in the cost of framed prints. Framed prints have generated substantial rev- enues and profi ts for the stores. Increasing the cost of framed prints to the stores could create one of three problems: First, a store manager may elect to keep the selling price of framed-print items the same. The results of this would be no change in revenues, but profi ts would decline because of the increase in cost of framed prints.

Second, a store manager may elect to increase the selling price of the framed prints to offset the cost increase. In this case, sales of framed prints would surely decline and so would revenues and profi ts. In addi- tion, stores would likely see a decline in related sales of other expensive, high-quality, high-margin items. This is because sales data indicate that customers who purchase high-quality, high-price framed prints also purchase high-quality, high-margin items such as watches, jewelry, and cosmetics.

Third, a store manager may elect to search the outside market for framed prints.”

Mr. Burns offered you the challenge of helping him bring change to the company’s transfer prices so that both business units, Greetings stores and Wall Décor, win. From his explanation, you could see and appreciate that setting the transfer price for unframed and framed prints impacts sale revenues and profi ts for related items and for the company overall. You immediately recognized the error in your presentation by simply providing a solution for Wall Décor alone.

You drove home that night thinking about the challenge. You recognized the need and importance of anticipating the reaction of Greetings store customers to changes in the prices of unframed and framed prints. The next day, the marketing team provided you with the following average data.

• For every unframed print sold (assume one print per customer), that cus- tomer purchases related products resulting in $4 of additional profi t.

• For every framed print sold (assume one print per customer), that customer purchases related products resulting in $8 of additional profi t.

• Each Greetings store sets its own selling price for unframed and framed prints. Store managers need this type of fl exibility to be responsive to com- petitive pressures. On average the pricing for stores is as follows: unframed prints $21, steel-framed without matting $50, wood-framed with matting $70.

Instructions Answer each of the following questions.

1. Prepare for class discussion what you think were the critical challenges for Mr. Burns. Recognize that Wall Décor is a profi t center and each Greetings store is a profi t center.

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2. After lengthy and sometimes heated negotiations between Wall Décor and the store managers, a new transfer price was determined that calls for the stores and Wall Décor to split the profi ts on unframed prints 30/70 (30% to the store, 70% to Wall Décor) and the profi ts on framed prints 50/50. The following additional terms were also agreed to: • “Profi ts” are defi ned as the store selling price less the ABC cost. • Stores do not share the profi ts from related products with Wall Décor. • Wall Décor will not seek to sell unframed and framed print items through anyone

other than Greetings. • Wall Décor will work to decrease costs. • Greetings stores will not seek suppliers of prints other than Wall Décor. • Stores will keep the selling price of framed prints as it was before the change in trans-

fer price. On average, stores will decrease the selling price of unframed prints to $20, with an expected increase in volume to 100,000 prints.

Analyze how Wall Décor and the stores benefi ted from this new agreement. In your analysis, fi rst (a) compute the profi ts of the stores and Wall Décor using traditional amounts related to pricing, cost, and a 20% markup on Wall Décor costs. Next, (b) compute the profi ts of the stores and Wall Décor using the ABC cost and negotiated transfer price approach. Finally, (c) explain your fi ndings, linking the overall profi ts for stores and Wall Décor.

The following data apply to this analysis. (Round all calculations to three decimal places.)

Unframed Steel-Framed, Wood-Framed, Print No Matting with Matting

Average selling price by stores before transfer pricing study $21 $50 $70 Average selling price by stores after transfer pricing study $20 $50 $70 Volume at traditional selling price 80,000 15,000 7,000 Volume at new selling price 100,000 15,000 7,000 Wall Décor cost (traditional) $17.36 $33.48 $48.10 ABC cost $15.258 $39.028 $55.328

3. Review the additional terms of the agreement listed in instruction 2 above. In each case, state whether the item is appropriate, unnecessary, ineffective, or potentially harmful to the overall company.

case 3 Cases for Management Decision-Making CA-13Greet ings

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Case 4

Greet ings Inc.

Greetings Inc.: Capital Budgeting

Developed by Thomas L. Zeller, Loyola University Chicago, and Paul D. Kimmel, University of Wisconsin–Milwaukee

The Business Situation

Greetings Inc. stores, as well as the Wall Décor division, have enjoyed healthy prof- itability during the last two years. Although the profi t margin on prints is often thin, the volume of print sales has been substantial enough to generate 15% of Greetings’ store profi ts. In addition, the increased customer traffi c resulting from the prints has generated signifi cant additional sales of related non-print products. As a result, the company’s rate of return has exceeded the industry average during this two-year period. Greetings’ store managers likened the e-business leverage cre- ated by Wall Décor to a “high-octane” fuel to supercharge the stores’ profi tability.

This high rate of return (ROI) was accomplished even though Wall Décor’s venture into e-business proved to cost more than originally budgeted. Why was it a profi table venture even though costs exceeded estimates? Greetings stores were able to generate a considerable volume of business for Wall Décor. This helped spread the high e-business operating costs, many of which were fi xed, across many unframed and framed prints. This experience taught top management that maintaining an e-business structure and making this business model successful are very expensive and require substantial sales as well as careful monitoring of costs.

Wall Décor’s success gained widespread industry recognition. The business press documented Wall Décor’s approach to using information technology to increase profi tability. The company’s CEO, Robert Burns, has become a frequent business-luncheon speaker on the topic of how to use information technology to offer a great product mix to the customer and increase shareholder value. From the outside looking in, all appears to be going very well for Greetings stores and Wall Décor.

However, the sun is not shining as brightly on the inside at Greetings. The mall stores that compete with Greetings have begun to offer prints at very com- petitive prices. Although Greetings stores enjoyed a selling price advantage for a few years, the competition eventually responded, and now the pressure on selling price is as intense as ever. The pressure on the stores is heightened by the fact that the company’s recent success has led shareholders to expect the stores to gener- ate an above-average rate of return. Mr. Burns is very concerned about how the stores and Wall Décor can continue on a path of continued growth.

Fortunately, more than a year ago, Mr. Burns anticipated that competitors would eventually fi nd a way to match the selling price of prints. As a consequence, he formed a committee to explore ways to employ technology to further reduce

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costs and to increase revenues and profi tability. The committee is comprised of store managers and staff members from the information technology, marketing, fi nance, and accounting departments. Early in the group’s discussion, the focus turned to the most expensive component of the existing business model—the large inventory of prints that Wall Décor has in its centralized warehouse. In ad- dition, Wall Décor incurs substantial costs for shipping the prints from the cen- tralized warehouse to customers across the country. Ordering and maintaining such a large inventory of prints consumes valuable resources.

One of the committee members suggested that the company should pursue a model that music stores have experimented with, where CDs are burned in the store from a master copy. This saves the music store the cost of maintaining a large inventory and increases its ability to expand its music offerings. It virtually guarantees that the store can always provide the CDs requested by customers.

Applying this idea to prints, the committee decided that each Greetings store could invest in an expensive color printer connected to its online ordering system. This printer would generate the new prints. Wall Décor would have to pay a royalty on a per print basis. However, this approach does offer certain advantages. First, it would eliminate all ordering and inventory maintenance costs related to the prints. Second, shrinkage from lost and stolen prints would be reduced. Finally, by reducing the cost of prints for Wall Décor, the cost of prints to Greetings stores would decrease, thus allowing the stores to sell prints at a lower price than com- petitors. The stores are very interested in this option because it enables them to maintain their current customers and to sell prints to an even wider set of cus- tomers at a potentially lower cost. A new set of customers means even greater related sales and profi ts.

As the accounting/fi nance expert on the team, you have been asked to per- form a fi nancial analysis of this proposal. The team has collected the information presented in Illustration CA 4-1.

Instructions Mr. Burns has asked you to do the following as part of your analysis of the capital investment project.

1. Calculate the net present value using the numbers provided. Assume that annual cash fl ows occur at the end of the year.

2. Mr. Burns is concerned that the original estimates may be too optimistic. He has sug- gested that you do a sensitivity analysis assuming all costs are 10% higher than ex- pected and that all infl ows are 10% less than expected.

3. Identify possible fl aws in the numbers or assumptions used in the analysis, and identify the risk(s) associated with purchasing the equipment.

4. In a one-page memo, provide a recommendation based on the above analysis. Include in this memo: (a) a challenge to store and Wall Décor management and (b) a suggestion on how Greetings stores could use the computer connection for related sales.

Illustration CA 4-1 Information about the proposed capital investment project

Available Data Amount

Cost of equipment (zero residual value) $800,000 Cost of ink and paper supplies (purchase immediately) 100,000 Annual cash fl ow savings for Wall Décor 175,000 Annual additional store cash fl ow from increased sales 100,000 Sale of ink and paper supplies at end of 5 years 50,000 Expected life of equipment 5 years Cost of capital 12%

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Case 5

Auburn Circular Club Pro Rodeo Roundup

Developed by Jessica Johnson Frazier, Eastern Kentucky University, and Patricia H. Mounce, University of Central Arkansas

The Business Situation

When Shelley Jones became president-elect of the Circular Club of Auburn, Kansas, she was asked to suggest a new fundraising activity for the club. After a consider- able amount of research, Shelley proposed that the Circular Club sponsor a pro- fessional rodeo. In her presentation to the club, Shelley said that she wanted a fundraiser that would (1) continue to get better each year, (2) give back to the com- munity, and (3) provide the club a presence in the community. Shelley’s goal was to have an activity that would become an “annual community event” and that would break even the fi rst year and raise $5,000 the following year. In addition, based on the experience of other communities, Shelley believed that a rodeo could grow in popularity so that the club would eventually earn an average of $20,000 annually.

A rodeo committee was formed. Shelley contacted the world’s oldest and largest rodeo-sanctioning agency to apply to sponsor a professional rodeo. The sanction- ing agency requires a rodeo to consist of the following fi ve events: Bareback Riding, Bronco Riding, Steer Wrestling, Bull Riding, and Calf Roping. Because there were a number of team ropers in the area and because they wanted to include females in the competition, members of the rodeo committee added Team Roping and Women’s Barrels. Prize money of $3,000 would be paid to winners in each of the seven events.

Members of the rodeo committee contracted with RJ Cattle Company, a livestock contractor on the rodeo circuit, to provide bucking stock, fencing, and chutes. Realizing that costs associated with the rodeo were tremendous and that ticket sales would probably not be suffi cient to cover the costs, the rodeo com- mittee sent letters to local businesses soliciting contributions in exchange for various sponsorships. Exhibiting Sponsors would contribute $1,000 to exhibit their products or services, while Major Sponsors would contribute $600. Chute Sponsors would contribute $500 to have the name of their business on one of the six bucking chutes. For a contribution of $100, individuals would be included in a Friends of Rodeo list found in the rodeo programs. At each performance the rodeo announcer would repeatedly mention the names of the businesses and in- dividuals at each level of sponsorship. In addition, large signs and banners with the names of the businesses of the Exhibiting Sponsors, Major Sponsors, and Chute Sponsors were to be displayed prominently in the arena.

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A local youth group was contacted to provide concessions to the public and divide the profi ts with the Circular Club. The Auburn Circular Club Pro Rodeo Roundup would be held on June 1, 2, and 3. The cost of an adult ticket was set at $8 in advance or $10 at the gate; the cost of a ticket for a child 12 or younger was set at $6 in advance or $8 at the gate. Tickets were not date-specifi c. Rather, one ticket would admit an individual to one performance of his or her choice— Friday, Saturday, or Sunday. The rodeo committee was able to secure a location through the county supervisors board at a nominal cost to the Circular Club. The arrangement allowed the use of the county fair grounds and arena for a one-week period. Several months prior to the rodeo, members of the rodeo committee had been assured that bleachers at the arena would hold 2,500 patrons. On Saturday night, paid attendance was 1,663, but all seats were fi lled due to poor gate con- trols. Attendance was 898 Friday and 769 on Sunday.

The following revenue and expense fi gures relate to the fi rst year of the rodeo.

On Wednesday after the rodeo, members of the rodeo committee met to dis- cuss and critique the rodeo. Jonathan Edmunds, CPA and President of the Cir- cular Club, commented that the club did not lose money. Rather, Jonathan said, “The club made an investment in the rodeo.”

Illustration CA 5-1 Revenue and expense data, year 1

Receipts

Contributions from sponsors $22,000 Receipts from ticket sales 28,971 Share of concession profi ts 1,513 Sale of programs 600

Total receipts $53,084

Expenses

Livestock contractor 26,000 Prize money 21,000 Contestant hospitality 3,341* Sponsor signs for arena 1,900 Insurance 1,800 Ticket printing 1,050 Sanctioning fees 925 Entertainment 859 Judging fees 750 Port-a-potties 716 Rent 600 Hay for horses 538 Programs 500 Western hats to fi rst 500 children 450 Hotel rooms for stock contractor 325 Utilities 300 Sand for arena 251 Miscellaneous fi xed costs 105 Total expenses 61,410

Net loss $ (8,326)

*The club contracted with a local caterer to provide a tent and food for the contestants. The cost of the food was contingent on the number of contestants each evening. Information con- cerning the number of contestants and the costs incurred are as follows:

Contestants Total Cost

Friday 68 $ 998 Saturday 96 1,243 Sunday 83 1,100

$3,341

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CA-18 case 5 Cases for Management Decision-Making

Instructions Answer each of the following questions.

1. Do you think it was necessary for Shelley Jones to stipulate that she wanted a fundraiser that would (1) continue to get better each year, (2) give back to the community, and (3) pro- vide the club a presence in the community? Why or why not?

2. What did Jonathan Edmunds mean when he said the club had made an investment in the rodeo?

3. Is Jonathan’s comment concerning the investment consistent with Shelley’s idea that the club should have a fundraiser that would (1) continue to get better each year, (2) give back to the community, and (3) provide the club a presence in the community? Why or why not?

4. What do you believe is the behavior of the rodeo expenditures in relation to ticket sales?

5. Determine the fi xed and variable cost components of the catering costs using the high- low method.

6. Assume you are elected chair of the rodeo committee for next year. What steps would you suggest the committee take to make the rodeo profi table?

7. Shelley, Jonathan, and Adrian Stein, the Fundraising Chairperson, are beginning to make plans for next year’s rodeo. Shelley believes that by negotiating with local feed stores, inn- keepers, and other business owners, costs can be cut dramatically. Jonathan agrees. After carefully analyzing costs, Jonathan has estimated that the fi xed expenses can be pared to approximately $51,000. In addition, Jonathan estimates that variable costs are 4% of total gross receipts.

After talking with business owners who attended the rodeo, Adrian is confi dent that funds solicited from sponsors will increase. Adrian is comfortable in budgeting revenue from sponsors at $25,600. The local youth group is unwilling to provide con- cessions to the audience unless they receive all of the profi ts. Not having the personnel to staff the concession booth, members of the Circular Club reluctantly agree to let the youth group have 100% of the profi ts from the concessions. In addition, members of the rodeo committee, recognizing that the net income from programs was only $100, decide not to sell rodeo programs next year. Compute the break-even point in dollars of ticket sales assuming Adrian and Jonathan are correct in their assumptions.

8. Shelley has just learned that you are calculating the break-even point in dollars of ticket sales. She is still convinced that the Club can make a profi t using the assump- tions in number 7 above. (a) Calculate the dollars of ticket sales needed in order to earn a target profi t of

$6,000. (b) Calculate the dollars of ticket sales needed in order to earn a target profi t of

$12,000.

9. Are the facilities at the fairgrounds adequate to handle crowds needed to generate ticket revenues calculated in number 8 above to earn a $6,000 profi t? Show calcula- tions to support your answers.

10. Prepare a budgeted income statement for next year using the estimated revenues from sponsors and other assumptions in number 7 above. In addition, use ticket sales based on the target profi t of $12,000 estimated in 8(b). The cost of the livestock contractor, prize money, sanctioning fees, entertainment, judging fees, rent, and utilities will re- main the same next year.

Changes in expenses include the following: Members of the Club have decided to eliminate all costs related to contestant hospitality by soliciting a tent and food for the contestants and taking care of the “Contestant Hospitality Tent” themselves. The county has installed permanent restrooms at the arena, eliminating the need to rent port-a- potties. The rodeo committee intends to pursue arrangements to have hotel rooms, hay, and children’s hats provided at no charge in exchange for sponsorships. The cost of ban- ners varies with the number of sponsors. Signs and More charged the Circular Club $130 for each Exhibiting Sponsor banner and $48 for each Major Sponsor banner. At this time there is no way to know whether additional sponsors will be Exhibiting Spon- sors or Major Sponsors. Therefore, for budgeting purposes you should increase the cost of the banners by the percentage increase in sponsor contributions. (Hint: Round

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all calculations to three decimal places.) By checking prices, the Circular Club will be able to obtain insurance providing essentially the same amount of coverage as this year for only $600. For the fi rst rodeo the Club ordered 10,000 tickets. Realizing the con- straints on available seating, the Club is ordering only 5,000 tickets for next year, and therefore its costs are reduced 50%. The sand for the arena for next year will be $300, and miscellaneous fi xed costs are to be budgeted at $100.

11. A few members in the Circular Club do not want to continue with the annual rodeo. However, Shelley is insistent that the Club must continue to conduct the rodeo as an annual fundraiser. Shelley argues that she has spent hundreds of dollars on western boots, hats, and other items of clothing to wear to the rodeo. Are the expenses related to Shelley’s purchases of rodeo clothing relevant costs? Why or why not?

12. Rather than hire the local catering company to cater the Contestant Hospitality Tent, members of the Circular Club are considering asking Shady’s Bar-B-Q to cater the event in exchange for a $600 Major Sponsor spot. In addition, The Fun Shop, a local party supply business, will be asked to donate a tent to use for the event. The Fun Shop will also be given a $600 Major Sponsor spot. Several members of the Club are opposed to this consideration, arguing that the two Major Sponsor spots will take away from the money to be earned through other sponsors. Adrian Stein has explained to the mem- bers that the Major Sponsor signs for the arena cost only $48 each. In addition, there is more than enough room to display two additional sponsor signs. What would you encourage the Club to do concerning the Contestant Hospitality Tent? Would your an- swer be different if the arena were limited in the number of additional signs that could be displayed? What kind of cost would we consider in this situation that would not be found on a fi nancial statement?

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Case 6

Sweats Galore, Inc.

Developed by Jessica Johnson Frazier, Eastern Kentucky University, and Patricia H. Mounce, University of Central Arkansas

The Business Situation

After graduating with a degree in business from Eastern University in Campus Town, USA, Michael Woods realized that he wanted to remain in Campus Town. After a number of unsuccessful attempts at getting a job in his discipline, Michael decided to go into business for himself. In thinking about his business venture, Michael determined that he had four criteria for the new business:

1. He wanted to do something that he would enjoy.

2. He wanted a business that would give back to the community.

3. He wanted a business that would grow and be more successful every year.

4. Realizing that he was going to have to work very hard, Michael wanted a busi- ness that would generate a minimum net income of $25,000 annually.

While refl ecting on the criteria he had outlined, Michael, who had been presi- dent of his fraternity and served as an offi cer in several other student organiza- tions, realized that there was no place in Campus Town to have custom sweatshirts made using a silk-screen process. When student organizations wanted sweatshirts for their members or to market on campus, the offi cers had to make a trip to a city 100 miles away to visit “Shirts and More.’’

Michael had worked as a part-time employee at Shirts and More while he was in high school and had envisioned owning such a shop. He realized that a sweatshirt shop in Campus Town had the potential to meet all four of his cri- teria. Michael set up an appointment with Jayne Stoll, the owner of Shirts and More, to obtain information useful in getting his shop started. Because Jayne liked Michael and was intrigued by his entrepreneurial spirit, she answered many of Michael’s questions.

In addition, Jayne provided information concerning the type of equipment Michael would need for his business and its average useful life. Jayne knows a competitor who is retiring and would like to sell his equipment. Michael can pur- chase the equipment at the beginning of 2013, and the owner is willing to give him terms of 50% due upon purchase and 50% due the quarter following the purchase. Michael decided to purchase the following equipment as of January 1, 2013.

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Useful Cost Life

Hand-operated press that applies ink to the shirt $7,500 5 yrs. Light-exposure table 1,350 10 yrs. Dryer conveyer belt that makes ink dry on the shirts 2,500 10 yrs. Computer with graphics software and color printer 3,500 4 yrs. Display furniture 2,000 10 yrs. Used cash register 500 5 yrs.

Michael has decided to use the sweatshirt supplier recommended by Jayne. He learned that a gross of good-quality sweatshirts to be silk-screened would cost $1,440. Jayne has encouraged Michael to ask the sweatshirt supplier for terms of 40% of a quarter’s purchases to be paid in the quarter of purchase, with the remaining 60% of the quarter’s purchases to be paid in the quarter following the purchase.

Michael also learned from talking with Jayne that the ink used in the silk- screen process costs approximately $0.75 per shirt.

Knowing that the silk-screen process is somewhat labor-intensive, Michael plans to hire six college students to help with the process. Each one will work an average of 20 hours per week for 50 weeks during the year. Michael estimates total annual wages for the workers to be $72,000.

In addition, Michael will need one person to take orders, bill customers, and operate the cash register. Cary Sue Smith, who is currently Director of Student Development at Eastern University, has approached Michael about a job in sales. Cary Sue knows the offi cers of all of the student organizations on campus. In addition, she is very active in the community. Michael thinks Cary Sue can bring in a lot of business. In addition she also has the clerical skills needed for the position. Because of her contacts, Michael is willing to pay Cary Sue $1,200 per month plus a commission of 10% of sales. Michael estimates Cary Sue will spend 50% of the workday focusing on sales, and the remaining 50% will be spent on clerical and administrative duties.

Michael realizes that he will have diffi culty fi nding a person skilled in com- puter graphics to generate the designs to be printed on the shirts. Jayne recently hired a graphics designer in that position for Shirts and More at a rate of $500 per month plus $0.10 for each shirt printed. Michael believes he can fi nd a university graphics design student to work for the same rate Jayne is paying her designer.

Michael was fortunate to fi nd a commercial building for rent near the uni- versity and the downtown area. The landlord requires a one-year lease. Although the monthly rent of $1,000 is more than Michael had anticipated paying, the building is nice, has adequate parking, and there is room for expansion. Michael anticipates that 75% of the building will be used in the silk-screen process and 25% will be used for sales.

Michael’s fraternity brothers have encouraged him to advertise weekly in the Eastern University student newspaper. Upon inquiring, Michael found that a 30 3 30 ad would cost $25 per week. Michael also plans to run a weekly ad in the local newspaper that will cost him $75 per week.

Michael wants to sell a large number of quality shirts at a reasonable price. He estimates the selling price of each customized shirt to be $16. Jayne has suggested that he should ask customers to pay for 70% of their purchases in the quarter purchased and pay the additional 30% in the quarter following the purchases.

After talking with the insurance agent and the property valuation administra- tor in his municipality, Michael estimates that the property taxes and insurance on the machinery will cost $2,240 annually; property tax and insurance on dis- play furniture and cash register will total $380 annually.

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Jayne reminded Michael that maintenance of the machines is required for the silk-screen process. In addition, Michael realizes that he must consider the cost of utilities. The building Michael wants to rent is roughly the same size as the building occupied by Shirts and More. In addition, Shirts and More sells ap- proximately the same number of shirts Michael plans to sell in his store. There- fore, Michael is confi dent that the maintenance and utility costs for his shop will be comparable to the maintenance and utility costs for Shirts and More, which are as follows within the relevant range of zero to 8,000 shirts.

Shirts Sold Maintenance Costs Utility Costs

January 2,000 $1,716 $1,100 February 2,110 1,720 1,158 March 2,630 1,740 1,171 April 3,150 1,740 1,198 May 5,000 1,758 1,268 June 5,300 1,818 1,274 July 3,920 1,825 1,205 August 2,080 1,780 1,117 September 8,000 1,914 1,400 October 6,810 1,860 1,362 November 6,000 1,855 1,347 December 3,000 1,749 1,193

Michael estimates the number of shirts to be sold in the fi rst fi ve quarters, beginning January 2013, to be:

First quarter, year 1 8,000 Second quarter, year 1 10,000 Third quarter, year 1 20,000 Fourth quarter, year 1 12,000 First quarter, year 2 18,000

Michael decides to establish his company as a corporation. He will invest $10,000 of his personal savings in the company.

Seeing how determined his son was to become an entrepreneur, Michael’s father offered to co-sign a note for an amount up to $20,000 to help Michael open his sweatshirt shop, Sweats Galore, Inc. However, when Michael and his father approached the loan offi cer at First Guarantee Bank, the loan offi cer asked Michael to produce the following budgets for 2013.

Sales budget Schedule of expected collections from customers Shirt purchases budget Schedule of expected payments for purchases Silk-screen labor budget Selling and administrative expenses budget Silk-screen overhead expenses budget Budgeted income statement Cash budget Budgeted balance sheet

The loan offi cer advised Michael that the interest rate on a 12-month loan would be 8%. Michael expects the loan to be taken out as of January 1, 2013.

Michael has estimated that his income tax rate will be 20%. He expects to pay the total tax due when his returns are fi led in 2014.

Instructions Answer the following questions.

1. Do you think it was important for Michael to stipulate his four criteria for the business (see page CA-20), including the goal of generating a net income of at least $25,000 an- nually? Why or why not?

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2. If the company has sales of $12,000 during January of the fi rst year of business, de- termine the amount of variable and fi xed costs associated with utilities and mainte- nance using the high-low method for each. (Round unit variable costs to three decimal places where necessary.)

3. Using the format below, prepare a sales budget for the year ending 2013.

Sweats Galore, Inc. Sales Budget

For the Year Ended December 31, 2013

Quarter

1 2 3 4 Year

Expected unit sales Unit selling price Budgeted sales revenue

4. Prepare a schedule of expected collections from customers.

Sweats Galore, Inc. Schedule of Expected Collections from Customers

For the Year Ending December 31, 2013

Quarter

1 2 3 4

Accounts receivable 1/1/13 –0– First quarter Second quarter Third quarter Fourth quarter Total collections

5. Michael learned from talking with Jayne that the supplier is so focused on making quality sweatshirts that many times the shirts are not available for several days. She encouraged Michael to maintain an ending inventory of shirts equal to 25% of the next quarter’s sales.

Prepare a shirt purchases budget for shirts using the format provided.

Sweats Galore, Inc. Shirt Purchases Budget

For the Year Ended December 31, 2013

Quarter

1 2 3 4 Year

Shirts to be silk-screened Plus: Desired ending inventory Total shirts required Less: Beginning inventory Total shirts needed Cost per shirt Total cost of shirt purchases

6. Prepare a schedule of expected payments for purchases.

Sweats Galore, Inc. Schedule of Expected Payments for Purchases

For the Year Ended December 31, 2013

Quarter

1 2 3 4

Accounts payable 1/1/13 –0– First quarter Second quarter Third quarter Fourth quarter Total payments

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7. Prepare a silk-screen labor budget.

Sweats Galore, Inc. Silk-Screen Labor Budget

For the Year Ended December 31, 2013

Quarter

1 2 3 4 Year

Units to be produced Silk-screen labor hours per unit Total required silk-screen labor hours Silk-screen labor cost per hour Total silk-screen labor cost

8. Prepare a selling and administrative expenses budget for Sweats Galore, Inc. for the year ending December 31, 2013.

Sweats Galore, Inc. Selling and Administrative Expenses Budget

For the Year Ended December 31, 2013

Quarter

1 2 3 4 Year

Variable expenses: Sales commissions Total variable expenses Fixed expenses: Advertising Rent Sales salaries Offi ce salaries Depreciation

Property taxes and insurance Total fi xed expenses Total selling and administrative expenses

9. Prepare a silk-screen overhead expenses budget for Sweats Galore, Inc. for the year ending December 31, 2013.

Sweats Galore, Inc. Silk-Screen Overhead Expenses Budget For the Year Ended December 31, 2013

Quarter

1 2 3 4 Year

Variable expenses: Ink Maintenance Utilities Graphics design Total variable expenses Fixed expenses: Rent Maintenance Utilities Graphics design

Property taxes and insurance Depreciation Total fi xed expenses Total silk-screen overhead Direct silk-screen hours Overhead rate per silk-screen hour

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10. Using the information found in the case and the previous budgets, prepare a budgeted income statement for Sweats Galore, Inc. for the year ended December 31, 2013.

Sweats Galore, Inc. Budgeted Income Statement

For the Year Ended December 31, 2013

Sales Cost of goods sold Gross profi t Selling and administrative expenses Income from operations Interest expense Income before income taxes Income tax expense Net income

11. Using the information found in the case and the previous budgets, prepare a cash budget for Sweats Galore, Inc. for the year ended December 31, 2013.

Sweats Galore, Inc. Cash Budget

For the Year Ended December 31, 2013

Quarter

1 2 3 4

Beginning cash balance Add: Receipts Collections from customers Total available cash Less: Disbursements Payments for shirt purchases Silk-screen labor Silk-screen overhead Selling and administrative expenses Payment for equipment purchase Total disbursements Excess (defi ciency) of available cash over disbursements

Financing Borrowings Ending cash balance

12. Using the information contained in the case and the previous budgets, prepare a bud- geted balance sheet for Sweats Galore, Inc. for the year ended December 31, 2013.

Sweats Galore, Inc. Budgeted Balance Sheet

December 31, 2013

Assets

Cash Accounts receivable Sweatshirt inventory Equipment Less: Accumulated depreciation Total assets

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Liabilities and Stockholders’ Equity

Accounts payable Notes payable Interest payable Taxes payable Total liabilities Common stock Retained earnings Total stockholders’ equity Total liabilities and stockholders’ equity

13. (a) Using the information contained in the case and the previous budgets, calculate the estimated contribution margin per unit for 2013. (Hint: Silk-screened labor and the taxes are both fi xed costs.)

(b) Calculate the total estimated fi xed costs for 2013 (including interest and taxes). (c) Compute the break-even point in units and dollars for 2013.

14. (a) Michael is very disappointed that the company did not have an income of $25,000 for its fi rst year of budgeted operations as he had wanted. How many shirts would the company have had to sell in order to have had a profi t of $25,000? (Ignore changes in income tax expense.)

(b) Why does the company’s net income differ from its ending cash balance?

15. Do you think it was a good idea to offer Cary Sue a salary plus 10% of sales? Why or why not?

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Case 7

ARM

ST R

O N

G

HELMET C

O M

PANY

Armstrong Helmet Company

Developed by Dick Wasson, Southwestern College

The Business Situation

Armstrong Helmet Company manufactures a unique model of bicycle helmet. The company began operations December 1, 2013. Its accountant quit the second week of operations, and the company is searching for a replacement. The com- pany has decided to test the knowledge and ability of all candidates interviewing for the position. Each candidate will be provided with the information below and then asked to prepare a series of reports, schedules, budgets, and recommenda- tions based on that information. The information provided to each candidate is as follows.

Cost Items and Account Balances

Administrative salaries $15,500 Advertising for helmets 11,000 Cash, December 1 –0– Depreciation on factory building 1,500 Depreciation on offi ce equipment 800 Insurance on factory building 1,500 Miscellaneous expenses—factory 1,000 Offi ce supplies expense 300 Professional fees 500 Property taxes on factory building 400 Raw materials used 70,000 Rent on production equipment 6,000 Research and development 10,000 Sales commissions 40,000 Utility costs—factory 900 Wages—factory 70,000 Work in process, December 1 –0– Work in process, December 31 –0– Raw materials inventory, December 1 –0– Raw materials inventory, December 31 –0– Raw material purchases 70,000 Finished goods inventory, December 1 –0–

CA-27

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CA-28 case 7 Cases for Management Decision-Making

Production and Sales Data

Number of helmets produced 10,000 Expected sales in units for December ($40 unit sales price) 8,000 Expected sales in units for January 10,000 Desired ending inventory 20% of next month’s sales Direct materials per fi nished unit 1 kilogram Direct materials cost $7 per kilogram Direct labor hours per unit .35 Direct labor hourly rate $20

Cash Flow Data

Cash collections from customers: 75% in month of sale and 25% the following month. Cash payments to suppliers: 75% in month of purchase and 25% the following month. Income tax rate: 45%. Cost of proposed production equipment: $720,000. Manufacturing overhead and selling and administrative costs are paid as incurred. Desired ending cash balance: $30,000.

Instructions Using the data presented above (including data on page CA-27), do the following.

1. Classify the costs as either product costs or period costs using a fi ve-column table as shown below. Enter the dollar amount of each cost in the appropriate column and total each classifi cation.

Product Costs

Direct Direct Manufacturing Item Materials Labor Overhead Period Costs

2. Classify the costs as either variable or fi xed costs. Assume there are no mixed costs. Enter the dollar amount of each cost in the appropriate column and total each classifi - cation. Use the format shown below. Assume that Utility costs—factory are a fi xed cost.

Variable Fixed Total Item Costs Costs Costs

3. Prepare a schedule of cost of goods manufactured for the month of December 2013.

4. Determine the cost of producing a helmet.

5. Identify the type of cost accounting system that Armstrong Helmet Company is prob- ably using at this time. Explain.

6. Under what circumstances might Armstrong use a different cost accounting system?

7. Compute the unit variable cost for a helmet.

8. Compute the unit contribution margin and the contribution margin ratio.

9. Calculate the break-even point in units and in sales dollars.

10. Prepare the following budgets for the month of December 2013. (a) Sales. (b) Production. (c) Direct materials. (d) Direct labor. (e) Selling and administrative expenses. (f) Cash. (g) Budgeted income statement.

ARMSTRONG HELMET COMPANY

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11. Prepare a fl exible budget for manufacturing costs for activity levels between 8,000 and 10,000 units, in 1,000-unit increments.

12. Identify one potential cause of direct materials, direct labor, and manufacturing over- head variances in the production of the helmet.

13. Determine the cash payback period on the proposed production equipment purchase, assuming a monthly cash fl ow as indicated in the cash budget (requirement 10f).

case 7 Cases for Management Decision-Making CA-29 ARMSTRONG HELMET COMPANY

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