Managerial Accounting I

Study Guide

Managerial Accounting

INSTRUCTIONS TO STUDENTS 1

LESSON ASSIGNMENTS 5

LESSON 1: COST CONCEPTS AND TYPES OF ACCOUNTING 7

LESSON 2: TOOLS FOR MANAGEMENT AND AIDS TO DECISION MAKING 39

LESSON 3: BUDGETS, ANALYSIS, AND PERFORMANCE MEASUREMENT FOR DECISION MAKING 67

LESSON 4: CAPITAL, CASHFLOWS, AND FINANCIAL STATEMENT ANALYSIS 97

SELF-CHECK ANSWERS 121

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YOUR COURSE Welcome to the world of Managerial Accounting! It’s a practical world of analysis, interpretation, and problem solving. This study guide is designed to help you develop an understanding of the topic in conjunction with your textbook, Managerial Accounting. There are four lessons in the study guide, each containing three or four assignments. Most assignments conclude with suggested exercises and problems selected from the textbook, and each assignment concludes with a self-check. The answers to the self-checks are found at the back of the study guide. At the end of each lesson is an examination. The examinations consist of multiple-choice questions drawn from topics covered by your textbook. You’ll have to work through transactions, complete calculations and financial statements, and analyze and interpret your results to answer the questions. You’ll also need to keep your eye on the goal of sound decision making.

Whatever your major, understanding how to apply what you learn in this Managerial Accounting course to everyday busi- ness situations can help make you a more effective decision maker. May your judgment be sound and your choices lead you to success.

OBJECTIVES When you complete this course, you’ll be able to

n Understand cost classifications as applied to preparing financial statements, predicting cost behavior, and making decisions

n Understand the flow of cost in job-order costing and use activity-based absorption costing to compute product costs

n Understand the flow of process costing, computing the cost per equivalent unit using the weighted-average method and FIFO method, and allocating department costs using the direct and step-down methods

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n Explain how changes in activity affect contribution margin and net operating income and examine cost-volume- profit relationships, such as margin of safety and break-even points

n Explain how variable costing differs from absorption costing and prepare income statements using the differ- ent approaches as tools for management

n Understand activity-based costing and how it differs from a traditional costing system

n Understand budgets, the process used to create budgets, and the preparation of various kinds of budgets

n Compute and record various variances

n Understand and compute various performance measurements

n Prepare differential analysis as a key to decision making

n Evaluate calculations for capital budgeting decisions

n Prepare a statement of cash flows using the direct and indirect methods and compute free cash flow

n Compute and interpret financial ratios

YOUR TEXTBOOK Your textbook for this course is Managerial Accounting, Fifteenth Edition, by Ray H. Garrison, Eric W. Noreen, and Peter C. Brewer. Professor Garrison teaches at Brigham Young University, Provo, Utah. Professor Noreen teaches at the University of Washington. Professor Brewer teaches at Wake Forest University, Winston-Salem, North Carolina. Each author has published a number of scholarly pieces in academic journals and has years of accounting experience.

Instructions to Students2

PROGRAM MATERIALS The course provides you with the following materials:

1. Your textbook, Managerial Accounting, Fifteenth Edition, by Ray H. Garrison, Eric W. Noreen, and Peter C. Brewer, which contains the reading assignments, exercises, and problems.

2. This study guide, which contains reading, exercises, problems, and self-check assignments, as well as the self-check answers.

3. The answers to these textbook problems are found on your student portal as a Solution Manual under the sec- tion for Managerial Accounting.

A STUDY PLAN This study guide is intended to help you achieve the maxi- mum benefit from the time you spend on this course. It doesn’t replace the textbook in any way. It serves as an introduction to material that you’ll read in the book and as an aid to assist you in understanding this material. This study guide provides your assignments in four lessons. Each lesson contains three or four assignments, a set of textbook problems and exercises for most assignments, a self-check for each assignment, and a comprehensive examination on the material covered in the lesson. Be sure to complete all work related to a lesson before moving on to the next lesson.

For each lesson, do the following:

1. Read the introduction to the lesson in this study guide.

2. Read the assigned pages in your textbook.

3. Be sure to work through any review problems and the solutions at the end of a chapter if applicable.

4. Do only what’s assigned to you in the study guide. If the textbook references Web sites, CDs, DVDs, or other sup- plemental material and it hasn’t been assigned to you in the study guide, then you aren’t responsible for it. This includes any “Applying Excel” exercise in the textbook.

Instructions to Students 3

5. Complete the self-check in this study guide for each assignment in the lesson. Remember: Do not send in your answers to the self-checks.

6. Determine your own progress by comparing your answers for the self-checks to the answers given in the answer section of this study guide.

7. Review the material covered in the lesson and complete the corresponding examination.

At any point in your studies, you can e-mail your instructor for further information or clarification of your study materials. Your instructor’s guidance and suggestions should be very helpful to you as you progress with your course. However, your instructors can’t help you with exam questions.

Now, review the lesson assignments and then begin your study of Managerial Accounting with Lesson 1, Assignment 1. When you’ve completed Lesson 1 and the associated self-checks, complete your first examination. Good luck and have fun!

Instructions to Students4

Lesson 1: Cost Concepts and Types of Costing For: Read in the Read in study guide: the textbook:

Assignment 1 Pages 7–10 Pages 1–18, 23–25

Assignment 2 Pages 10–18 Pages 27–49, 67–69, 73–79

Assignment 3 Pages 19–27 Pages 83–111, 130–133, 138–140

Assignment 4 Pages 27–38 Pages 148–163, 172–177, 180–183

Examination 061400 Material in Lesson 1

Lesson 2: Tools for Management and Aids to Decision Making For: Read in the Read in study guide: the textbook:

Assignment 5 Pages 39–45 Pages 187–214

Assignment 6 Pages 45–51 Pages 233–258, 279–282

Assignment 7 Pages 52–59 Pages 286–314, 331–338

Assignment 8 Pages 60–66 Pages 342–369

Examination 061401 Material in Lesson 2

Lesson 3: Budget Analysis and Performance Measurements for Decision Making For: Read in the Read in study guide: the textbook:

Assignment 9 Pages 67–71 Pages 393–409

Assignment 10 Pages 72–80 Pages 427–447, 459–465, 471–472

Assignment 11 Pages 81–89 Pages 477–479, 512–519, 524–528

Assignment 12 Pages 90–96 Pages 531–557

Examination 061402 Material in Lesson 3

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Lesson 4: Capital, Cashflows, and Financial Statement Analysis For: Read in the Read in study guide: the textbook:

Assignment 13 Pages 97–106 Pages 583–605, 621–625, 627–631

Assignment 14 Pages 107–112 Pages 634–657, 671–673

Assignment 15 Pages 113–119 Pages 675–697

Examination 061403 Material in Lesson 4

Lesson Assignments6

Note: To access and complete any of the examinations for this study

guide, click on the appropriate Take Exam icon on your student portal.

You should not have to enter the examination numbers. These numbers

are for reference only if you have reason to contact Student CARE.

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Cost Concepts and Types of Costing

ASSIGNMENT 1: MANAGERIAL ACCOUNTING: AN OVERVIEW Read this assignment. Then read pages 1–18 and 23–25 in your textbook.

What is Managerial Accounting? At one time, managerial accounting was all about managing by the numbers. Today, managerial accounting is about creating value; however, the numbers are still important in cre- ating that value.

Financial accounting is concerned with reporting the num- bers, whereas managerial accounting is concerned with providing information so that managers can (1) plan the use of budgets, (2) control the use of performance reports, and (3) make decisions that will add value to the business. Exhibit 1- 1 on page 2 of your textbook provides a comparison between financial accounting and managerial accounting. Note that all financial reporting must comply with rules, such as generally accepted accounting principles (GAAP) and international fnancial reporting standards (IFRS).

Why Does Managerial Accounting Matter to Your Career? Exhibit 1-3 on page 6 of your textbook relates managerial accounting to three business majors—marketing, supply chain management, and human resource management. Yet, that exhibit could easily be expanded to many other majors or areas of study, such as the business major of hospitality management or an area of study such as project manage- ment. It’s a fundamental subject for Certified Management Accountants (CMA) or Certified Public Accountants (CPA).

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Managers of companies have three main activities. First, they need to plan. Managers must be able to look at the choices they have from where they are to make decisions in keeping with the company’s strategy and objectives. Second, good managers know how to delegate, direct, and motivate people to get things done. In short, they need to be leaders. Lastly, managers must be able to look at the results and adjust to what’s happening to maintain the course. They must be able to control the situation. If they must make an adjustment throughout any of the processes, they must be able to decide the best course of action. Being able to make decisions is at the heart of all good managers.

Managerial Accounting: Beyond the Numbers Successful managers use six different perspectives that go beyond measurement skills to add value when planning, controlling, and decision making.

1. An Ethics Perspective

2. A Strategic Management Perspective

3. An Enterprise Risk Management Perspective

4. A Corporate Social Responsibility Perspective

5. A Process Management Perspective

6. A Leadership Perspective

While the goal of a business is to make money, in today’s world how a business goes about making that money and the impact of decisions made from a social perspective are just as important. The public (people) are less tolerant to environ- mental concerns, such as oil spills, pollution, and dumping. They look unfavorably at a company that uses child and slave labor. Therefore, today’s manager not only needs to manage by the numbers, but must also go beyond the numbers.

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Appendix 1A: Corporate Governance It seems as if every month there’s a headline story about top executive management that, through mismanagement, leaves shareholders harmed or at least wary. Enron and Qualcomm are examples. However, the vast majority of companies have effective corporate governance that puts the best interest of the stockholders before the interests of top management. Left unchecked, there will be those who will take advantage. In 2002, The Sarbanes-Oxley Act was created to protect and build stockholders’ confidence by improving the reliability of companies’ reporting information.

Self-Check 1 At the end of each section of Managerial Accounting, you’ll be asked to pause and check

your understanding of what you’ve just read by completing a “Self-Check” exercise.

Answering these questions will help you review what you’ve studied so far. Please

complete Self-Check 1 now.

Questions 1–10: Indicate whether each of the following sentences is True or False.

______ 1. Managerial accounting must follow GAAP/IFRS.

______ 2. Financial accounting is not mandatory for external reports.

______ 3. A detailed plan for the future is usually expressed in formal quantitative terms as

a budget.

______ 4. A CMA designation is not a globally respected credential that will increase your

credibility if you plan to become an accounting major.

______ 5. Ethical behavior is the foundation of managerial accounting.

(Continued)

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Self-Check 1 ______ 6. The Leadership Perspective enables a company to attract customers by distinguishing

itself from competitors.

______ 7. A process used by a company to identify risks and develop responses is a part of enter-

prise risk management

______ 8. Corporate social responsibility considers stakeholders when making decisions.

______ 9. Process Management involves only the business process and the value chain.

______ 10. Leaders need to understand how intrinsic motivation, extrinsic incentives and cognitive

bias influence human behavior.

Check your answers with those on page 121.

ASSIGNMENT 2: MANAGERIAL ACCOUNTING AND COST CONCEPTS Read this assignment. Then read pages 27–49, 67–69, and 73– 79 in your textbook.

Cost Classifications for (1) Assigning Costs to Cost Objects and (2) Manufacturing Companies There are three basic manufacturing cost categories:

n Direct materials

n Direct labor

n Manufacturing overhead

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Direct materials and direct labor can further be broken down into direct materials and indirect materials and direct labor and indirect labor. Now the categories look like this:

1. Direct materials

a. Direct materials

b. Indirect materials

2. Direct labor

a. Direct labor

b. Indirect labor

3. Manufacturing overhead (all other manufacturing costs)

When considering manufacturing costs, we’re talking about the costs to manufacture a product to sell. The product is the finished good and is part of our inventory, which is on the bal- ance sheet. An entry is then made to move that inventory, once it’s sold, to our cost-of-goods-sold (COGS) account, which is on the income statement.

Understanding what costs are associated with manufacturing a product is important because not all expenses in a business are manufacturing costs. These are known as nonmanufacturing costs. This includes selling and administrative costs.

Our income statement will show our sales, less our COGS. This provides our gross margin (or gross profit). From our gross margin we then deduct our selling and administrative expenses to get our net income (or net profit/loss).

What about something like janitorial services? Doesn’t the janitor clean the public restrooms, the offices, and quite possi- bly the manufacturing floor? Or what about an electric bill for lighting? You get one bill for the entire facility, yet not all of the electricity is being used to manufacture the product. Later in your textbook, you’ll learn what to consider in these situations. For now, it’s important to understand that not all expenses are associated with manufacturing overhead.

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Cost Classifications for Preparing Financial Statements There are other ways to look at costs. As a manager, you can look at manufacturing costs and nonmanufacturing costs. The manufacturing costs are also known as product costs. Product costs are looked at irrespective of time. Internally, using this information is appropriate. What happens when the information is to go to external users? Financial accounting uses the matching principle, which matches the revenues with the expenses for the specific period in time. All of the costs that aren’t product costs, such as selling and administrative expenses, are period costs. These are considered when there’s a need for financial statements to be created.

To break down the information for even further use, two additional categories are created—prime costs and conversion costs. Prime costs are direct material and direct labor. Conversion costs are direct labor and manufacturing overhead.

Costs are costs. That’s the basic information a manager has to work with. From this basic (raw) data, different companies will group the information differently depending on their needs. However, all companies will follow generally accepted accounting principles (GAAP), especially when the informa- tion will be provided to external users.

Cost Classifications for Predicting Cost Behavior Costs can be further broken up into two categories—fixed costs and variable costs. Exhibit 2-4 on page 37 of your text- book shows the difference in behavior between variable and fixed costs. Variable costs change in direct proportion to the level of activity, whereas fixed costs stay the same regardless of the level of activity. However, both must be taken within context, which is known as the relevant range.

Exhibit 2-2 on page 35 of your textbook illustrates variable and fixed cost behavior. It varies in direct proportion to changes in activity level. This is why the variable graph on the left has a slope—the total cost of the meal changes. Yet,

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the fixed graph on the right doesn’t change. However, variable costs must be variable in relation to something—that’s the activity base. The activity base in the graphs is the total cost of meals and the cost of building rental.

Variable costs can also have differing behavior patterns—true variable costs and step-variable costs. True variable costs, such as direct labor, vary in direct proportion to the level of production activity. Step-variable costs increase or decrease in response to wide changes in activity.

On the other hand, fixed costs remain the same within the relevant range of activity. Exhibit 2-3 on page 36 of your text- book depicts fixed costs and the relevant range. Fixed costs that are used for planning purposes are either committed or discretionary fixed costs.

Exhibit 2-5 on page 38 of your textbook shows mixed cost behavior. It has elements of both fixed and variable costs and is represented by a straight line.

The Analysis of Mixed Costs Various methods are used in the analysis of mixed costs.

1. Scattergraph method

2. High-low method

3. Least-squares regression method

4. Multiple regression analysis method

The scattergraph method is rarely used, due to the nature of quickly estimating fixed and variable costs, and is inappropri- ate for financial analysis. However, it does have a use. If it confirms that the relationship between the fixed and variable costs is linear, then the high-low method or least-squares regression method can be used.

The high-low method is fairly simple to use. However, it does have a major drawback—it uses only two data points, which isn’t enough to produce accurate results. If data points are chosen from periods of unusual activity, the data points aren’t truly representative of normal cost behavior during

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normal periods. Although this is a drawback, it’s a better alternative to the scattergraph method (see Exhibit 2-7 on page 42 of your textbook).

The least-squares regression method uses all of the data points. Computer software can easily handle many data points and provide further statistical analysis.

The least-squares regression method is driven by one factor; the multiple regression analysis method is used when the cost is driven by more than one factor. The principles are the same as in the least-squares method, but the computations become increasingly difficult.

Traditional and Contribution Format Income Statements Exhibit 2-9 on page 44 of your textbook provides a comparison of the traditional approach to creating an income statement versus the contribution approach to creating an income state- ment. While the traditional approach is often sufficient for external reporting purposes, internally the lumping together of fixed and variable costs is a hindrance to managers, who need the distinction between the fixed and variable costs to facilitate planning, control, and decision making. The variable costs are deducted from sales to create the contribution margin, from which the fixed expenses are then deducted to calculate the net operating income.

Cost Classifications for Decision Making Just as we assign different classifications to different costs in the manufacturing process, we also assign costs different classifications to be used for the decision-making process. These classifications are the differential costs and revenues, opportunity costs, and sunk costs. These can be thought of as “unseen” costs.

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As a manager looking at differential costs and revenues, you’re looking at the difference between two alternatives. As an example, you make and sell jewelry—bracelets, to be exact. They cost $0.60 each to manufacture. You nor- mally price them at $3.00 each. Here’s an alternative. What if you sell them at $3.00 each or two for $5.00? Which is the better alternative? This illustrates making decisions when looking at differential costs and revenues. (There’s no answer to this specific example because you don’t have enough infor- mation, such as how many you sell for a given period of time and/or how many you would expect to sell during that same period of time.)

Opportunity costs are the potential benefits given up when you select one alternative over another, and sunk costs are costs already incurred that can’t be changed by any decision you’ll make.

Making decisions is at the heart of being a manager. Consideration for costs other than what’s in front of you on the paper is also important.

Appendix 2A: Least-Squares Regression Computations Least-squares regression computations can be calculated by hand. However, software programs, such as Microsoft Excel, can be used to do the calculations. In a perfect world, statis- tical applications are used.

An understanding of the concept of least squares regression is required. However, you will not need to perform the calcu- lations using Excel or other computer software as this is beyond the scope of this subject.

Appendix 2B: Cost of Quality— Quality Cost Reports Manufacturers constantly struggle to produce high-quality products. The objective is to have high quality of conformance, which is a product that meets or exceeds expectations. In

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obtaining this, a quality cost is associated with the manufac- turing of the product. These quality costs are perceived as prevention costs, appraisal costs, internal failure costs, external failure costs, and distribution of quality costs. An assessment of these costs can be seen in quality cost reports. The information can be used to improve the product, which brings the manager back full circle to performing his three main activities—planning, directing, and motivating. He controls and uses that information to improve upon the processes using the company’s strategy and meeting its objectives.

International Aspects of Quality The International Organization for Standardization (ISO) cre- ated control guidelines known as the ISO 9000 standards, largely due to the effects caused by the work of W. Edwards Deming when he was hired to help management in Japan after World War II. (Through his teachings, companies like SONY and Honda became household brand names that exemplified quality. Would-be business managers are well advised to study the works of Deming. While some of the concepts he imple- mented in Japan have made their way into textbooks, many have not. However, his written works can be purchased and are well worth the read and will have a profound effect in your business if implemented.) An ISO 9000 certification is the “international gold standard” when it comes to quality and is not limited to manufacturing. The AICPA (American Institute of Certified Public Accountants) became the first professional organization to be ISO 9000-certified.

Review Problems Be sure to go over and fully understand the “Review Problems” at the end of each chapter/appendix as they apply many of the concepts found in the chapter.

Lesson 1 17

TexTbook ProbleMS for ASSignMenT 2

Exercises: #2–1 (page 53), #2–2, #2–3, #2–4 (page 54),

#2–5, #2–6 (page 55), #2–7 (page 56), #2–11,

#2–12 (page 57), #2–13 (page 58)

Problems: #2–19, #2–20 (page 61), #2–21 (page 62), #2–

22, #2–23 (page 63), #2–24, #2–25 (page 64)

Appendix 2B: #2B–2 (page 80), #2B–3 (page 81),

#2B–4 (page 82)

Check your answers in the Textbook Exercises and

Problem Solutions Supplement.

Self-Check 2 Questions 1–20: Indicate whether each of the following sentences is True or False.

______ 1. Selling costs can be either direct or indirect costs.

______ 2. A direct cost is a cost that can’t be easily traced to the particular cost object

under consideration.

______ 3. Property taxes and insurance premiums paid on a factory building are examples of

period costs.

______ 4. Conversion cost equals product cost less direct labor cost.

______ 5. Thread that is used in the production of mattresses is an indirect material that is

therefore classified as manufacturing overhead.

______ 6. Direct labor is a part of prime cost, but not conversion cost.

______ 7. Conversion cost is the sum of direct labor cost and direct materials cost.

(Continued)

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Self-Check 2 ______ 8. Direct material costs are generally fixed costs.

______ 9. Product costs are recorded as expenses in the period in which the related products are sold.

______ 10. Depreciation on manufacturing equipment is a product cost.

______ 11. Manufacturing salaries and wages incurred in the factory are period costs.

______ 12. Depreciation on office equipment would be included in product costs.

______ 13. Rent on a factory building used in the production process would be classified as a

product cost and as a fixed cost.

______ 14. A fixed cost remains constant if expressed on a unit basis.

______ 15. Total variable cost is expected to remain unchanged as activity changes within

the relevant range.

______ 16. The R2 (i.e., R-squared) is a measure of the goodness-of-fit in

least-squares regression.

______ 17. When analyzing a mixed cost, you should always plot the data in a scattergraph, but it

is particularly important to check the data visually on a scattergraph when the R2 from

a least squares regression is low. A quick look at the scattergraph can reveal that there

is little relation between the cost and the activity or that the relation is something

other than a simple straight line.

______ 18. Quality of conformance is the degree to which an actual product meets its design

specifications and is free of defects or other problems that might affect appearance

or performance.

______ 19. An increase in appraisal costs will usually result in a decrease in internal failure costs.

______ 20. Internal failure costs result from identification of defects during the appraisal process.

Such costs may include scrap, rejected products, rework, and downtime.

Check your answers with those on page 121.

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ASSIGNMENT 3: JOB-ORDER COSTING Read this assignment. Then read pages 83–111, 130–133, and 138–140 in your textbook.

Job-Order Costing—An Overview Process costing can be thought of as creating the same prod- ucts over long periods of time, such as a table where you obtain the wood, cut it up, assemble it, and finally paint it. The table goes through a “process” to create a finished good.

Job-order costing can be thought of as creating many different products for a specific period of time. For example, take the con- struction of a convenience store. There are many different “jobs” that need to occur, such as building the building, laying out the floor plan, assembling and installing walk-in coolers, installing air conditioning/heating, electrical, plumbing, etc. All of this is contracted to be completed by a specific date.

Jobs need to be measured to know how far along the project is and how much more needs to be done until completion. Measuring is done through documentation and recorded on job-cost sheets. (See Exhibit 3-2 on page 87 of your text- book for an example.) Direct materials are recorded using bill of materials and materials requisition forms. Direct labor can be found on time cards. Manufacturing overhead is more complicated.

Manufacturing overhead is based on allocation. A common allocation base that’s used is estimated direct-labor hours to calculate a predetermined overhead rate. The predetermined overhead rate is then multiplied by the actual direct labor hours to calculate how much overhead needs to be applied against a specific job. The allocation base is the cost driver and doesn’t have to be labor. It’s whatever makes sense for that particular job.

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Exhibit 3-5 on page 94 of your textbook shows the costflows and classifications in a manufacturing company. Understanding the flow will give you a structure for working with all of the data and information you’ll receive during the course of a job.

Job-Order Costing—The Flow of Costs, Schedules of Goods Manufactured, and Cost of Goods Sold Exhibits 3-6 through 3-8 on pages 95–98 of your textbook illustrate the flow of costs for job-order costing. Understanding these exhibits is crucial to understanding the journal entries to be made for a job. Exhibit 3-9 on page 100 of your textbook provides a summary of the journal entries, and Exhibit 3-10 on page 101 provides the effects on the general ledger accounts using T-accounts. Exhibits 3-11 and 3-12 on pages 102 and 104 of your textbook shows the reporting via the schedule of cost of goods manufactured and cost of goods sold along with the income statement. These exhibits provide a visual representation of the flow of information.

Remember, direct material has two components: direct material and indirect materials. Raw materials need to be purchased. A materials requisition form provides the information for direct and indirect materials. All of it is raw materials and is credited to the raw materials account. However, the raw materials are categorized as direct and indirect materials. The indirect mate- rials are debited to manufacturing overhead, while the direct materials are recorded in two different places—a debit to work in process and also to the job-cost sheets. Think of this as recording and accounts receivable or accounts payable. You hit the accounts receivable or accounts payable general ledger account, but you also must enter it into the specific receivable or payable account in the subsidiary ledger.

The same happens with direct labor. It has two components and is entered the same exact way as direct materials; the only difference is that for labor you use time cards, whereas for

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materials you use materials requisition forms and/or bills of materials. If you understand how to allocate materials, you understand how to allocate labor.

Manufacturing overhead costs are handled differently. These costs are applied directly by debiting the manufacturing overhead general ledger account as they occur. How are they applied to work in process? The predetermined over- head rate is used to apply overhead costs to each job. (See Exhibit 3-8 on page 98 in your textbook.) The applied overhead is credited to the manufacturing overhead account, while the debits are entered on the job-cost sheets and to the work-in- process account.

Nonmanufacturing costs don’t go in the manufacturing overhead account. Nonmanufacturing costs are selling and administrative expenses and should be recorded in the appro- priate expense accounts.

When the job is completed, an additional entry is made for the amount on the job-cost sheet, out of the work-in-process account and into the finished-goods account. (Finished goods = inventory available for sale.) When the finished good is delivered to the customer, it needs to be reduced by recording the entry to move the amount of the finished good to COGS and recording the sale.

Underapplied and Overapplied Overhead—A Closer Look The predetermined overhead rate is an estimate. Because it’s an estimate, there’s almost always a difference from the actual overhead costs in the work-in-process account. It’s either underapplied or overapplied. This difference needs to be corrected. Whether it’s underapplied or overapplied will determine what journal entry needs to be made when clos- ing out the manufacturing overhead account to the COGS account. Exhibit 3-13 on page 105 illustrates a summary of the overhead concepts.

The question may arise as to why we don’t close the entire balance to the COGS account in the first place. The answer lies in accuracy—we assign the overhead costs to where they

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should have gone in the first place, had it not been for the errors created by using the estimate in the predetermined overhead rate.

When you first contract for a job, you base the sale price on your estimate of what you think the costs will be. You gener- ally have a good idea as to what your labor hours are going to be, but this is still an estimate. Your crew may take more time, or they may take less time. You can get pretty accurate costs for materials because you need to purchase them to do the job. When determining your manufacturing overhead, you’ll estimate using the predetermined overhead rate. Again, your estimate may be over or under what you actually incurred. You always need to be thinking in terms of how much you estimated. This is what the actual costs are. You need to ask how much you’re overapplied or underapplied, and then you need to make the appropriate adjustment.

Exhibit 3-14 on page 108 of your textbook provides a general model of cost flows. Again, build a framework in your mind and understand it.

Job-Order Costing in Service Companies Job-order costing in service companies—such as law firms, accounting firms, and so on—is very much like that in manu- facturing companies even though they don’t produce a product. They still have labor, and, depending on the type of service, they may have materials. They’ll also have to account for overhead .

Appendix 3A: Activity-Based Absorption Costing While Chapter 3 showed the method used for a traditional absorption system, this appendix will present an alternative approach called activity-based absorption costing. This approach differs in that it assigns the manufacturing overhead based upon the “activities” performed to make the product. One approach isn’t better than the other. While less

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commonly used, the activity-based absorption costing fits the needs of businesses where the traditional approach doesn’t. Exhibits 3A-1 and 3A-2 on pages 131 and 132 of your text- book illustrate the differences in the two approaches.

Appendix 3B: The Predetermined Overhead Rate and Capacity Previous discussions looked at the predetermined overhead rate. What if capacity is the cost driver and is limited? The calculation is the same, but the limited capacity must be taken into consideration.

Review Problems Be sure to go over and fully understand the “Review Problems” at the end of each chapter/appendix as they apply many of the concepts found in the chapter.

TexTbook ProbleMS for ASSignMenT 3

Exercises: #3–1, #3–2, #3–3, #3–4 (page 115),

#3–5, #3–6, #3–7 (page 116), #3–11 (page 117),

#3–18 (page 121)

Problems: #3–26 (page 126), #3–27 (page 127)

Appendix 3A: #3A–1 (page 133), #3A–2 (page 134),

#3A–4 (page 135)

Appendix 3B: #3B–1 (page 140), #3B–2 (page 141)

Check your answers in the Textbook exercises and

Problem Solutions Supplement.

Managerial Accounting24

Self-Check 3 Questions 1–10: Indicate whether each of the following sentences is True or False.

______ 1. Job-order costing is usually not used in service organizations such as hospitals and

law firms.

______ 2. The three cost categories appearing on a job-cost sheet are selling expense, manufacturing

expense, and administrative expense.

______ 3. To improve the accuracy of unit costs, most companies recompute the predetermined

overhead rate each month.

______ 4. Use of a single, plantwide overhead rate is generally appropriate only for very large

manufacturing companies.

______ 5. The following journal entry would be made to apply overhead cost to jobs in a job-order

costing system:

______ Work in Process XXX

Manufacturing Overhead XXX

______ 6. When completed goods are sold, the transaction is recorded as a debit to cost of goods

sold and a credit to work in process.

______ 7. Actual manufacturing overhead costs are traced to specific jobs.

______ 8. A credit balance in the manufacturing overhead account at the end of the year means

that overhead was underapplied.

______ 9. The sum of all amounts transferred from the work-in-process account and into the

finished-goods account represents the cost of goods manufactured for the period.

______ 10. The most common accounting treatment of underapplied manufacturing overhead is to

transfer it to the manufacturing overhead control account.

(Continued)

Lesson 1 25

Self-Check 3 11. Computing unit product costs involves averaging in which of the following?

a. Choice A c. Choice C

b. Choice B d. Choice D

12. In job-order costing, all of the following statements are correct with respect to labor time and

cost except for which one?

a. Time tickets are kept by employees to show the amount of work on specific jobs.

b. The job-cost sheet for a job will contain all direct labor charges to that particular job.

c. Labor cost that can be traced to a job only with a great deal of effort is treated as part of

manufacturing overhead.

d. A machine operator performing routine annual maintenance work on a piece of equipment

would charge the maintenance time to a specific job.

13. In a job-order costing system, the journal entry to record the application of overhead cost to

jobs would include a

a. credit to the manufacturing overhead account.

b. credit to the work-in-process inventory account.

c. debit to cost of goods sold.

d. debit to the manufacturing overhead account.

(Continued)

Job-order Costing Process Costing

A Yes No

B Yes Yes

C No Yes

D No No

Managerial Accounting26

Self-Check 3 14. Ivory Company uses a job-order costing system. Which year-end journal entry could Ivory

make to dispose of (close out) $4,150 of overapplied manufacturing overhead cost?

15. In a job-order costing system, the use of indirect materials would usually be recorded as a

debit to

a. raw materials. c. manufacturing overhead.

b. work in process. d. finished goods.

16. Which account is debited when indirect labor is recorded?

a. Work in process c. Salaries and wages payable

b. Salaries and wages expense d. Manufacturing overhead

17. In a job-order costing system, the amount of overhead cost that has been applied to a job

that remains incomplete at the end of a period is

a. deducted on the income statement as overapplied overhead.

b. closed to cost of goods sold.

c. transferred to finished goods at the end of the period.

d. part of the ending balance of the work-in-process inventory account.

(Continued)

a Finished Goods

Manufacturing Overhead

$4,150

$4,150

b Cost of Goods Sold

Manufacturing Overhead

$4,150

$4,150

c Manufacturing Overhead

Finished Goods

$4,150

$4,150

d Manufacturing Overhead

Cost of Goods Sold

$4,150

$4,150

Lesson 1 27

Self-Check 3 18. If a company applies overhead to jobs on the basis of a predetermined overhead rate, a credit

balance in the manufacturing overhead account at the end of any period means that

a. more overhead cost has been charged to jobs than has been incurred during the period.

b. more overhead cost has been incurred during the period than has been charged to jobs.

c. the amount of overhead cost charged to jobs is greater than the estimated cost for the

period.

d. the amount of overhead cost charged to jobs is less than the estimated overhead cost for

the period.

19. Which situation always results in underapplied overhead?

a. Actual overhead is greater than applied overhead.

b. Actual overhead is less than applied overhead.

c. Estimated overhead is greater than actual overhead.

d. Estimated overhead is less than actual overhead.

20. When closing overapplied manufacturing overhead to cost of goods sold, which of the

following would be true?

a. Work in process will decrease. c. Net income will decrease.

b. Cost of goods sold will increase. d. Gross margin will increase.

Check your answers with those on page 122.

Managerial Accounting28

ASSIGNMENT 4: PROCESS COSTING Read this assignment. Then read pages 144–159, 171–176, and 179–182 in your textbook.

Comparison of Job-Order and Process Costing Process costing can be thought of as creating the same prod- ucts over long periods of time, such as a table where you obtain the wood, cut it up, assemble it, and finally paint it. The table goes through a “process” to create a finished good.

Job-order costing can be thought of as creating many different products for a specific period of time. For example, take the con- struction of a convenience store. There are many different “jobs” that need to occur, such as building the building, laying out the floor plan, assembling and installing walk-in coolers, installing air conditioning/heating, electrical, plumbing, etc. All of this is contracted to be completed by a specific date.

There are similarities between job-order and process costing. Both have the same basic purposes in assigning costs. Both use the same basic manufacturing accounts. Both have the flow of costs going through the manufacturing accounts the same way.

Exhibit 4-1 on page 146 of your textbook relates some of the differences between job-order and process costing. Process-costing accounts for a single product are created on a continuous basis and are generally identical. Costs are accumulated by department, and unit costs are computed by department.

Go back to the example of building a convenience store versus manufacturing a table. The convenience store is one-and-done. The table would need the raw material cut (cutting depart- ment), then assembled (assembly department), and finally painted (painting department) to create the finished good. For the convenience store, all materials, labor, and overhead are applied to that one specific job. With the table, the costs are

Lesson 1 29

allocated between departments because more than one table is being produced and they can be in different stages of the man- ufacturing process.

Cost Flows in Process Costing Exhibit 4-3 on page 147 of your textbook illustrates a T-account model of process costing flows. Notice how the materials, labor, and overhead associated with each individual department flow into the specific work-in-process account. But also notice how the work in process for the first department flows into the sec- ond department, each one building on the next.

Using the table as an example, lumber is piled up outside the building. As the worker from the cutting department gets the lumber and cuts it into legs and tabletops, the cutting department incurs material, labor, and overhead costs. The raw materials are his beginning inventory. The legs and table- tops he cuts become his finished goods, or ending inventory, which is the beginning inventory for the assembly department. At this point in time, there’s already a cost associated with manufacturing the table. This is the work in process created from the cutting department. To this, the assembly depart- ment adds additional costs for the materials, labor, and overhead used to assemble the table and create its finished good or ending inventory, which becomes the beginning inven- tory for the painting department. At this point in time, there’s again a cost associated with the assembled table from both the cutting and assembly department. The painting depart- ment again adds costs for materials, labor, and overhead to the cost of the table, which again becomes a finished good. (This process continues. Many departments are necessary to create the final product, and along the way, each department adds to the final cost to manufacture the product.) An entry is made to move the table from the work-in-process account in the painting department to the finished-goods account and then from the finished-goods account to the COGS account when the table is sold.

Managerial Accounting30

Equivalent Units of Production In table manufacturing, each department would most likely finish off the last piece at the end of the day and call it quits for the day. But what about more complicated products like motors, airplanes, tractors, and so on? At the end of the day, departments most likely won’t have finished their stage of the process. Costs have incurred, but there’s no finished good for that department. This is where the concept of equivalent units of production comes in. It’s the product of number of partially completed units and the percentage of completion of those units with respect to the processing in the department. Equivalent units of production can be calculated using the weighted- average method or the First In, First Out (FIFO) method (which will be covered in Appendix 4A).

Exhibit 4-6 on page 153 of your textbook provides a visual perspective of equivalent units of production. The exhibit shows that at the beginning of the period, there were 200 units that were 30% complete in beginning work in process. At the end of the period, those 200 were completed, along with an additional 4,600 units that were started and com- pleted, totaling 4,800 units finished and transferred to the next department. However, 400 more units had been started but were only 25% completed. To obtain the equivalent units of production, we multiply the 400 units by 25% to get 100 equivalent units. This is the equivalent units that would have been completed for the same period of time if we were able to start and finish each unit instead of starting 400 units at one time but not being able to complete them for one reason or another. We then add the 4,800 units completed to the 100 we would have completed to obtain the 4,900 equivalent units.

Compute and Apply Costs Once we know the equivalent units of production, we can then compute the cost per equivalent unit. We know our costs of the beginning work-in-process inventory. We add costs incurred during the period and divide that by the number of equivalent units to obtain our cost per equivalent unit. This is done for each cost category, and a cost reconciliation report is created if necessary.

Lesson 1 31

Operation Costing Job-order costing and process costing are the most common costing methods. However, one size shoe doesn’t fit all, and there are adaptations for particular situations in between. Operation costing is a method that’s used when a product has both common characteristics and individual characteris- tics—much like shoes. Shoes involve cutting and sewing, yet styles of shoes are very individual. Costing for shoes employs aspects of both job-order costing and process costing. Specific styles of shoes are created in batches, reflecting the aspects of job-order costing. However, shoes are also created in an assembly line–like process and reflect the aspects of process costing. Each manufacturer decides which process to use and when to use it based on the situation at hand.

Appendix 4A: FIFO Method Exhibit 4A-2 on page 173 of your textbook shows a visual perspective of equivalent units of production for the FIFO method, compared with the weighted-average method. The dif- ference is in the treatment of the beginning work in process. While the weighted-average method treats the beginning work in process as completed, the FIFO method considers the com- pleted portion up to that point as water under the bridge. It factors in the amount yet to be completed—in the example, 70% under the FIFO method, compared with 100% under the weighted-average method.

The costs per equivalent unit are also calculated differently under FIFO and don’t take into account the costs of the beginning work-in-process inventory.

On the surface, this may seem easier. However, it’s more complicated than the weighted-average method because the costs of the units transferred out consist of the cost of the beginning work-in-process inventory, the cost to complete the units in the beginning inventory, and the cost of units started and completed during the period. Compare the cost of the ending work-in-process inventory and the units-transferred-

Managerial Accounting32

out schedule for the weighted-average method on page 155 of your textbook with the same schedule for the FIFO method on page 175 and note the differences.

While the weighted-average method is simpler to use, the FIFO method is superior because under the weighted-average method, the manager’s apparent performance in the current period is influenced by what happened in prior periods. Under the FIFO method, a clear distinction is made between costs incurred in differing periods.

Appendix 4B: Service Department Allocations Some large organizations have not only operating depart- ments but also service departments. Three methods are generally used to allocate service costs:

1. Direct method

2. Step-down method

3. Reciprocal method

Using the direct method, page 180 of your textbook explains that “any of the allocation base attributable to the service departments themselves is ignored; only the amount of the allocation base attributable to the operating departments is used in the allocation.” Page 182 explains that “in both the direct and step-down methods, any amount of the allocation base attributable to the service department whose cost is being allocated is always ignored.” Also, “in the step-down method, any amount of the allocation base that is attributable to a service department whose cost has already been allocated is ignored.” Page 182 also states that “the reciprocal method gives full recognition to interdepartmental services.”

Review Problems Be sure to go over and fully understand the “Review Problems” at the end of each chapter/appendix as they apply many of the concepts found in the chapter.

Lesson 1 33

Note: Once you have completed the following textbook exer- cises and problems and the Self-Check, you’ll need to take the Lesson Exam. To access and complete any of the examinations for this study guide, click on the appropriate Take Exam but- ton on your student portal. You shouldn’t have to enter the examination numbers. These numbers are for reference only if you have any reason to contact Student Care. Once you have completed the exam, move on to your next lesson/assignment.

TexTbook ProbleMS for ASSignMenT 4

Exercises: #4–1, #4–2 (page 162), #4–3, #4–4, #4–5, #4–

6, #4–7 (page 163), #4–8 (page 164), #4–11 (page 165)

Problems: #4–15, #4–15 (page 167), #4–16,

#4–17 (page 168)

Appendix 4A: #4A–1, #4A–2, #4A–3 (page 176),

#4A–4 (page 177), #4A–9, #4A-10 (page 178)

Appendix 4B: #4B–1 (page 182), #4B–2, #4B–3, #4B–4,

#4B–5 (page 183), #4B–6 (page 184)

Check your answers in the Textbook exercises and

Problem Solutions Supplement.

Managerial Accounting34

Self-Check 4 Questions 1–10: Indicate whether each of the following sentences is True or False.

______ 1. The following journal entry would be made in a processing costing system when units

that have been completed in the final processing department are transferred to the

finished-goods warehouse:

______ Work in Process XXX

Manufacturing Overhead XXX

______ 2. The “costs to be accounted for” portion of the cost reconciliation report includes

the cost of beginning work-in-process inventory and the cost of ending

work-in-process inventory.

______ 3. The “costs accounted for” portion of the cost reconciliation report includes the cost of

ending work-in-process inventory and the cost of units transferred out.

______ 4. The cost per equivalent unit for conversion costs will always be the same under

both the FIFO and the weighted-average methods if there’s no beginning work-in-

process inventory.

______ 5. Under the FIFO process costing method, the equivalent units of production relate only

to work done during the current period.

______ 6. The cost per equivalent unit under the FIFO method of process costing is equal to the

cost of beginning work-in-process inventory plus the costs added during the period, all

divided by the equivalent units of production for the period.

______ 7. In both the direct and step-down methods of allocating service department costs, any

amount of the allocation base that’s attributable to the service department whose cost

is being allocated is ignored.

(Continued)

Lesson 1 35

Self-Check 4 ______ 8. The direct method has the disadvantage that it may leave some service department

costs unallocated.

______ 9. If personnel department expenses are allocated on the basis of the number of employees in

various departments, the number of employees in the personnel department itself must

be included in the allocation base when the step-down method is used.

______ 10. The step-down method requires that an order of allocation be established before service

department costs can be allocated to operating departments.

11. Process costing would be appropriate for each of the following except

a. custom furniture manufacturing. c. grain milling.

b. oil refining. d. newsprint production.

12. An operation costing system is

a. identical to a process costing system except that actual manufacturing overhead costs are

traced to units of product.

b. the same as a process costing system except that direct materials costs are accounted for

in the same way as in job-order costing.

c. the same as a job-order system except that direct materials costs are accounted for in the

same way as in process costing.

d. identical to a job-order costing system except that actual manufacturing overhead costs

are traced to units of product.

13. Assume there’s no beginning work-in-process inventory and the ending work-in-process inven-

tory is 100% complete with respect to materials costs. The number of equivalent units with

respect to materials costs under the weighted-average method is

a. the same as the number of units put into production.

b. less than the number of units put into production.

c. the same as the number of units completed.

d. less than the number of units completed.

(Continued)

Managerial Accounting36

Self-Check 4 14. Assume there’s no beginning work-in-process inventory and the ending work-in-process inventory

is 70% complete with respect to conversion costs. Under the weighted-average method, the

number of equivalent units of production with respect to conversion costs would be

a. the same as the units completed.

b. less than the units completed.

c. the same as the units started during the period.

d. less than the units started during the period.

15. Sala Corporation uses the weighted-average method in its process costing system. The Fitting

Department is the second department in its production process. The data below summarize

the department’s operations in March.

Units Percent Complete with

Respect to Conversion

Beginning work in process inventory . . 9,400 20%

Transferred in from the prior department

during March. . . . . . . . . . . . . . . . . . 45,000

Ending work in process inventory . . . . 4,600 90%

The Fitting Department’s cost per equivalent unit for conversion cost for March was $2.64.

How much conversion cost was assigned to the units transferred out of the Fitting Department

during March?

a. $118,800.00 c. $131,472.00

b. $126,508.80 d. $143,616.00

(Continued)

Lesson 1 37

Self-Check 4 16. Yimron Corporation uses the weighted-average method in its process costing system.

Information for the month of March concerning Department A, the first stage of the company’s

production process, follows:

Materials Conversion Cost

Work in process, beginning . . . . . . . . . $4,000 $3,000

Costs added during March . . . . . . . . . $20,000 $16,000

Costs per equivalent unit . . . . . . . . . . $0.24 $0.20

Units completed and transferred to

the next department . . . . . . . . . . . . 90,000 units

Work in process, ending . . . . . . . . . . . 10,000 units

Materials are added at the beginning of the process. The ending work-in-process inventory is

50% complete with respect to conversion costs. Which cost would be recorded for the ending

work-in-process inventory?

a. $1,700 c. $3,400

b. $2,200 d. $4,400

17. In July, one of the processing departments at Feickert Corporation had a beginning work-in-

process inventory of $23,000 and an ending work-in-process inventory of $16,000. During the

month, $268,000 of costs were added to production, and the cost of units transferred out

from the department was $275,000. In the department’s cost reconciliation report for July, the

total cost to be accounted for would be

a. $39,000. c. $559,000.

b. $291,000. d. $582,000.

(Continued)

Managerial Accounting38

Self-Check 4 18. All production costs have been steadily rising in the Donner Company for several periods. The

company maintains large work-in-process inventories. Donner Company’s cost per equivalent

unit computed using the FIFO method would be

a. the same as that computed under the weighted-average method.

b. higher than that computed under the weighted-average method.

c. lower than that computed under the weighted-average method.

d. lower than, the same as, or higher than that computed under the weighted-average

method.

19. Creer Company uses the FIFO method in its process costing system. Department A had

20,000 units in process at the beginning of January, which were 40% complete with respect to

conversion costs. All materials are added at the beginning of the process in Department A.

The January 1 work-in-process inventory in Department A contained $10,000 in materials cost

and $11,600 in conversion cost. During January, materials costs were $0.50 per equivalent

unit, and conversion costs were $1.50 per equivalent unit. All of the units in the beginning

work-in-process inventory were completed and transferred out during the month. What was

the total cost attached to these units when they were transferred to the next department?

a. $33,600 c. $39,600

b. $37,600 d. $45,600

20. Reciprocal service department costs are

a. allocated to producing departments under the direct method but not allocated to producing

departments at all under the step-down method.

b. allocated to producing departments under the step-down method but not allocated to

producing departments at all under the direct method.

c. not allocated to producing departments under either the direct or the step-down methods.

d. allocated to producing departments under both the direct and step-down methods.

Check your answers with those on page 123.

39

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Tools in Management and Aids to Decision Making

ASSIGNMENT 5: COST-VOLUME- PROFIT RELATIONSHIPS Read this assignment. Then read pages 187–214 in your textbook.

The Basics of Cost-Volume-Profit (CVP) Analysis Understanding the relationship between cost, volume, and profit through analysis is vital in many business decisions. These analysis methods are affected by five factors:

1. Selling prices

2. Sales volume

3. Unit variable costs

4. Total fixed costs

5. Mix of products sold

In the previous lesson, we covered contribution margin. Briefly, it’s the sales less the variable costs. What’s left over is used to cover the fixed costs. Any amount remaining is the net operat- ing income. If the net operating income is zero, we’re at the break-even point. Once we’re at the break-even point, any increase in income is directly related to the contribution margin of each unit sold. Exhibit 5-2 on page 193 in your textbook illustrates these relationships in graphic form. Understanding this allows us to understand how changes in one variable affect other variables.

The contribution margin ratio is such an example. The contri- bution margin (CM) ratio is the contribution margin divided by the sales. As the contribution margin or the sales change, so does the percentage. The change in percentage affects the net operating income over break-even for each unit sold.

Managerial Accounting40

Break-Even and Target Profit Analysis A key use of CVP analysis is target profit analysis. There are two methods used to calculate the target profit—the equa- tion method and the formula method. Both arrive at the same answers.

The equation method uses the following equation:

Profit = Unit contribution margin (CM) � Sales – Fixed expenses

The formula method uses the following equation:

Unit sales to attain the target profit = (Target profit + Fixed expenses)/Unit CM

The difference between the two is the number of steps used in the calculation; the formula method has fewer steps. Also, the formula method makes it easier to perform the calculations for either units or for a dollar target profit.

When we calculate for a target profit of zero, we’re actually performing a break-even analysis in either unit sales or dollar sales, which is another reason for using the formula method rather than the equation method.

A core principle of project management is that whenever you budget, tack on an additional 20–25% because you’ll almost always have cost overruns. This principle can be seen in the concept of margin of safety using break-even analysis. If you calculate break-even but don’t leave yourself a margin of safety, you’ll most likely incur losses. The margin of safety can be calculated in either dollars or as a percentage.

CVP Considerations in Choosing a Cost Structure The extremes of a cost structure are high variable costs and low fixed costs versus low variable costs and high fixed costs. Which is the most correct? There’s no answer. Both have advantages and disadvantages. It’s a balancing act, unless you have a crystal ball and can predict the future. What managers can do is to plan and control their costs.

Lesson 2 41

A key tool in accomplishing this is the concept known as operating leverage. The degree of operating leverage at a given level is the contribution margin divided by the net operating income. By running some scenarios, a manager can see how a change in sales affects the net operating income and the leverage it brings. Page 208 of your textbook shows an example of changes in sales and how the degree of operating leverage changes.

Structuring Sales Commissions Since sales are vital to a business, structuring sales commis- sions for salespeople can have an impact. Companies usually compensate salespeople as a commission based on sales, a salary, or both. Provided that fixed costs remain the same, conflicts arise when commissions are based on sales, which can lead to lower profits. Companies should base commis- sions on contribution margin. Salespeople will then try to sell products with the higher contribution margin, thereby maximizing profits.

Sales Mix With a variety of products to sell, break-even analysis becomes more complex. The sales mix is the relative proportion in which a company’s products are sold with the idea of being able to maximize profit. Exhibits 5-4 and 5-5 on page 211 of your textbook provide an example of a multiproduct break-even analysis and a shift in the sales mix for the break-even analysis. If the sales mix changes, the break-even point most likely changes.

Review Problems Be sure to go over and fully understand the “Review Problems” at the end of each chapter/appendix as they apply many of the concepts found in the chapter.

Managerial Accounting42

TexTbook ProbleMS for ASSignMenT 5

Exercises: #5–1, #5–2, #5–3, #5–4, #5–5 (page 218), #5–

6, #5–7, #5–8, #5–9 (page 219), #5–10 (page 220), #5–15

(page 221), #5–18 (page 222)

Problems: #5–20 (page 223), #5–21 (page 224),

#5–23 (page 225), #5–27. #5–28 (page 227),

#5–29, #5–30 (page 228)

Check your answers in the Textbook Exercises and

Problem Solutions Supplement.

Self-Check 5 Questions 1–10: Indicate whether each of the following sentences is True or False.

______ 1. Fixed cost per unit increases as activity decreases and decreases as activity increases.

______ 2. A cost formula may not be valid outside the relevant range of activity.

______ 3. The relevant range concept isn’t applicable to mixed costs.

______ 4. The planning horizons for committed fixed costs and discretionary fixed costs are

generally the same.

______ 5. With automation, fixed costs increase relative to variable costs.

______ 6. The high-low method is generally less accurate than the least-squares regression

method for analyzing the behavior of mixed costs.

______ 7. The fact that the high-low method uses only two data points is a major defect

of the method.

(Continued)

Lesson 2 43

Self-Check 5 ______ 8. The contribution approach to the income statement classifies costs by behavior rather

than by function.

______ 9. On an income statement prepared by the traditional approach, costs are organized and

presented according to function.

______ 10. The R2 (i.e., R-squared) indicates the proportion of a mixed cost that’s variable.

11. Expense A is a fixed cost; expense B is a variable cost. During the current year, the activity

level has increased but is still within the relevant range. In terms of cost per unit of activity,

we would expect that

a. expense A has remained unchanged. c. expense A has decreased.

b. expense B has decreased. d. expense B has increased.

12. When the level of activity increases within the relevant range, how does each of the

following change?

a. Choice A c. Choice C

b. Choice B d. Choice D

(Continued)

Average cost

per unit Total variable cost

Fixed cost

per unit

A Increases Increases Increases

B Increases No change Increases

C Decreases No change Decreases

D Decreases Increases Decreases

Managerial Accounting44

Self-Check 5 13. The linear equation Y = a + bX is often used to express cost formulas. In this equation, the

a. b term represents variable cost per unit of activity.

b. a term represents variable cost in total.

c. X term represents total cost.

d. Y term represents total fixed cost.

14. An example of a discretionary fixed cost is

a. insurance.

b. taxes on real estate.

c. management training.

d. depreciation of buildings and equipment.

15. A cost driver is

a. the largest single category of cost in a company.

b. a fixed cost that can’t be avoided.

c. a factor that causes variations in a cost.

d. an indirect cost that’s essential to the business.

16. A disadvantage of the high-low method of cost analysis is that

a. it can’t be used when there are a very large number of observations.

b. it’s too time-consuming to apply.

c. it uses two extreme data points, which may not be representative of normal conditions.

d. it relies totally on the judgment of the person performing the cost analysis.

17. The contribution approach to the income statement

a. organizes costs on a functional basis.

b. is useful to managers in planning and decision making.

c. shows a contribution margin rather than a net operating income figure at the bottom of

the statement.

d. can be used only by manufacturing companies.

(Continued)

Lesson 2 45

ASSIGNMENT 6: VARIABLE COSTING AND SEGMENT REPORTING: TOOLS FOR MANAGEMENT Read this assignment. Then read pages 233–258 and 279–282 in your textbook.

Overview of Variable and Absorption Costing; Variable and Absorption Costing—An Example Absorption costing treats all costs as product costs. On the other hand, variable costing treats only those manufacturing costs that vary with output as product costs. Selling and administrative expenses are never treated as product costs under either the absorption or variable cost methods.

Self-Check 5 18. Contribution margin is the excess of revenues over

a. cost of goods sold. c. all direct costs.

b. manufacturing cost. d. all variable costs.

19. The _______ approach to the income statement organizes costs by function.

a. contribution c. comparable

b. traditional d. None of these is true.

20. _______ is a method of separating a mixed cost into its fixed and variable elements by fitting

a regression line that minimizes the sum of the squared errors.

a. Quick-and-dirty c. High-low

b. Scattergraph d. Least-squares regression

Check your answers with those on page 125.

Managerial Accounting46

Exhibit 6-1 on page 235 of your textbook provides an overview of variable costing versus absorption costing, and pages 236– 239 provide an example illustrating the differences. The result is an example of variable costing income statements in Exhibit 6-2 on page 237 and an example of absorption costing income statement in Exhibit 6-3 on page 238.

Reconciliation of Variable Costing with Absorption Costing Income Exhibit 6-5 on page 241 of your textbook provides a compari- son of income effects between absorption costing and variable costing. On the surface, one would think a cost is a cost and that the net operating income should be the same whether using absorption costing or variable costing. However, dig- ging deeper reveals why the net income isn’t the same in both methods. The difference is due to the amount of fixed manufacturing overhead that’s deferred in or released from inventories during the period under absorption costing.

Advantages of Variable Costing and the Contribution Approach There are three advantages to using variable costing together with the contribution approach when preparing internal reports:

1. Enabling CVP analysis

2. Explaining changes in net operating income

3. Supporting decision making

CVP analysis using variable costing is easier to use because the costs are categorized as fixed or variable, whereas absorp- tion costing mixes together both fixed and variable costs.

In explaining changes to net income, variable costing income statements are easier to understand. The number of units produced does not affect the net income. Absorption costing income statements are easily misunderstood. Attention needs to be paid to changes in inventory levels.

Lesson 2 47

Variable costing supports decision making by correctly identi- fying additional variable costs. Using absorption costing, fixed manufacturing overhead costs appear to be variable with respect to the number of units sold. However, they are not.

Segmented Income Statements and the Contribution Approach; Segmented Income Statements—An Example Income statements for different business segments can be created using the contribution approach. The segmented income statements, depending upon the complexity of the business, can become difficult to construct due to the differ- ence between the traceable fixed costs and the common fixed costs to create the segmented margin. Distinction between traceable and common fixed costs is crucial in segment reporting. It is hard sometimes to determine whether a cost should be classified as traceable or common. The fact that a cost can be both traceable and common only adds to the confusion.

As an example, Exhibit 6-6 on page 247 provides a variable costing income statement for ProphetMax, Inc. Page 247 also provides an example of the business segments for ProphetMax, Inc. Exhibit 6-8 on page 248 shows the segmented income statements in the contribution format.

Segmented Income Statements— Decision Making and Break-Even Analysis Once a contribution format segmented income statement is created, it can be used in a decision making process, during- which managers should be mindful of the break even points. The break-even analysis can be calculated for the dollar sales for both a company to break-even and for a segment to break-even.

Managerial Accounting48

Segmented Income Statements—Common Mistakes Only costs for a segment should be assigned to the segment. It sounds like common sense. However, various mistakes are commonly made. Some of the more common mistakes are:

n Omission of costs

n Inappropriate methods for assigning traceable costs among segments

n Arbitrarily dividing common costs among segments

When segmenting, greater control over costs is achieved and a better analysis for decision making is provided. However, with segmentation, the possibility for mistakes to be made is also greater. Only by recognizing the possible mistakes can they be avoided.

Income Statements— An External Reporting Perspective GAAP and IFRS both require the use of absorption costing for “external” reports (meaning reports that go outside of the com- pany itself). The contribution approach is simpler but can only be used for “internal” reporting (meaning the reports stay inside the company and are not seen by outside entities.) Each company must determine for themselves how they will recon- cile internal vs. external reporting.

GAAP and IFRS also require that publicly traded companies include segmented financial and other data in their annual reports and that the method to be used is the same as creating the internal reports. Segmented contribution format income statements may contain inside information that the company does not want the public or competitors to see.

Lesson 2 49

Review Problems Be sure to go over and fully understand the “Review Problems” at the end of each chapter/appendix as they apply many of the concepts found in the chapter.

TexTbook ProbleMS for ASSignMenT 6

Exercises: #6–1 (page 262), #6–2, #6–3, #6–4 (page 263),

#6–5, #6–6, #6–7, #6–8 (page 264), #6–10 (page 265),

Problems: #6–23, #6–24 (page 272), #6–25 (page 273),

#6–26 (page 274)

Appendix 6A: #6A–2, #6A–3 (page 283), #6A–4,

#6A–5 (page 284)

Check your answers in the Textbook Exercises and

Problem Solutions Supplement.

Self-Check 6 Questions 1–20: Indicate whether each of the following sentences is True or False.

______ 1. Under variable costing, product cost does not contain any fixed manufacturing

overhead cost.

______ 2. Under conventional absorption costing, the fixed costs associated with idle production

capacity are not included as part of the product cost.

______ 3. Under absorption costing, the profit for a period is affected by a change in the number

of units of finished goods in inventory.

(Continued)

Managerial Accounting50

Self-Check 6 ______ 4. When variable costing is used, and if selling prices exceed variable expenses and if the

unit contribution margins, the sales mix, and fixed costs remain the same, profits move

in the same direction as sales.

______ 5. Because absorption costing emphasizes costs by behavior, it works well with

cost-volume-profit analysis.

______ 6. Net operating income is affected by the number of units produced when absorption

costing is used.

______ 7. Under absorption costing, it is possible to defer a portion of the fixed manufacturing

overhead costs of the current period to future periods through the inventory account.

______ 8. When the number of units in work in process and finished goods inventories decrease,

absorption costing net operating income will typically be greater than variable costing

net operating income.

______ 9. Assuming the LIFO inventory flow assumption, if production is less than sales for the

period, absorption costing net operating income will generally be greater than variable

costing net operating income.

______ 10. Assuming the LIFO inventory flow assumption, if production equals sales for the period,

absorption costing and variable costing will produce the same net operating income.

______ 11. When viewed over the long term, cumulative net operating income will be the same for

variable and absorption costing if ending inventories exceed beginning inventories.

______ 12. A common fixed cost is a fixed cost that supports more than one business segment and

is traceable in whole or in part to at least one of the business segments.

______ 13. Common fixed costs should not be charged to the individual segments when preparing

a segmented income statement.

(Continued)

Lesson 2 51

Self-Check 6 ______ 14. If a cost must be arbitrarily allocated in order to be assigned to a particular segment,

then that cost should not be considered a common cost.

______ 15. A common fixed cost is a fixed cost that is incurred because of the existence of a par-

ticular business segment and that would be eliminated if the segment were eliminated.

______ 16. Segment margin is a better measure of the long-run profitability of a segment than

contribution margin.

______ 17. When using segmented income statements, the dollar sales for a company to break

even equals the sum of the traceable fixed expenses and the common fixed expenses

divided by the overall CM ratio.

______ 18. Common fixed expenses should be allocated to business segments when performing

break-even calculations and making decisions.

______ 19. Super-variable costing is a costing method that treats direct labor and manufacturing

overhead costs as period costs and includes only direct materials cost in unit

product costs.

______ 20. All differences between super-variable costing and absorption costing net operating

income are explained by the accounting for direct materials costs.

Check your answers with those on page 125.

Managerial Accounting52

ASSIGNMENT 7: ACTIVITY-BASED COSTING: A TOOL TO AID DECISION MAKING Read this assignment. Then read pages 286–314 and 331–338 in your textbook.

Activity-Based Costing: An Overview Page 287 of your textbook summarizes how activity-based costing (ABC) differs from traditional costing in three ways:

1. Nonmanufacturing as well as manufacturing costs may be assigned to products, but only on a cause-and- effect basis.

2. Some manufacturing costs may be excluded from product costs

3. Numerous overhead cost pools are used, each of which is allocated to products and other cost objects using ABC’s unique measure of activity.

Under ABC, all costs—both manufacturing and nonmanufactur- ing—are assigned to the product. Previously, we thought of only manufacturing costs. ABC uses the entire cost of the product, such as a salesperson’s commission, and not just the manufacturing costs.

Manufacturing overhead under ABC isn’t arbitrarily assigned as costs as it is under traditional costing systems. Instead it’s treated as organization-sustaining costs. Also, products are charged for only the costs of the capacity they use and not for costs that they don’t use, such as idle time.

Traditionally, many companies use direct labor hours or machine hours to base overhead allocations. This makes sense when financial statements are being created for exter- nal reporting and/or in situations where overhead costs are

Lesson 2 53

directly correlated. However, when plantwide overhead costs don’t directly correlate with direct labor or machine hours, the information becomes distorted. ABC defines five levels of activity to compensate for the distortions:

1. Unit-level activities

2. Batch-level activities

3. Product-level activities

4. Customer-level activities

5. Organization-sustaining activities

Designing an Activity-Based Costing (ABC) System There are five steps for implementing an ABC system:

1. Define activities, activity cost pools, and activity measures.

2. Assign overhead costs to activity cost pools.

3. Calculate activity rates.

4. Assign overhead costs to cost objects using the activity rates and activity measures.

5. Prepare management reports.

This section will cover step 1—defining activities, activity cost pools, and activity measures. The next section will cover the other four steps.

Identifying activities is the foundation for the system. They can be grouped together into activity cost pools, and then a basis for measuring the activities must be developed. The number of activities is an important factor. The more activities used, the more complex the system. However, this allows for more accurate costing. There’s one caution, though: activities should be grouped together at the appropriate level.

Managerial Accounting54

The Mechanics of Activity-Based Costing

Step 2: Assign Overhead Costs to Activity Cost Pools

Overhead costs are assigned to activity pools using first-stage allocation, where overhead costs are derived from a company’s general ledger into activity cost pools. Exhibits 7-5 and 7-6 on page 297 of your textbook provide an example of a breakdown in distribution of activities into activity cost pools and then the actual allocations using first-stage allocations to those activity pools.

Step 3: Calculate Activity Rates

Exhibit 7-7 on page 299 of your textbook shows an example of computations of activity rates. Exhibit 7-8 on page 300 provides an ABC model. Study the exhibit carefully to grasp how different costs are assigned to products and other cost objects in the ABC system.

Step 4: Assign Overhead Costs to Cost Objects

This next step uses what’s known as second-stage allocation, where the activity rates are used to apply overhead costs to products and customers. Exhibit 7-9 on page 301 of your textbook illustrates how overhead costs are assigned to prod- ucts; a further example shows how activity costs are assigned to customers.

Step 5: Prepare Management Reports

Finally, reports are generated showing profit margins for products and customer margins for customers. Then prof- itability reports can be created by product and by customer.

Lesson 2 55

Comparison of Traditional and ABC Product Costs Exhibit 7-13 on page 307 of your textbook shows an example of product margins calculated under a traditional costing sys- tem. However, the differences between the traditional and ABC cost assignments are best illustrated in Exhibit 7-14 on page 308. The product margins under traditional cost assignments differ from ABC cost assignments. There are three reasons:

1. A traditional cost system allocates all manufacturing overhead costs to products.

2. A traditional cost system allocates all of the manufactur- ing overhead costs using a volume-related overhead base—e.g., machine hours—that may or may not reflect what actually causes the costs.

3. ABC systems assign the manufacturing overhead costs caused by products to those products on a cause-and- effect basis.

Targeting Process Improvements ABC can be used for process improvement and is referred to as activity-based management. The Theory of Constraints and Six Sigma—both defect-eliminating methodologies—can be used once decisions have been made on what to improve after exam- ining activity rates. Benchmarking helps to identify those areas that have the room for the greatest improvement.

Activity-Based Costing and External Reports Activity-based costing makes sense. Each company is in itself unique, and ABC can be tailored to each individual company. However, for reporting purposes, it becomes prob- lematic. While it does provide more accurate product costs than traditional costing systems, external reporting needs a framework where apples can be compared with apples. If an investor is looking at financial reports, there needs to be a

Managerial Accounting56

basis for comparison. ABC loses that ability due to the uniqueness of the information. Therefore, ABC is relegated to special studies for management and isn’t a part of formal cost accounting systems.

The Limitations of Activity-Based Costing ABC, while more accurate, has limitations in the area of requiring substantial resources to implement and is more costly to maintain than traditional systems. Costs can easily be misapplied, creating overstated costs and understated mar- gins that result in poor decision making. Additionally, the data can easily be misinterpreted.

Appendix 7A: ABC Action Analysis Exhibit 7A-3 on page 333 of your textbook gives an example of an action analysis cost matrix. The report shows where costs would have to be adjusted as a result of an action. To help managers in the use of ABC data, a color-coding system can be used to reflect the ease of adjustments. Exhibit 7A-6 on page 337 illustrates a flowchart of the steps to pro- duce an action analysis report and an activity analysis as shown in the chapter.

Review Problems Be sure to go over and fully understand the “Review Problems” at the end of each chapter/appendix as they apply many of the concepts found in the chapter.

Lesson 2 57

TexTbook ProbleMS for ASSignMenT 7

Exercises: #7–1, #7–2 (page 318), #7–3 (page 319), #7–4,

#7–5 (page 320), #7–12 (page 324), #7–15 (page 325)

Problems: #7–17 (page 327), #7–20 (page 329)

Appendix 7A: #7A–2 (page 339), #7A–3, #7A–4 (page 340)

Check your answers in the Textbook Exercises and

Problem Solutions Supplement.

Self-Check 7 Questions 1–10: Indicate whether each of the following sentences is True or False.

______ 1. When combining activities in an activity-based costing system, activities should be

grouped together at the same level. For example, batch-level activities shouldn’t be

combined with unit-level activities.

______ 2. In activity-based costing, organization-sustaining costs shouldn’t be included in product

costs for internal management reports that are used for decision making. However,

companies frequently include organization-sustaining costs in product costs to satisfy

external reporting requirements.

______ 3. An activity-based costing system is generally easier to set up and run than a traditional

cost system.

(Continued)

Managerial Accounting58

Self-Check 7 ______ 4. Duration drivers ordinarily require more effort to record than transaction drivers.

______ 5. In activity-based costing, as in traditional costing systems, nonmanufacturing costs

aren’t assigned to products.

______ 6. In activity-based costing, a plantwide overhead rate is used to apply overhead

to products.

______ 7. Changing a cost accounting system is likely to meet with little resistance in an

organization because it’s a technical matter of little interest to individuals outside

of the accounting department.

______ 8. The first-stage allocation in activity-based costing is the process by which overhead

costs are assigned to products before they’re assigned to customers.

______ 9. An action analysis report reconciles activity-based costing product costs with traditional

product costs based on direct labor.

______ 10. An action analysis report reconciles activity-based costing product costs with traditional

product costs based on direct labor.

11.Purchase-order processing is an example of a/an _______ activity.

a. unit-level c. product-level

b. batch-level d. organization-sustaining

12. Overhead allocation based solely on a measure of volume, such as direct-labor hours,

a. is a key aspect of the activity-based costing model.

b. will systematically overcost high-volume products and undercost low-volume products.

c. will systematically overcost low-volume products and undercost high-volume products.

d. must be used for external financial reporting.

13. Arranging for a shipment of a number of different products to a customer is an example of an

activity at which level?

a. Unit c. Customer

b. Batch d. Organization-sustaining

(Continued)

Lesson 2 59

Self-Check 7 14. Testing a prototype of a new product is an example of a/an _______ activity.

a. unit-level c. product-level

b. batch-level d. organization-sustaining

15. Setting up equipment is an example of a/an _______ activity.

a. unit-level c. product-level

b. batch-level d. organization-sustaining

16. The clerical activity associated with processing purchase orders to produce an order for a

standard product is an example of a/an _______ activity.

a. unit-level c. product-level

b. batch-level d. organization-sustaining

17. Worker recreational facilities is an example of a cost that would ordinarily be considered to be

a. unit-level. c. product-level.

b. batch-level. d. organization-sustaining.

18. If a cost object, such as a product or customer, has a negative yellow margin, then its green

margin

a. will be positive. c. will be negative.

b. may be positive, negative, or zero. d. will be zero.

19. If a cost object, such as a product or customer, has a positive green margin, then its

red margin

a. will be positive. c. will be negative.

b. may be either positive, negative, or zero. d. will be zero.

20. If a cost object, such as a product or customer, has a positive red margin, then its

yellow margin

a. will be positive. c. will be negative.

b. may be positive, negative, or zero. d. will be zero.

Check your answers with those on page 126.

Managerial Accounting60

ASSIGNMENT 8: MASTER BUDGETING Read this assignment. Then read pages 342–369 in your textbook.

What Is a Budget? Businesses are in business to make a profit. The more suc- cessful businesses use a process called profit planning through the use of creating budgets. Good budgets allow for planning and control. Page 343 of your textbook lists six advantages of keeping a budget:

1. Budgets communicate management’s plans throughout the organization.

2. Budgets force managers to think about and plan for the future.

3. The budgeting process provides a means of allocating resources to those parts of the organization where they can be used most effectively.

4. The budgeting process can uncover potential bottlenecks before they occur.

5. Budgets coordinate the activities of the entire organiza- tion by integrating the plans of its various parts.

6. Budgets define goals and objectives that can serve as benchmarks for evaluating subsequent performance.

Budgets are no good unless there’s some responsibility and accountability for those items that are under the control of amanager. It’s a waste of time and money to put together a budget that works when no one will strive to follow it. Therefore, the most effective budgets are those that are self-imposed. On the lower levels, self-imposed budgets are created. They have the greatest chance of succeeding because each manager creates the budget that he or she thinks is possible for him or her. These budgets are then submitted to the next-higher level of management, where they’re adjusted up or down and added to as necessary.

Lesson 2 61

These are reviewed and consolidated as they move up the organization until they get to the budget committee, where a final budget is approved.

Exhibit 8-1 on page 346 of your textbook illustrates the mas- ter budget interrelationships. The master budget begins with the sales budget. This drives all other budgets. The master budget ends with a cash budget, budgeted income statement, and budgeted balance sheet.

Preparing the Master Budget A typical budget consists of the following:

The schedules show how the various budgets feed information into each other. If the assessments are correct when initially determining each individual budget, collectively they’ll paint a picture for profit planning and control. Problem areas will stand out and can be addressed. Once the budget is in place

Document Illustrative Example by Schedule and

Page Number in your textbook

1. A sales budget, including a schedule of expected cash collections

Schedule 1, Page 353

2. A production budget Schedule 2 Page 354

3. A direct-materials budget, including a schedule of expected cash disbursements for purchases of materials

Schedule 3, Page 356

4. A direct-labor budget Schedule 4, Page 357

5. A manufacturing-overhead budget Schedule 5, Page 358

6. An ending finished-goods inventory budget Schedule 6, Page 359

7. A selling and administrative expense budget Schedule 7, Page 360

8. A cash budget Schedule 8, Page 362

9. A budgeted income statement Schedule 9, Page 365

10. A budgeted balance sheet Schedule 10, Page 366

Managerial Accounting62

to reflect a reasonable level of profitability, it becomes the manager’s responsibility to control activities in order to attain the projections.

Review Problems Be sure to go over and fully understand the “Review Problems” at the end of each chapter/appendix as they apply many of the concepts found in the chapter.

Note: Once you have completed the following textbook exer- cises and problems and the Self-Check, you’ll need to take the Lesson Exam. To access and complete any of the exami- nations for this study guide, click on the appropriate Take Exam button on your student portal. You shouldn’t have to enter the examination numbers. These numbers are for ref- erence only if you have any reason to contact Student Care. Once you have completed the exam, move on to your next lesson/assignment.

TexTbook ProbleMS for ASSignMenT 8

Exercises: #8–1 (page 372), #8–2, #8–3, #8–4 (page 373),

#8–5, #8–6, #8–7 (page 374), #8–8, #8–9 (page 375)

Problems: #8–17 (page 379), #8–27 (page 385)

Check your answers in the Textbook Exercises and

Problem Solutions Supplement.

Lesson 2 63

Self-Check 8 Questions 1–10: Indicate whether each of the following sentences is True or False.

______ 1. The cash budget is developed from the budgeted income statement.

______ 2. The usual starting point in budgeting is to make a forecast of cash receipts and

cash disbursements.

______ 3. Budgets are used for planning rather than for controlling operations.

______ 4. A production budget is to a manufacturing firm as a merchandise purchases budget is

to a merchandising firm.

______ 5. In the merchandise purchases budget, the required purchases (in units) for a period

can be determined by subtracting the beginning merchandise inventory (in units) from

the budgeted sales (in units).

______ 6. When preparing a materials purchase budget, desired ending inventory is deducted

from total needs of the period to arrive at materials to be purchased.

______ 7. In companies that have “no lay-off” policies, the total direct-labor cost for a budget

period is computed by multiplying the total direct-labor hours needed to make the

budgeted output of completed units by the direct-labor wage rate.

______ 8. If the expected level of activity is appreciably above or below the company’s present

capacity, it may be desirable to adjust fixed costs in the budget.

______ 9. In the manufacturing overhead budget, the noncash charges (such as depreciation) are

added to the total budgeted manufacturing overhead to determine the expected cash

disbursements for manufacturing overhead.

______ 10. The beginning cash balance isn’t included in the cash budget because the cash budget

deals exclusively with cash flows rather than with balance-sheet amounts.

(Continued)

Managerial Accounting64

Self-Check 8 11. The materials purchase budget

a. is the beginning point in the budget process.

b. must provide for desired ending inventory as well as for production.

c. is accompanied by a schedule of cash collections.

d. is completed after the cash budget.

12. The budget or schedule that provides necessary input data for the direct labor budget is the

a. raw materials purchases budget. c. schedule of cash collections.

b. production budget. d. cash budget.

13. Which budgets are prepared before the sales budget?

a. Choice A c. Choice C

b. Choice B d. Choice D

14. The master budget process usually begins with the _______ budget.

a. production c. sales

b. operating d. cash

15. The cash budget must be prepared before you can complete the

a. production budget. c. raw-materials purchases budget.

b. budgeted balance sheet. d. schedule of cash disbursements.

16. Which of the following is not a benefit of budgeting?

a. It uncovers potential bottlenecks before they occur.

b. It coordinates the activities of the entire organization by integrating the plans and

objectives of the various parts.

c. It ensures that accounting records comply with generally accepted accounting principles.

d. It provides benchmarks for evaluating subsequent performance.

(Continued)

Manufacturing Overhead Budget Cash Budget

A Yes Yes

B Yes No

C No Yes

D No No

Lesson 2 65

Self-Check 8 17. The concept of responsibility accounting means that

a. budgetary data should be reviewed and approved by the budget committee.

b. budgetary data should be reviewed and approved by all levels of management.

c. an employee’s performance should be evaluated only on those items under his or her

control.

d. an employee’s performance should be evaluated only by his or her immediate supervisor.

18. Fairmont Inc. uses an accounting system that charges costs to the manager who has been

delegated the authority to make decisions concerning costs. For example, if the sales manager

accepts a rush order that will result in higher-than normal manufacturing costs, these additional

costs are charged to the sales manager because the authority to accept or decline the rush

order was given to the sales manager. This type of accounting system is known as

a. responsibility accounting. c. absorption accounting.

b. contribution accounting. d. operational budgeting.

19. A self-imposed budget, or _______ budget, is a budget that’s prepared with the full

cooperation of managers at all levels.

a. perpetual c. participative

b. master d. responsibility

20. There are various budgets within the master budget. One of these budgets is the production

budget. Which of the following best describes the production budget?

a. It details the required direct-labor hours.

b. It details the required raw-materials purchases.

c. It’s calculated based on the sales budget and the desired ending inventory.

d. It summarizes the costs of producing units for the budget period.

Check your answers with those on page 127.

Managerial Accounting66

NOTES

Budget Analysis and Performance Measurement in Decision Making

ASSIGNMENT 9: FLEXIBLE BUDGETS AND PERFORMANCE ANALYSIS Read this assignment. Then read pages 393–409 in your textbook.

The Variance Analysis Cycle The Variance Analysis Cycle is used to evaluate and improve performance. Exhibit 9-1 on page 393 of your text- book shows the cycle. Variances to budgets are expected. When variances are too large, they need to be looked at to determine the cause so that corrections can be made if nec- essary.

Managers determine which deviations between the actual results and the budget should be investigated by using what is known as “management by exception,” which is used in conjunction with the variance analysis cycle. This allows them to focus on the more important variances.

Flexible Budgets The previous lesson explored how to create a planned budget before a period begins that’s valid only for the planned level of activity. In this lesson, we’ll explore how changes in activity affect costs using a flexible budget. A flexible budget can be adjusted to show what costs should be for the actual level of activity. Exhibit 9-4 on page 396 of your textbook compares a static planning budget to actual results. Exhibit 9-5 on page 397 shows a flexible budget based on actual activity. Study the relationship carefully. The planned budget is prepared for a

67

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Managerial Accounting68

period of time. The actual results are obtained. The flexible budget reflects what the actual numbers should have been based on the level of activity.

Flexible Budget Variances The differences between the planned budget and actual level of activity are known as the activity variances, whether favorable (F) or unfavorable (U). Exhibit 9-6 on page 398 of your text- book provides an example of a statement of activity variances between the planned budget and flexible budget based on actual activity.

Revenue and spending variances can also be depicted by comparing the flexible budget to the actual results, as seen in Exhibit 9-7 on page 400. Combining activity variances, revenue, and spending variances can produce an overall performance report, as shown in exhibit 9-8 on page 402.

Flexible Budgets with Multiple Cost Drivers Flexible budgets can be created using multiple cost drivers. The reporting processes for activity variances and revenue and spending variances are the same. The difference lies in using more than one cost driver; the variances will be more accurate.

Some Common Errors A common error in preparing budgets is to assume that all costs are fixed or that all costs are variable. This leads to inaccurate benchmarks and incorrect variances. Exhibits 9-10 and 9-11 on pages 406 and 407 of your textbook show faulty analysis, when all items are assumed to be fixed versus when all items are assumed to be variable.

Lesson 3 69

Review Problems Be sure to go over and fully understand the “Review Problems” at the end of each chapter/appendix as they apply many of the concepts found in the chapter.

TexTbook ProbleMS for ASSignMenT 9

Exercises: #9–1 (page 412), #9–2, #9–3 (page 413), #9–4,

#9–5 (page 414), #9–6 (page 415), #9–10 (page 416), #9–

11, #9–12, #9–13, #9–14 (page 417), #9–18 (page 419)

Problems: #9–19 (page 419), #9–23 (page 422)

Check your answers in the Textbook Exercises and

Problem Solutions Supplement.

Self-Check 9 Questions 1–12: Indicate whether each of the following sentences is True or False.

______ 1. A flexible budget is an estimate of what revenues and costs should have been, given

the level of activity that had been planned for the period.

______ 2. An unfavorable activity variance for a cost indicates that spending was higher than it

should have been for the actual level of activity for the period.

______ 3. The activity variance for revenue is unfavorable if the actual revenue for the period is

less than the revenue in the static planning budget.

(Continued)

Managerial Accounting70

Self-Check 9 ______ 4. The revenue and spending variances are the differences between the static planning

budget and the flexible budget.

______ 5. A revenue variance is unfavorable if the actual revenue is less than what the revenue

should have been for the actual level of activity for the period.

______ 6. When the activity measure is the number of units sold, the revenue variance is

unfavorable if the average actual selling price is less than expected.

______ 7. A favorable spending variance occurs when the actual cost is less than the amount of

that cost in the flexible budget.

______ 8. A flexible budget performance report should contain fixed as well as variable and

mixed costs.

______ 9. It may be easier to control fixed costs than variable costs.

______ 10. A static planning budget is suitable for planning and for evaluating how well costs are

controlled.

______ 11. If the actual level of activity is 4% less than planned, then the costs in the static

budget should be reduced by 4% before comparing them with actual costs.

______ 12. If the actual level of activity is 4% more than planned, then the fixed costs in the static

budget should be increased by 4% before comparing them with actual costs.

(Continued)

Lesson 3 71

Self-Check 9 13. A flexible budget

a. classifies budget requests by activity and estimates the benefits arising from each activity.

b. presents a statement of expectations for a period of time but doesn’t present a firm

commitment.

c. presents the plan for only one level of activity and doesn’t adjust to changes in the level

of activity.

d. presents the plan for a range of activity so that the plan can be adjusted for changes in

activity levels.

14. A flexible budget is a budget that

a. is updated with actual costs as they occur during the period.

b. is updated to reflect the actual level of activity during the period.

c. is prepared using a computer spreadsheet application.

d. contains only variable production costs.

15. Which comparison best isolates the impact that changes in prices of inputs and outputs have

on performance?

a. Static planning budget and flexible budget

b. Static planning budget and actual results

c. Flexible budget and actual results

d. Master budget and static planning budget

Check your answers with those on page 128.

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ASSIGNMENT 10: STANDARD COSTS AND VARIANCES Read this assignment. Then read pages 427–447, 459–464, and 471–472 in your textbook.

Standard Costs—Setting the Stage Managers can set standards for costs, quantity, and price based on past experience. As the actual quantities and prices are received, they can be compared with the standards. If there are significant departures from the standards, these exceptions can be investigated and corrective action taken.

There are two types of standards—ideal and practical. Ideal standards are met under the optimum or “ideal” circumstances (think working at 100% peak performance). Practical standards allow for the inevitable, such as rest periods for employees, machine downtime for maintenance, etc. The practical standard strives for peak performance but allows for reality in setting the standard costs.

Direct-material standards are usually set as a standard price per unit or a standard quantity per unit. The standard price per unit should reflect the final cost of the materials after discounts have been taken. The standard quantity per unit also reflects the finished product after allowances have been made for unavoidable waste, such as scrap, waste, spoilage, rejects, etc.

Direct-labor standards are set as a standard rate per hour or standard hours per unit. The standard rate per hour includes all wage considerations, such as wages, employment taxes, and fringe benefits. Standard hours per unit is the most diffi- cult to calculate because the time it takes to produce a unit varies from unit to unit. Allowances also need to be made for breaks, machine downtime, etc.

Variable manufacturing overhead standards can also be expressed in rates and hours and are calculated the same as for direct materials and labor. Exhibit 10-1 on page 430 of your textbook shows how standard costs are calculated for materials, labor, and overhead.

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A General Model for Standard Cost Variance Analysis Exhibit 10-3 on page 433 of your textbook provides a general model for variance analysis. It shows how price variance is calculated and what variances make up the price variance. It also shows how the quantity variance is calculated and what variances make up the quantity variance. Together they make up the total variance for variable manufacturing costs.

Using Standard Costs— Direct Materials Variances The general model for variance analysis is used for direct materials variance analysis. Exhibit 10-4 on page 434 of your textbook shows how the price and quantity variances are cal- culated for direct materials. It should be noted that the price variance is usually computed by most companies when the materials are purchased rather than when used. This practice simplifies bookkeeping and also produces timelier reporting.

When calculating materials price variance, it should be noted that with a formula approach, a negative variance is always labeled favorable (F) and a positive variance is always labeled unfavorable (U).

It can be confusing at first to decide whether your variance is favorable or unfavorable. The formula for materials price variance is the actual price (AP) minus the standard price (SP) times the actual quantity (AQ). The formula for materials price variance = AQ (AP – SP).

When the variance is favorable, you’ve set up a standard price. For example, let’s use 100 for the standard price. Now, let’s also assume that the quantity is 1 to keep the math simple. If our actual price comes in at 80, then we have 80 – 100 = –20, which is negative. However, this is favorable to you (even though the math gives us a negative number) because we set the standard higher than what our actual was. It’s like saying I gave you $100 and you used only $80, so you have $20 left over, which is favorable to you.

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When the variance is unfavorable, you again set up the standard price. Again, let’s assume the price is 100, with the quantity being 1 to keep the math simple. However, this time the actual price comes in at 130. We then have 130 – 100 = 30, which is positive. However, this is unfavorable to you (even though the math gives us a positive number). Again, I gave you $100, but this time you spent $130. Even though the math shows a positive number, it’s unfavorable to you because you’re out of pocket $30. It costs more than what you expected or set as your standard.

Materials quantity variance is best isolated when materials are used in production. Excess use of materials can be spot- ted and corrective action taken based on what has been set as standard.

Using Standard Costs— Direct Labor Variances Once you understand direct materials variances, you basi- cally also understand how to calculate direct labor variances. Exhibit 10-6 on page 437 of your textbook provides the general model for variance analysis as applied to direct labor. Comparing it with Exhibit 10-4 on page 434 for direct mate- rials, you can see they’re very similar. The hours and rate are used instead of quantity and price in the calculations.

Unfavorable labor efficiency variances are common. Some reasons for this are poor supervision, poor-quality materials (which requires more labor time), and inaccurate standards. Also, insufficient demand for a company’s product can be a cause. For example, air conditioning and refrigeration service- men are busy through the warm to hot months of spring, summer, and fall. However, during the cool and cold months, work tapers off. A company may choose not to lay off the ser- vicemen for a variety of reasons. This causes an unfavorable labor variance.

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Using Standard Costs—Variable Manufacturing Overhead Variances The variable portion of manufacturing overhead can be analyzed using the same formulas (with minor differences) that are used for direct materials and direct labor (see Exhibit 10-8 on page 440 of your textbook). For direct labor efficiency variance, the difference is multiplied by the direct labor rate. For the variable overhead efficiency variance, the difference is multiplied by the variable overhead rate. So, when direct labor is used as the base for overhead, if the direct labor efficiency variance is favorable, the variable overhead efficiency variance will be favorable. The opposite is also true.

An Important Subtlety in the Materials Variances Exhibit 10-10, Standard Cost Variance Analysis—Direct Materials and Exhibit 10-11, Direct Materials Variances: The Equations-Based Approach (when the quantity of materials purchased does not equal the quantity used in production) on page 443 can always be used to compute direct materials variances. This is important because most companies use the quantity of materials purchased to compute the materials price variance and the quantity of materials used in production to compute the materials quantity variance. The two variances do not generally sum to the spending variance from the flexible budget. Exhibits 10-4, Standard Cost Variance Analysis— Direct Materials and Exhibit 10-5, Direct Materials Variances: The Equation-Based Approach on pages 434 and 436 can only be used in the special case when the quantity of materials purchased equals the quantity of materials used.

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Standard Costs— Managerial Implications Using a standard cost system, care needs to be taken by man- agers. Page 444 of your textbook lists advantages and potential problems in using standard costs. It becomes too easy to focus on the negatives in using the standard costs instead of the positives which can have unintended consequences.

Appendix 10A: Predetermined Overhead Rates and Overhead Analysis in a Standard Costing System Recall that the formula for the predetermined overhead rate is equal to the estimated total manufacturing overhead rate divided by the estimated total amount of the allocation base. This can then been broken down into variable and fixed components. We can then calculate the applied overhead. Exhibit 10A-2 on page 460 of your textbook shows that the difference between a normal cost system and a standard cost system for applied overhead costs is that the normal cost system uses actual hours and the standard cost system uses standard hours allowed for actual output. In a standard cost system, the same amount of overhead cost is charged per unit produced, regardless of the time it takes to produce that unit.

In using a standard costing system for fixed manufacturing overhead variances, a budget variance and a volume variance are computed to make up the total variance. The formula for the budget variance is equal to the actual fixed overhead minus the budgeted fixed overhead. The volume variance is equal to the budgeted fixed overhead minus the fixed over- head applied to work in process. The computation and relationship of the fixed overhead variances is shown in Exhibit 10A-3 on page 461 of your textbook. Again, when working with variances, pay attention to what’s favorable and unfavorable by thinking of the actual in relation to the budgeted (standard).

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Caution must be used when working with fixed overhead analysis. Managers can think that fixed costs are, in fact, variable. This happens because when applying costs to work in process, we act as if fixed costs are variable.

In a standard cost system, the underapplied or overapplied overhead for a period equals the sum of the overhead vari- ances. Thus, when underapplied, the total of the standard cost overhead variances is generally unfavorable; when overapplied, the total of the standard cost overhead variances is generally favorable.

Appendix 10B: Journal Entries to Record Variances Bookkeeping becomes immensely simplified when using a standard cost system. By assigning standard costs, the actual costs don’t need to be tracked on a continuing basis. Pages 471–472 of your textbook illustrate journal entries for both direct materials variances and direct labor variances. Exhibit 10B-1 on page 472 provides a graphic example of the cost flows in a standard cost system.

Review Problems Be sure to go over and fully understand the “Review Problems” at the end of each chapter/appendix as they apply many of the concepts found in the chapter.

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Self-Check 10 Questions 1–20: Indicate whether each of the following sentences is True or False.

______ 1. A direct materials quantity standard generally includes an allowance for waste.

______ 2. The materials price variance is computed by multiplying the difference between the

actual price and the standard price by the actual quantity of materials purchased.

______ 3. Waste on the production line will result in an unfavorable materials quantity variance.

______ 4. A materials price variance is unfavorable if the actual price exceeds the standard price.

______ 5. A favorable materials quantity variance occurs when the actual quantity used in pro-

duction is less than the standard quantity allowed for the actual output of the period.

______ 6. The standard price per unit for direct materials should not include the cost of delivering

the materials.

(Continued)

TexTbook ProbleMS for ASSignMenT 10

Exercises: #10–1 (page 450), #10–2, #10–3, #10–4

(page 451)

Problems: #10–9, (page 453), #10–14, #10–15

(page 456), #10–16 (page 457)

Appendix 10A: #10A–5 (page 466), #10A–6 (page 467),

#10A–10, #10A–11 (page 469)

Appendix 10B: #10B–1, #10B–2 (page 473)

Check your answers in the Textbook Exercises and

Problem Solutions Supplement.

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Self-Check 10 ______ 7. Purchase of poor quality materials may cause a favorable materials price variance and

an unfavorable labor efficiency variance.

______ 8. An unfavorable labor rate variance can occur if workers with high hourly wage rates are

assigned to work on products with standards that assume workers have low hourly

wage rates.

______ 9. The standard labor rate per hour defines the company's expected direct labor wage

rate per hour, including employment taxes and fringe benefits.

______ 10. The variable overhead efficiency variance measures how efficiently variable manufac-

turing overhead resources were used.

______ 11. A company has a standard cost system in which fixed and variable manufacturing over-

head costs are applied to products on the basis of direct labor-hours. A fixed

manufacturing overhead volume variance will NOT necessarily occur in a month in

which production volume differs from sales volume.

______ 12. The fixed manufacturing overhead volume variance is more meaningful than the budget

variance for cost control purposes.

______ 13. In a standard costing system, if the actual fixed manufacturing overhead cost exceeds

the budgeted fixed manufacturing overhead cost for the period, then fixed manufactur-

ing overhead cost would be overapplied for the period.

______ 14. If all four of Argo Corporation's overhead variances are favorable, Argo's overhead will

be underapplied.

______ 15. A company has a standard cost system in which fixed and variable manufacturing over-

head costs are applied to products on the basis of direct labor-hours. The company's

choice of the denominator level of activity affects the fixed manufacturing overhead

budget variance.

(Continued)

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Self-Check 10 ______ 16. If the actual quantity of materials used is less than the standard quantity of materials

allowed for the actual output, then the journal entry to record the direct materials

quantity variance would be a debit.

______ 17. If the actual purchase price for materials exceeds the standard purchase price, then

the journal entry to record the direct materials price variance would be a credit.

______ 18. An unfavorable labor rate variance is recorded as a debit in the Labor Rate

Variance account.

______ 19. A favorable labor efficiency variance is recorded as a debit in the Labor Efficiency

Variance account.

______ 20. An unfavorable labor efficiency variance is recorded as a debit in the Labor Efficiency

Variance account.

Check your answers with those on page 128.

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ASSIGNMENT 11: PERFORMANCE MEASUREMENT IN DECENTRALIZED ORGANIZATIONS Read this assignment. Then read pages 477–497, 512–519, and 524–528 in your textbook.

Decentralization in Organizations Recall from Chapter 1 that decentralization is the delegation of decision-making authority throughout an organization by giving managers the authority to make decisions relating to their area of responsibility. Therefore, a decentralized organi- zation spreads the authority throughout an organization instead of just to a few top executives. Page 478 in your textbook enumerates the major advantages and disadvan- tages of decentralization.

Responsibility Accounting With the decision-making authority is spread throughout an organization, responsibility accounting systems must be put into place to monitor the outcomes of those decisions. The three types of responsibility centers are (1) cost centers, which control costs or the use of investment funds, (2) profit centers, which control both costs and revenues but not the use of investment funds, and (3) investment centers, which control all three—costs, revenue, and investment funds.

Evaluating Investment Center Performance—Return on Investment There are two methods for evaluating investment center per- formance: (1) return on investment (ROI), which is covered in this section and (2) residual income, which is covered in the next section.

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ROI is the net operating income divided by the average oper- ating assets. Net operating income is income before interest and taxes (also known as EBIT—earnings before interest and taxes). Operating assets are the assets held for operating pur- poses. This definition of ROI is of limited value to managers to help in decision making to increase their ROI. ROI is also the margin multiplied by turnover. Margin is the net operating income divided by sales. Turnover is the sales divided by the average operating assets. Exhibit 11-1 on page 483 of your textbook provides a visual understanding of the elements that go into calculating ROI.

ROI can be increased by increasing sales, reducing operat- ing expenses, or reducing operating assets. However, it may not be that simple. Managers may not know how to increase ROI. They may increase ROI in a way that doesn’t align with the overall strategic plan. They may increase ROI in the short term, but it may end up being harmful in the long term. Managers may also be taking over committed costs that were created by someone else and that they now have no control over.

Residual Income To calculate residual income, multiply the average operating assets by the minimum required rate of return and then sub- tract this from the net operating income. Companies use residual income to measure performance. If the intent is to maximize ROI, then they would produce only one product— the one that gives the greatest return. The table at the bottom of page 484 of your textbook shows a comparison between measuring performance using ROI and residual income. In the table, the ROI is calculated under the criticisms of using ROI covered in the previous section. With the residual income, the required rate of return is predetermined. This allows a man- ager the ability to measure performance because the residual income over and above the rate of return can be tracked, eliminating some of the drawbacks of using ROI strictly as a performance measure. Using residual income allows man- agers to make the investments that are best for the company.

Lesson 3 83

A manager may reject an investment if it’s below the com- pany’s current ROI. On the other hand, managers would pursue investments that are greater than the rate of return because it would increase the residual income.

Using residual income has one major disadvantage, which becomes evident when performance is compared between divisions of different sizes. Just because of sheer size, the residual income will be larger for larger-sized divisions and not because they’re being managed better.

Operating Performance Measures Financial statements reflect the results of what occurs in an organization; however, they don’t measure what drives organizational performance. Performance can be measured by using delivery cycle time, throughput (manufacturing cycle) time, and manufacturing cycle efficiency (MCE).

Exhibit 11-2 on page 487 of your textbook shows the relation- ship between delivery cycle time and throughput time. Delivery cycle time is a concern to customers. It measures the time from when the order is placed to when it’s delivered. Often sales are lost if the product can’t be delivered within an adequate time frame. Often the customer needs the product within a specific period of time, and if it can’t be delivered, the customer will find someone who can deliver it.

Throughput time is a subset of the delivery cycle time. It encompasses the time from when production begins until the product is shipped. The difference between throughput time and delivery cycle time is the wait time. Throughput time has both value-added (processing time) and non-value-added time components. Being able to cut down on non-value-added time and the wait time increases the MCE.

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Balanced Scorecard Page 490 of your textbook defines a balanced scorecard as “an integrated set of performance measures that are derived from and support the company’s strategy.” Management translates its strategy into performance measures that employees can understand, carry out, and influence. The measures tend to fall into four broad categories:

1. Financial

2. Customer

3. Internal business process

4. Learning and growth

The performance measures are specific to each organization. Exhibit 11-3 on page 491 of your textbook provides an example of performance measures for balanced scorecards. There can be a balanced scorecard for the overall organization, but each individual responsible can also have his or her own balanced scorecard. Cause-and-effect is the key. The thought process should follow an if/then process: “If we do this, then this should improve.” This process is specific to each organization, and an example of a possible strategy is shown in Exhibit 11- 5 on page 494 of your textbook.

Appendix 11A: Transfer Pricing Managers are keenly aware of the price they get for their goods and/or services between segments of an organization because it affects the profitability of their divisions. This process is known as transfer pricing. Prices can be negotiated between managers. Prices can be set at cost using either variable costs or full (absorption) costs, or they can be set at the market price. An example would be the company PepisCo. PepsiCo makes the soda Pepsi, but it also owns the Pizza Hut fran- chise. Of course, it puts Pepsi in the Pizza Hut restaurants. It must determine what the transfer price for Pepsi will be between Pepsi and Pizza Hut.

When negotiating transfer prices, there’s a range of accept- able transfer prices. The lower limit is the seller’s cost. Below that, it will take a loss on the sale. The upper limit is where

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