Managerial Accounting

144 Chapter 4 Activity-Based Costing and Analysis

those customers. Generally, ABC provides better customer profitability information by including all resources consumed to serve a customer. This allows managers to make better pricing decisions on custom orders and to better manage customers by focusing on those that are most profitable.

Better Management of Activities Being competitive requires that managers be able to use resources efficiently. Understanding how costs are incurred is a first step toward controlling costs. One important contribution of ABC is helping managers identify the causes of costs, that is, the activities driving them. Activity-based management (ABM) is an outgrowth of ABC that draws on the link between activities and cost incurrence for better management. Activity-based manage- ment can be useful in distinguishing value-added activities, which add value to a product, from non-value-added activities, which do not. For KartCo, its value-added activities include machining, assembly, and the costs of engineering design changes. Its non-value-added activity is machine repair. The way to control a cost requires changing how much of an activity is performed.

The ABCs of Decisions Business managers must make long-term strategic decisions, day-to-day operating decisions, and decisions on the type of financing the business needs. Survey evidence suggests that managers find ABC more useful in making strategic, operating, and financing decisions than non- ABC methods. ■

Decision Insight

Costing systems and decisions

0 1 2 3 4 5 6

Financial

Strategic

Operational

Ty p

e o

f d

ec is

io n

Non-ABC methods ABC method

Average response, 0=Not useful, 6=Extremely useful Source: Stratton et al., Management Accounting Quarterly, 2009

Costs of Quality A focus on the costs of activities, via ABC and ABM, lends itself to as- sessments of the costs of quality. These costs refer to costs resulting from manufacturing defec- tive products or providing services that do not meet customer expectations. Exhibit 4.16 summarizes the typical costs of quality. These costs can be summarized in a cost of quality report, which lists the costs of quality activities by category. A focus on activities and quality costs can lead to higher quality and lower costs.

EXHIBIT 4.16 Types of Quality Costs

Prevention costs Internal failure costs

Costs of Good Quality Costs of Poor Quality

Appraisal costs External failure costs

Cost of Quality Report Cost

Prevention Training. . . . . . . . . . . . . . . . . . . . . $ 22,000 Appraisal Inspecting materials . . . . . . . . . . . 37,500 Testing finished goods . . . . . . . . . 14,200 Internal failure Rework . . . . . . . . . . . . . . . . . . . . . 8,250 Scrap. . . . . . . . . . . . . . . . . . . . . . . 11,750 External failure Warranty claims . . . . . . . . . . . . . . 45,700 Total cost of quality . . . . . . . . . $139,400

Prevention and appraisal costs are incurred before a good or service is provided to a cus- tomer. The purpose of these costs is to reduce the chance the customer is provided a defective good or service. These are the costs of trying to ensure that only good-quality items are pro- duced. Prevention activities focus on quality training and improvement programs to ensure quality is built into the product or service. Common appraisal costs include the costs of inspec- tions to ensure that materials and supplies meet specifications and inspections of finished goods.

Internal and external failure costs are the costs of making poor-quality items. Internal failure costs are incurred after a company has manufactured a defective product but before that product has been delivered to a customer. Internal failure costs include the costs of reworking products, reinspecting reworked products, and scrap.

Finally, external failure costs are incurred after a customer has been provided a defective product or service. Examples of this type of cost include costs of warranty repairs and costs of

Point: Prevention and appraisal costs are usually considered value-added costs, while internal and external costs are considered non- value-added costs.

© Getty Images

Chapter 4 Activity-Based Costing and Analysis 145

recalling products. This category also includes lost profits due to dissatisfied customers buying from other companies.

Disadvantages of Activity-Based Costing Costs to Implement and Maintain ABC Designing and implementing an activity-based costing system requires management commitment and financial resources. For ABC to be effective, a thorough analysis of cost activities must be performed and appropriate cost pools must be determined. Collecting and analyzing cost data is expensive and so is maintaining an ABC system. While technology, such as bar coding, has made it possible for many companies to use ABC, it is still too costly for some. Managers must weigh the cost of implementing and main- taining an ABC system against the potential benefits of ABC in light of company circumstances.

Uncertainty with Decisions Remains As with all cost information, managers must in- terpret ABC data with caution in making decisions. In the KartCo case, given the huge design- modification costs for custom go-karts determined under the ABC system, a manager might be tempted to decline some custom go-kart orders to save overhead costs. However, in the short run, some or all of the design-modification costs cannot be saved even if some custom go-kart orders are rejected. Managers must examine carefully the controllability of costs before making decisions.

ABC for Service Providers Although we’ve shown how to use ABC in a manufacturing setting, ABC also applies to service providers. The only requirements for ABC are the existence of costs and demand for reliable cost information. First Tennessee National Corporation, a bank, applied ABC and found that 30% of its certificate of deposit (CD) customers provided nearly 90% of its profits from CDs. Further, 30% of the bank’s CD customers were actually losing money for the bank. The bank’s management used ABC to correct the problem and increase profits. Laboratories performing medical tests, accounting and law offices, and advertising agencies are other examples of ser- vice firms that can benefit from ABC. (Refer to this chapter’s Decision Analysis for an example of applying ABC to assess customer profitability and this chapter’s Comprehensive Need-To- Know for an example of applying ABC to a law firm.)

Types of Activities Activities causing overhead costs can be separated into four levels of types of activities: (1) unit- level activities, (2) batch-level activities, (3) product-level activities, and (4) facility-level activities. These four activities are described as follows.

C3 Describe the four types of activities that cause overhead costs.

Batch-level activities are performed only on each batch or group of units. For example, machine setup is needed only for each batch regardless of the units in that batch, and customer order processing must be performed for each order regardless of the number of units ordered. Batch-level costs do not vary with the number of units, but instead vary with the number of batches.

Unit-level activities are performed on each product unit. For example, the machining department needs electricity to power the machinery to produce each unit of product. Unit-level costs tend to change with the number of units produced.

Product-level activities are performed on each product line and are not affected by either the numbers of units or batches. For example, product design is needed only for each product line. Product-level costs do not vary with the number of units or batches produced.

Facility-level activities are performed to sustain facility capacity as a whole and are not caused by any specific product. For example, rent and factory maintenance costs are incurred no matter what is being produced. Facility-level costs do not vary with what is manufactured, how many batches are produced, or the output quantity.

Activity Levels

146 Chapter 4 Activity-Based Costing and Analysis

In the KartCo example, the craftsmanship pool reflects unit-level costs, the setup pool reflects batch-level costs, the design-modification pool reflects product-level costs, and plant services reflect facility-level costs.

Exhibit 4.17 shows additional examples of activities commonly found within each of the four activity levels. This is not a complete list, but reviewing it can help in understanding this hierar- chy of production activities. This list also includes common measures used to reflect the specific activity identified. Knowing this hierarchy can help us simplify and understand activity-based costing.

EXHIBIT 4.17 Examples of Activities by Activity Level

Activity Level Examples of Activity Activity Driver (Measure)

Unit level Cutting parts Machine hours Assembling components Direct labor hours Printing checks Number of checks Batch level Calibrating machines Number of batches Receiving shipments Number of orders Sampling product quality Number of lots produced Product level Designing modifications Change requests Organizing production Engineering hours Controlling inventory Parts per product Facility level Cleaning workplace Square feet of floors* Providing electricity Kilowatt hours* Providing personnel support Number of employees*

* Facility-level costs are not traceable to individual product lines, batches, or units. They are normally assigned to units using a unit-level driver such as direct labor hours or machine hours even though they are caused by another activity.

QC3

GLOBAL VIEW Toyota Motor Corporation pioneered lean manufacturing, which focuses on eliminating waste while satisfying customers. Many lean manufacturers embrace lean accounting, which has two key compo- nents. First, the company applies lean thinking to eliminate waste in its accounting process. Second, instead of focusing on cost allocation methods such as activity-based costing, the company develops alternative performance measures that better reflect the benefits of manufacturing process changes. Examples include the percentage of products produced without defects, the percentage of ontime deliv- eries, and the level of sales per employee.

Sustainability and Accounting Suja Juice Co. also relies on lean techniques. The company must use extremely fresh raw materials, thus it employs just-in-time inventory management. Likewise, its finished product has a limited shelf life, so managers must carefully monitor sales demand to ensure that no juice is wasted.

Customer ProfitabilityDecision Analysis

Are all customers equal? To help answer this, let’s return to the KartCo case and assume that costs of providing customer support (such as delivery, installation, and warranty work) are related to the distance a technician must travel to provide services. Also assume that, as a result of applying activity-based cost- ing, KartCo plans to sell its standard go-kart for $1,200 per unit. If the annual cost of customer services is expected to be $250,000 and the distance traveled by technicians is 100,000 miles annually, KartCo would want to link the cost of customer services with individual customers to make efficient marketing decisions. Using these data, an activity rate of $2.50 per mile ($250,000y100,000 miles) is computed for assign- ing customer service costs to individual customers. For KartCo, it would compute a typical customer profitability report for one of its customers, Six Flags, as follows.

© Robert Gallagher/Forbes Magazine/ Forbes Collection/Corbis Outline

Silver Law Firm provides litigation and mediation services to a variety of clients. Attorneys keep track of the time they spend on each case, which is used to charge fees to clients at a rate of $300 per hour. A man- agement advisor commented that activity-based costing might prove useful in evaluating the costs of its legal services, and the firm has decided to evaluate its fee structure by comparing ABC to its alternative cost allocations. The following data relate to a typical month at the firm. During a typical month the firm handles seven mediation cases and three litigation cases.

COMPREHENSIVE

NEED-TO-KNOW

Chapter 4 Activity-Based Costing and Analysis 147

Analysis indicates that a total profit margin of $1,000 is generated from this customer. The management of KartCo can see that if this customer requires service technicians to travel more than 600 miles ($1,500 4 $2.50 per mile), the sale of 10 standard go-karts to this customer would be unprofitable. ABC encourages management to consider all resources consumed to serve a customer, not just manufacturing costs that are the focus of traditional costing methods.

Customer Profitability Report—Six Flags

Sales (10 standard go-karts 3 $1,200) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $12,000 Less: Product costs Direct materials (10 go-karts 3 $400 per go-kart) . . . . . . . . . . . . . . . . $4,000 Direct labor (10 go-karts 3 $350 per go-kart) . . . . . . . . . . . . . . . . . . . . 3,500 Overhead (10 go-karts 3 $300 per go-kart, Exhibit 4.14) . . . . . . . . . . 3,000 10,500 Product profit margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500 Less: Customer service costs (200 miles 3 $2.50 per mile) . . . . . . . . . . . . . 500 Customer profit margin. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,000

Required

1. Determine the cost of providing legal services to each type of case using activity-based costing (ABC). 2. Determine the cost of each type of case using a single plantwide rate for nonattorney costs based on

billable hours. 3. Determine the cost of each type of case using multiple departmental overhead rates for the internal

support department (based on number of documents) and external support department (based on bill- able hours).

4. Compare and discuss the costs assigned under each method for management decisions.

PLANNING THE SOLUTION Compute pool rates and assign costs to cases using ABC. Compute costs for the cases using the volume-based methods and discuss differences between these

costs and the costs computed using ABC.

Consumption by

Activity

Total Service Type

Activity Driver Amount Litigation Mediation Cost

Providing legal advice. . . . . . . . . . . . . . . . . Billable hours 200 75 125 $30,000 Overhead costs Internal support departments Preparing documents . . . . . . . . . . . . . . Documents 30 16 14 $ 4,000 Occupying office space . . . . . . . . . . . . Billable hours 200 75 125 1,200 Heating and lighting of office . . . . . . . . Billable hours 200 75 125 350 External support departments Registering court documents . . . . . . . . Documents 30 16 14 1,250 Retaining consultants (investigators, psychiatrists) . . . . . . . . Court dates 6 5 1 10,000 Using contract services (couriers, security guards) . . . . . . . . Court dates 6 5 1 5,000 Total overhead costs $21,800

148 Chapter 4 Activity-Based Costing and Analysis

SOLUTION 1. We need to set up activity pools and compute pool rates for ABC. All activities except “occupying of-

fice space” and “heating and lighting” are unit-level activities (meaning they are traceable to the indi- vidual cases handled by the law firm). “Preparing documents” and “registering documents” are both driven by the number of documents associated with each case. We can therefore combine these activi- ties and their costs into a single pool, which we call “clerical support.” Similarly, “retaining consul- tants” and “using services” are related to the number of times the attorneys must go to court (court dates). We combine these activities and their costs into another activity cost pool labeled “litigation support.” The costs associated with occupying office space and the heating and lighting are facility- level activities and are not traceable to individual cases. Yet they are costs that must be covered by fees charged to clients. We assign these costs using a convenient base—in this example we use the number of billable hours, which attorneys record for each client. Providing legal advice is the direct labor for a law firm.

Activity Pool Activity Pool Rate (Pool Cost Activity Pool Cost Cost Driver 4 Activity Driver)

Providing legal advice . . . . . . . . . . . . $30,000 $30,000 200 billable hours $150 per billable hour Clerical support Preparing documents . . . . . . . . . . 4,000 Registering documents . . . . . . . . . 1,250 5,250 30 documents $175 per document Litigation support Retaining consultants . . . . . . . . . . 10,000 Using services . . . . . . . . . . . . . . . . 5,000 15,000 6 court dates $2,500 per court date Facility costs Occupying office space . . . . . . . . 1,200 Heating and lighting . . . . . . . . . . . 350 1,550 200 billable hours $7.75 per billable hour

We next determine the cost of providing each type of legal service as shown in the following table. Specifically, the pool rates from above are used to assign costs to each type of service provided by the law firm. Since litigation consumed 75 billable hours of attorney time, we assign $11,250 (75 billable hours 3 $150 per billable hour) of the cost of providing legal advice to this type of case. Mediation required 125 hours of attorney time, so $18,750 (125 billable hours 3 $150 per billable hour) of the cost to pro- vide legal advice is assigned to mediation cases. Clerical support costs $175 per document, so the costs associated with activities in this cost pool are assigned to litigation cases (16 documents 3 $175 per document 5 $2,800) and mediation cases (14 documents 3 $175 per document 5 $2,450). The costs of activities in the litigation support and the facility cost pools are similarly assigned to the two case types.

We compute the total cost of litigation ($27,131.25) and mediation ($24,668.75) and divide these totals by the number of cases of each type to determine the average cost of each case type: $9,044 for litigation and $3,524 for mediation. This analysis shows that charging clients $300 per billable hour without regard to the type of case results in litigation clients being charged less than the cost to provide that service ($7,500 versus $9,044).

* (75 billable hours 3 $300 per hour) 4 3 cases † (125 billable hours 3 $300 per hour) 4 7 cases

Pool Rate Litigation Mediation

Providing legal advice. . . . . . $150 per 75 hours $11,250.00 125 hours $18,750.00 billable hour Clerical support . . . . . . . . . . $175 per 16 docs 2,800.00 14 docs 2,450.00 document Litigation support . . . . . . . . $2,500 per 5 court dates 12,500.00 1 court date 2,500.00 court date Facility costs . . . . . . . . . . . . $7.75 per 75 hours 581.25 125 hours 968.75 billable hour Total cost . . . . . . . . . . . . . . . $27,131.25 $24,668.75 4 Number of cases. . . . . . . 3 cases 7 cases Average cost per case . . . . . $9,044 $3,524 Average fee per case . . . . . . $7,500* $5,357†

Chapter 4 Activity-Based Costing and Analysis 149

2. The cost of each type of case using a single plantwide rate for nonattorney costs (that is, all costs ex- cept for those related to providing legal advice) based on billable hours is as follows.

Total overhead costyTotal billable hours 5 $21,800y200 billable hours 5 $109 per hour

We then determine the cost of providing each type of legal service as follows.

Litigation Mediation

Providing legal advice. . . . . . . . . . . $150 per billable hour 75 hours $11,250 125 hours $18,750 Overhead (from part 2) . . . . . . . . $109 per billable hour 75 hours 8,175 125 hours 13,625 Total cost . . . . . . . . . . . . . . . . . . . . $19,425 $32,375 4 Number of cases. . . . . . . . . . . . 3 cases 7 cases Average cost per case . . . . . . . . . . $6,475 $4,625 Average fee per case . . . . . . . . . . . $7,500 $5,357 (from part 1)

3. The cost of each type of case using multiple departmental overhead rates for the internal support de- partment (based on number of documents) and external support department (based on billable hours) is determined as follows.

Departmental Departmental Rate Cost Base (Departmental Cost 4 Base)

Internal support departments Preparing documents. . . . . . . . . $ 4,000 Occupying office space . . . . . . 1,200 Heating and lighting of office . . . 350 $ 5,550 30 documents $185 per document External support departments Registering documents . . . . . . . 1,250 Retaining consultants . . . . . . . . 10,000 Using contract services . . . . . . . 5,000 16,250 200 billable $81.25 per hour hours

The departmental overhead rates computed above are used to assign overhead costs to the two types of legal services. For the internal support department we use the overhead rate of $185 per document to assign $2,960 ($185 3 16 documents) to litigation and $2,590 ($185 3 14 documents) to mediation. For the external support department we use the overhead rate of $81.25 per hour to assign $6,093.75 ($81.25 3 75 hours) to litigation and $10,156.25 ($81.25 3 125 hours) to mediation. As shown below, the resulting average costs of litigation cases and mediation cases are $6,768 and $4,499, respectively. Using this method of cost assignment, it appears that the fee of $300 per billable hour is adequate to cover costs associated with each case.

Litigation Mediation

Attorney fees . . . . . . . . . . $150 per billable hour 75 hours $11,250.00 125 hours $18,750.00 Internal support . . . . . . . . $185 per document 16 documents 2,960.00 14 documents 2,590.00 External support . . . . . . . $81.25 per hour 75 hours 6,093.75 125 hours 10,156.25 Total cost . . . . . . . . . . . . . $20,303.75 $31,496.25 4 Number of cases. . . . . 3 cases 7 cases Average cost per case . . . $6,768 $4,499 Average fee per case . . . . $7,500 $5,357 (from part 1)

4. A comparison and discussion of the costs assigned under each method follows.

Method of Assigning Overhead Costs

Activity-Based Plantwide Departmental Average Cost per Case Costing Overhead Rate Overhead Rates

Litigation cases. . . . . . . . . . . . . . . . . . . $9,044 $6,475 $6,768 Mediation cases . . . . . . . . . . . . . . . . . . 3,524 4,625 4,499

150 Chapter 4 Activity-Based Costing and Analysis

The departmental and plantwide overhead rate methods assign overhead on the basis of volume- related measures (billable hours and document filings). Litigation costs appear profitable under these methods, because the average costs are below the average revenue of $7,500. ABC, however, focuses attention on activities that drive costs. A large part of overhead costs was for consultants and contract services, which were unrelated to the number of cases, but related to the type of cases consuming those resources. Using ABC, the costs shift from the high-volume cases (mediation) to the low-volume cases (litigation). When the firm considers the consumption of resources for these cases using ABC, it finds that the fees charged to litigate cases is insufficient (average revenue of $7,500 versus average cost of $9,044). The law firm is charging too little for the complex cases that require litigation.

C1 Distinguish between the plantwide overhead rate method, the departmental overhead rate method, and the activity-based costing method. Overhead costs can be as- signed to cost objects using a plantwide rate that combines all overhead costs into a single rate, usually based on direct labor hours, machine hours, or direct labor cost. Multiple departmen- tal overhead rates that include overhead costs traceable to de- partments are used to allocate overhead based on departmental functions. ABC links overhead costs to activities and assigns overhead based on how much of each activity is required for a product.

C2 Explain cost flows for activity-based costing. With ABC, overhead costs are first traced to the activities that cause them, and then cost pools are formed combining costs caused by the same activity. Overhead rates based on these activities are then used to assign overhead to products in proportion to the amount of activity required to produce them.

C3 Describe the four types of activities that cause over-head costs. The four types of activities that cause overhead costs are: (1) unit-level activities, (2) batch-level activities, (3) product-level activities, and (4) facility-level activities. Unit-level activities are performed on each unit, batch-level activities are performed only on each group of units, and product-level activities are performed only on each product line. Facility-level activities are performed to sustain facility capacity and are not caused by any specific product. Understanding these types of activities can help in applying activity-based costing.

A1 Identify and assess advantages and disadvantages of the plantwide overhead and departmental overhead rate methods. A single plantwide overhead rate is a simple way to assign overhead cost. A disadvantage is that it can inaccu- rately assign costs when costs are caused by multiple factors and when different products consume different amounts of

inputs. Overhead costing accuracy is improved by use of mul- tiple departmental rates because differences across departmental functions can be linked to costs incurred in departments. Yet, accuracy of cost assignment with departmental rates suffers from the same problems associated with plantwide rates be- cause activities required for each product are not identified with costs of providing those activities.

A2 Identify and assess advantages and disadvantages of activity-based costing. ABC improves product costing accuracy and draws management attention to relevant factors to control. The cost of constructing and maintaining an ABC system can sometimes outweigh its value.

P1 Allocate overhead costs to products using the plant-wide overhead rate method. The plantwide overhead rate equals total budgeted overhead divided by budgeted plant vol- ume, the latter often measured in direct labor hours or machine hours. This rate multiplied by the number of direct labor hours (or machine hours) required for each product provides the over- head assigned to each product.

P2 Allocate overhead costs to products using the depart-mental overhead rate method. When using multiple departmental rates, overhead costs must first be traced to each department and then divided by the measure of output for that department to yield the departmental overhead rate. Overhead is applied to products using this rate as products pass through each department.

P3 Allocate overhead costs to products using activity-based costing. With ABC, overhead costs are matched to activities that cause them. If there is more than one cost with the same activity, these costs are combined into pools. An overhead rate for each pool is determined by dividing total cost for that pool by its activity measure. Overhead costs are assigned to products by multiplying the ABC pool rate by the amount of the activity required for each product.

Summary

Department Manager When dividing a bill, common sense suggests fairness. That is, if one department consumes more services than another, we attempt to share the bill in proportion to consumption. Equally dividing the bill among the number of de- partments is fair if each consumed equal services. This same no- tion applies in assigning costs to products and services. For

example, dividing overhead costs by the number of units is fair if all products consumed overhead in equal proportion.

Entrepreneur Cleaning and sterilizing costs are not directly related to the volume of product manufactured. Thus, changing the number of units produced does not necessarily reduce these

Guidance Answers to Decision Maker and Decision Ethics

Chapter 4 Activity-Based Costing and Analysis 151

Multiple Choice Quiz Answers at end of chapter

1. In comparison to a traditional cost system, and when there are batch-level or product-level costs, an activity-based costing system usually: a. Shifts costs from low-volume to high-volume products. b. Shifts costs from high-volume to low-volume products. c. Shifts costs from standardized to specialized products. d. Shifts costs from specialized to standardized products.

2. Which of the following statements is (are) true? a. An activity-based costing system is generally easier to

implement and maintain than a traditional costing system. b. One of the goals of activity-based management is the

elimination of waste by allocating costs to products that waste resources.

c. Activity-based costing uses a number of activity cost pools, each of which is allocated to products on the ba- sis of direct labor hours.

d. Activity rates in activity-based costing are computed by dividing costs from the first-stage allocations by the ac- tivity measure for each activity cost pool.

3. All of the following are examples of batch-level activities except: a. Purchase order processing. b. Setting up equipment. c. Clerical activity associated with processing purchase

orders to produce an order for a standard product. d. Employee recreational facilities.

4. A company has two products: A and B. It uses activity- based costing and prepares the following analysis showing budgeted cost and activity for each of its three activity cost pools.

Annual production and sales level of Product A is 18,188 units, and the annual production and sales level of Product B is 31,652 units. The approximate overhead cost per unit of Product B under activity-based costing is: a. $2.02 c. $12.87 b. $5.00 d. $22.40

5. A company uses activity-based costing to determine the costs of its two products: A and B. The budgeted cost and activity for each of the company’s three activity cost pools follow.

The activity rate under the activity-based costing method for Activity 3 is. a. $4.00 c. $18.00 b. $8.59 d. $20.00

Budgeted Budgeted Activity Activity Overhead

Cost Pool Cost Product A Product B Total

Activity 1 $ 80,000 200 800 1,000 Activity 2 58,400 1,000 500 1,500 Activity 3 360,000 600 5,400 6,000

Activity Budgeted Budgeted Activity

Cost Pool Cost Product A Product B Total

Activity 1 $19,800 800 300 1,100 Activity 2 16,000 2,200 1,800 4,000 Activity 3 14,000 400 300 700

costs. Further, expressing costs of cleaning and sterilizing on a per unit basis is often misleading for the person responsible for controlling costs. Costs of cleaning and sterilizing are related to changing from one product line to another. Consequently, the

way to control those costs is to control the number of times the packaging system has to be changed for a different product line. Thus, efficient product scheduling would help reduce those over- head costs and improve profitability.

Activity Activity-based costing (ABC) Activity-based management (ABM) Activity cost driver Activity cost pool

Activity overhead (pool) rate Batch-level activities Cost object Cost of quality report Costs of quality

Facility-level activities Lean accounting Product-level activities Unit-level activities Value-added activities

Key Terms

Icon denotes assignments that involve decision making.

1. Why are overhead costs allocated to products and not traced to products as direct materials and direct labor are?

2. What are three common methods of assigning overhead costs to a product?

3. Why are direct labor hours and machine hours commonly used as the bases for overhead allocation?

4. What are the advantages of using a single plantwide over- head rate?

Discussion Questions

152 Chapter 4 Activity-Based Costing and Analysis

5. The usefulness of a single plantwide overhead rate is based on two assumptions. What are those assumptions?

6. What is a cost object? 7. Explain why a single plantwide overhead rate can dis-

tort the cost of a particular product. 8. Why are multiple departmental overhead rates more ac-

curate for product costing than a single plantwide overhead rate?

9. In what way are departmental overhead rates similar to a single plantwide overhead rate? How are they different?

10. Why is overhead allocation under ABC usually more accu- rate than either the plantwide overhead allocation method or the departmental overhead allocation method?

11. Google reports costs in financial statements. If plantwide overhead rates are allowed for reporting costs to external users, why might a company choose to use a more complicated and

more expensive method for assigning overhead costs to products?

12. What is the first step in applying activity-based costing? 13. What is an activity cost driver? 14. Apple’s production requires activities. What

are value-added activities? 15. What are the four activity levels associated with activity-

based costing? Define each. 16. Samsung is a manufacturer.

“Activity-based costing is only use- ful for manufacturing companies.” Is this a true statement? Explain.

17. Apple must assign overhead costs to its products. Activity-based costing is generally considered more accurate than other methods of assigning overhead. If this is so, why don’t all manufacturing compa- nies use it?

APPLE

APPLE GOOGLE

Samsung

1. Which costing method assumes all products use overhead costs in the same proportions? a. Activity-based costing c. Departmental overhead rate method b. Plantwide overhead rate method d. All cost allocation methods

2. Which of the following would usually not be used in computing plantwide overhead rates? a. Direct labor hours c. Direct labor dollars b. Number of quality inspections d. Machine hours

3. With ABC, overhead costs should be traced to which cost object first? a. Units of product c. Activities b. Departments d. Product batches

QS 4-2 Cost allocation methods

C1

QS 4-3 Plantwide rate method

P1

A manufacturer uses machine hours to assign overhead costs to products. Budgeted information for the next year follows. Compute the plantwide overhead rate for the next year based on machine hours.

Budgeted factory overhead costs . . . . . . . . . . . . . . . . . . . . . . $544,000 Budgeted machine hours . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,400

QS 4-4 Compute plantwide overhead rates

P1

Rafner Manufacturing identified the following budgeted data in its two production departments.

Assembly Finishing

Manufacturing overhead costs . . . . . . . . . $1,200,000 $600,000 Direct labor hours . . . . . . . . . . . . . . . . . . 12,000 DLH 20,000 DLH Machine hours . . . . . . . . . . . . . . . . . . . . . 6,000 MH 16,000 MH

QUICK STUDY

QS 4-1 Overhead cost allocation methods

C1

In the blank next to each of the following terms, place the letter A through D that corresponds to the description of that term. Some letters are used more than once.

1. Activity-based costing 2. Plantwide overhead rate method 3. Departmental overhead rate method

A. Uses more than one rate to allocate overhead costs to products.

B. Uses only volume-based measures such as direct labor hours to allocate overhead costs to products.

C. Typically uses the most overhead allocation rates. D. Focuses on the costs of carrying out activities.

Chapter 4 Activity-Based Costing and Analysis 153

1. What is the company’s single plantwide overhead rate based on direct labor hours? 2. What is the company’s single plantwide overhead rate based on machine hours? (Round your answer

to two decimal places.)

QS 4-5 Compute departmental overhead rates P2

Refer to the information in QS 4-4. What are the company’s departmental overhead rates if the assembly department assigns overhead based on direct labor hours and the finishing department assigns overhead based on machine hours?

QS 4-6 Advantages of plantwide and departmental rate methods A1

List the three main advantages of the plantwide and departmental overhead rate methods.

QS 4-9 Assigning costs using ABC

P3

Aziz Company sells two types of products, Basic and Deluxe. The company provides technical support for users of its products, at an expected cost of $250,000 per year. The company expects to process 10,000 customer service calls per year. 1. Determine the company’s cost of technical support per customer service call. 2. During the month of January, Aziz received 550 calls for customer service on its Deluxe model and

250 calls for customer service on its Basic model. Assign technical support costs to each model using activity-based costing (ABC).

QS 4-7 Costing terminology

C2

In the blank next to the following terms, place the letter A through D corresponding to the best description of that term.

1. Activity 2. Activity driver 3. Cost object 4. Cost pool

A. Measurement associated with an activity. B. A group of costs that have the same activity drivers. C. Anything to which costs will be assigned. D. A task that causes a cost to be incurred.

QS 4-8 Computing activity rates

P3

A manufacturer uses activity-based costing to assign overhead costs to products. Budgeted information for selected activities for next year follows. Form two cost pools and compute activity rates for each of the cost pools.

Activity Expected Cost Cost Driver Expected Usage of Cost Driver

Purchasing . . . . . . . . . . . . . . $135,000 Purchase orders 4,500 purchase orders Cleaning factory . . . . . . . . . . 32,000 Square feet 5,000 square feet Providing utilities . . . . . . . . . 65,000 Square feet 5,000 square feet

QS 4-10 Computing activity rates

P3

A company uses activity-based costing to determine the costs of its three products: A, B, and C. The bud- geted cost and cost driver activity for each of the company’s three activity cost pools follow. Compute the activity rates for each of the company’s three activities.

Budgeted Activity of Cost Driver

Activity Cost Pool Budgeted Cost Product A Product B Product C

Activity 1 . . . . . . . . . . . . . . . . . $140,000 20,000 9,000 6,000 Activity 2 . . . . . . . . . . . . . . . . . $ 90,000 8,000 15,000 7,000 Activity 3 . . . . . . . . . . . . . . . . . $ 82,000 1,625 1,000 2,500

154 Chapter 4 Activity-Based Costing and Analysis

1. If management wants the most accurate product cost, which of the following costing methods should be used? a. Volume-based costing using departmental overhead rates b. Volume-based costing using a plantwide overhead rate c. Normal costing using a plantwide overhead rate d. Activity-based costing

2. Which costing method tends to overstate the cost of high-volume products? a. Traditional volume-based costing c. Job order costing b. Activity-based costing d. Differential costing

3. Disadvantages of activity-based costing include a. It is not acceptable under GAAP c. It can be used in an activity-based management. for external reporting. d. Both a. and b. b. It can be costly to implement.

QS 4-11 Multiple choice overhead questions A2

e. Cost of additional materials to rework a product f. Inspecting finished goods inventory g. Scrapping defective goods h. Lost sales due to customer dissatisfaction

A list of activities that generate quality costs is provided below. For each activity, indicate whether it relates to a prevention activity (P), appraisal activity (A), internal failure activity (I), or external failure activity (E). a. Inspecting raw materials b. Training workers in quality techniques c. Collecting data on a manufacturing process d. Overtime labor to rework products

QS 4-12 Costs of quality

A2

Classify each of the following activities as unit level (U), batch level (B), product level (P), or facility level (F) for a manufacturer of organic juices.

1. Cutting fruit 4. Receiving fruit shipments 2. Developing new types of juice 5. Cleaning blending machines 3. Blending fruit into juice

QS 4-13 Identify activity levels

C3

Classify each of the following activities as unit level (U), batch level (B), product level (P), or facility level (F) for a manufacturer of trail mix.

1. Roasting peanuts 4. Providing utilities for factory 2. Cleaning roasting machines 5. Calibrating mixing machines 3. Sampling product quality

QS 4-14 Identify activity levels

C3

Toyota embraces lean techniques, including lean accounting. What are the two key components of lean accounting?

QS 4-15 Lean accounting and ABC

A2

EXERCISES

Exercise 4-1 Compute plantwide overhead rates

P1

Xie Company identified the following activities, costs, and activity drivers for 2015. The company manu- factures two types of go-karts: Deluxe and Basic.

Activity Expected Costs Expected Activity

Handling materials . . . . . . . . . . . . . . . . $625,000 100,000 parts Inspecting product . . . . . . . . . . . . . . . . 900,000 1,500 batches Processing purchase orders . . . . . . . . . 105,000 700 orders Paying suppliers . . . . . . . . . . . . . . . . . . 175,000 500 invoices Insuring the factory . . . . . . . . . . . . . . . 300,000 40,000 square feet Designing packaging . . . . . . . . . . . . . . . 75,000 2 models

Required

1. Compute a single plantwide overhead rate assuming that the company assigns overhead based on 125,000 budgeted direct labor hours.

2. In January 2015 the Deluxe model required 2,500 direct labor hours, and the Standard model required 6,000 direct labor hours. Assign overhead costs to each model using the single plantwide overhead rate.

Chapter 4 Activity-Based Costing and Analysis 155

Exercise 4-2 Compute overhead rates under ABC P3

Refer to the information in Exercise 4-1. Compute the activity rate for each activity, assuming the com- pany uses activity-based costing.

Exercise 4-5 Departmental overhead rates

P2

Refer to the information in Exercise 4-4.

Required

1. Compute a departmental overhead rate for the molding department based on machine hours and a department overhead rate for the trimming department based on direct labor hours.

2. Determine the total overhead cost assigned to each product line using the departmental overhead rates from requirement 2.

3. Determine the overhead cost per unit for each product line using the departmental rate.

Exercise 4-3 Assigning costs using ABC

P3

Refer to the information in Exercise 4-1. Assume that the following information is available for the com- pany’s two products for the first quarter of 2015.

Deluxe Model Basic Model

Production volume. . . . . . . . . 10,000 units 30,000 units Parts required . . . . . . . . . . . . 20,000 parts 30,000 parts Batches made . . . . . . . . . . . . . 250 batches 100 batches Purchase orders . . . . . . . . . . 50 orders 20 orders Invoices . . . . . . . . . . . . . . . . . 50 invoices 10 invoices Space occupied . . . . . . . . . . . 10,000 square feet 7,000 square feet Models . . . . . . . . . . . . . . . . . . 1 model 1 model

Required

Compute activity rates for each activity and assign overhead costs to each product model using activity- based costing (ABC). What is the overhead cost per unit of each model?

Exercise 4-4 Plantwide overhead rate

P1

Textra Plastics produces parts for a variety of small machine manufacturers. Most products go through two operations, molding and trimming, before they are ready for packaging. Expected costs and activities for the molding department and for the trimming department for 2015 follow.

Molding Trimming

Direct labor hours . . . . . . . . . . . . . . . . 52,000 DLH 48,000 DLH Machine hours . . . . . . . . . . . . . . . . . . . 30,500 MH 3,600 MH Overhead costs . . . . . . . . . . . . . . . . . . $730,000 $590,000

Data for two special order parts to be manufactured by the company in 2015 follow:

Required

1. Compute the plantwide overhead rate using direct labor hours as the base. 2. Determine the overhead cost assigned to each product line using the plantwide rate computed in

requirement 1.

Part A27C Part X82B

Number of units . . . . . . . . . . . . . . . . . . 9,800 units 54,500 units Machine hours Molding . . . . . . . . . . . . . . . . . . . . . . . 5,100 MH 1,020 MH Trimming . . . . . . . . . . . . . . . . . . . . . . 2,600 MH 650 MH Direct labor hours Molding . . . . . . . . . . . . . . . . . . . . . . . 5,500 DLH 2,150 DLH Trimming . . . . . . . . . . . . . . . . . . . . . . 700 DLH 3,500 DLH

156 Chapter 4 Activity-Based Costing and Analysis

Exercise 4-6 Assigning overhead costs using the plantwide rate and departmental rate methods

P1 P2

Laval produces lamps and home lighting fixtures. Its most popular product is a brushed aluminum desk lamp. This lamp is made from components shaped in the fabricating department and assembled in its as- sembly department. Information related to the 35,000 desk lamps produced annually follow.

Fabricating Assembly

Direct labor hours . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75,000 DLH 125,000 DLH Machine hours . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000 MH 62,500 MH Overhead cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $300,000 $200,000

Expected overhead cost and related data for the two production departments follow.

Required

1. Determine the plantwide overhead rate for Laval using direct labor hours as a base. 2. Determine the total manufacturing cost per unit for the aluminum desk lamp using the plantwide over-

head rate. 3. Compute departmental overhead rates based on machine hours in the fabricating department and direct

labor hours in the assembly department. 4. Use departmental overhead rates from requirement 3 to determine the total manufacturing cost per unit

for the aluminum desk lamps.

Check (2) $26.90 per unit

Check (4) $27.60 per unit

Way Cool produces two different models of air conditioners. The company produces the mechanical sys- tems in their components department. The mechanical systems are combined with the housing assembly in its finishing department. The activities, costs, and drivers associated with these two manufacturing processes and the production support process follow.

Exercise 4-7 Using the plantwide overhead rate to assess prices

P1

Process Activity Overhead Cost Driver Quantity

Components Changeover $ 500,000 Number of batches 800 Machining 279,000 Machine hours 6,000 Setups 225,000 Number of setups 120 $1,004,000

Finishing Welding $ 180,300 Welding hours 3,000 Inspecting 210,000 Number of inspections 700 Rework 75,000 Rework orders 300 $ 465,300

Support Purchasing $ 135,000 Purchase orders 450 Providing space 32,000 Number of units 5,000 Providing utilities 65,000 Number of units 5,000 $ 232,000

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $280,000 Direct labor Fabricating department (7,000 DLH 3 $20 per DLH) . . . . . . . . . . . . . . . . . . . . . . $140,000 Assembly department (16,000 DLH 3 $29 per DLH) . . . . . . . . . . . . . . . . . . . . . . $464,000 Machine hours Fabricating department . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,040 MH Assembly department . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,000 MH

Chapter 4 Activity-Based Costing and Analysis 157

Additional production information concerning its two product lines follows.

Model 145 Model 212

Units produced . . . . . . . . . . . . . . . 1,500 3,500 Welding hours . . . . . . . . . . . . . . . . 800 2,200 Batches . . . . . . . . . . . . . . . . . . . . . 400 400 Number of inspections . . . . . . . . . 400 300 Machine hours . . . . . . . . . . . . . . . . 1,800 4,200 Setups . . . . . . . . . . . . . . . . . . . . . . 60 60 Rework orders . . . . . . . . . . . . . . . 160 140 Purchase orders . . . . . . . . . . . . . . 300 150

Required

1. Using a plantwide overhead rate based on machine hours, compute the overhead cost per unit for each product line.

2. Determine the total cost per unit for each product line if the direct labor and direct materials costs per unit are $250 for Model 145 and $180 for Model 212.

3. If the market price for Model 145 is $820 and the market price for Model 212 is $480, determine the profit or loss per unit for each model. Comment on the results.

Check (3) Model 212, $(40.26) per unit loss

Exercise 4-8 Using departmental overhead rates to assess prices

P2

Refer to the information in Exercise 4-7 to answer the following requirements.

Required

1. Determine departmental overhead rates and compute the overhead cost per unit for each product line. Base your overhead assignment for the components department on machine hours. Use welding hours to assign overhead costs to the finishing department. Assign costs to the support department based on number of purchase orders.

2. Determine the total cost per unit for each product line if the direct labor and direct materials costs per unit are $250 for Model 145 and $180 for Model 212.

3. If the market price for Model 145 is $820 and the market price for Model 212 is $480, determine the profit or loss per unit for each model. Comment on the results.

Check (3) Model 212, $(20.38) per unit loss

Exercise 4-9 Using ABC to assess prices

P3

Refer to the information in Exercise 4-7 to answer the following requirements.

Required

1. Using ABC, compute the overhead cost per unit for each product line. 2. Determine the total cost per unit for each product line if the direct labor and direct materials costs per

unit are $250 for Model 145 and $180 for Model 212. 3. If the market price for Model 145 is $820 and the market price for Model 212 is $480, determine the

profit or loss per unit for each model. Comment on the results. Check (3) Model 212, $34.88 per unit profit

Exercise 4-10 Using ABC for strategic decisions

P1 P3

Consider the following data for two products of Gitano Manufacturing.

Overhead Cost Product A Product B

Number of units produced . . . . . . . . . . . . . . . . 10,000 units 2,000 units Direct labor cost (@$24 per DLH) . . . . . . . . . 0.20 DLH per unit 0.25 DLH per unit Direct materials cost . . . . . . . . . . . . . . . . . . . . . $2 per unit $3 per unit

Activity Machine setup . . . . . . . . . . . . . . . . . . . . . . . . $121,000 Materials handling . . . . . . . . . . . . . . . . . . . . . 48,000 Quality control inspections . . . . . . . . . . . . . . 80,000

$249,000

158 Chapter 4 Activity-Based Costing and Analysis

Exercise 4-11 Activity-based costing and overhead cost allocation

P3

The following is taken from Ronda Co.’s internal records of its factory with two production departments. The cost driver for indirect labor and supplies is direct labor costs, and the cost driver for the remaining overhead items is number of hours of machine use. Compute the total amount of overhead cost allocated to Department 1 using activity-based costing.

Direct Labor Machine Use Hours

Department 1 . . . . . . . . . . . . . . . . . . . . . . . $18,800 2,000 Department 2 . . . . . . . . . . . . . . . . . . . . . . . 13,200 1,200 Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $32,000 3,200

Factory overhead costs Rent and utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $12,200 Indirect labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,400 General office expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000 Depreciation — Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,600 Total factory overhead. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $27,200Check Dept. 1 allocation,

$16,700

Exercise 4-12 Activity-based costing rates and allocations

P3

A company has two products: standard and deluxe. The company expects to produce 36,375 standard units and 62,240 deluxe units. It uses activity-based costing and has prepared the following analysis show- ing budgeted cost and cost driver activity for each of its three activity cost pools.

Budgeted Activity of Cost Driver

Activity Cost Pool Budgeted Cost Standard Deluxe

Activity 1 . . . . . . . . . . . . . . . . . $93,000 2,500 5,250 Activity 2 . . . . . . . . . . . . . . . . . $92,000 4,500 5,500 Activity 3 . . . . . . . . . . . . . . . . . $87,000 3,000 2,800

Required

1. Compute overhead rates for each of the three activities. 2. What is the expected overhead cost per unit for the standard units? 3. What is the expected overhead cost per unit for the deluxe units?

Required

1. Using direct labor hours as the basis for assigning overhead costs, determine the total production cost per unit for each product line.

2. If the market price for Product A is $20 and the market price for Product B is $60, determine the profit or loss per unit for each product. Comment on the results.

3. Consider the following additional information about these two product lines. If ABC is used for as- signing overhead costs to products, what is the cost per unit for Product A and for Product B?

Check (2) Product B, $26.10 per unit profit

4. Determine the profit or loss per unit for each product. Should this information influence company strategy? Explain.

Product A Product B

Number of setups required for production . . . . . . . . . 10 setups 12 setups Number of parts required . . . . . . . . . . . . . . . . . . . . . . . 1 part/unit 3 parts/unit Inspection hours required . . . . . . . . . . . . . . . . . . . . . . . 40 hours 210 hours

(4) Product B, ($24.60) per unit loss

Chapter 4 Activity-Based Costing and Analysis 159

Exercise 4-13 Using ABC in a service company

P3

Cardiff and Delp is an architectural firm that provides services for residential construction projects. The following data pertain to a recent reporting period.

Check (2) $150,200

Required

1. Using ABC, compute the firm’s activity overhead rates. Form activity cost pools where appropriate. 2. Assign costs to a 9,200-square-foot job that requires 450 contact hours, 340 design hours, and 200 days

to complete.

Activities Costs

Design department Client consultation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500 contact hours $270,000 Drawings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000 design hours 115,000 Modeling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 square feet 30,000 Project management department Supervision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600 days $120,000 Billings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 jobs 10,000 Collections . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 jobs 12,000

She has also collected the following information about the cost drivers for each category (cost pool) and the amount of each driver used by the two product lines.

Exercise 4-14 Activity-based costing

P3 A2

Glassworks Inc. produces two types of glass shelving, rounded edge and squared edge, on the same pro- duction line. For the current period, the company reports the following data.

Rounded Edge Squared Edge Total

Direct materials . . . . . . . . . . . . . . . . . . . . . . . $19,000 $ 43,200 $ 62,200 Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,200 23,800 36,000 Overhead (300% of direct labor cost) . . . . . . 36,600 71,400 108,000 Total cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $67,800 $138,400 $206,200 Quantity produced . . . . . . . . . . . . . . . . . . . . . 10,500 ft. 14,100 ft. Average cost per ft. (rounded) . . . . . . . . . . . . $ 6.46 $ 9.82

Glassworks’s controller wishes to apply activity-based costing (ABC) to allocate the $108,000 of over- head costs incurred by the two product lines to see whether cost per foot would change markedly from that reported above. She has collected the following information.

Overhead Cost Category (Activity Cost Pool) Cost

Supervision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,400 Depreciation of machinery . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56,600 Assembly line preparation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46,000 Total overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $108,000

Overhead Cost Category Usage

(Activity Cost Pool) Driver Rounded Edge Squared Edge Total

Supervision . . . . . . . . . . . . . . . . . . Direct labor cost ($) $12,200 $23,800 $36,000 Depreciation of machinery . . . . . . Machine hours 500 hours 1,500 hours 2,000 hours Assembly line preparation . . . . . . Setups (number) 40 times 210 times 250 times

Required

1. Assign these three overhead cost pools to each of the two products using ABC. 2. Determine average cost per foot for each of the two products using ABC. 3. Compare the average cost per foot under ABC with the average cost per foot under the current method

for each product. Explain why a difference between the two cost allocation methods exists.

Check (2) Rounded edge, $5.19; Squared edge, $10.76

160 Chapter 4 Activity-Based Costing and Analysis

Exercise 4-15 Activity-based costing

P3

Surgery Center is an outpatient surgical clinic that was profitable for many years, but Medicare has cut its reimbursements by as much as 40%. As a result, the clinic wants to better understand its costs. It decides to prepare an activity-based cost analysis, including an estimate of the average cost of both general sur- gery and orthopedic surgery. The clinic’s three activity cost pools and their cost drivers follow.

Activity Cost Pool Cost Cost Driver Driver Quantity

Professional salaries . . . . . . . . . . . . . . . . $1,600,000 Professional hours 10,000 Patient services and supplies . . . . . . . . 27,000 Number of patients 600 Building cost . . . . . . . . . . . . . . . . . . . . . 150,000 Square feet 1,500

Service Hours Square Feet* Patients

General surgery . . . . . . . . . . . . . . . . . . . . . . 2,500 600 400 Orthopedic surgery . . . . . . . . . . . . . . . . . . . 7,500 900 200

* Orthopedic surgery requires more space for patients, supplies, and equipment.

The two main surgical units and their related data follow.

Required

1. Compute the cost per cost driver for each of the three activity cost pools. 2. Use the results from part 1 to allocate costs to both the general surgery and the orthopedic surgery

units. Compute total cost and average cost per patient for both the general surgery and the orthopedic surgery units.

Check (2) Average cost of general (orthopedic) surgery, $1,195 ($6,495) per patient

Exercise 4-16 Comparing costs under ABC to traditional plantwide overhead rate

P1 P3 A1 A2

Smythe Crystal makes fine tableware in its Ireland factory. The following data are taken from its produc- tion plans for the year.

Wineglasses Commemorative Vases

Expected production . . . . . . . . . . . . . . . . . . . . . . . . 211,000 units 17,000 units Direct labor hours required . . . . . . . . . . . . . . . . . . 254,000 DLH 16,400 DLH Machine setups required . . . . . . . . . . . . . . . . . . . . . 200 setups 800 setups

Required

1. Determine the setup cost per unit for the wineglasses and for the commemorative vases if setup costs are assigned using a single plantwide overhead rate based on direct labor hours.

2. Determine setup costs per unit for the wineglasses and for the commemorative vases if the setup costs are assigned based on the number of setups.

3. Which method is better for assigning costs to each product? Explain.

Check (2) Vases, €29.65 per unit

Direct labor costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . €5,870,000 Setup costs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 630,000

Exercise 4-17 Identify activity levels

C3

Identify each of the following activities as unit level (U), batch level (B), product level (P), or facility level (F) to indicate the way each is incurred with respect to production.

1. Paying real estate taxes on the factory building 2. Attaching labels to collars of shirts 3. Redesigning a bicycle seat in response to customer feedback 4. Cleaning the assembly department 5. Polishing of gold wedding rings 6. Mixing of bread dough in a commercial bakery 7. Sampling cookies to determine quality

Chapter 4 Activity-Based Costing and Analysis 161

The company’s direct labor rate is $20 per direct labor hour (DLH). Additional information follows.

Exercise 4-18 Activity classification

C3

Following are activities in providing medical services at Healthsmart Clinic. A. Registering patients E. Ordering medical equipment B. Cleaning beds F. Heating the clinic C. Stocking examination rooms G. Providing security services D. Washing linens H. Filling prescriptions

Required

1. Classify each activity as unit level (U), batch level (B), product level (P), or facility level (F). 2. Identify an activity driver that might be used to measure these activities at the clinic.

PROBLEM SET A

Problem 4-1A Comparing costs using ABC with the plantwide overhead rate

P1 P3 A1 A2

The following data are for the two products produced by Tadros Company.

Product A Product B

Direct materials . . . . . . . . . . . . . . . . $15 per unit $24 per unit Direct labor hours . . . . . . . . . . . . . . 0.3 DLH per unit 1.6 DLH per unit Machine hours . . . . . . . . . . . . . . . . . 0.1 MH per unit 1.2 MH per unit Batches . . . . . . . . . . . . . . . . . . . . . . . 125 batches 225 batches Volume . . . . . . . . . . . . . . . . . . . . . . . 10,000 units 2,000 units Engineering modifications . . . . . . . . 12 modifications 58 modifications Number of customers . . . . . . . . . . . 500 customers 400 customers Market price. . . . . . . . . . . . . . . . . . . $30 per unit $120 per unit

Costs Driver

Indirect manufacturing Engineering support . . . . . . . . . $24,500 Engineering modifications Electricity . . . . . . . . . . . . . . . . . . 34,000 Machine hours Setup costs . . . . . . . . . . . . . . . . 52,500 Batches Nonmanufacturing Customer service. . . . . . . . . . . . 81,000 Number of customers

Required

1. Compute the manufacturing cost per unit using the plantwide overhead rate based on direct labor hours. What is the gross profit per unit?

2. How much gross profit is generated by each customer of Product A using the plantwide overhead rate? How much gross profit is generated by each customer of Product B using the plantwide overhead rate? What is the cost of providing customer service to each customer? What information is provided by this comparison?

3. Determine the manufacturing cost per unit of each product line using ABC. What is the gross profit per unit?

4. How much gross profit is generated by each customer of Product A using ABC? How much gross profit is generated by each customer of Product B using ABC? Is the gross profit per customer adequate?

5. Which method of product costing gives better information to managers of this company? Explain why.

Check (1) Product A, $26.37 per unit cost

(3) Product A, $24.30 per unit cost

Problem 4-2A Assessing impacts of using a plantwide overhead rate versus ABC

A1 A2

Xylon Company manufactures custom-made furniture for its local market and produces a line of home furnishings sold in retail stores across the country. The company uses traditional volume-based methods of assigning direct materials and direct labor to its product lines. Overhead has always been assigned by using a plantwide overhead rate based on direct labor hours. In the past few years, management has seen its line of retail products continue to sell at high volumes, but competition has forced it to lower prices on these items. The prices are declining to a level close to its cost of production.

162 Chapter 4 Activity-Based Costing and Analysis

Meanwhile, its custom-made furniture is in high demand and customers have commented on its favor- able (lower) prices compared to its competitors. Management is considering dropping its line of retail products and devoting all of its resources to custom-made furniture.

Required

1. What reasons could explain why competitors are forcing the company to lower prices on its high- volume retail products?

2. Why do you believe the company charges less for custom-order products than its competitors? 3. Does a company’s costing method have any effect on its pricing decisions? Explain. 4. Aside from the differences in volume of output, what production differences do you believe exist be-

tween making custom-order furniture and mass-market furnishings? 5. What information might the company obtain from using ABC that it might not obtain using volume-

based costing methods?

Problem 4-3A Applying activity-based costing

P1 P3 A1 A2 C3

Craft Pro Machining produces machine tools for the construction industry. The following details about overhead costs were taken from its company records.

Production Activity Indirect Labor Indirect Materials Other Overhead

Grinding . . . . . . . . . . . . . . . . . . . . $320,000 Polishing . . . . . . . . . . . . . . . . . . . . $135,000 Product modification . . . . . . . . . . 600,000 Providing power . . . . . . . . . . . . . . $255,000 System calibration . . . . . . . . . . . . 500,000

Additional information on the drivers for its production activities follows.

Required

1. Classify each activity as unit level, batch level, product level, or facility level. 2. Compute the activity overhead rates using ABC. Form cost pools as appropriate. 3. Determine overhead costs to assign to the following jobs using ABC.

Job 3175 Job 4286

Number of units . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200 units 2,500 units Machine hours . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 550 MH 5,500 MH Engineering hours . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 eng. hours 32 eng. hours Batches . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 batches 90 batches Direct labor hours . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500 DLH 4,375 DLH

Grinding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,000 machine hours Polishing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,000 machine hours Product modification . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500 engineering hours Providing power . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,000 direct labor hours System calibration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400 batches

4. What is the overhead cost per unit for Job 3175? What is the overhead cost per unit for Job 4286? 5. If the company used a plantwide overhead rate based on direct labor hours, what is the overhead cost

for each unit of Job 3175? Of Job 4286? 6. Compare the overhead costs per unit computed in requirements 4 and 5 for each job. Which method

more accurately assigns overhead costs?

Check (4) Job 3175, $373.25 per unit

Chapter 4 Activity-Based Costing and Analysis 163

Problem 4-4A Evaluating product line costs and prices using ABC

P3

Bright Day Company produces two beverages, Hi-Voltage and EasySlim. Data about these products follow.

Hi-Voltage EasySlim

Production volume . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,500 bottles 180,000 bottles Liquid materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,400 gallons 37,000 gallons Dry materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 620 pounds 12,000 pounds Bottles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,500 bottles 180,000 bottles Labels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 labels per bottle 1 label per bottle Machine setups . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500 setups 300 setups Machine hours . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200 MH 3,750 MH

Department Driver Cost

Mixing department Liquid materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gallons $ 2,304 Dry materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Pounds 6,941 Utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Machine hours 1,422 Bottling department Bottles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Units $77,000 Labeling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Labels per bottle 6,525 Machine setup . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Setups 20,000

Additional data from its two production departments follow.

Required

1. Determine the cost of each product line using ABC. 2. What is the cost per bottle for Hi-Voltage? What is the cost per bottle of EasySlim? (Hint: Your answer

should draw on the total cost for each product line computed in requirement 1.) 3. If Hi-Voltage sells for $3.75 per bottle, how much profit does the company earn per bottle of

Hi-Voltage that it sells? 4. What is the minimum price that the company should set per bottle of EasySlim? Explain.

Check (3) $2.22 profit per bottle

Problem 4-5A Pricing analysis with ABC and a plantwide overhead rate

A1 A2 P1 P3

Sara’s Salsa Company produces its condiments in two types: Extra Fine for restaurant customers and Family Style for home use. Salsa is prepared in department 1 and packaged in department 2. The activi- ties, overhead costs, and drivers associated with these two manufacturing processes and the company’s production support activities follow.

Process Activity Overhead Cost Driver Quantity

Department 1 Mixing $ 4,500 Machine hours 1,500 Cooking 11,250 Machine hours 1,500 Product testing 112,500 Batches 600 $128,250

Department 2 Machine calibration $250,000 Production runs 400 Labeling 12,000 Cases of output 120,000 Defects 6,000 Cases of output 120,000 $268,000

Support Recipe formulation $ 90,000 Focus groups 45 Heat, lights, and water 27,000 Machine hours 1,500 Materials handling 65,000 Container types 8 $182,000

164 Chapter 4 Activity-Based Costing and Analysis

Additional production information about its two product lines follows.

Extra Fine Family Style

Units produced . . . . . . . . . . . . . . . . . . . . . . 20,000 cases 100,000 cases Batches . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200 batches 400 batches Machine hours . . . . . . . . . . . . . . . . . . . . . . . 500 MH 1,000 MH Focus groups . . . . . . . . . . . . . . . . . . . . . . . . 30 groups 15 groups Container types . . . . . . . . . . . . . . . . . . . . . . 5 containers 3 containers Production runs . . . . . . . . . . . . . . . . . . . . . . 200 runs 200 runs

Required

1. Using a plantwide overhead rate based on cases, compute the overhead cost that is assigned to each case of Extra Fine Salsa and each case of Family Style Salsa.

2. Using the plantwide overhead rate, determine the total cost per unit for the two products if the direct materials and direct labor cost is $6 per case of Extra Fine and $5 per case of Family Style.

3. If the market price of Extra Fine Salsa is $18 per case and the market price of Family Style Salsa is $9 per case, determine the gross profit per case for each product. What might management conclude about each product line?

4. Using ABC, compute the total cost per case for each product type if the direct labor and direct materi- als cost is $6 per case of Extra Fine and $5 per case of Family Style.

5. If the market price is $18 per case of Extra Fine and $9 per case of Family Style, determine the gross profit per case for each product. How should management interpret the market prices given your computations?

6. Would your pricing analysis be improved if the company used departmental rates based on machine hours in department 1 and number of cases in department 2, instead of ABC? Explain.

Check (2) Cost per case: Extra Fine, $10.82; Family Style, $9.82

(4) Cost per case: Extra Fine, $20.02; Family Style, $7.98

The company’s direct labor rate is $20 per direct labor hour (DLH). Additional information follows.

Wade Company makes two distinct products with the following information available for each.PROBLEM SET B

Problem 4-1B Comparing costs using ABC with the plantwide overhead rate

A1 A2 P1 P3

Standard Deluxe

Direct materials . . . . . . . . . . . . . . . $4 per unit $8 per unit Direct labor hours . . . . . . . . . . . . . 4 DLH per unit 5 DLH per unit Machine hours . . . . . . . . . . . . . . . . . 3 MH per unit 3 MH per unit Batches . . . . . . . . . . . . . . . . . . . . . . 175 batches 75 batches Volume . . . . . . . . . . . . . . . . . . . . . . . 40,000 units 10,000 units Engineering modifications . . . . . . . . 50 modifications 25 modifications Number of customers . . . . . . . . . . . 1,000 customers 1,000 customers Market price . . . . . . . . . . . . . . . . . . $92 per unit $125 per unit

Costs Driver

Indirect manufacturing Engineering support . . . . . . . . . . $ 56,250 Engineering modifications Electricity . . . . . . . . . . . . . . . . . . . 112,500 Machine hours Setup costs. . . . . . . . . . . . . . . . . . 41,250 Batches Nonmanufacturing Customer service. . . . . . . . . . . . . 250,000 Number of customers

Chapter 4 Activity-Based Costing and Analysis 165

Required

1. Compute the manufacturing cost per unit using the plantwide overhead rate based on machine hours. What is the gross profit per unit?

2. How much gross profit is generated by each customer of the standard product using the plantwide overhead rate? How much gross profit is generated by each customer of the deluxe product using the plantwide overhead rate? What is the cost of providing customer service to each customer? What in- formation is provided by this comparison?

3. Determine the manufacturing cost per unit of each product line using ABC. What is the gross profit per unit?

4. How much gross profit is generated by each customer of the standard product using ABC? How much gross profit is generated by each customer of the deluxe product using ABC? Is the gross profit per customer adequate?

5. Which method of product costing gives better information to managers of this company? Explain.

Check (1) Gross profit per unit: Standard, $3.80; Deluxe, $12.80

(3) Gross profit per unit: Standard, $4.09; Deluxe, $11.64

Problem 4-2B Assessing impacts of using a plantwide overhead rate versus ABC

A1 A2

Midwest Paper produces cardboard boxes. The boxes require designing, cutting, and printing. (The boxes are shipped flat and customers fold them as necessary.) Midwest has a reputation for providing high-quality products and excellent service to customers, who are major U.S. manufacturers. Costs are assigned to products based on the number of machine hours required to produce them. Three years ago, a new marketing executive was hired. She suggested the company offer custom design and manufacturing services to small specialty manufacturers. These customers required boxes for their products and were eager to have Midwest as a supplier. Within one year Midwest found that it was so busy with orders from small customers, it had trouble supplying boxes to all its customers on a timely basis. Large, long-time customers began to complain about slow service, and several took their business elsewhere. Within another 18 months, Midwest was in financial distress with a backlog of orders to be filled.

Required

1. What do you believe are the major costs of making its boxes? How are those costs related to the vol- ume of boxes produced?

2. How did Midwest’s new customers differ from its previous customers? 3. Would the unit cost to produce a box for new customers be different from the unit cost to produce a

box for its previous customers? Explain. 4. Could Midwest’s fate have been different if it had used ABC for determining the cost of its boxes? 5. What information would have been available with ABC that might have been overlooked using a tra-

ditional volume-based costing method?

Problem 4-3B Applying activity-based costing

P1 P3 A1 A2 C3

Ryan Foods produces gourmet gift baskets that it distributes online as well as from its small retail store. The following details about overhead costs are taken from its records.

Production Activity Indirect Labor Indirect Materials Other Overhead

Wrapping . . . . . . . . . . . . . . . . . . . . . . . $300,000 $200,000 Assembling . . . . . . . . . . . . . . . . . . . . . 400,000 Product design . . . . . . . . . . . . . . . . . . . 180,000 Obtaining business licenses . . . . . . . . . $100,000 Cooking . . . . . . . . . . . . . . . . . . . . . . . . 150,000 120,000

Additional information on the drivers for its production activities follows.

Wrapping . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 units Assembling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 direct labor hours Product design . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 design hours Obtaining business licenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 direct labor hours Cooking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000 batches

166 Chapter 4 Activity-Based Costing and Analysis

4. What is the overhead cost per unit for the Holiday Basket? What is the overhead cost per unit for the Executive Basket?

5. If the company used a plantwide overhead rate based on direct labor hours, what is the overhead cost for each Holiday Basket unit? What would be the overhead cost for each Executive Basket unit if a single plantwide overhead rate is used?

6. Compare the costs per unit computed in requirements 4 and 5 for each job. Which cost assignment method provides the most accurate cost? Explain.

Check (4) Holiday Basket, $14.25 per unit

(5) Holiday Basket, $18.13 per unit

Problem 4-4B Evaluating product line costs and prices using ABC

P3

Mathwerks produces two electronic, handheld educational games: Fun with Fractions and Count Calculus. Data on these products follow.

Fun with Fractions Count Calculus

Production volume . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150,000 units 10,000 units Components . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 450,000 parts 100,000 parts Direct labor hours . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000 DLH 2,000 DLH Packaging materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150,000 boxes 10,000 boxes Shipping cartons . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 units per carton 25 units per carton Machine setups . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52 setups 52 setups Machine hours . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 MH 2,000 MH

Additional data from its two production departments follow.

Department Driver Cost

Assembly department Component cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Parts $495,000 Assembly labor. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Direct labor hours 244,800 Maintenance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Machine hours 100,800 Wrapping department Packaging materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Boxes $460,800 Shipping . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cartons 27,360 Machine setup . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Setups 187,200

Required

1. Using ABC, determine the cost of each product line. 2. What is the cost per unit for Fun with Fractions? What is the cost per unit of Count Calculus? 3. If Count Calculus sells for $59.95 per unit, how much profit does the company earn per unit of Count

Calculus sold? 4. What is the minimum price that the company should set per unit of Fun with Fractions? Explain.

Check (3) $32.37 profit per unit

Holiday Basket Executive Basket

Number of units . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000 units 1,000 units Direct labor hours . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000 DLH 500 DLH Design hours . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 design hours 40 design hours Batches . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80 batches 200 batches

Required

1. Classify each activity as unit level, batch level, product level, or facility level. 2. Compute the activity overhead rates using ABC. Form cost pools as appropriate. 3. Determine the overhead cost to assign to the following jobs using ABC.

Chapter 4 Activity-Based Costing and Analysis 167

Additional production information on the two lines of tents follows.

Problem 4-5B Pricing analysis with ABC and a plantwide overhead rate

A1 A2 P1 P3

Tent Pro produces two lines of tents sold to outdoor enthusiasts. The tents are cut to specifications in department A. In department B the tents are sewn and folded. The activities, costs, and drivers associ- ated with these two manufacturing processes and the company’s production support activities follow.

Process Activity Overhead Cost Driver Quantity

Department A Pattern alignment $ 64,400 Batches 560 Cutting 50,430 Machine hours 12,300 Moving product 100,800 Moves 2,400 $215,630

Department B Sewing $327,600 Direct labor hours 4,200 Inspecting 24,000 Inspections 600 Folding 47,880 Units 22,800 $399,480

Support Design $280,000 Modification orders 280 Providing space 51,600 Square feet 8,600 Materials handling 184,000 Square yards 920,000 $515,600

Pup Tent Pop-Up Tent

Units produced . . . . . . . . . . . . . . . 15,200 units 7,600 units Moves . . . . . . . . . . . . . . . . . . . . . . . 800 moves 1,600 moves Batches . . . . . . . . . . . . . . . . . . . . . . 140 batches 420 batches Number of inspections . . . . . . . . . 240 inspections 360 inspections Machine hours . . . . . . . . . . . . . . . . 7,000 MH 5,300 MH Direct labor hours . . . . . . . . . . . . . 2,600 DLH 1,600 DLH Modification orders . . . . . . . . . . . . 70 modification orders 210 modification orders Space occupied . . . . . . . . . . . . . . . 4,300 square feet 4,300 square feet Material required . . . . . . . . . . . . . . 450,000 square yards 470,000 square yards

Required

1. Using a plantwide overhead rate based on direct labor hours, compute the overhead cost that is as- signed to each pup tent and each pop-up tent.

2. Using the plantwide overhead rate, determine the total cost per unit for the two products if the direct materials and direct labor cost is $25 per pup tent and $32 per pop-up tent.

3. If the market price of the pup tent is $65 and the market price of the pop-up tent is $200, determine the gross profit per unit for each tent. What might management conclude about the pup tent?

4. Using ABC, compute the total cost per unit for each tent if the direct labor and direct materials cost is $25 per pup tent and $32 per pop-up tent.

5. If the market price is $65 per pup tent and $200 per pop-up tent, determine the gross profit per unit for each tent. Comment on the results.

6. Would your pricing analysis be improved if the company used, instead of ABC, departmental rates determined using machine hours in department A and direct labor hours in department B? Explain.

Check (4) Pup tent, $58.46 per unit cost

SERIAL PROBLEM Business Solutions

P3

(This serial problem began in Chapter 1 and continues through most of the book. If previous chapter seg- ments were not completed, the serial problem can begin at this point. It is helpful, but not necessary, to use the Working Papers that accompany the book.)

SP 4 After reading an article about activity-based costing in a trade journal for the furniture industry, Santana Rey wondered if it was time to critically analyze overhead costs at Business Solutions. In a recent

168 Chapter 4 Activity-Based Costing and Analysis

REPORTING IN ACTION C3 A2

Beyond the Numbers

BTN 4-1 Refer to financial statements of Apple (Apple.com) and Google (Google.com) to answer the following.

Required

1. Identify at least two activities at Apple and at Google that cause costs to be incurred. Do you be- lieve these companies should be concerned about controlling costs of the activities you identified? Explain.

2. Would you classify Apple and Google as service, merchandising, or manufacturing companies? Explain.

3. Is activity-based costing useful for companies such as Apple and Google? Explain.

APPLE GOOGLE

APPLE GOOGLE

BTN 4-2 Apple and Google are competitors in the sales of electronic devices. Compare these compa- nies’ income statements and answer the following.

Required

1. Which company has a higher ratio of costs, defined as cost of goods sold plus total operating ex- penses, to revenues? Use the two most recent years’ income statements from Appendix A. Show your analysis.

2. How might the use of activity-based costing help the less competitive company become more competitive?

3. Assume Apple is considering opening a new retail store. What are the activities associated with open- ing a new retail store?

COMPARATIVE ANALYSIS C2 A2

Activity Cost Driver

Setting up machines . . . . . . . . . . . $20,000 25 batches Inspecting components . . . . . . . . $ 7,500 5,000 parts Providing utilities . . . . . . . . . . . . . $10,000 5,000 machine hours

Required

1. Classify each of its three overhead activities as unit level, batch level, product level, or facility level. 2. What is the total cost of Job 615 if Business Solutions applies overhead at 50% of direct labor cost? 3. What is the total cost of Job 615 if Business Solutions uses activity-based costing? 4. Which approach to assigning overhead gives a better representation of the costs incurred to produce

Job 615? Explain.

Overhead has been applied to output at a rate of 50% of direct labor costs. The following data pertain to Job 615.

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . $2,500 Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,500 Batches . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 batches Number of parts . . . . . . . . . . . . . . . . . . . . . . . . . 400 parts Machine hours . . . . . . . . . . . . . . . . . . . . . . . . . . . 600 machine hours

month, Santana found that setup costs, inspection costs, and utility costs made up most of its overhead. Additional information about overhead follows.

Chapter 4 Activity-Based Costing and Analysis 169

BTN 4-3 In conducting interviews and observing factory operations to implement an activity-based costing system, you determine that several activities are unnecessary or redundant. For example, ware- house personnel were inspecting purchased components as they were received at the loading dock. Later that day, the components were inspected again on the shop floor before being installed in the final product. Both of these activities caused costs to be incurred but were not adding value to the product. If you include this observation in your report, one or more employees who perform inspections will likely lose their jobs.

Required

1. As a plant employee, what is your responsibility to report your findings to superiors? 2. Should you attempt to determine if the redundancy is justified? Explain. 3. What is your responsibility to the employees whose jobs will likely be lost because of your report? 4. What facts should you consider before making your decision to report or not?

ETHICS CHALLENGE A2 C3

BTN 4-4 The chief executive officer (CEO) of your company recently returned from a luncheon meeting where activity-based costing was presented and discussed. Though her background is not in accounting, she has worked for the company for 15 years and is thoroughly familiar with its operations. Her impres- sion of the presentation about ABC was that it was just another way of dividing up total overhead cost and that the total would still be the same “no matter how you sliced it.”

Required

Write a memorandum to the CEO, no more than one page, explaining how ABC is different from tradi- tional volume-based costing methods. Also, identify its advantages and disadvantages vis-à-vis traditional methods. Be sure it is written to be understandable to someone who is not an accountant.

COMMUNICATING IN PRACTICE A2

BTN 4-5 Accounting professionals who work for private companies often obtain the Certified Management Accountant (CMA) designation to indicate their proficiency in several business areas in ad- dition to managerial accounting. The CMA examination is administered by the Institute of Management Accountants (IMA).

Required

Go to the IMA website (IMAnet.org) and determine which parts of the CMA exam likely cover activity- based costing. A person planning to become a CMA should take what college course work?

TAKING IT TO THE NET A2

BTN 4-6 Observe the operations at your favorite fast-food restaurant.

Required

1. How many people does it take to fill a typical order of sandwich, beverage, and one side order? 2. Describe the activities involved in its food service process. 3. What costs are related to each activity identified in requirement 2?

TEAMWORK IN ACTION C2 C3

BTN 4-7 Suja Juice Co. has expanded its product offerings to include many varieties of cold-pressed organic juices. Company founders know that financial success depends on cost control as well as revenue generation.

ENTREPRENEURIAL DECISION

C3

170 Chapter 4 Activity-Based Costing and Analysis

ANSWERS TO MULTIPLE CHOICE QUIZ 1. b; Under traditional costing methods, overhead costs are allocated to

products on the basis of some measure of volume such as direct la- bor hours or machine hours. This results in much of the overhead cost being allocated to high-volume products. In contrast, under activity-based costing, some overhead costs are allocated on the ba- sis of batch-level or product-level activities. This change in alloca- tion bases results in shifting overhead costs from high-volume products to low-volume products.

2. d; Generally, an activity-based costing system is more difficult to implement and maintain than a traditional costing system (thus an- swer a is false). Instead of eliminating waste by allocating costs to products that waste resources, activity-based management is a management approach that focuses on managing activities as a means of eliminating waste and reducing delays and defects (thus

answer b is false). Instead of using a single allocation base (such as direct labor hours), activity-based costing uses a number of al- location bases for assigning costs to products (thus answer c is false). Answer d is true.

3. d; Batch-level activities are activities that are performed each time a batch of goods is handled or processed, regardless of how many units are in a batch. Further, the amount of resources consumed de- pends on the number of batches rather than on the number of units in the batch. Worker recreational facilities relate to the organization as a whole rather than to specific batches and, as such, are not consid- ered to be batch level. On the other hand, purchase order processing, setting up equipment, and the clerical activities described are activi- ties that are performed each time a batch of goods is handled or processed, and, as such, are batch-level activities.

BTN 4-8 Visit and observe the processes of three different fast-food restaurants—these visits can be done as individuals or as teams. The objective of activity-based costing is to accurately assign costs to products and to improve operational efficiency.

Required

1. Individuals (or teams) can be assigned to each of three different fast-food establishments. Make a list of the activities required to process an order of a sandwich, beverage, and one side order at each res- taurant. Record the time required for each process, from placing the order to receiving the completed order.

2. What activities do the three establishments have in common? What activities are different across the establishments?

3. Is the number of activities related to the time required to process an order? Is the number of activities related to the price charged to customers? Explain both.

4. Make recommendations for improving the processes you observe. Would your recommendations in- crease or decrease the cost of operations?

HITTING THE ROAD C2 C3

BTN 4-9 Visit the websites and review the financial statements for Apple (Apple.com) and Samsung (Samsung.com). Each of these companies sells electronic devices like smartphones in global markets.

Required

1. For Apple in 2013, what are the largest three geographic markets in which it sells products? What is the amount (in millions of dollars) of sales in each market?

2. For Samsung in 2013, what are the largest three geographic markets in which it sells products? What is the amount (in millions of Korean won) of sales in each market? (Use “revenue from exter- nal customers.”)

3. How would customer service activities differ across different geographic markets?

GLOBAL DECISION C3

Required

1. If Suja Juice Co. wanted to expand its product line to include organic energy bars, what activities would it need to perform that are not required for its current product lines?

2. Related to part 1, should the additional overhead costs related to new product lines be shared by exist- ing product lines? Explain your reasoning.

APPLE Samsung

Chapter 4 Activity-Based Costing and Analysis 171

(A) (B) (A 3 B) Activity Rate Overhead (Budgeted overhead Cost cost 4 Budgeted Actual Applied to activity) Activity Production

Activity 1 . . . . ($80,000 4 1,000) 5 $80.00 800 $ 64,000 Activity 2 . . . . ($58,400 4 1,500) 5 $38.93* 500 19,465 Activity 3 . . . . ($360,000 4 6,000) 5 $60.00 5,400 324,000 Total overhead cost per unit for Product B . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $407,465 Divided by number of units produced . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 31,652 Overhead cost per unit of Product B . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 12.87

*rounded

4. c; 5. d; The activity rate for Activity 3 is determined as follows: Budgeted cost 4 Budgeted activity 5 Activity rate $14,000 4 700 5 $20

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Cost Behavior and Cost-Volume-Profit Analysis

Learningg Objjectivvves

CONCEPTUAL C1 Describe different types of cost

behavior in relation to production and sales volume.

C2 Describe several applications of cost-volume-profit analysis.

ANALYTICAL A1 Compute the contribution margin and

describe what it reveals about a company’s cost structure.

A2 Analyze changes in sales using the degree of operating leverage.

PROCEDURAL P1 Determine cost estimates using

the scatter diagram, high-low, and regression methods of estimating costs.

P2 Compute the break-even point for a single product company.

P3 Graph costs and sales for a single product company.

P4 Compute the break-even point for a multiproduct company.

MEASURING COST

BEHAVIOR

P1 Scatter diagrams High-low method

Least-squares regression

Comparison of cost estimation methods

CONTRIBUTION MARGIN AND BREAK-EVEN

ANALYSIS

A1 Computing contribution margin

P2 Computing break- even

Computing margin of safety

P3 Preparing a cost- volume-profit chart

Impact of estimates on break-even analysis

IDENTIFYING COST

BEHAVIOR

C1 Fixed costs Variable costs

Mixed costs

Step-wise costs and relevant range

Curvilinear costs

APPLYING COST- VOLUME-PROFIT

ANALYSIS

C2 Computing income from sales and costs

Computing sales for target income

Sensitivity analysis

P4 Computing multi- product break-even

A2 Analyzing sales with operating leverage

COLUMBIA, MO—After finishing his marketing degree and

obtaining over 13 years of professional marketing and design

experience, Reid Lyle needed a change. “I wanted to produce

creative quality products with talented, genuine people in a

business that I could actually influence for the better” says

Reid. Reid, along with partners Ryan Montgomery and Jordan

Roudenis, opened a custom T-shirt shop, Fast Yeti Custom

Tees (fastyetitees.com).

“We all contributed to every aspect of starting this busi-

ness” says Reid. That includes brainstorming to find a name

for their company. The trio came up with a mythical character,

Freddie the Yeti, who allegedly trekked from

the Ozark Mountains to convince the group

to start a business. “Fast Yeti is memorable

and fun,” says Reid. “It’s interesting. It raises

questions.” During the week, Freddie roams the streets of

Columbia, and customers who capture a photo of him receive

a discount on merchandise. “A common misconception is that

he’s a human wearing a costume,” jokes Ryan. “It’s a real yeti.”

While humor is a large part of their business, the owners

have a serious focus on providing high-quality products to

meet customer demands. “Everyone has a favorite T-shirt,”

says Reid. “We want to be the shop that designs and sells it.”

Jordan, the company’s production manager, says he “is very

particular about how I do things. If I mess up, I fix it and try

not to let it happen again. I try to perfect what I do.”

Operating at a small scale, in a highly competitive industry,

requires the owners to understand and control their costs.

Successful entrepreneurs must understand cost behavior to

succeed. Identifying fixed and variable costs is key to under-

standing break-even points determining the amount of sales

required to make a target income, key topics in this chapter. In

addition to selling custom T-shirts, Fast Yeti also sells custom

hats and polo shirts. Understanding multiproduct break-even

points and sales mix is important in companies with diverse

product lines. Contribution margin income statements, which

separate fixed and variable costs, enable entrepreneurs to

quickly see how changes in selling prices,

variable costs, or fixed costs impact profit.

Understanding contribution margins and

cost-volume-profit analyses enables small

businesses to profit and grow.

Reid, Ryan, and Jordan agree that young entrepreneurs

should follow their passion and “make it happen.” “We all are

interested in apparel, humor, and design,” says Reid. “Still, we

all had to strip out old carpet and make our own shelves to get

this store opened.” While still a young company, the trio is

seeing their hard work rewarded with increasing sales. “We

work hard,” says Ryan, “but it’s really fun.” And, if you see a

yeti roaming around . . . take a photo.

Sources: Fast Yeti Custom Tees website, January 2015; Columbia Missourian, May 14, 2014; Columbia Daily Tribune, June 16, 2014

“The T-shirt is the epitome of creativity”

—Reid Lyle

173

Find the YetiCou rt

es y

o f

Fa st

Y et

i T ee

s

174 Chapter 5 Cost Behavior and Cost-Volume-Profit Analysis

IDENTIFYING COST BEHAVIOR Planning a company’s future activities and events is crucial to successful management. One of the first steps in planning is to predict the volume of activity, the costs to be incurred, sales to be made, and profit to be earned. An important tool in such planning is cost-volume-profit (CVP) analysis, which helps managers predict how changes in costs and sales levels affect profit. In its basic form, CVP analysis involves computing the sales level at which a company neither earns an income nor incurs a loss, called the break-even point. For this reason, this basic form of cost- volume-profit analysis is often called break-even analysis.

Managers use variations of CVP analysis to answer questions like:

How much does income increase if we install a new machine to reduce labor costs? What is the change in income if selling prices decline and sales volume increases? How will income change if we change the sales mix of our products or services? What sales volume is needed to earn a target income?

Consequently, cost-volume-profit analysis is useful in a wide range of business decisions. The concept of relevant range is important to classifying costs for CVP analysis. The relevant

range of operations is the normal operating range for a business. Except for unusually good or bad times, management typically plans for operations within a range of volume neither close to zero nor at maximum capacity. The relevant range excludes extremely high or low operating levels that are unlikely to recur. CVP analysis requires management to classify costs as either fixed or variable with respect to production or sales volume, within the relevant range of operations. The remainder of this section discusses concepts of cost behavior as they relate to CVP analysis.

Fixed Costs Fixed costs remain unchanged despite variations in the volume of activity within a relevant range. For example, $32,000 in monthly rent paid for a factory building remains the same whether the factory operates with a single eight-hour shift or around the clock with three shifts. This means that rent cost is the same each month at any level of output from zero to the plant’s full productive capacity. Common examples of fixed costs include depreciation, property taxes, office salaries, and many service department costs.

Be sure to realize that the idea of fixed cost not changing as the level of production changes applies to the total dollar amount. It does not apply to the per unit amount. Rather, the fixed cost per unit of output decreases as volume increases. For instance, if 200 units are produced when monthly rent is $32,000, the average rent cost per unit is $160 (computed as $32,000/200 units). When production increases to 1,000 units per month, the average rent cost per unit decreases to $32 (computed as $32,000y1,000 units).

When production volume and costs are graphed, units of product are usually plotted on the horizontal axis and dollars of cost are plotted on the vertical axis. Fixed costs then are

represented as a horizontal line because they remain constant at all levels of production. To illustrate, the top graph in Exhibit 5.1 shows that fixed costs remain at $32,000 at all pro- duction levels up to the company’s monthly capacity of 2,000 units of output. The bottom graph in Exhibit 5.1 shows that fixed costs per unit fall as production levels increase. This drop in costs per unit as production levels in- crease is known as economies of scale. The relevant range for fixed costs in Exhibit 5.1 is 0 to 2,000 units. If the relevant range changes (that is, production capacity extends beyond this range), the amount of fixed costs will likely change.

C1 Describe different types of cost behavior in relation to production and sales volume.

gerenme/Vetta/Getty Images

Chapter 5 Cost Behavior and Cost-Volume-Profit Analysis 175

Variable Costs Variable costs change in proportion to changes in volume of activity. The direct materials cost of a product is one example of a variable cost. If one unit of product requires materials costing $20, total materials costs are $200 when 10 units of product are manufactured, $400 for 20 units, $600 for 30 units, and so on. In addition to direct materials, common variable costs include direct labor (if employees are paid per unit), sales commissions, shipping costs, and some overhead costs.

Notice that variable cost per unit remains constant but the total amount of variable cost changes with the level of production. When variable costs are plotted on a graph of cost and volume, they appear as a straight line starting at the zero cost level. This straight line is upward (positive) sloping. The line rises as volume of activity increases. A vari- able cost line using a $20 per unit cost is graphed in Exhibit 5.1. The bottom graph in Exhibit 5.1 shows that variable cost per unit is constant as production levels change.

Mixed Costs Are costs either fixed or variable? No—another category, mixed costs, includes both fixed and variable cost components. For example, compensation for sales representatives often includes a fixed monthly salary and a variable commission based on sales. Utilities can also be considered a mixed cost; even if no units are produced, it is not likely a manufacturing plant will use no electricity or water. Like a fixed cost, a mixed cost is greater than zero when volume is zero; but unlike a fixed cost, it increases steadily in proportion to increases in volume.

EXHIBIT 5.1 Relations of Total and Per Unit Costs to Volume

0 0

200 400 800600 1,400 1,600 1,800 2,0001,2001,000

10,000

20,000

30,000

40,000

50,000

60,000

$80,000

70,000

Volume (Units)

C o

st

Monthly Capacity

Variable Costs, $20 per Unit

Fixed Costs, $32,000

Total (Mixed) Costs

Relation of Total Fixed and Variable Costs to Volume

0 0

200 400 800600 1,400 1,600 1,800 2,0001,2001,000

20

40

60

80

100

120

160

180

$200

140

Volume (Units)

C o

st p

er u

n it

Variable Costs per Unit

Fixed Costs per Unit

Total (Mixed) Costs per Unit

Relations of Per Unit Fixed and Variable Costs to Volume

Example: If the level of fixed costs in Exhibit 5.1 changes, does the slope of the total cost line change? Answer: No, the slope doesn’t change. The total cost line is simply shifted upward or downward.

Point: Fixed costs are con- stant in total but vary (decline) per unit as more units are produced. Variable costs vary in total but are fixed per unit.

Total Costs C

o st

0 0

200 400 800600 1,400 1,600 1,800 2,0001,2001,000

10,000

20,000

30,000

40,000

50,000

60,000

$80,000

70,000

Volume (Units)

M C

Example: If the fixed cost line in Exhibit 5.1 is shifted upward, does the total cost line shift up, down, or remain in the same place? Answer: It shifts up by the same amount.

176 Chapter 5 Cost Behavior and Cost-Volume-Profit Analysis

The total (mixed) cost line in the top graph in Exhibit 5.1 starts on the vertical axis at the $32,000 fixed cost point. Thus, at the zero volume level, total cost equals the fixed costs. As the activity level increases, the total cost line increases at an amount equal to the variable cost per unit. This line is highest when the volume of activity is at 2,000 units (the end point of the relevant range). In CVP analysis, mixed costs should be separated into fixed and variable components. The fixed component is added to other fixed costs, and the variable component is added to other variable costs.

Step-wise Costs and the Relevant Range A step-wise cost (or stair-step cost) reflects a step pattern in costs. Salaries of production supervi- sors often behave in a step-wise manner in that their salaries are fixed within a relevant range of the current production volume. However, if production volume expands significantly (for example, with the addition of another shift), additional supervisors must be hired. This means that the total cost for supervisory salaries goes up by a lump-sum amount. Similarly, if production volume takes another significant step up, supervisory salaries will increase by another lump sum. This behavior is graphed in Exhibit 5.2. See how the step-wise cost line is flat within ranges, called the relevant range. Then, when volume significantly changes, the cost shifts to another level for that range.

In CVP analysis, a step-wise cost is usually treated as either a fixed cost or a variable cost. This treatment involves manager judgment and depends on the width of the relevant range and the expected volume. To illustrate, suppose after the production of every 25 snowboards, an operator lubricates the finishing machine. The cost of this lubricant reflects a step-wise pattern. Also, suppose that after the production of every 1,000 units, the snowboard cutting tool is re- placed. Again, this is a step-wise cost. Note that the relevant range of 25 snowboards is much narrower than the relevant range of 1,000 snowboards. Some managers might treat the lubricant cost as a variable cost and the cutting tool cost as a fixed cost.

Curvilinear Costs As shown earlier, variable costs increase at a constant rate as the volume of activity increases. For example, a salesperson’s commission of 7% of sales volume would increase at a constant rate as sales volume increases. Curvilinear costs also increase as volume increases, but at a nonconstant rate. The curved line in Exhibit 5.2 shows a curvilinear cost beginning at zero (when production is zero) and increasing at different rates as volume increases.

An example of a curvilinear cost is total direct labor cost when workers are paid by the hour. For example, a company might add new employees assigned to specialize in certain tasks. When production levels are relatively low, adding those specialized employees often yields more out- put. This is reflected in a flatter slope in the curvilinear cost graph in Exhibit 5.2. At some point, however, adding still more employees creates inefficiencies (they get in each other’s way); this inefficiency is reflected in a steeper slope for the curvilinear cost graph. In CVP analysis, curvi- linear costs are often treated as variable costs, within a relevant range. This is reasonable for most types of curvilinear costs.

EXHIBIT 5.2 Step-wise and Curvilinear Costs

0 0

200 400 800600 1,400 1,600 1,800 2,0001,2001,000

20,000

40,000

60,000

80,000

100,000

120,000

$160,000

140,000

Volume (Units)

C o

st

Step-wise Cost

Curvilinear Cost

Monthly Capacity

Relevant Range

Point: Computer spread- sheets are important and effective tools for CVP analysis and for analyzing alternative “what-if” strategies.

Chapter 5 Cost Behavior and Cost-Volume-Profit Analysis 177

Determine whether each of the following is best described as a fixed, variable, mixed, step-wise, or curvi- linear cost with respect to product units.

C1

NEED-TO-KNOW 5-1 Classifying Costs

Type of Cost

Rubber used to manufacture tennis balls . . . . . . . . . . . . . . . . . . . a. Depreciation (straight-line method) . . . . . . . . . . . . . . . . . . . . . . . b. Electricity usage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . c. Supervisory salaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . d. A salesperson’s commission is 7% for sales of up to $100,000, and 10% of sales for sales above $100,000 . . . . . . . . . e.

Solution

a. variable b. fi xed c. mixed d. fi xed* e. curvilinear

MEASURING COST BEHAVIOR Identifying and measuring cost behavior requires careful analysis and judgment. An important part of this process is to identify costs that can be classified as either fixed or variable, which often requires analysis of past cost behavior. A goal of classifying costs is to develop a cost equation. The cost equation expresses total costs as a function of fixed costs plus variable cost per unit. Three methods are commonly used to analyze past costs: scatter diagrams, the high- low method, and least-squares regression. Each method is discussed in this section using the unit and cost data shown in Exhibit 5.3, which are taken from a start-up company that uses units produced as the activity base in estimating cost behavior.

Scatter Diagrams Scatter diagrams display past cost and unit data in graphical form. In preparing a scatter dia- gram, units are plotted on the horizontal axis, and costs are plotted on the vertical axis. Each individual point on a scatter diagram reflects the cost and number of units for a prior period. In Exhibit 5.4, the prior 12 months’ costs and numbers of units are graphed. Each point reflects total costs incurred and units produced for one of those months. For instance, the point labeled March had units produced of 25,000 and costs of $25,000.

The estimated line of cost behavior is drawn on a scatter diagram to reflect the relation between cost and unit volume. This line best visually “fits” the points in a scatter diagram. Fitting this line demands judgment, or can be done with spreadsheet software, as we illustrate

P1 Determine cost estimates using the scatter diagram, high-low, and regression methods of estimating costs.

Month Units Produced Total Cost

January . . . . . . . . . . . . 27,500 $21,500 February . . . . . . . . . . . 17,500 20,500 March . . . . . . . . . . . . . 25,000 25,000 April . . . . . . . . . . . . . . 35,000 21,500 May . . . . . . . . . . . . . . . 47,500 25,500 June . . . . . . . . . . . . . . 22,500 18,500 July . . . . . . . . . . . . . . . 30,000 23,500 August . . . . . . . . . . . . 52,500 28,500 September . . . . . . . . . 37,500 26,000 October . . . . . . . . . . . 67,500 29,000 November . . . . . . . . . 62,500 31,000 December . . . . . . . . . 57,500 26,000

EXHIBIT 5.3 Data for Estimating Cost Behavior

QC1

Do More: QS 5-1, QS 5-2, E 5-1, E 5-2, E 5-3

*If more shifts are added, then supervisory salaries behave like a step-wise cost with respect to the number of shifts.

178 Chapter 5 Cost Behavior and Cost-Volume-Profit Analysis

in Appendix 5A. The line drawn in Exhibit 5.4 intersects the vertical axis at approximately $16,000, which reflects fixed cost. To compute variable cost per unit, or the slope, we perform three steps. First, we select any two points on the horizontal axis (units), say 0 and 40,000. Second, we draw a vertical line from each of these points to intersect the estimated line of cost behavior. The point on the vertical axis (cost) corresponding to the 40,000 units point that intersects the estimated line is roughly $24,000. Similarly, the cost corresponding to zero units is $16,000 (the fixed cost point). Third, we compute the slope of the line, or variable cost, as the change in cost divided by the change in units. Exhibit 5.5 shows this computation.

EXHIBIT 5.4 Scatter Diagram

0 0

10,000 20,000 40,00030,000 70,000 80,00060,00050,000

5,000

10,000

15,000

20,000

25,000

30,000

$40,000

35,000

Volume (Units) C

o st

March Estimated Fixed Cost Component ($16,000)

Estimated Line of Cost Behavior

Change in cost Change in units

5 $24,000 2 $16,000

40,000 2 0 5

$8,000 40,000

5 $0.20 per unit EXHIBIT 5.5 Variable Cost per Unit (Scatter Diagram)

Change in cost Change in units

5 $29,000 2 $20,500 67,500 2 17,500

5 $8,500 50,000

5 $0.17 per unit EXHIBIT 5.6 Variable Cost per Unit (High-Low Method)

Variable cost is $0.20 per unit. Thus, the cost equation that management will use to estimate costs for different unit levels is $16,000 plus $0.20 per unit produced.

High-Low Method The high-low method is a way to estimate the cost equation using just two points: the highest and lowest volume levels. The high-low method follows these steps:

Step 1: Identify the highest and lowest volume levels. It is important to note that these might not be the highest or lowest levels of costs. Step 2: Compute the slope (variable cost per unit) using the high and low activity levels. Step 3: Compute the total fixed costs by computing the total variable cost at either the high or low activity level, and then subtracting that amount from the total cost at that activity level.

We illustrate the high-low method next.

Step 1: In our case, the lowest number of units is 17,500, and the highest is 67,500. The costs corresponding to these unit volumes are $20,500 and $29,000, respectively (see the data in Exhibit 5.3). Step 2: The variable cost per unit is calculated using a simple formula: change in cost divided by the change in units. Using the data from the high and low unit volumes, this results in a slope, or variable cost per unit, of $0.17 as computed in Exhibit 5.6.

Example: In Exhibits 5.4 and 5.5, if units are projected at 30,000, what is the predicted cost? Answer: Approximately $22,000.

Chapter 5 Cost Behavior and Cost-Volume-Profit Analysis 179

Step 3: To estimate the fixed cost for the high-low method, we use the knowledge that total cost equals fixed cost plus variable cost per unit times the number of units. Then we pick either the high or low point to determine the fixed cost. This computation is shown in Exhibit 5.7—where we use the high point (67,500 units) in determining the fixed cost of $17,525. (Use of the low point yields the same fixed cost estimate.)

Thus, the cost equation from the high-low method is $17,525 plus $0.17 per unit produced. This cost equation differs slightly from that determined from the scatter diagram method. A weakness of the high-low method is that it ignores all cost points except the highest and lowest volume levels.

Least-Squares Regression Least-squares regression is a statistical method for identifying cost behavior. For our pur- poses, we use the cost equation estimated from this method but leave the computational details for more advanced courses. Such computations for least-squares regression are readily done using most spreadsheet programs or calculators. We illustrate this using Excel in Appendix 5A. Using least-squares regression, the cost equation for the data presented in Exhibit 5.3 is $16,947 plus $0.19 per unit produced; that is, the fixed cost is estimated as $16,947 and the variable cost at $0.19 per unit.

Comparison of Cost Estimation Methods The three cost estimation methods result in slightly different estimates of fixed and variable costs as summarized in Exhibit 5.8. Estimates from the scatter diagram, unless done with spreadsheet soft- ware, are based on a visual fit of the cost line and are subject to interpretation. Estimates from the high-low method use only two sets of values corresponding to the lowest and highest unit volumes. Sometimes these two extreme activity levels do not reflect the more usual conditions likely to recur. Estimates from least-squares regression use a statistical technique and all available data points.

EXHIBIT 5.7 Determining Fixed Costs (High-Low Method)

Total cost 5 Fixed cost 1 (Variable cost per unit 3 Units) $29,000 5 Fixed cost 1 ($0.17 per unit 3 67,500 units) $29,000 5 Fixed cost 1 $11,475

Fixed cost 5 $17,525

We must remember that all three methods use past data. Thus, cost estimates resulting from these methods are only as good as the data used for estimation. Managers must establish that the data are reliable in deriving cost estimates for the future. If the data are reliable, the use of more data points, as in the regression or scatter diagram methods, should yield more accurate esti- mates than the high-low method. However, the high-low method is easier to apply and thus might be useful for obtaining a quick cost equation estimate.

Using the information below, apply the high-low method to determine the cost equation (total fixed costs plus variable costs per unit).

P1

NEED-TO-KNOW 5-2 High-Low Method

Activity Level Units Produced Total Cost

Lowest . . . . . . . . . . . . 1,600 $ 9,800 Highest . . . . . . . . . . . . 4,000 17,000

Example: Using information from Exhibit 5.6, what is the amount of fixed cost at the low level of volume? Answer: $17,525, computed as $29,000 2 ($0.17 3 17,500 units).

EXHIBIT 5.8 Comparison of Cost Estimation Methods

Estimation Method Fixed Cost Variable Cost

Scatter diagram . . . . . . . . . . . . . . . . $16,000 $0.20 per unit High-low method . . . . . . . . . . . . . . 17,525 0.17 per unit Least-squares regression . . . . . . . . . 16,947 0.19 per unit

Solution

The variable cost per unit is computed as: [$17,000 2 $9,800]y[4,000 units 2 1,600 units] 5 $3 per unit. Total fixed costs using the lowest activity level is computed from the following equation: $9,800 5 Fixed costs 1 ($3 3 1,600 units); thus, fixed costs 5 $5,000. This implies the cost equation is $5,000 plus $3 per unit produced. We can prove the accuracy of this cost equation at either the highest or lowest point shown here.

Highest point: Lowest point: Total cost 5 $5,000 1 ($3 per unit 3 4,000 units) Total cost 5 $5,000 1 ($3 per unit 3 1,600 units) 5 $5,000 1 $12,000 5 $5,000 1 $4,800 5 $17,000 5 $9,800

180 Chapter 5 Cost Behavior and Cost-Volume-Profit Analysis

Do More: QS 5-3, E 5-6

QC2

Another way to calculate contribution margin is as a ratio. The contribution margin ratio, which is the percent of a unit’s selling price that exceeds total unit variable cost, is also useful for business decisions. It can be interpreted as the percent of each sales dollar that remains after deduct- ing the total unit variable cost. Exhibit 5.10 shows the formula for the contribution margin ratio.

To illustrate the use of contribution margin, let’s consider Rydell, which sells footballs for $100 each and incurs variable costs of $70 per football sold. Its fixed costs are $24,000 per month with monthly capacity of 1,800 units (footballs). Rydell’s contribution margin per unit is $30, which is computed as follows.

Thus, at a selling price of $100 per unit, Rydell covers its variable costs and makes $30 per football to contribute to fixed costs and profit. Rydell’s contribution margin ratio is 30%, com- puted as $30/$100. A contribution margin ratio of 30% implies that for each $1 in sales, Rydell has $0.30 that contributes to fixed cost and profit. Next we show how to use these contribution margin measures in break-even analysis.

CONTRIBUTION MARGIN AND BREAK-EVEN ANALYSIS In this section we introduce the concept of contribution margin, the key measure in cost- volume-profit analysis. We also discuss break-even analysis, an important special case of cost- volume-profit analysis.

Contribution Margin and Its Measures CVP analysis requires managers to classify costs as being fixed or variable with respect to vol- ume of activity. In manufacturing companies, volume of activity usually refers to the number of units produced. We then classify a cost as either fixed or variable, depending on whether total cost changes as the number of units produced changes. Once we classify costs by behavior, we can then compute a product’s contribution margin. Contribution margin per unit, or unit con- tribution margin, is the amount by which a product’s unit selling price exceeds its total variable cost per unit. This amount contributes to covering fixed costs and generating profits. Exhibit 5.9 shows the formula used to calculate contribution margin per unit.

A1 Compute the contribution margin and describe what it reveals about a company’s cost structure.

Contribution margin 5 Selling price per unit 2 Total variable cost per unit per unit

EXHIBIT 5.9 Contribution Margin per Unit

Contribution margin ratio 5 Contribution margin per unit

Selling price per unit

EXHIBIT 5.10 Contribution Margin Ratio

Selling price per unit . . . . . . . . . . . . . . . . $100 Variable cost per unit . . . . . . . . . . . . . . . 70 Contribution margin per unit . . . . . . . . . $ 30AP Images/Skip Peterson

Chapter 5 Cost Behavior and Cost-Volume-Profit Analysis 181

If Rydell sells 800 units, its profit will be zero. Profit increases or decreases by $30 for every unit sold above or below that break-even point; if Rydell sells 801 units, profit will equal $30. We also can calculate the break-even point in dollars. Also called break-even sales dollars, it uses the contribution margin ratio to determine the required sales dollars needed for the com- pany to break even. Exhibit 5.12 shows the formula and Rydell’s break-even point in dollars:

To verify that Rydell’s monthly break-even point equals $80,000 (or 800 units), we prepare a simplified income statement in Exhibit 5.13. It shows that the $80,000 revenue from sales of 800 units exactly equals the sum of variable and fixed costs.

Sales Manager You are evaluating orders from two customers but can accept only one of the orders because of your company’s limited capacity. The first order is for 100 units of a product with a contribution margin ratio of 60% and a selling price of $1,000 per unit. The second order is for 500 units of a product with a contribution mar- gin ratio of 20% and a selling price of $800 per unit. The incremental fixed costs are the same for both orders. Which order do you accept? ■ [Answers follow the chapter’s Summary.]

Decision Maker

Computing the Break-Even Point The break-even point is the sales level at which a company neither earns a profit nor incurs a loss. The concept of break-even applies to nearly all organizations, activities, and events. A key concern when launching a project is whether it will break even—that is, whether sales will at least cover total costs. The break-even point can be expressed in either units or dollars of sales.

To illustrate break-even analysis, let’s again look at Rydell, which sells footballs for $100 per unit and incurs $70 of variable costs per unit sold. Its fixed costs are $24,000 per month. We compute the break-even point using the formula in Exhibit 5.11. This formula uses the contribu- tion margin per unit (calculated above), which for Rydell is $30 ($100 2 $70). From this we can compute the break-even sales volume in units as follows:

P2 Compute the break-even point for a single product company.

Break-even point in units 5 Fixed costs

Contribution margin per unit 5 $24,000y$30 5 800 units per month

EXHIBIT 5.11 Formula for Computing Break-Even Sales (in Units)

Break-even point in dollars 5 Fixed costs

Contribution margin ratio 5 $24,000y30% 5 $24,000y0.30 5 $80,000 of monthly sales

EXHIBIT 5.12 Formula for Computing Break-Even Sales (in Dollars)

Point: Even if a company operates at a level above its break-even point, management may decide to stop operating because it is not earning a rea- sonable return on investment.

Point: Selling prices and vari- able costs are usually expressed in per unit amounts. Fixed costs are usually expressed in total amounts.

RYDELL COMPANY Contribution Margin Income Statement (at Break-Even)

For Month Ended January 31, 2015

Sales (800 units at $100 each) . . . . . . . . . . . . . . . $80,000 Variable costs (800 units at $70 each) . . . . . . . . . 56,000 Contribution margin . . . . . . . . . . . . . . . . . . . . 24,000 Fixed costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 0

EXHIBIT 5.13 Contribution Margin Income Statement for Break-Even Sales

182 Chapter 5 Cost Behavior and Cost-Volume-Profit Analysis

The statement in Exhibit 5.13 is called a contribution margin income statement. It differs in format from a conventional income statement in two ways. First, it separately classifies costs and expenses as variable or fixed. Second, it reports contribution margin (Sales 2 Variable costs). We will use the contribution margin income statement format in this chapter’s assign- ment materials because of its usefulness in CVP analysis.

Computing the Margin of Safety All companies wish to sell more than the break-even number of units. The excess of expected sales over the break-even sales level is called a company’s margin of safety, the amount that sales can drop before the company incurs a loss. It is often expressed in dollars or as a percent of the expected sales level.

To illustrate, recall that Rydell’s break-even point in dollars is $80,000. If its expected sales are $100,000, the margin of safety is $20,000 (5 $100,000 2 $80,000). As a percent, the mar- gin of safety is 20% of expected sales as shown in Exhibit 5.14.

Management must assess whether the margin of safety is adequate in light of factors such as sales variability, competition, consumer tastes, and economic conditions.

Preparing a Cost-Volume-Profit Chart Exhibit 5.15 is a graph of Rydell’s cost-volume-profit relations. This graph is called a cost- volume-profit (CVP) chart, or a break-even chart or break-even graph. The horizontal axis is the number of units produced and sold, and the vertical axis is dollars of sales and costs. The lines in the chart depict both sales and costs at different output levels.

We follow three steps to prepare a CVP chart:

1. Plot fixed costs on the vertical axis ($24,000 for Rydell). Draw a horizontal line at this level to show that fixed costs remain unchanged regardless of output volume (drawing this fixed cost line is not essential to the chart).

2. Draw the total (variable plus fixed) cost line for a relevant range of volume levels. This line starts at the fixed costs level on the vertical axis because total costs equal fixed costs

Point: A contribution margin income statement is also re- ferred to as a variable costing income statement. This differs from the traditional absorption costing approach where all product costs are assigned to units sold and to units in ending inventory. Recall that variable costing expenses all fixed prod- uct costs. Thus, income for the two approaches differs depend- ing on the level of finished goods inventory; the lower in- ventory is, the more similar the two approaches are. GAAP requires financial statements for external users be prepared using absorption costing.

Margin of safety (in percent) 5

Expected sales 2 Break-even sales Expected sales

5 $100,000 2 $80,000

$100,000 5 $20,000y$100,000 5 20%

EXHIBIT 5.14 Computing Margin of Safety (in Percent)

A manufacturer predicts fixed costs of $400,000 for the next year. Its one product sells for $170 per unit, and it incurs variable costs of $150 per unit. The company predicts total sales of 25,000 units for the next year. 1. Compute the contribution margin per unit. 2. Compute the break-even point (in units). 3. Compute the margin of safety (in dollars).

Solution

1. Contribution margin per unit 5 $170 2 $150 5 $20 2. Break-even point 5 $400,000y$20 5 20,000 units 3. Margin of safety 5 [25,000 3 $170] 2 [20,000 3 $170] 5 $850,000

NEED-TO-KNOW 5-3

A1 P2

Contribution Margin, Break-Even Point, Margin of Safety

Do More: QS 5-5, QS 5-6, QS 5-10, E 5-8, E 5-9,

E 5-16

P3 Graph costs and sales for a single product company.

Point: CVP charts can also be drawn with computer programs.

Chapter 5 Cost Behavior and Cost-Volume-Profit Analysis 183

EXHIBIT 5.15 Cost-Volume-Profit Chart

0 200 400 600 800 1,000 1,200 1,400 1,600 1,800 0

20,000

40,000

60,000

80,000

100,000

120,000

140,000

160,000

$180,000

Volume (Number of units produced)

D o

lla rs

Break-Even Point (sales of 800 units or $80,000)

Loss Area Profit Area

Total Costs

Sales

Sales

Total Costs

Fixed Costs ($24,000)

at zero volume. The slope of the total cost line equals the variable cost per unit ($70). To draw the line, compute the total costs for any volume level, and connect this point with the vertical axis intercept ($24,000). Do not draw this line beyond the productive capacity for the planning period (1,800 units for Rydell).

3. Draw the sales line. Start at the origin (zero units and zero dollars of sales) and make the slope of this line equal to the selling price per unit ($100). To draw the line, compute dollar sales for any volume level and connect this point with the origin. Do not extend this line beyond the productive capacity. Total sales will be highest at maximum capacity.

The total cost line and the sales line intersect at 800 units in Exhibit 5.15, which is the break- even point—the point where total dollar sales of $80,000 equals the sum of both fixed and vari- able costs ($80,000). (Note that 800 units is the same result we calculated earlier using the formula in Exhibit 5.11.)

On either side of the break-even point, the vertical distance between the sales line and the total cost line at any specific volume reflects the profit or loss expected at that point. At volume levels to the left of the break-even point, this vertical distance is the amount of the expected loss because the total costs line is above the total sales line. At volume levels to the right of the break-even point, the vertical distance represents the expected profit because the total sales line is above the total cost line.

Working with Changes in Estimates Because CVP analysis uses estimates, knowing how changes in those estimates impact break- even is useful. For example, a manager might form three estimates for each of the components of break-even: optimistic, most likely, and pessimistic. Then ranges of break-even points in units can be computed, using the formula from Exhibit 5.11. To illustrate, assume Rydell’s man- agers provide the set of estimates in Exhibit 5.16.

Point: CVP analysis is often based on sales volume, using either units sold or dollar sales. Other output measures, such as the number of units pro- duced, can also be used.

Example: In Exhibit 5.15, the sales line intersects the total cost line at 800 units. At what point would the two lines intersect if selling price is increased by 20% to $120 per unit? Answer: $24,000/($120 2 $70) 5 480 units

QC3

Selling Price Variable Cost Total Fixed per Unit per Unit Costs

Optimistic . . . . . . . . . $105 $68 $21,000 Most likely . . . . . . . . . 100 70 24,000 Pessimistic . . . . . . . . . 95 72 27,000

EXHIBIT 5.16 Alternative Estimates for Break-Even Analysis

If, for example, Rydell’s managers believe they can raise the selling price of a football to $105, without any change in unit variable or total fixed costs, then the revised contribution margin per football is $35 ($105 2 $70), and the revised break-even in units follows in Exhibit 5.17.

184 Chapter 5 Cost Behavior and Cost-Volume-Profit Analysis

Repeating this calculation using each of the other eight separate estimates above, and graphing the results, yields the three graphs in Exhibit 5.18.

These graphs show how changes in selling prices, variable costs, and fixed costs impact break-even. When selling prices can be increased without impacting unit variable costs or total fixed costs, break-even decreases (graph A). When competition reduces selling prices, and the company cannot reduce costs, break-even increases (graph A). Increases in either variable (graph B) or fixed costs (graph C), if they cannot be passed on to customers via higher selling prices, will increase break- even. If costs can be reduced and selling prices held constant, the break-even point decreases.

Revised break-even point in units

5 $24,000

$35 5 686 units (rounded)

EXHIBIT 5.17 Revised Break-Even in Units

EXHIBIT 5.18 Break-Even Points for Alternative Estimates

Point: This analysis changed only one estimate at a time; managers can examine how combinations of changes in estimates will impact break-even.

500

800 850 900 950

1,000

750 700 650 600 550

B re

a k

-E ve

n (

U n

it s)

$94 $96 $98 $100 $102 $104 Price (per unit)

Impact of Price Changes on Break-Even in Units

(A)

$106 $73$71 $72 740

860

880

840

820

800

780

760

B re

a k

-E ve

n (

U n

it s)

$67 $68 $69 $70 Variable Cost (per unit)

Impact of Changes in Variable Cost on Break-Even in Units

(B)

800

850

900

950

750

700

650

600

B re

a k

-E ve

n (

U n

it s)

$1 5,

00 0

$1 8,

00 0

$2 1,

00 0

$2 4,

00 0

$2 7,

00 0

$3 0,

00 0

Total Dollars of Fixed Costs

Impact of Changes in Fixed Costs on Break-Even in Units

(C)

Supervisor Your team is conducting a cost-volume-profit analysis for a new product. Different sales projections have different incomes. One member suggests picking numbers yielding favorable income because any estimate is “as good as any other.” Another member points to a diagram of 20 months’ production on a comparable product and suggests dropping unfavorable data points for cost estimation. What do you do? ■ [Answers follow the chapter’s Summary.]

Decision Ethics

APPLYING COST-VOLUME-PROFIT ANALYSIS Managers consider a variety of strategies in planning business operations. Cost-volume-profit analysis is useful in helping managers evaluate the likely effects of these strategies.

Computing Income from Sales and Costs An important question managers often ask is “What is the predicted income from a predicted level of sales?” To answer this, we look at four variables in CVP analysis—sales, variable costs, contri- bution margin, and fixed costs. Exhibit 5.19 shows these variables and their relations to income (pretax). We use these relations to compute expected income from predicted sales and cost levels.

Sales 2 Variable costs Contribution margin 2 Fixed costs Income (pretax)

EXHIBIT 5.19 Income Relations in CVP Analysis

C2 Describe several applications of cost- volume-profit analysis.

Chapter 5 Cost Behavior and Cost-Volume-Profit Analysis 185

To illustrate, let’s assume that Rydell’s management expects to sell 1,500 units in January 2015. What is the amount of income if this sales level is achieved? Using the calculation format in Exhibit 5.19, we compute Rydell’s expected income in Exhibit 5.20.

This income amount can also be computed as (units sold 3 contribution margin per unit) 2 fixed costs, or (1,500 3 $30) 2 $24,000. The $21,000 income is pretax. To find the amount of after-tax income from selling 1,500 units, management must apply the proper tax rate. Assume that the tax rate is 25%. Then we can prepare a projected after-tax income statement, shown in Exhibit 5.21. We can also compute pretax income as after-tax income divided by (1 2 tax rate); for Rydell, this is $15,750y(1 2 0.25), or $21,000.

RYDELL COMPANY Contribution Margin Income Statement

For Month Ended January 31, 2015

Sales (1,500 units at $100 each) . . . . . . . . . . . . . . . $150,000 Variable costs (1,500 units at $70 each) . . . . . . . . . 105,000 Contribution margin . . . . . . . . . . . . . . . . . . . . . . . . 45,000 Fixed costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000 Income (pretax) . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 21,000

EXHIBIT 5.20 Computing Expected Pretax Income from Expected Sales

EXHIBIT 5.21 Computing Expected After-Tax Income from Expected Sales

RYDELL COMPANY Contribution Margin Income Statement

For Month Ended January 31, 2015

Sales (1,500 units at $100 each) . . . . . . . . . . . . . . . $150,000 Variable costs (1,500 units at $70 each) . . . . . . . . . 105,000 Contribution margin . . . . . . . . . . . . . . . . . . . . . . . . 45,000 Fixed costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000 Pretax income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,000 Income taxes (25%) . . . . . . . . . . . . . . . . . . . . . . . . . 5,250 Net income (after tax) . . . . . . . . . . . . . . . . . . . . . . $ 15,750

Management then assesses whether this income is an adequate return on assets invested. Management should also consider whether sales and income can be in- creased by raising or lowering prices. CVP analysis is a good tool for addressing these kinds of “what-if” questions.

Computing Sales for a Target Income Many companies’ annual plans are based on certain income targets (sometimes called budgets). Rydell’s income target for this year is to increase income by 10% over the prior year. When prior year income is known, Rydell easily computes its target income. CVP analysis helps to determine the sales level needed to achieve the target income. Planning for the year is then based on this level.

We use the formula shown in Exhibit 5.22 to compute sales for a target income (pretax). To illustrate, Rydell has monthly fixed costs of $24,000 and a 30% contribution margin ratio. As- sume that it sets a target monthly income of $12,000. Using the formula in Exhibit 5.22, we find that Rydell needs $120,000 of sales to produce a $12,000 pretax target income.

"How many units must we sell to earn $50,000?"

Dollar sales at target income 5

Fixed costs

1 Target income

Contribution margin ratio

5 $24,000 1 $12,000

30% 5 $120,000

EXHIBIT 5.22 Computing Sales (Dollars) for a Target Income

Point: 1,500 units of sales is 700 units above Rydell’s break- even point. Income can also be computed as 700 units 3 $30 contribution margin per unit.

186 Chapter 5 Cost Behavior and Cost-Volume-Profit Analysis

Alternatively, we can compute unit sales instead of dollar sales. To do this, we substitute contribution margin per unit for the contribution margin ratio in the denominator. This gives the number of units to sell to reach the target income. Exhibit 5.23 illustrates this for Rydell. The two computations in Exhibits 5.22 and 5.23 are equivalent because sales of 1,200 units at $100 per unit equal $120,000 of sales.

Unit sales at target income 5

Fixed costs

1 Target income

Contribution margin per unit

5 $24,000 1 $12,000

$30 5 1,200 units

EXHIBIT 5.23 Computing Sales (Units) for a Target Income

We can also use the contribution margin income statement approach to compute sales for a target income, in two steps.

Step 1: Insert the fixed costs ($24,000) and the target profit level ($12,000) into a contribution margin income statement, as shown in Exhibit 5.24. To cover its fixed costs of $24,000 and yield target income of $12,000, Rydell must generate a contribution margin of $36,000 (com- puted as $24,000 plus $12,000). Step 2: Enter $36,000 in the contribution margin row as step 2. With a contribution margin ratio of 30%, sales must be $120,000, computed as $36,000y0.30, to yield a contribution margin of $36,000. We enter $120,000 in the sales row of the contribution margin income statement and solve for variable costs of $84,000 (computed as $120,000 2 $36,000). At a selling price of $100 per unit, Rydell must sell 1,200 units ($120,000y$100) to earn a target income of $12,000.

Point: Break-even is a special case of the formulas in Exhibits 5.22 and 5.23; simply set target income to $0 and the formulas reduce to those in Exhibits 5.11 and 5.12.

EXHIBIT 5.24 Using the Contribution Margin Income Statement to Find Target Sales

RYDELL COMPANY Contribution Margin Income Statement

For Month Ended January 31, 2015

Step 1 Step 2 Sales . . . . . . . . . . . . . . . . . . . . . ? $120,000 Variable costs . . . . . . . . . . . . . . ? 84,000 Contribution margin . . . . . . . . ? 36,000 Fixed costs . . . . . . . . . . . . . . . . 24,000 24,000 Target income . . . . . . . . . . . . . $12,000 $ 12,000

$36,000y0.30$24,000 1 $12,000

A manufacturer predicts fixed costs of $502,000 for the next year. Its one product sells for $180 per unit, and it incurs variable costs of $126 per unit. Its target (pretax) income is $200,000. 1. Compute the contribution margin ratio. 2. Compute the dollar sales needed to yield the target income. 3. Compute the unit sales needed to yield the target income.

Solution

1. Contribution margin ratio 5 [$180 2 $126]y$180 5 30% 2. Dollar sales at target income 5 [$502,000 1 $200,000]y0.30 5 $2,340,000 3. Unit sales at target income 5 [$502,000 1 $200,000]y[$180 2 $126] 5 13,000 units

NEED-TO-KNOW 5-4

A1 C2

Contribution Margin and Target Income

Do More: QS 5-9, QS 5-13, E 5-12, E 5-17

Chapter 5 Cost Behavior and Cost-Volume-Profit Analysis 187

Using Sensitivity Analysis Earlier we showed how changing one of the estimates in a CVP analysis impacts break-even. We can also examine strategies that impact several estimates in the CVP analysis. For in- stance, we might want to know what happens to income if we automate a currently manual process. We can use sensitivity analysis to predict income if we can describe how these changes affect a company’s fixed costs, variable costs, selling price, and volume. CVP analy- ses based on different estimates can be useful to management in planning business strategy. We provide examples next.

Buy a New Machine Assume Rydell is considering buying a new machine that would increase monthly fixed costs from $24,000 to $30,000 and would decrease variable costs by $10 per unit (from $70 per unit to $60 per unit). Recall from Exhibit 5.12 that Rydell’s break-even point in dollars is currently $80,000. Management needs to know how the new machine would affect Rydell’s break-even point in dollars. If Rydell maintains its selling price of $100 per unit, its contribution margin per unit will increase to $40—computed as the sales price of $100 per unit minus the (new) variable costs of $60 per unit. With this new machine, the revised contribution margin ratio per unit is 40% (computed as $40y$100). Rydell’s revised break-even point in dollars would be $75,000, as computed in Exhibit 5.25. The new machine would lower Rydell’s break-even point by $5,000, or 50 units, per month. The revised margin of safety increases to 25%, computed as ($100,000 2 $75,000)y$100,000.

Increase Advertising Instead of buying a new machine, Rydell’s advertising manager suggests increasing advertising instead. She believes that an increase of $3,000 in the monthly advertising budget will increase sales by $25,000 per month (at a selling price of $100 per unit). The contribution margin will continue to be $30 per unit. Recall from Exhibit 5.14 that the com- pany’s margin of safety was 20% when Rydell’s expected sales level was $100,000. Management wants to know how a new advertising campaign would affect Rydell’s break-even point and margin of safety. With the advertising campaign, Rydell’s revised break-even point in dollars is $90,000, as computed in Exhibit 5.26.

Revised break-even point in dollars

5 Revised fixed costs

Revised contribution margin ratio 5

$30,000 40%

5 $75,000

EXHIBIT 5.25 Revised Break-Even

Revised break-even point in dollars

5 Revised fixed costs

Revised contribution margin ratio 5

$27,000 30%

5 $90,000 EXHIBIT 5.26 Revised Break-Even (in dollars)

EXHIBIT 5.27 Revised Margin of Safety (in percent)

Revised margin of safety (in percent) 5 Expected sales 2 Break-even sales

Expected sales

5 $125,000 2 $90,000

$125,000 5 28%

The revised margin of safety is then computed as shown in Exhibit 5.27. Without considering other factors, the advertising campaign would increase Rydell’s margin of safety from 20% (see Exhibit 5.14) to 28%. QC4

188 Chapter 5 Cost Behavior and Cost-Volume-Profit Analysis

We then use the contribution margin per composite unit to determine Hair-Today’s break-even point in composite units in Exhibit 5.29.

Hair-Today’s fixed costs are $192,000 per year, and its unit variable costs of the three products are basic, $13; ultra, $18; and budget, $8. Variable costs for a composite unit of these products follow.

We calculate the contribution margin for a composite unit using essentially the same formula used earlier (see Exhibit 5.9), as shown in Exhibit 5.28:

Computing a Multiproduct Break-Even Point So far we have looked only at cases where the company sells a single product or service. How- ever, many companies sell multiple products or services, and we can modify the CVP analysis for use in these cases. An important assumption in a multiproduct setting is that the sales mix of different products is known and remains constant during the planning period. Sales mix is the ratio (proportion) of the sales volumes for the various products. For instance, if a company nor- mally sells 10,000 footballs, 5,000 softballs, and 4,000 basketballs per month, its sales mix can be expressed as 10:5:4 for footballs, softballs, and basketballs.

In multiproduct CVP analysis, we estimate the break-even point by using a composite unit, which summarizes the sales mix and contribution margins of each product. Multiproduct CVP analysis treats this composite unit as a single product. To illustrate, let’s look at Hair-Today, a styling salon that offers three cuts: basic, ultra, and budget in the ratio of 4 basic units to 2 ultra units to 1 budget unit (expressed as 4:2:1). Management wants to estimate its break-even point for next year. Unit selling prices for these three cuts are basic, $20; ultra, $32; and budget, $16. Using the 4:2:1 sales mix, the selling price of a composite unit of the three products is computed as follows.

P4 Compute the break-even point for a multiproduct company.

Selling price per composite unit 4 units of basic @ $20 per unit . . . . . . . . . . $ 80 2 units of ultra @ $32 per unit . . . . . . . . . . 64 1 unit of budget @ $16 per unit . . . . . . . . . 16 Selling price of a composite unit . . . . . . . . . $160

Variable costs per composite unit 4 units of basic @ $13 per unit . . . . . . . . . . . . $ 52 2 units of ultra @ $18 per unit . . . . . . . . . . . . 36 1 unit of budget @ $8 per unit . . . . . . . . . . . . 8 Variable costs of a composite unit . . . . . . . . . $96

EXHIBIT 5.28 Contribution Margin per Composite Unit

Contribution margin 5 Selling price 2 Variable cost per composite unit per composite unit per composite unit $64 5 $160 2 $96

Break-even point in composite units 5 Fixed costs

Contribution margin per composite unit

5 $192,000

$64 5 3,000 composite units

EXHIBIT 5.29 Break-Even Point in Composite Units

E+/Getty Images

Chapter 5 Cost Behavior and Cost-Volume-Profit Analysis 189

Exhibit 5.30 verifies the results for composite units by showing Hair-Today’s sales and costs at this break-even point using a forecasted contribution margin income statement.

This computation implies that Hair-Today breaks even when it sells 3,000 composite units. To determine how many units of each product it must sell to break even, we use the expected sales mix of 4:2:1 and multiply the number of units of each product in the composite by 3,000 as follows.

Point: The break-even point in dollars for Exhibit 5.29 is $192,000y($64y$160) 5 $480,000.

Basic: 4 3 3,000 . . . . . . . . 12,000 units Ultra: 2 3 3,000 . . . . . . . . 6,000 units Budget: 1 3 3,000 . . . . . . . . 3,000 units 21,000 units

Point: Each composite unit represents 7 haircuts. Total haircuts at the break-even point equal 21,000 (3,000 composite units 3 7 haircuts per composite unit).

EXHIBIT 5.30 Multiproduct Break-Even Income Statement

HAIR-TODAY Forecasted Contribution Margin Income Statement (at Break-Even)

Basic Ultra Budget Total

Sales Basic (12,000 @ $20) . . . . . . . . . . $240,000 Ultra (6,000 @ $32) . . . . . . . . . . . $192,000 Budget (3,000 @ $16) . . . . . . . . . $48,000 Total sales . . . . . . . . . . . . . . . . . . . $480,000 Variable costs Basic (12,000 @ $13) . . . . . . . . . . 156,000 Ultra (6,000 @ $18) . . . . . . . . . . . 108,000 Budget (3,000 @ $8) . . . . . . . . . . 24,000 Total variable costs. . . . . . . . . . . . 288,000 Contribution margin . . . . . . . . . . . . $ 84,000 $ 84,000 $24,000 192,000 Fixed costs . . . . . . . . . . . . . . . . . . . . 192,000 Net income . . . . . . . . . . . . . . . . . . . $ 0

A CVP analysis using composite units can be used to answer a variety of planning questions. Once a product mix is set, all answers are based on the assumption that the mix remains con- stant at all relevant sales levels as other factors in the analysis do. If the sales mix changes, it is likely that the break-even point will change also. For example, if Hair-Today sells more ultra cuts and fewer basic cuts, its break-even point will decrease. We can vary the sales mix to see what happens under alternative strategies.

Point: Enterprise resource planning (ERP) systems can quickly generate multiproduct break-even analyses.

Entrepreneur A CVP analysis indicates that your start-up, which markets electronic products, will break even with the current sales mix and price levels. You have a target income in mind. What analysis might you perform to assess the likelihood of achieving this income? ■ [Answers follow the chapter’s Summary.]

Decision Maker

P4

NEED-TO-KNOW 5-5 Contribution Margin and Break-Even Point, Composite Units

The sales mix of a company’s two products, X and Y, is 2:1. Unit variable costs for both products are $2, and unit selling prices are $5 for X and $4 for Y. The company has $640,000 of fixed costs. 1. What is the contribution margin per composite unit? 2. What is the break-even point in composite units? 3. How many units of X and how many units of Y will be sold at the break-even point?

190 Chapter 5 Cost Behavior and Cost-Volume-Profit Analysis

Solution

1.

Selling price of a composite unit 2 units of X @ $5 per unit . . . . . . . . . . . . . . $10 1 unit of Y @ $4 per unit . . . . . . . . . . . . . . . 4 Selling price of a composite unit . . . . . . . . . . $14

Variable costs of a composite unit 2 units of X @ $2 per unit . . . . . . . . . . . . . . $4 1 unit of Y @ $2 per unit . . . . . . . . . . . . . . . 2 Variable costs of a composite unit . . . . . . . . . $6

Therefore, the contribution margin per composite unit is $8. 2. The break-even point in composite units 5 $640,000y$8 5 80,000 units. 3. At break-even, the company will sell 160,000 units (80,000 3 2) of X and 80,000 units of Y (80,000 3 1).

Making Assumptions in Cost-Volume-Profit Analysis CVP analysis assumes that costs can be classified as variable or fixed. CVP analysis also as- sumes that selling prices per unit, variable costs per unit, and total fixed costs are all held con- stant. Further, multiproduct CVP analysis assumes a constant sales mix. If the expected costs and sales behavior differ from the assumptions, the results of CVP analysis can be limited. While the behavior of individual costs and sales may not be perfectly consistent with CVP as- sumptions, we can still perform useful analyses in spite of these assumptions’ limitations, for reasons we describe next.

Summing Costs Offsets Individual Deviations Deviations from assumptions with individual costs are often minor when these costs are summed. That is, individual variable cost items may not be perfectly variable, but when we sum these variable costs, their in- dividual deviations can offset each other. This means the assumption of variable cost be- havior can be proper for total variable costs. Similarly, an assumption that total fixed costs are constant can be proper even when individual fixed cost items are not exactly constant.

CVP Applies to a Relevant Range of Operations Sales, variable costs, and fixed costs often are reasonably reflected in straight lines on a graph when the assumptions are ap- plied over a relevant range. The validity of assuming that a specific cost is fixed or variable is more acceptable when operations are within the relevant range. As shown in Exhibit 5.2, a curvilinear cost can be treated as variable and linear if the relevant range covers volumes where it has a nearly constant slope. If the normal range of activity changes, some costs might need reclassification.

CVP Analysis Yields Estimates CVP analysis yields approximate answers to questions about costs, volumes, and profits. These answers do not have to be precise because the analy- sis makes rough estimates about the future. As long as managers understand that CVP analysis gives estimates, it can be a useful tool for starting the planning process. Other qualitative fac- tors also must be considered.

GLOBAL VIEW Survey evidence shows that many German companies have elaborate and detailed cost accounting sys- tems. Over 90 percent of companies surveyed report their systems focus on contribution margin. This focus helps German companies like Volkswagen control costs and plan their production levels. Recently, Volkswagen announced it expects its Spanish brand SEAT to break even within five years. For 2012, the SEAT brand lost €156 million on revenue of €6.485 billion.

Do More: QS 5-14, E 5-21, E 5-23

QC5

Chapter 5 Cost Behavior and Cost-Volume-Profit Analysis 191

To illustrate, let’s return to Rydell Company and assume it sells 1,200 footballs. At this sales level, its contribution margin (in dollars) and pretax income are computed as:

Rydell’s degree of operating leverage (DOL) is then computed as shown in Exhibit 5.32.

We then can use DOL to measure the effect of changes in the level of sales on pretax income. For example, if Rydell expects sales can either increase or decrease by 10%, and these changes would be within Rydell’s relevant range, we can compute the change in pretax income using DOL as shown in Exhibit 5.33.

Sustainability and Accounting Volkswagen (VW) is regarded as the most sustainable auto- motive group in the Dow Jones Sustainability Index—in part because of its efforts to embrace oppor- tunities and manage risks deriving from economic, environmental, and social developments. The company recently entered a long-term contract to buy wind-generated power for several of its Mexican manufacturing facilities. VW expects the use of wind power not only to reduce its carbon emissions but also to save $3.5 million per year in electric utility costs. Smaller companies can also make a dif- ference. Fast Yeti Custom Tees, this chapter’s feature company, buys its T-shirts from suppliers with good environmental practices. All of the company’s shirts are made from 100% cotton, a natural and renewable fiber.

Degree of Operating Leverage Decision Analysis

A2 Analyze changes in sales using the degree of operating leverage.

CVP analysis is especially useful when management begins the planning process and wishes to predict outcomes of alternative strategies. These strategies can involve changes in selling prices, fixed costs, vari- able costs, sales volume, and product mix. Managers are interested in seeing the effects of changes in some or all of these factors. One goal of all managers is to get maximum benefits from their fixed costs. Managers would like to use 100% of their output capacity so that fixed costs are spread over the largest number of units. This would decrease fixed cost per unit and increase income. The extent, or relative size, of fixed costs in the total cost structure is known as operating leverage. Companies having a higher proportion of fixed costs in their total cost structure are said to have higher operating leverage. An example of this is a company that chooses to automate its processes instead of using direct labor, increasing its fixed costs and lowering its variable costs. A useful managerial measure to help assess the effect of changes in the level of sales on income is the degree of operating leverage (DOL), calculated as shown in Exhibit 5.31.

DOL 5 Total contribution margin (in dollars)yPretax income EXHIBIT 5.31 Degree of Operating Leverage

Sales (1,200 3 $100) . . . . . . . . . . . . . . . $120,000 Variable costs (1,200 3 $70). . . . . . . . . 84,000 Contribution margin. . . . . . . . . . . . . 36,000 Fixed costs . . . . . . . . . . . . . . . . . . . . . . . 24,000 Income (pretax). . . . . . . . . . . . . . . . . $ 12,000

DOL 5 Total contribution margin (in dollars)yPretax income DOL 5 $36,000y$12,000 5 3.0

EXHIBIT 5.32 Rydell’s Degree of Operating Leverage

Change in income (%) 5 DOL 3 Change in sales (%) 5 3.0 3 10%

5 30%

EXHIBIT 5.33 Impact of Change in Sales on Income

192 Chapter 5 Cost Behavior and Cost-Volume-Profit Analysis

Thus, if Rydell’s sales increase by 10%, its income will increase by $3,600 (computed as $12,000 3 30%), to $15,600. If, instead, Rydell’s sales decrease by 10%, its net income will decrease by $3,600, to $8,400. We can prove these results with contribution margin income statements, as shown below.

Sales Increase Sales Decrease Current by 10% by 10%

Sales . . . . . . . . . . . . . . . . . . . . . . . . $120,000 $132,000 $108,000 Variable costs . . . . . . . . . . . . . . . . . 84,000 92,400 75,600 Contribution margin . . . . . . . . . . . $ 36,000 $ 39,600 $ 32,400 Fixed costs . . . . . . . . . . . . . . . . . . . 24,000 24,000 24,000 Target (pretax) income . . . . . . . . . $ 12,000 $ 15,600 $ 8,400

Sport Caps Co. manufactures and sells caps for different sporting events. The fixed costs of operating the company are $150,000 per month, and the variable costs are $5 per cap. The caps are sold for $8 per unit. The fixed costs provide a production capacity of up to 100,000 caps per month.

Required

1. Use the formulas in the chapter to compute the following: a. Contribution margin per cap. b. Break-even point in terms of the number of caps produced and sold. c. Amount of income at 30,000 caps sold per month (ignore taxes). d. Amount of income at 85,000 caps sold per month (ignore taxes). e. Number of caps to be produced and sold to provide $60,000 of income (pretax). 2. Draw a CVP chart for the company, showing cap output on the horizontal axis. Identify (a) the break-

even point and (b) the amount of pretax income when the level of cap production is 70,000. (Omit the fixed cost line.)

3. Use the formulas in the chapter to compute the a. Contribution margin ratio. b. Break-even point in terms of sales dollars. c. Amount of income at $250,000 of sales per month (ignore taxes). d. Amount of income at $600,000 of sales per month (ignore taxes). e. Dollars of sales needed to provide $60,000 of pretax income.

PLANNING THE SOLUTION Identify the formulas in the chapter for the required items expressed in units and solve them using the

data given in the problem. Draw a CVP chart that reflects the facts in the problem. The horizontal axis should plot the volume in

units up to 100,000, and the vertical axis should plot the total dollars up to $800,000. Plot the total cost line as upward sloping, starting at the fixed cost level ($150,000) on the vertical axis and increasing until it reaches $650,000 at the maximum volume of 100,000 units. Verify that the break-even point (where the two lines cross) equals the amount you computed in part 1.

Identify the formulas in the chapter for the required items expressed in dollars and solve them using the data given in the problem.

SOLUTION 1. a. Contribution margin per cap 5 Selling price per unit 2 Variable cost per unit 5 $8 2 $5 5 $3

b. Break-even point in caps

5 Fixed costs

Contribution margin per cap 5

$150,000 $3

5 50,000 caps

COMPREHENSIVE

NEED-TO-KNOW

Chapter 5 Cost Behavior and Cost-Volume-Profit Analysis 193

0 25,000 50,000 75,000 0

100,000

200,000

300,000

400,000

500,000

600,000

700,000

$800,000

Volume (Units)

D o

lla rs

Break-Even Point

100,000

Profit at 70,000 Units

Monthly Capacity

Sales

Total Costs

c. Income at 30,000 caps sold 5 (Units 3 Contribution margin per unit) 2 Fixed costs 5 (30,000 3 $3) 2 $150,000 5 $(60,000) loss d. Income at 85,000 caps sold 5 (Units 3 Contribution margin per unit) 2 Fixed costs 5 (85,000 3 $3) 2 $150,000 5 $105,000 profit

e. Units needed for $60,000 income

5

Fixed costs 1 Target income

Contribution margin per cap

5

$150,000 1 $60,000 $3

5 70,000 caps

2. CVP chart.

3. a. Contribution margin ratio

5 Contribution margin per unit

Selling price per unit 5

$3 $8

5 0.375, or 37.5%

b. Break-even point in dollars

5 Fixed costs

Contribution margin ratio 5

$150,000 37.5%

5 $400,000

c. Income at sales of $250,000 5 (Sales 3 Contribution margin ratio) 2 Fixed costs 5 ($250,000 3 37.5%) 2 $150,000 5 $(56,250) loss

d. Income at sales of $600,000 5 (Sales 3 Contribution margin ratio) 2 Fixed costs 5 ($600,000 3 37.5% ) 2 $150,000 5 $75,000 income

e. Dollars of sales to yield

5 Fixed costs 1 Target pretax income

Contribution margin ratio $60,000 pretax income

5

$150,000 1 $60,000 37.5%

5 $560,000

Using Excel to Estimate Least-Squares Regression 5A Microsoft Excel® and other spreadsheet software can be used to perform least-squares regressions to iden- tify cost behavior. In Excel, the INTERCEPT and SLOPE functions are used. The following screen shot reports the data from Exhibit 5.3 in cells Al through C13 and shows the cell contents to find the intercept (cell B15) and slope (cell B16). Cell B15 uses Excel to find the intercept from a least-squares regression of total cost (shown as C2:C13 in cell B15) on units produced (shown as B2:B13 in cell B15). Spreadsheet

APPENDIX

194 Chapter 5 Cost Behavior and Cost-Volume-Profit Analysis

software is useful in understanding cost behavior when many data points (such as monthly total costs and units produced) are available.

27,500 17,500 25,000 35,000 47,500 22,500 30,000 52,500 37,500 67,500 62,500 57,500

$21,500

Result $16,947.17 $ 0.1930

20,500 25,000 21,500 25,500 18,500 23,500 28,500 26,000 29,000 31,000 26,000

A B C

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17

Month Units Produced Total Cost January February March April May June July August September October November December

Intercept Slope

=INTERCEPT(C2:C13, B2:B13) =SLOPE(C2:C13, B2:B13)

Excel can also be used to create scatter diagrams such as that in Exhibit 5.4. In contrast to visually draw- ing a line that “fits” the data, Excel more precisely fits the regression line. To draw a scatter diagram with a line of fit, follow these steps:

1. Highlight the data cells you wish to diagram; in this example, start from cell C13 and highlight through cell B2.

2. Then select “Insert” and “Scatter” from the drop-down menus. Selecting the chart type in the upper left corner of the choices under “Scatter” will produce a diagram that looks like that in Exhibit 5.4, without a line of fi t.

3. To add a line of fi t (also called a trend line), select “Layout” and “Trendline” from the drop-down menus. Selecting “Linear Trendline” will produce a diagram that looks like that in Exhibit 5.4, in- cluding the line of fi t.

Variable Costing and Performance Reporting5B This chapter showed the usefulness of contribution margin, or selling price minus variable costs, in CVP analysis. The contribution margin income statement introduced in this chapter is also known as a variable costing income statement. In variable costing, only costs that change in total with changes in production levels are included in product costs. These costs include direct materials, direct labor, and variable overhead costs. Thus, under variable costing, fixed overhead costs are excluded from product costs. As we showed in this chapter, a variable costing approach can be useful in many managerial analyses and decisions. The variable costing method is not allowed, however, for external financial reporting. Instead, GAAP requires absorption costing. Under absorption costing, product costs include direct materials, direct la- bor, and all overhead, both variable and fixed. Managers can use variable costing information for internal decision making, but they must use absorption costing for external reporting purposes. Exhibit 5B.1 shows product cost per unit computations for both absorption and variable costing.

APPENDIX

EXHIBIT 5B.1 Unit Cost Computation

Absorption Costing Variable Costing

Direct materials cost per unit . . . . . . . . . . . . . . $ 4 $ 4 Direct labor cost per unit . . . . . . . . . . . . . . . . . 8 8 Overhead cost Variable overhead cost per unit . . . . . . . . . . 3 3 Fixed overhead cost per unit . . . . . . . . 10 — Total product cost per unit . . . . . . . . . . . . . . . . $25 $15

Chapter 5 Cost Behavior and Cost-Volume-Profit Analysis 195

C1 Describe different types of cost behavior in relation to production and sales volume. Cost behavior is described in terms of how its amount changes in relation to changes in volume of activity within a relevant range. Fixed costs remain constant to changes in volume. Total variable costs change in direct proportion to volume changes. Mixed costs display the effects of both fixed and variable components. Step-wise costs remain constant over a small volume range, then change by a lump sum and remain constant over another volume range, and so on. Curvilinear costs change in a nonlinear relation to volume changes.

C2 Describe several applications of cost-volume-profit analysis. Cost-volume-profit analysis can be used to pre- dict what can happen under alternative strategies concerning sales volume, selling prices, variable costs, or fixed costs. Applications include “what-if” analysis, computing sales for a target income, and break-even analysis.

A1 Compute the contribution margin and describe what it reveals about a company’s cost structure. Contribution margin per unit is a product’s selling price less its total variable costs. Contribution margin ratio is a product’s contribution mar- gin per unit divided by its selling price. Unit contribution mar- gin is the amount received from each sale that contributes to fixed costs and income. The contribution margin ratio reveals what portion of each sales dollar is available as contribution to fixed costs and income.

A2 Analyze changes in sales using the degree of operating leverage. The extent, or relative size, of fixed costs in a company’s total cost structure is known as operating leverage. One tool useful in assessing the effect of changes in sales on in- come is the degree of operating leverage, or DOL. DOL is the ratio of the contribution margin divided by pretax income. This

ratio can be used to determine the expected percent change in income given a percent change in sales.

P1 Determine cost estimates using the scatter diagram, high-low, and regression methods of estimating costs. Three different methods used to estimate costs are the scatter di- agram, the high-low method, and least-squares regression. All three methods use past data to estimate costs. Cost estimates from a scatter diagram are based on a visual fit of the cost line. Estimates from the high-low method are based only on costs corresponding to the lowest and highest sales. The least-squares regression method is a statistical technique and uses all data points.

P2 Compute the break-even point for a single product company. A company’s break-even point for a period is the sales volume at which total revenues equal total costs. To compute a break-even point in terms of sales units, we divide total fixed costs by the contribution margin per unit. To compute a break-even point in terms of sales dollars, divide total fixed costs by the contribution margin ratio.

P3 Graph costs and sales for a single product company. The costs and sales for a company can be graphically il- lustrated using a CVP chart. In this chart, the horizontal axis represents the number of units sold and the vertical axis repre- sents dollars of sales or costs. Straight lines are used to depict both costs and sales on the CVP chart.

P4 Compute the break-even point for a multiproduct company. CVP analysis can be applied to a multiproduct company by expressing sales volume in terms of composite units. A composite unit consists of a specific number of units of each product in proportion to their expected sales mix. Multiproduct CVP analysis treats this composite unit as a single product.

Summary

Sales Manager The contribution margin per unit for the first order is $600 (60% of $1,000); the contribution margin per unit for the second order is $160 (20% of $800). You are likely tempted to accept the first order based on its high contribution margin per unit, but you must compute the total contribution margin based on the number of units sold for each order. Total contribution margin is $60,000 ($600 per unit 3 100 units) and $80,000 ($160 per unit 3 500 units) for the two orders, respec- tively. The second order provides the largest return in absolute dollars and is the order you would accept. Another factor to con- sider in your selection is the potential for a long-term relation- ship with these customers including repeat sales and growth.

Supervisor Your dilemma is whether to go along with the suggestions to “manage” the numbers to make the project look like it will achieve sufficient profits. You should not succumb to these suggestions. Many people will likely be affected negatively if you manage the predicted numbers and the project eventually

is unprofitable. Moreover, if it does fail, an investigation would likely reveal that data in the proposal were “fixed” to make it look good. Probably the only benefit from managing the num- bers is the short-term payoff of pleasing those who proposed the product. One way to deal with this dilemma is to prepare several analyses showing results under different assumptions and then let senior management make the decision.

Entrepreneur You must first compute the level of sales re- quired to achieve the desired net income. Then you must conduct sensitivity analysis by varying the price, sales mix, and cost esti- mates. Results from the sensitivity analysis provide information you can use to assess the possibility of reaching the target sales level. For instance, you might have to pursue aggressive market- ing strategies to push the high-margin products, or you might have to cut prices to increase sales and profits, or another strat- egy might emerge.

Guidance Answers to Decision Maker and Decision Ethics

196 Chapter 5 Cost Behavior and Cost-Volume-Profit Analysis

Icon denotes assignments that involve decision making.

1. What is a variable cost? Identify two variable costs. 2. When output volume increases, do variable costs per

unit increase, decrease, or stay the same within the relevant range of activity? Explain.

3. When output volume increases, do fixed costs per unit increase, decrease, or stay the same within the relevant range of activity? Explain.

4. How is cost-volume-profit analysis useful? 5. How do step-wise costs and curvilinear costs differ? 6. Describe the contribution margin ratio in layperson’s terms. 7. Define and explain the contribution margin ratio. 8. Define and describe contribution margin per unit. 9. In performing CVP analysis for a manufacturing company,

what simplifying assumption is usually made about the vol- ume of production and the volume of sales?

10. What two arguments tend to justify classifying all costs as either fixed or variable even though individual costs might not behave exactly as classified?

11. How does assuming that operating activity occurs within a relevant range affect cost-volume-profit analysis?

12. List three methods to measure cost behavior. 13. How is a scatter diagram used to identify and measure the

behavior of a company’s costs? 14. In cost-volume-profit analysis, what is the estimated profit

at the break-even point? 15. Assume that a straight line on a CVP chart intersects the

vertical axis at the level of fixed costs and has a positive slope that rises with each additional unit of volume by the amount of the variable costs per unit. What does this line represent?

16. Apple has both fixed and variable costs. Why are fixed costs depicted as a horizontal line on a CVP chart?

17. Each of two similar companies has sales of $20,000 and total costs of $15,000 for a month. Company A’s total costs include $10,000 of variable costs and $5,000 of fixed costs. If Company B’s total costs include $4,000 of variable costs and $11,000 of fixed costs, which company will enjoy more profit if sales double?

18. of reflects expected sales in excess of the level of break-even sales.

Discussion Questions

A Superscript letter A denotes assignments based on Appendix 5A.

APPLE

Multiple Choice Quiz Answers at end of chapter

1. A company’s only product sells for $150 per unit. Its vari- able costs per unit are $100, and its fixed costs total $75,000. What is its contribution margin per unit? a. $50 c. $100 e. $25 b. $250 d. $150

2. Using information from question 1, what is the company’s contribution margin ratio? a. 662⁄3% c. 50% e. 331⁄3% b. 100% d. 0%

3. Using information from question 1, what is the company’s break-even point in units? a. 500 units c. 1,500 units e. 1,000 units b. 750 units d. 3,000 units

4. A company’s forecasted sales are $300,000 and its sales at break-even are $180,000. Its margin of safety in dol- lars is a. $180,000. c. $480,000. e. $300,000. b. $120,000. d. $60,000.

5. A product sells for $400 per unit and its variable costs per unit are $260. The company’s fixed costs are $840,000. If the company desires $70,000 pretax income, what is the re- quired dollar sales? a. $2,400,000 c. $2,600,000 e. $1,400,000 b. $200,000 d. $2,275,000

Absorption costing Break-even point Composite unit Contribution margin per unit Contribution margin ratio Cost-volume-profit (CVP) analysis Cost-volume-profit (CVP) chart

Curvilinear cost Degree of operating leverage (DOL) Estimated line of cost behavior High-low method Least-squares regression Margin of safety Mixed cost

Operating leverage Relevant range of operations Sales mix Scatter diagram Step-wise cost Variable costing Variable costing income statement

Key Terms

Chapter 5 Cost Behavior and Cost-Volume-Profit Analysis 197

19. Google produces tablet computers for sale. Identify some of the variable and fixed product costs associated with that production.

[Hint: Limit costs to product costs.] 20. Should Apple use single product or

multiproduct break-even analysis? Explain.

21. Samsung is thinking of expand- ing sales of its most popular smart- phone model by 65%. Should we expect its variable and fixed costs for this model to stay within the relevant range? Explain.

GOOGLE

APPLE

Samsung

QUICK STUDY

QS 5-1 Cost behavior identification C1

Listed here are four series of separate costs measured at various volume levels. Examine each series and identify whether it is best described as a fixed, variable, step-wise, or curvilinear cost. (It can help to graph the cost series.)

Volume (Units) Series 1 Series 2 Series 3 Series 4

0 . . . . . . . . . . $ 0 $450 $ 800 $100 100 . . . . . . . . . . 800 450 800 105 200 . . . . . . . . . . 1,600 450 800 120 300 . . . . . . . . . . 2,400 450 1,600 145 400 . . . . . . . . . . 3,200 450 1,600 190 500 . . . . . . . . . . 4,000 450 2,400 250 600 . . . . . . . . . . 4,800 450 2,400 320

Determine whether each of the following is best described as a fixed, variable, or mixed cost with respect to product units.

1. Rubber used to manufacture athletic shoes. 2. Maintenance of factory machinery. 3. Packaging expense. 4. Wages of an assembly-line worker paid on

the basis of acceptable units produced.

QS 5-2 Cost behavior identification

C1 5. Factory supervisor’s salary. 6. Taxes on factory building. 7. Depreciation expense of warehouse.

The following information is available for a company’s maintenance cost over the last seven months. Using the high-low method, estimate both the fixed and variable components of its maintenance cost.

QS 5-3 Cost behavior estimation—high-low method

P1

Month Maintenance Hours Maintenance Cost

June. . . . . . . . . . . . . . 9 $5,450 July . . . . . . . . . . . . . . 18 6,900 August . . . . . . . . . . . 12 5,100 September . . . . . . . . 15 6,000 October . . . . . . . . . . 21 6,900 November . . . . . . . . 24 8,100 December . . . . . . . . 6 3,600

This scatter diagram reflects past maintenance hours and their corresponding maintenance costs. QS 5-4 Cost behavior estimation—scatter diagram

P1

0

$12,000

10,000

8,000

6,000

4,000

2,000

M a

in te

n a

n c

e C

o st

s

0 1,000 2,000 Maintenance Hours

3,000 4,000 5,000

1. Draw an estimated line of cost behavior. 2. Estimate the fixed and variable components of maintenance costs.

198 Chapter 5 Cost Behavior and Cost-Volume-Profit Analysis

QS 5-6 Contribution margin per unit and break-even units P2

SBD Phone Company sells its waterproof phone case for $90 per unit. Fixed costs total $162,000, and variable costs are $36 per unit. Determine the (1) contribution margin per unit and (2) break-even point in units.

QS 5-9 CVP analysis and target income P2

SBD Phone Company sells its waterproof phone case for $90 per unit. Fixed costs total $162,000, and variable costs are $36 per unit. Compute the units of product that must be sold to earn pretax income of $200,000. (Round to the nearest whole unit.)

QS 5-10 Computing break- even P2

Zhao Co. has fixed costs of $354,000. Its single product sells for $175 per unit, and variable costs are $116 per unit. Determine the break-even point in units.

QS 5-11 Margin of safety P2

Zhao Co. has fixed costs of $354,000. Its single product sells for $175 per unit, and variable costs are $116 per unit. If the company expects sales of 10,000 units, compute its margin of safety (a) in dollars and (b) as a percent of expected sales.

QS 5-12 Contribution margin income statement P2

Zhao Co. has fixed costs of $354,000. Its single product sells for $175 per unit, and variable costs are $116 per unit. The company expects sales of 10,000 units. Prepare a contribution margin income statement for the year ended December 31, 2015.

QS 5-13 Target income C2

Zhao Co. has fixed costs of $354,000. Its single product sells for $175 per unit, and variable costs are $116 per unit. Compute the level of sales in units needed to produce a target (pretax) income of $118,000.

QS 5-14 Multiproduct break- even P4

US-Mobile manufactures and sells two products, tablet computers and smartphones, in the ratio of 5:3. Fixed costs are $105,000, and the contribution margin per composite unit is $125. What number of each type of product is sold at the break-even point?

QS 5-15 CVP graph P3

Corme Company expects sales of $34 million (400,000 units). The company’s total fixed costs are $17.5 million and its variable costs are $35 per unit. Prepare a CVP chart from this information.

QS 5-8 Contribution margin ratio and break-even dollars P2

SBD Phone Company sells its waterproof phone case for $90 per unit. Fixed costs total $162,000, and variable costs are $36 per unit. Determine the (1) contribution margin ratio and (2) break-even point in dollars.

QS 5-5 Contribution margin ratio

A1

Compute and interpret the contribution margin ratio using the following data: sales, $5,000; total variable cost, $3,000.

QS 5-7 Assumptions in CVP analysis C2

SBD Phone Company sells its waterproof phone case for $90 per unit. Fixed costs total $162,000, and variable costs are $36 per unit. How will the break-even point in units change in response to each of the following independent changes in selling price per unit, variable cost per unit, or total fixed costs? Use I for increase and D for decrease. (It is not necessary to compute new break-even points.)

Change Break-Even in Units Will

1. Total fixed costs to $190,000 . . . . . . . . . 2. Variable costs to $34 per unit . . . . . . . . . 3. Selling price per unit to $80 . . . . . . . . . . 4. Variable costs to $67 per unit . . . . . . . . . 5. Total fixed costs to $150,000 . . . . . . . . . 6. Selling price per unit to $120 . . . . . . . . .

Singh Co. reports a contribution margin of $960,000 and fixed costs of $720,000. (1) Compute the company’s degree of operating leverage. (2) If sales increase by 15%, what amount of income will Singh Co. report?

QS 5-16 Operating leverage analysis A2

Chapter 5 Cost Behavior and Cost-Volume-Profit Analysis 199

A recent income statement for Volkswagen reports the following (in € millions). Assume 75 percent of the cost of sales and 75 percent of the selling and administrative costs are variable costs, and the remain- ing 25 percent of each is fixed. Compute the contribution margin (in € millions). (Round computations using percentages to the nearest whole euro.)

QS 5-17 Contribution margin

A1

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . €126,875 Cost of sales . . . . . . . . . . . . . . . . . . . . . . . . . . 105,431 Selling and administrative expenses . . . . . . . . 15,500

The left column lists several cost classifications. The right column presents short definitions of those costs. In the blank space beside each of the numbers in the right column, write the letter of the cost best described by the definition. A. Total cost B. Mixed cost C. Variable cost D. Curvilinear cost E. Step-wise cost F. Fixed cost

Exercise 5-2 Cost behavior defined

C1 1. This cost is the combined amount of all the other costs. 2. This cost remains constant over a limited range of volume; when

it reaches the end of its limited range, it changes by a lump sum and remains at that level until it exceeds another limited range.

3. This cost has a component that remains the same over all vol- ume levels and another component that increases in direct pro- portion to increases in volume.

4. This cost increases when volume increases, but the increase is not constant for each unit produced.

5. This cost remains constant over all volume levels within the pro- ductive capacity for the planning period.

6. This cost increases in direct proportion to increases in volume; its amount is constant for each unit produced.

Following are five series of costs A through E measured at various volume levels. Examine each series and identify which is fixed, variable, mixed, step-wise, or curvilinear.

Exercise 5-3 Cost behavior identification

C1 A B C D E F

1 2 3 4 5 6 7

0 400 800

1,200 1,600 2,000 2,400

Volume (Units) $2,500 3,100 3,700 4,300 4,900 5,500 6,100

Series B Series D $5,000 5,000 5,000 5,000 5,000 5,000 5,000

Series ESeries CSeries A 0

3,600 7,200

10,800 14,400 18,000 21,600

$ 0 6,000 6,600 7,200 8,200 9,600

13,500

$ $1,000 1,000 2,000 2,000 3,000 3,000 4,000

EXERCISES

Exercise 5-1 Cost behavior in graphs

C1

Following are five graphs representing various cost behaviors. (1) Identify whether the cost behavior in each graph is mixed, step-wise, fixed, variable, or curvilinear. (2) Identify the graph (by number) that best illustrates each cost behavior: (a) Factory policy requires one supervisor for every 30 factory workers; (b) real estate taxes on factory; (c) electricity charge that includes the standard monthly charge plus a charge for each kilowatt hour; (d) commissions to salespersons; and (e) costs of hourly paid workers that provide substantial gains in efficiency when a few workers are added but gradually smaller gains in effi- ciency when more workers are added.

C o

st s

Volume VolumeVolume Volume Volume

C o

st s

C o

st s

C o

st s

2.1. 4.3. 5.

C o

st s

200 Chapter 5 Cost Behavior and Cost-Volume-Profit Analysis

A company reports the following information about its sales and its cost of sales. Each unit of its product sells for $500. Use these data to prepare a scatter diagram. Draw an estimated line of cost behavior and determine whether the cost appears to be variable, fixed, or mixed.

Exercise 5-4 Measurement of cost behavior using a scatter diagram

P1 Period Sales Cost of Sales

1 . . . . . . . . . . . . . . $22,500 $15,150 2 . . . . . . . . . . . . . . 17,250 11,250 3 . . . . . . . . . . . . . . 15,750 10,500

Period Sales Cost of Sales

4 . . . . . . . . . . . . . . $11,250 $ 8,250 5 . . . . . . . . . . . . . . 13,500 9,000 6 . . . . . . . . . . . . . . 18,750 14,250

Felix & Co. reports the following information about its sales and cost of sales. Draw an estimated line of cost behavior using a scatter diagram, and compute fixed costs and variable costs per unit sold. Then use the high-low method to estimate the fixed and variable components of the cost of sales.

Exercise 5-6 Cost behavior estimation—scatter diagram and high-low

P1 Units Cost of Units Cost of Period Sold Sales Period Sold Sales

1 . . . . . . . . . . . . . 0 $2,500 6 . . . . . . . . . . . . . 2,000 $5,500 2 . . . . . . . . . . . . . 400 3,100 7 . . . . . . . . . . . . . 2,400 6,100 3 . . . . . . . . . . . . . 800 3,700 8 . . . . . . . . . . . . . 2,800 6,700 4 . . . . . . . . . . . . . 1,200 4,300 9 . . . . . . . . . . . . . 3,200 7,300 5 . . . . . . . . . . . . . 1,600 4,900 10 . . . . . . . . . . . . . 3,600 7,900

Exercise 5-7A Measurement of cost behavior using regression P1

Refer to the information from Exercise 5-6. Use spreadsheet software to use ordinary least-squares regres- sion to estimate the cost equation, including fixed and variable cost amounts.

Exercise 5-8 Contribution margin

A1

A jeans maker is designing a new line of jeans called Slims. The jeans will sell for $205 per pair and cost $164 per pair in variable costs to make. 1. Compute the contribution margin per pair. 2. Compute the contribution margin ratio. 3. Describe what the contribution margin ratio reveals about this new jeans line.

Use the following information about sales and costs to prepare a scatter diagram. Draw a cost line that reflects the behavior displayed by this cost. Determine whether the cost is variable, step-wise, fixed, mixed, or curvilinear.

Exercise 5-5 Scatter diagram and measurement of cost behavior

P1 Period Sales Costs Period Sales Costs

1 . . . . . . . . . . . . . $760 $590 9 . . . . . . . . . . . . . $580 $390 2 . . . . . . . . . . . . . 800 560 10 . . . . . . . . . . . . . 320 240 3 . . . . . . . . . . . . . 200 230 11 . . . . . . . . . . . . . 240 230 4 . . . . . . . . . . . . . 400 400 12 . . . . . . . . . . . . . 720 550 5 . . . . . . . . . . . . . 480 390 13 . . . . . . . . . . . . . 280 260 6 . . . . . . . . . . . . . 620 550 14 . . . . . . . . . . . . . 440 410 7 . . . . . . . . . . . . . 680 590 15 . . . . . . . . . . . . . 380 260 8 . . . . . . . . . . . . . 540 430

Chapter 5 Cost Behavior and Cost-Volume-Profit Analysis 201

Exercise 5-9 Contribution margin and break-even P2

Blanchard Company manufactures a single product that sells for $180 per unit and whose total variable costs are $135 per unit. The company’s annual fixed costs are $562,500. Use this information to compute the company’s (a) contribution margin, (b) contribution margin ratio, (c) break-even point in units, and (d) break-even point in dollars of sales.

Exercise 5-10 CVP chart P3

Blanchard Company manufactures a single product that sells for $180 per unit and whose total variable costs are $135 per unit. The company’s annual fixed costs are $562,500. Prepare a CVP chart for the company.

Exercise 5-11 Income reporting and break-even analysis C2

Blanchard Company manufactures a single product that sells for $180 per unit and whose total variable costs are $135 per unit. The company’s annual fixed costs are $562,500. 1. Prepare a contribution margin income statement for Blanchard Company showing sales, variable

costs, and fixed costs at the break-even point. 2. If the company’s fixed costs increase by $135,000, what amount of sales (in dollars) is needed to break

even? Explain.

Exercise 5-12 Computing sales to achieve target income C2

Blanchard Company manufactures a single product that sells for $180 per unit and whose total variable costs are $135 per unit. The company’s annual fixed costs are $562,500. Management targets an annual pretax income of $1,012,500. Assume that fixed costs remain at $562,500. Compute the (1) unit sales to earn the target income and (2) dollar sales to earn the target income.

Exercise 5-14 Predicting sales and variable costs using contribution margin C2

Bloom Company management predicts that it will incur fixed costs of $160,000 and earn pretax income of $164,000 in the next period. Its expected contribution margin ratio is 25%. Use this information to compute the amounts of (1) total dollar sales and (2) total variable costs.

Exercise 5-15 Computation of variable and fixed costs C2

Cooper Company expects to sell 200,000 units of its product next year, which would generate total sales of $17 million. Management predicts that pretax net income for next year will be $1,250,000 and that the contribution margin per unit will be $25. Use this information to compute next year’s total expected (a) variable costs and (b) fixed costs.

Exercise 5-13 Forecasted income statement C2

Blanchard Company manufactures a single product that sells for $180 per unit and whose total variable costs are $135 per unit. The company’s annual fixed costs are $562,500. The sales manager predicts that annual sales of the company’s product will soon reach 40,000 units and its price will increase to $200 per unit. According to the production manager, the variable costs are expected to increase to $140 per unit but fixed costs will remain at $562,500. The income tax rate is 20%. What amounts of pretax and after-tax income can the company expect to earn from these predicted changes? (Hint: Prepare a forecasted contri- bution margin income statement as in Exhibit 5.21.)

Check Forecasted after- tax income, $1,470,000

Exercise 5-16 Break-even P2

Hudson Co. reports the contribution margin income statement for 2015 below. Using this information, compute Hudson Co.’s (1) break-even point in units and (2) break-even point in sales dollars.

HUDSON CO. Contribution Margin Income Statement

For Year Ended December 31, 2015

Sales (9,600 units at $225 each) . . . . . . . . . . . . . . . . $2,160,000 Variable costs (9,600 units at $180 each) . . . . . . . . . 1,728,000 Contribution margin . . . . . . . . . . . . . . . . . . . . . . . . . $ 432,000 Fixed costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 324,000 Pretax income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 108,000

202 Chapter 5 Cost Behavior and Cost-Volume-Profit Analysis

Exercise 5-17 Target income and margin of safety (in dollars) C2

Refer to the information in Exercise 5-16. 1. Assume Hudson Co. has a target pretax income of $162,000 for 2016. What amount of sales (in dol-

lars) is needed to produce this target income? 2. If Hudson achieves its target pretax income for 2016, what is its margin of safety (in percent)? (Round

to one decimal place.)

Exercise 5-18 Sensitivity analysis C2

Refer to the information in Exercise 5-16. Assume the company is considering investing in a new machine that will increase its fixed costs by $40,500 per year and decrease its variable costs by $9 per unit. Prepare a forecasted contribution margin income statement for 2016 assuming the company purchases this machine.

Exercise 5-19 Sensitivity analysis C2

Refer to the information in Exercise 5-16. If the company raises its selling price to $240 per unit, compute its (1) contribution margin per unit, (2) contribution margin ratio, (3) break-even point in units, and (4) break-even point in sales dollars.

Exercise 5-20 Sensitivity analysis C2

Refer to the information in Exercise 5-16. The marketing manager believes that increasing advertising costs by $81,000 in 2016 will increase the company’s sales volume to 11,000 units. Prepare a forecasted contribu- tion margin income statement for 2016 assuming the company incurs the additional advertising costs.

Exercise 5-21 Predicting unit and dollar sales C2

Nombre Company management predicts $390,000 of variable costs, $430,000 of fixed costs, and a pretax income of $155,000 in the next period. Management also predicts that the contribution margin per unit will be $9. Use this information to compute the (1) total expected dollar sales for next period and (2) num- ber of units expected to be sold next period.

Exercise 5-22 CVP analysis using composite units P4

Handy Home sells windows and doors in the ratio of 8:2 (windows:doors). The selling price of each win- dow is $200 and of each door is $500. The variable cost of a window is $125 and of a door is $350. Fixed costs are $900,000. Use this information to determine the (1) selling price per composite unit, (2) variable costs per composite unit, (3) break-even point in composite units, and (4) number of units of each product that will be sold at the break-even point.

Check (3) 1,000 composite units

Exercise 5-23 CVP analysis using composite units

P4

R&R Tax Service offers tax and consulting services to individuals and small businesses. Data for fees and costs of three types of tax returns follow. R&R provides services in the ratio of 5:3:2 (easy, moderate, business). Fixed costs total $18,000 for the tax season. Use this information to determine the (1) selling price per composite unit, (2) variable costs per composite unit, (3) break-even point in composite units, and (4) number of units of each product that will be sold at the break-even point.

Fee Variable Cost Type of Return Charged per Return

Easy (Form 1040EZ) . . . . . . . . . . $ 50 $ 30 Moderate (Form 1040) . . . . . . . . 125 75 Business . . . . . . . . . . . . . . . . . . . . 275 100

Exercise 5-24 Operating leverage computed and applied

A2

Company A is a manufacturer with current sales of $6,000,000 and a 60% contribution margin. Its fixed costs equal $2,600,000. Company B is a consulting firm with current service revenues of $4,500,000 and a 25% contribution margin. Its fixed costs equal $375,000. Compute the degree of operating lever- age (DOL) for each company. Identify which company benefits more from a 20% increase in sales and explain why.

Chapter 5 Cost Behavior and Cost-Volume-Profit Analysis 203

Exercise 5-25 Degree of operating leverage A2

Refer to the information in Exercise 5-16. 1. Compute the company’s degree of operating leverage for 2015. 2. If sales decrease by 5% in 2016, what will be the company’s pretax income? 3. Assume sales for 2016 decrease by 5%. Prepare a contribution margin income statement for 2016.

Required

1. Prepare a contribution margin income statement for the company. 2. Compute its contribution margin per unit and its contribution margin ratio.

Analysis Component

3. Interpret the contribution margin and contribution margin ratio from part 2.

Check (1) Net income, $101,250

Problem 5-2A Scatter diagram and cost behavior estimation

P1

Alden Co.’s monthly sales and cost data for its operating activities of the past year follow. Management wants to use these data to predict future fixed and variable costs.

Month Sales Total Cost Month Sales Total Cost

1 . . . . . . . . . . . . . $320,000 $160,000 7 . . . . . . . . . . . . $340,000 $220,000 2 . . . . . . . . . . . . . 160,000 100,000 8 . . . . . . . . . . . . 280,000 160,000 3 . . . . . . . . . . . . . 280,000 220,000 9 . . . . . . . . . . . . 80,000 64,000 4 . . . . . . . . . . . . . 200,000 100,000 10 . . . . . . . . . . . . 160,000 140,000 5 . . . . . . . . . . . . . 300,000 230,000 11 . . . . . . . . . . . . 100,000 100,000 6 . . . . . . . . . . . . . 200,000 120,000 12 . . . . . . . . . . . . 110,000 80,000

Required

1. Prepare a scatter diagram for these data with sales volume (in $) plotted on the horizontal axis and total cost plotted on the vertical axis.

2. Estimate both the variable costs per sales dollar and the total monthly fixed costs using the high-low method. Draw the total costs line on the scatter diagram in part 1.

3. Use the estimated line of cost behavior and results from part 2 to predict future total costs when sales volume is (a) $200,000 and (b) $300,000.

Check (2) Variable costs, $0.60 per sales dollar; fixed costs, $16,000

Variable production costs Plastic for casing . . . . . . . . . . . . . . . . . . . . . . . $ 17,000 Wages of assembly workers . . . . . . . . . . . . . . 82,000 Drum stands . . . . . . . . . . . . . . . . . . . . . . . . . . 26,000 Variable selling costs Sales commissions . . . . . . . . . . . . . . . . . . . . . . 15,000 Fixed manufacturing costs Taxes on factory . . . . . . . . . . . . . . . . . . . . . . . 5,000 Factory maintenance . . . . . . . . . . . . . . . . . . . . 10,000 Factory machinery depreciation . . . . . . . . . . . 40,000 Fixed selling and administrative costs Lease of equipment for sales staff . . . . . . . . . . 10,000 Accounting staff salaries . . . . . . . . . . . . . . . . . 35,000 Administrative management salaries . . . . . . . 125,000

PROBLEM SET A

Problem 5-1A Contribution margin income statement and contribution margin ratio

A1

The following costs result from the production and sale of 1,000 drum sets manufactured by Tight Drums Company for the year ended December 31, 2015. The drum sets sell for $500 each. The company has a 25% income tax rate.

204 Chapter 5 Cost Behavior and Cost-Volume-Profit Analysis

Praveen Co. manufactures and markets a number of rope products. Management is considering the future of Product XT, a special rope for hang gliding, that has not been as profitable as planned. Since Product XT is manufactured and marketed independently of the other products, its total costs can be precisely measured. Next year’s plans call for a $200 selling price per 100 yards of XT rope. Its fixed costs for the year are expected to be $270,000, up to a maximum capacity of 700,000 yards of rope. Forecasted variable costs are $140 per 100 yards of XT rope.

Required

1. Estimate Product XT’s break-even point in terms of (a) sales units and (b) sales dollars. 2. Prepare a CVP chart for Product XT like that in Exhibit 5.15. Use 7,000 units (700,000 yards/100

yards) as the maximum number of sales units on the horizontal axis of the graph, and $1,400,000 as the maximum dollar amount on the vertical axis.

3. Prepare a contribution margin income statement showing sales, variable costs, and fixed costs for Product XT at the break-even point.

Problem 5-3A CVP analysis and charting P2 P3

Check (1a) Break-even sales, 4,500 units

Problem 5-4A Break-even analysis; income targeting and forecasting

C2 P2 A1

Astro Co. sold 20,000 units of its only product and incurred a $50,000 loss (ignoring taxes) for the cur- rent year as shown here. During a planning session for year 2016’s activities, the production manager notes that variable costs can be reduced 50% by installing a machine that automates several operations. To obtain these savings, the company must increase its annual fixed costs by $200,000. The maximum output capacity of the company is 40,000 units per year.

ASTRO COMPANY Contribution Margin Income Statement

For Year Ended December 31, 2015

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000,000 Variable costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800,000 Contribution margin . . . . . . . . . . . . . . . . . . . . . . . . . 200,000 Fixed costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250,000 Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (50,000)

Required

1. Compute the break-even point in dollar sales for year 2015. 2. Compute the predicted break-even point in dollar sales for year 2016 assuming the machine is in-

stalled and there is no change in the unit selling price. 3. Prepare a forecasted contribution margin income statement for 2016 that shows the expected results

with the machine installed. Assume that the unit selling price and the number of units sold will not change, and no income taxes will be due.

4. Compute the sales level required in both dollars and units to earn $200,000 of target pretax income in 2016 with the machine installed and no change in unit sales price. Round answers to whole dollars and whole units.

5. Prepare a forecasted contribution margin income statement that shows the results at the sales level computed in part 4. Assume no income taxes will be due.

Check (3) Net income, $150,000

(4) Required sales, $1,083,333 or 21,667 units (both rounded)

Problem 5-5A Break-even analysis, different cost structures, and income calculations

C2 A1 P4

Henna Co. produces and sells two products, T and O. It manufactures these products in separate factories and markets them through different channels. They have no shared costs. This year, the company sold 50,000 units of each product. Sales and costs for each product follow.

Product T Product O

Sales . . . . . . . . . . . . . . . . . . . . . . . . . $2,000,000 $2,000,000 Variable costs . . . . . . . . . . . . . . . . . . 1,600,000 250,000 Contribution margin . . . . . . . . . . . . 400,000 1,750,000 Fixed costs . . . . . . . . . . . . . . . . . . . . 125,000 1,475,000 Income before taxes . . . . . . . . . . . . 275,000 275,000 Income taxes (32% rate) . . . . . . . . . 88,000 88,000 Net income . . . . . . . . . . . . . . . . . . . $ 187,000 $ 187,000

Chapter 5 Cost Behavior and Cost-Volume-Profit Analysis 205

Required

1. Compute the break-even point in dollar sales for each product. (Round the answer to whole dollars.) 2. Assume that the company expects sales of each product to decline to 30,000 units next year with no

change in unit selling price. Prepare forecasted financial results for next year following the format of the contribution margin income statement as just shown with columns for each of the two products (assume a 32% tax rate). Also, assume that any loss before taxes yields a 32% tax benefit.

3. Assume that the company expects sales of each product to increase to 60,000 units next year with no change in unit selling price. Prepare forecasted financial results for next year following the format of the contribution margin income statement shown with columns for each of the two products (assume a 32% tax rate).

Analysis Component

4. If sales greatly decrease, which product would experience a greater loss? Explain. 5. Describe some factors that might have created the different cost structures for these two products.

Check (2) After-tax income: T, $78,200; O, $(289,000)

(3) After-tax income: T, $241,400; O, $425,000

Problem 5-6A Analysis of price, cost, and volume changes for contribution margin and net income

P2 A1

This year Burchard Company sold 40,000 units of its only product for $25 per unit. Manufacturing and selling the product required $200,000 of fixed manufacturing costs and $325,000 of fixed selling and administrative costs. Its per unit variable costs follow.

Next year the company will use new material, which will reduce material costs by 50% and direct labor costs by 60% and will not affect product quality or marketability. Management is considering an increase in the unit selling price to reduce the number of units sold because the factory’s output is nearing its annual output capacity of 45,000 units. Two plans are being considered. Under plan 1, the company will keep the selling price at the current level and sell the same volume as last year. This plan will increase income because of the reduced costs from using the new material. Under plan 2, the company will increase the selling price by 20%. This plan will decrease unit sales volume by 10%. Under both plans 1 and 2, the total fixed costs and the variable costs per unit for overhead and for selling and administrative costs will remain the same.

Required

1. Compute the break-even point in dollar sales for both (a) plan 1 and (b) plan 2. 2. Prepare a forecasted contribution margin income statement with two columns showing the expected

results of plan 1 and plan 2. The statements should report sales, total variable costs, contribution mar- gin, total fixed costs, income before taxes, income taxes (30% rate), and net income.

Material . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $8.00 Direct labor (paid on the basis of completed units). . . . . . . . . . 5.00 Variable overhead costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.00 Variable selling and administrative costs . . . . . . . . . . . . . . . . . . . 0.50

Check (1) Break-even: Plan 1, $750,000; Plan 2, $700,000 (2) Net income: Plan 1, $122,500; Plan 2, $199,500

Problem 5-7A Break-even analysis with composite units

P4

Patriot Co. manufactures and sells three products: red, white, and blue. Their unit selling prices are red, $20; white, $35; and blue, $65. The per unit variable costs to manufacture and sell these products are red, $12; white, $22; and blue, $50. Their sales mix is reflected in a ratio of 5:4:2 (red:white:blue). Annual fixed costs shared by all three products are $250,000. One type of raw material has been used to manufacture all three products. The company has developed a new material of equal quality for less cost. The new material would reduce variable costs per unit as follows: red, by $6; white, by $12; and blue, by $10. However, the new material requires new equipment, which will increase annual fixed costs by $50,000. (Round answers to whole composite units.)

Required

1. If the company continues to use the old material, determine its break-even point in both sales units and sales dollars of each individual product.

2. If the company uses the new material, determine its new break-even point in both sales units and sales dollars of each individual product.

Analysis Component

3. What insight does this analysis offer management for long-term planning?

Check (1) Old plan break- even, 2,050 composite units (rounded) (2) New plan break- even, 1,364 composite units (rounded)

206 Chapter 5 Cost Behavior and Cost-Volume-Profit Analysis

PROBLEM SET B

Problem 5-1B Contribution margin income statement and contribution margin ratio

A1

The following costs result from the production and sale of 12,000 CD sets manufactured by Gilmore Company for the year ended December 31, 2015. The CD sets sell for $18 each. The company has a 25% income tax rate.

Variable manufacturing costs Plastic for CD sets . . . . . . . . . . . . . . . . . . . . . . $ 1,500 Wages of assembly workers . . . . . . . . . . . . . . . 30,000 Labeling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 Variable selling costs Sales commissions . . . . . . . . . . . . . . . . . . . . . . . 6,000 Fixed manufacturing costs Rent on factory . . . . . . . . . . . . . . . . . . . . . . . . . 6,750 Factory cleaning service . . . . . . . . . . . . . . . . . . 4,520 Factory machinery depreciation . . . . . . . . . . . . 20,000 Fixed selling and administrative costs Lease of office equipment . . . . . . . . . . . . . . . . . 1,050 Systems staff salaries . . . . . . . . . . . . . . . . . . . . . 15,000 Administrative management salaries . . . . . . . . . 120,000

Required

1. Prepare a contribution margin income statement for the company. 2. Compute its contribution margin per unit and its contribution margin ratio.

Analysis Component

3. Interpret the contribution margin and contribution margin ratio from part 2.

Check (1) Net income, $6,135

Required

1. Prepare a scatter diagram for these data with sales volume (in $) plotted on the horizontal axis and total costs plotted on the vertical axis.

2. Estimate both the variable costs per sales dollar and the total monthly fixed costs using the high-low method. Draw the total costs line on the scatter diagram in part 1.

3. Use the estimated line of cost behavior and results from part 2 to predict future total costs when sales volume is (a) $100 and (b) $170.

Problem 5-2B Scatter diagram and cost behavior estimation

P1

Sun Co.’s monthly sales and cost data for its operating activities of the past year follow. Management wants to use these data to predict future fixed and variable costs. (Dollar amounts are in thousands.)

Month Sales Total Cost Month Sales Total Cost

1 . . . . . . . . . . . . . $195 $ 97 7 . . . . . . . . . . . . $145 $ 93 2 . . . . . . . . . . . . . 125 87 8 . . . . . . . . . . . . 185 105 3 . . . . . . . . . . . . . 105 73 9 . . . . . . . . . . . . 135 85 4 . . . . . . . . . . . . . 155 89 10 . . . . . . . . . . . . 85 58 5 . . . . . . . . . . . . . 95 81 11 . . . . . . . . . . . . 175 95 6 . . . . . . . . . . . . . 215 110 12 . . . . . . . . . . . . 115 79

Check (2) Variable costs, $0.40 per sales dollar; fixed costs, $24,000

Problem 5-3B CVP analysis and charting

P2 P3

Hip-Hop Co. manufactures and markets several products. Management is considering the future of one product, electronic keyboards, that has not been as profitable as planned. Since this product is manufac- tured and marketed independently of the other products, its total costs can be precisely measured. Next year’s plans call for a $350 selling price per unit. The fixed costs for the year are expected to be $42,000, up to a maximum capacity of 700 units. Forecasted variable costs are $210 per unit.

Chapter 5 Cost Behavior and Cost-Volume-Profit Analysis 207

Check (1) Break-even sales, 300 units

Required

1. Estimate the keyboards’ break-even point in terms of (a) sales units and (b) sales dollars. 2. Prepare a CVP chart for keyboards like that in Exhibit 5.15. Use 700 keyboards as the maximum num-

ber of sales units on the horizontal axis of the graph, and $250,000 as the maximum dollar amount on the vertical axis.

3. Prepare a contribution margin income statement showing sales, variable costs, and fixed costs for keyboards at the break-even point.

Problem 5-4B Break-even analysis; income targeting and forecasting

C2 P2 A1

Rivera Co. sold 20,000 units of its only product and incurred a $50,000 loss (ignoring taxes) for the current year as shown here. During a planning session for year 2016’s activities, the production manager notes that variable costs can be reduced 50% by installing a machine that automates several operations. To obtain these savings, the company must increase its annual fixed costs by $150,000. The maximum output capacity of the company is 40,000 units per year.

Required

1. Compute the break-even point in dollar sales for year 2015. 2. Compute the predicted break-even point in dollar sales for year 2016 assuming the machine is installed

and no change occurs in the unit selling price. (Round the change in variable costs to a whole number.) 3. Prepare a forecasted contribution margin income statement for 2016 that shows the expected results

with the machine installed. Assume that the unit selling price and the number of units sold will not change, and no income taxes will be due.

4. Compute the sales level required in both dollars and units to earn $200,000 of target pretax income in 2016 with the machine installed and no change in unit sales price. (Round answers to whole dollars and whole units.)

5. Prepare a forecasted contribution margin income statement that shows the results at the sales level computed in part 4. Assume no income taxes will be due.

RIVERA COMPANY Contribution Margin Income Statement

For Year Ended December 31, 2015

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $750,000 Variable costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600,000 Contribution margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150,000 Fixed costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000 Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (50,000)

Check (3) Net income, $100,000

(4) Required sales, $916,667 or 24,445 units (both rounded)

Check (2) After-tax income: BB, $39,712; TT, $(66,640)

Problem 5-5B Break-even analysis, different cost structures, and income calculations

C2 P4 A1

Stam Co. produces and sells two products, BB and TT. It manufactures these products in separate fac- tories and markets them through different channels. They have no shared costs. This year, the company sold 50,000 units of each product. Sales and costs for each product follow.

Required

1. Compute the break-even point in dollar sales for each product. (Round the answer to the next whole dollar.) 2. Assume that the company expects sales of each product to decline to 33,000 units next year with no

change in the unit selling price. Prepare forecasted financial results for next year following the format

Product BB Product TT

Sales . . . . . . . . . . . . . . . . . . . . . . . . . $800,000 $800,000 Variable costs . . . . . . . . . . . . . . . . . . 560,000 100,000 Contribution margin . . . . . . . . . . . . 240,000 700,000 Fixed costs . . . . . . . . . . . . . . . . . . . . 100,000 560,000 Income before taxes . . . . . . . . . . . . 140,000 140,000 Income taxes (32% rate) . . . . . . . . . 44,800 44,800 Net income . . . . . . . . . . . . . . . . . . . $ 95,200 $ 95,200

208 Chapter 5 Cost Behavior and Cost-Volume-Profit Analysis

Problem 5-6B Analysis of price, cost, and volume changes for contribution margin and net income

A1 P2

This year Best Company earned a disappointing 5.6% after-tax return on sales (net income/sales) from marketing 100,000 units of its only product. The company buys its product in bulk and repackages it for resale at the price of $20 per unit. Best incurred the following costs this year.

The marketing manager claims that next year’s results will be the same as this year’s unless some changes are made. The manager predicts the company can increase the number of units sold by 80% if it reduces the selling price by 20% and upgrades the packaging. This change would increase variable packaging costs by 20%. Increased sales would allow the company to take advantage of a 25% quantity purchase discount on the cost of the bulk product. Neither the packaging change nor the volume discount would affect fixed costs, which provide an annual output capacity of 200,000 units.

Required

1. Compute the break-even point in dollar sales under the (a) existing business strategy and (b) new strat- egy that alters both unit selling price and variable costs. (Round answers to the next whole dollar.)

2. Prepare a forecasted contribution margin income statement with two columns showing the ex- pected results of (a) the existing strategy and (b) changing to the new strategy. The statements should report sales, total variable costs (unit and packaging), contribution margin, fixed costs, in- come before taxes, income taxes, and net income. Also determine the after-tax return on sales for these two strategies.

Total variable unit costs. . . . . . . . . . . . . . $800,000 Total variable packaging costs . . . . . . . . . $100,000 Fixed costs . . . . . . . . . . . . . . . . . . . . . . . . $950,000 Income tax rate . . . . . . . . . . . . . . . . . . . . 25%

Check (1b) Break-even sales for new strategy, $1,727,273 (rounded)

(2) Net income: Existing strategy, $112,500; new strategy, $475,500

(3) After-tax income: BB, $140,896; TT, $228,480

of the contribution margin income statement as shown here with columns for each of the two products (assume a 32% tax rate, and that any loss before taxes yields a 32% tax benefit).

3. Assume that the company expects sales of each product to increase to 64,000 units next year with no change in the unit selling prices. Prepare forecasted financial results for next year following the format of the contribution margin income statement as shown here with columns for each of the two products (assume a 32% tax rate).

Analysis Component

4. If sales greatly increase, which product would experience a greater increase in profit? Explain. 5. Describe some factors that might have created the different cost structures for these two products.

Problem 5-7B Break-even analysis with composite units

P4

Milano Co. manufactures and sells three products: product 1, product 2, and product 3. Their unit selling prices are product 1, $40; product 2, $30; and product 3, $20. The per unit variable costs to manufacture and sell these products are product 1, $30; product 2, $15; and product 3, $8. Their sales mix is reflected in a ratio of 6:4:2. Annual fixed costs shared by all three products are $270,000. One type of raw material has been used to manufacture products 1 and 2. The company has developed a new material of equal quality for less cost. The new material would reduce variable costs per unit as follows: product 1 by $10 and product 2 by $5. However, the new material requires new equipment, which will increase annual fixed costs by $50,000.

Required

1. If the company continues to use the old material, determine its break-even point in both sales units and sales dollars of each individual product.

2. If the company uses the new material, determine its new break-even point in both sales units and sales dollars of each individual product. (Round to the next whole unit.)

Analysis Component

3. What insight does this analysis offer management for long-term planning?

Check (1) Old plan break- even, 1,875 composite units

(2) New plan break- even, 1,429 composite units (rounded)

Chapter 5 Cost Behavior and Cost-Volume-Profit Analysis 209

SERIAL PROBLEM Business Solutions

P4

(This serial problem began in Chapter 1 and continues through most of the book. If previous chapter seg- ments were not completed, the serial problem can begin at this point. It is helpful, but not necessary, to use the working papers that accompany the book.)

SP 5 Business Solutions sells upscale modular desk units and office chairs in the ratio of 3:2 (desk unit:chair). The selling prices are $1,250 per desk unit and $500 per chair. The variable costs are $750 per desk unit and $250 per chair. Fixed costs are $120,000.

Required

1. Compute the selling price per composite unit. 2. Compute the variable costs per composite unit. 3. Compute the break-even point in composite units. 4. Compute the number of units of each product that would be sold at the break-even point.

Check (3) 60 composite units

Beyond the Numbers

REPORTING IN ACTION C1

BTN 5-1 Apple offers extended service contracts that provide repair coverage for its products. As you complete the following requirements, assume that Apple’s repair services department uses many of the company’s existing resources such as its facilities, repair machinery, and computer systems.

Required

1. Identify several of the variable, mixed, and fixed costs that Apple’s repair services department is likely to incur in carrying out its services.

2. Assume that Apple’s repair service revenues are expected to grow by 25% in the next year. How would we expect the costs identified in part 1 to change, if at all?

3. Based on the answer to part 2, can Apple use the contribution margin ratio to predict how income will change in response to increases in Apple’s repair service revenues?

BTN 5-2 Both Apple and Google sell electronic devices like phones and computers, and each of these companies has a different product mix.

Required

1. Assume the following data are available for both companies. Compute each company’s break-even point in unit sales. (Each company sells many devices at many different selling prices, and each has its own variable costs. This assignment assumes an average selling price per unit and an average cost per item.)

2. If unit sales were to decline, which company would experience the larger decline in operating profit? Explain.

COMPARATIVE ANALYSIS P2 A2

Apple Google

Average selling price per unit sold. . . . . . . . . . $550 per unit $470 per unit Average variable cost per unit sold . . . . . . . . . $250 per unit $270 per unit Total fi xed costs ($ in millions) . . . . . . . . . . . . $36,000 $10,000

BTN 5-3 Labor costs of an auto repair mechanic are seldom based on actual hours worked. Instead, the amount paid a mechanic is based on an industry average of time estimated to complete a repair job. The repair shop bills the customer for the industry average amount of time at the repair center’s billable cost per hour. This means a customer can pay, for example, $120 for two hours of work on a car when the ac- tual time worked was only one hour. Many experienced mechanics can complete repair jobs faster than the industry average. The average data are compiled by engineering studies and surveys conducted in the auto

ETHICS CHALLENGE C1

APPLE

APPLE GOOGLE

210 Chapter 5 Cost Behavior and Cost-Volume-Profit Analysis

repair business. Assume that you are asked to complete such a survey for a repair center. The survey calls for objective input, and many questions require detailed cost data and analysis. The mechanics and owners know you have the survey and encourage you to complete it in a way that increases the average billable hours for repair work.

Required

Write a one-page memorandum to the mechanics and owners that describes the direct labor analysis you will undertake in completing this survey.

BTN 5-4 Several important assumptions underlie CVP analysis. Assumptions often help simplify and focus our analysis of sales and costs. A common application of CVP analysis is as a tool to forecast sales, costs, and income.

Required

Assume that you are actively searching for a job. Prepare a half-page report identifying (1) three assump- tions relating to your expected revenue (salary) and (2) three assumptions relating to your expected costs for the first year of your new job. Be prepared to discuss your assumptions in class.

COMMUNICATING IN PRACTICE C2

BTN 5-5 Access and review the entrepreneurial information at Business Owner’s Toolkit [Toolkit.com]. Access and review its New Business Cash Needs Checklist (or similar worksheets related to controls of cash and costs) under the “Start Up” link. (Look under the heading “Free Startup Downloads.”)

Required

Write a half-page report that describes the information and resources available at the Business Owner’s Toolkit to help the owner of a start-up business to control and monitor its cash flows and costs.

TAKING IT TO THE NET C1

BTN 5-6 A local movie theater owner explains to you that ticket sales on weekends and evenings are strong, but attendance during the weekdays, Monday through Thursday, is poor. The owner proposes to offer a contract to the local grade school to show educational materials at the theater for a set charge per student during school hours. The owner asks your help to prepare a CVP analysis listing the cost and sales projections for the proposal. The owner must propose to the school’s administration a charge per child. At a minimum, the charge per child needs to be sufficient for the theater to break even.

Required

Your team is to prepare two separate lists of questions that enable you to complete a reliable CVP analysis of this situation. One list is to be answered by the school’s administration, the other by the owner of the movie theater.

TEAMWORK IN ACTION C2

BTN 5-7 Fast Yeti Custom Tees, launched by entrepreneurs Reid Lyle, Jordan Roudenis, and Ryan Montgomery, produces apparel products. The company has a diverse product line of T-shirts, hats, and polo shirts.

Required

1. Identify at least two fixed costs that will not change regardless of how many T-shirts Fast Yeti produces.

2. How could overly optimistic sales estimates potentially hurt Fast Yeti’s business? 3. Explain how cost-volume-profit analysis can help Reid, Jordan, and Ryan manage Fast Yeti.

ENTREPRENEURIAL DECISION

C1 A1

BTN 5-8 Multiproduct break-even analysis is often viewed differently when actually applied in practice. You are to visit a local fast-food restaurant and count the number of items on the menu. To apply multi- product break-even analysis to the restaurant, similar menu items must often be fit into groups. A reason- able approach is to classify menu items into approximately five groups. We then estimate average selling price and average variable cost to compute average contribution margin. (Hint: For fast-food restaurants, the highest contribution margin is with its beverages, at about 90%.)

HITTING THE ROAD P4

Chapter 5 Cost Behavior and Cost-Volume-Profit Analysis 211

Required

1. Prepare a one-year multiproduct break-even analysis for the restaurant you visit. Begin by establishing groups. Next, estimate each group’s volume and contribution margin. These estimates are necessary to compute each group’s contribution margin. Assume that annual fixed costs in total are $500,000 per year. (Hint: You must develop your own estimates on volume and contribution margin for each group to obtain the break-even point and sales.)

2. Prepare a one-page report on the results of your analysis. Comment on the volume of sales necessary to break even at a fast-food restaurant.

BTN 5-9 Access and review Samsung’s website (www.samsung.com) to answer the following questions.

Required

1. Do you believe that Samsung’s managers use single product CVP analysis or multiproduct break-even analysis? Explain.

2. How does the addition of a new product line affect Samsung’s CVP analysis?

GLOBAL DECISION P4

ANSWERS TO MULTIPLE CHOICE QUIZ 1. a; $150 2 $100 5 $50 2. e; ($150 2 $100)y$150 5 331⁄3% 3. c; $75,000y$50 CM per unit 5 1,500 units

4. b; $300,000 2 $180,000 5 $120,000 5. c; Contribution margin ratio 5 ($400 2 $260)y$400 5 0.35 Targeted sales 5 ($840,000 1 $70,000)y0.35 5 $2,600,000

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Variable Costing and Analysis

Learninggg Objjjeectivvvves

CONCEPTUAL C1 Describe how absorption costing can

result in overproduction.

ANALYTICAL A1 Use variable costing in pricing special

orders.

PROCEDURAL P1 Compute unit cost under both

absorption and variable costing.

P2 Prepare and analyze an income statement using absorption costing and using variable costing.

P3 Convert income under variable costing to the absorption cost basis.

P4 Determine product selling price based on absorption costing.

INCOME REPORTING IMPLICATIONS

P2 When production equals sales When production exceeds sales

When production is less than sales

Income reporting

P3 Converting income under variable costing to absorption costing

COMPARING VARIABLE COSTING AND

ABSORPTION COSTING

C1 Planning production P4 Setting prices

Controlling costs

CVP analysis

Limitations of variable costing

Variable costing for services

A1 Pricing special orders with variable costing

VARIABLE COSTING AND ABSORPTION

COSTING

Absorption costing

Variable costing

P1 Computing unit costs

213

Happy Times

incredible opportunity to build a meaningful brand,” says Shazi.

“[We] make a difference in a child’s life.” Shazi adds, “We

have been really blessed!”

Sources: Happy Family Brands website, January 2015; Inc., August 2011, March 2012, and September 2013; New Hope 360, March 2011; FOXBusiness, November 2011

“We let our investors see, and share, our passion” —Shazi Visram

NEW YORK—Shazi Visram grew up in Alabama, and she felt

entrepreneurship was her calling. “I always knew that I

wanted to be my own boss,” recalls Shazi. “I had this idea to

make baby food the way moms would.” However, entrepre-

neurship had its challenges. “There was an evening when I

got to the subway with nothing in my wallet but maxed out

credit cards and no way to pay for my ride home,” admits

Shazi. “The path of entrepreneurship isn’t smooth . . . it’s a

rollercoaster!” From these modest beginnings, Shazi created

Happy Family Brands (HappyBabyFood.com), which is

committed to quality foods for the entire family.

“We are an authentic mom-run company; we are real

people behind this business who care about the quality of

our products,” explains Shazi. “I made the first recipes in

my kitchen, using the best organic ingredients. Then, I sub-

jected these recipes to the critics; hundreds of babies, in-

cluding my own!” Along the way, Shazi set up an accounting

system to measure, track, summarize, and report on opera-

tions. An important part of this accounting system is a

focus on variable costs and product contribution margins.

“We are a small business with a big vision and a big heart,”

says Shazi. “Quality is of the utmost concern,” explains

Shazi.

“We’ve grown exponentially . . . now we’re in over 17,000

stores,” says Shazi. “What’s important [in both business and

accounting] is . . . being adaptable!” A variable costing ap-

proach allows Shazi to adapt to changing market conditions

and unique opportunities.

Shazi’s company is riding high, and she recently sold a

large portion of her company to Danone, a multinational cor-

poration based in France. "Our mission is to remove toxins

from children’s lives. With a mission that big, we need our

company to be as big as possible," says Shazi. “What an

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214 Chapter 6 Variable Costing and Analysis

INTRODUCING VARIABLE COSTING AND ABSORPTION COSTING Product costs consist of direct materials, direct labor, and overhead. Direct materials and direct labor costs are those that can be identified and traced to the product(s). Overhead, which con- sists of costs such as electricity, equipment depreciation, and supervisor salaries, is not traceable to the product. Overhead costs must be allocated to products.

There are a variety of costing methods for identifying and allocating overhead costs to prod- ucts. A prior chapter focused on how to allocate overhead costs to products. This chapter focuses on what overhead costs are included in product costs.

Under the traditional costing approach, all manufacturing costs are assigned to products. Those costs consist of direct materials, direct labor, and manufacturing overhead, both variable and fixed. This traditional approach is referred to as absorption costing (also called full cost- ing), which assumes that products absorb all costs incurred to produce them. While widely used for external financial reporting (GAAP), this costing method can result in misleading product cost information for managers’ business decisions.

Under variable costing, only costs that change in total with changes in production level are included in product costs. Those consist of direct materials, direct labor, and variable manufac- turing overhead. Fixed manufacturing overhead does not change with changes in production and, thus, it is excluded from product costs under variable costing. Instead, fixed overhead is treated as a period cost, meaning it is expensed in the period when it is incurred.

Exhibit 6.1 compares the absorption and variable costing methods. Under both methods, direct materials, direct labor, and variable overhead are included in product costs. The key dif- ference between the methods lies in their treatment of fixed overhead costs—such costs are in- cluded in product costs under absorption costing but included in period expenses under variable costing. Recall that product costs are included in inventory until the goods are sold, at which time they are included in cost of goods sold. Period expenses are reported as expenses immediately in the period in which they are incurred.

EXHIBIT 6.1 Absorption versus Variable Costing

Product Costs

Absorption Costing

Direct Materials

Direct Labor

Variable Overhead

Fixed Overhead Period Expenses

Variable Costing

Product Costs

Exhibit 6.1 helps us understand when the absorption and variable costing methods will yield different income amounts over a period. In particular, differences in income resulting from the alternative costing methods will be small when:

Fixed overhead is small as a percentage of total manufacturing costs. Inventory levels are low. As more companies adopt lean techniques, including just-in-time

manufacturing, inventory levels fall. Lower inventory levels reduce income differences be- tween absorption and variable costing.

Inventory turnover is rapid. The more quickly inventory turns over, the more product costs are included in cost of goods sold, relative to the product costs that remain in inventory.

The period of analysis is long. For example, different costing methods might yield very dif- ferent income numbers over a quarter or year, but these differences will decrease as income is compared over longer periods.

Point: Under variable costing, fixed overhead is expensed at the time the units are produced. Under absorption costing, fixed overhead is expensed at the time the units are sold (as a component of cost of goods sold).

Chapter 6 Variable Costing and Analysis 215

Computing Unit Cost To illustrate the difference between absorption costing and variable costing, let’s consider the product cost data in Exhibit 6.2 from IceAge, a skate manufacturer.

P1 Compute unit cost under both absorption and variable costing.

Drawing on the product cost data, Exhibit 6.3 shows the product cost per unit computations for both absorption and variable costing. These computations are shown both in a tabular format (left side of exhibit) and a visual format (right side of exhibit). For absorption costing, the prod- uct cost per unit is $25, which consists of $4 in direct materials, $8 in direct labor, $3 in variable overhead ($180,000y60,000 units), and $10 in fixed overhead ($600,000y60,000 units).

For variable costing, the product cost per unit is $15, which consists of $4 in direct materials, $8 in direct labor, and $3 in variable overhead. Fixed overhead costs of $600,000 are treated as a period cost and are recorded as expense in the period incurred. The difference between the two costing methods is the exclusion of fixed overhead from product costs for variable costing.

Direct materials cost . . . . . . . . . . . . . . . . . . . . . $4 per unit Direct labor cost . . . . . . . . . . . . . . . . . . . . . . . . $8 per unit Overhead cost Variable overhead cost . . . . . . . . . . . . . . . . . . $ 180,000 Fixed overhead cost . . . . . . . . . . . . . . . . . . . . 600,000 Total overhead cost . . . . . . . . . . . . . . . . . . . . . $ 780,000 Expected units produced . . . . . . . . . . . . . . . . . . 60,000 units

EXHIBIT 6.2 Summary Product Cost Data

EXHIBIT 6.3 Unit Cost Computation

A manufacturer reports the following data.

QC1

1. Compute the total product cost per unit under absorption costing. 2. Compute the total product cost per unit under variable costing.

Solution

Direct materials cost . . . . . . . . . . . . $6 per unit Variable overhead . . . . . . . . . $220,000 per year Direct labor cost . . . . . . . . . . . . . . . $14 per unit Fixed overhead . . . . . . . . . . . $680,000 per year Expected units produced . . . . . . . . 20,000 units

P1

NEED-TO-KNOW 6-1 Computing Product Cost per Unit

©TOSHIFUMI KITAMURA/AFP/ Getty Images

Product Cost per Unit

Absorption Variable Costing Costing

Direct materials . . . . . . . . . . . . . . . . . . $ 4 $ 4 Direct labor . . . . . . . . . . . . . . . . . . . . . 8 8 Overhead costs Variable overhead. . . . . . . . . . . . . . . 3 3 Fixed overhead . . . . . . . . . . . . . . . 10 — Total product cost per unit . . . . . . . . . $25 $15

Product Costs

Absorption Costing

$25 per unit

$4 DM

$8 DL

$3 VOH

$10 FOH Period Expenses $600,000

Variable Costing

Product Costs $ 15 per unit

Per Unit Costs (1) Absorption Costing (2) Variable Costing

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . $ 6 $ 6 Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 14 Variable overhead ($220,000y20,000) . . . . . . . . 11 11 Fixed overhead ($680,000y20,000)* . . . . . . . . . . 34 — Total product cost per unit . . . . . . . . . . . . . . . . $65 $31

*Not included in product costs under variable costing.

Do More: QS 6-1, QS 6-2, E 6-1, E 6-2

216 Chapter 6 Variable Costing and Analysis

The reported sales and production information for IceAge follows. Its sales price was a constant $40 per unit over this time period. We see that the units produced equal those sold for 2013, exceed those sold for 2014, and are less than those sold for 2015. IceAge began 2013 with no units in beginning inventory.

INCOME REPORTING IMPLICATIONS The prior section showed how the different treatment of fixed overhead costs leads to different product costs per unit under absorption and variable costing. This section shows the implica- tions of this difference for income reporting.

To illustrate the income reporting implications, we return to IceAge Company. Below are the manufacturing cost data for IceAge as well as additional data on selling and administrative ex- penses. Assume that IceAge’s variable costs per unit are constant and that its annual fixed costs remain unchanged during the three-year period 2013 through 2015.

Manufacturing Costs Selling and Administrative Expenses

Direct materials cost . . . . . . . . . . $4 per unit Variable. . . . . . . . . . . . . . . . . . . . $2 per unit Direct labor cost . . . . . . . . . . . . . $8 per unit Fixed. . . . . . . . . . . . . . . . . . . . . . $200,000 per year Variable overhead cost. . . . . . . . . $3 per unit Fixed overhead cost. . . . . . . . . . . $600,000 per year

Units Produced Units Sold Units in Ending Inventory

2013 . . . . . . . . 60,000 60,000 0 2014 . . . . . . . . 60,000 40,000 20,000 2015 . . . . . . . . 60,000 80,000 0

Drawing on the information above, we next prepare income statements for IceAge both under absorption costing and under variable costing. Our purpose is to highlight differences between these two costing methods under three different cases: when units produced are equal to, ex- ceed, or are less than units sold.

Units Produced Equal Units Sold Exhibit 6.4 presents the 2013 income statement for both costing methods (2014 and 2015 statements will follow). The income statement under variable costing (on the right) is referred to as the contribution margin income statement. Contribution margin is the excess of sales over variable costs. This margin contributes to covering all fixed costs and earning income. Under

P2 Prepare and analyze an income statement using absorption costing and using variable costing.

EXHIBIT 6.4 Income for 2013—Quantity Produced Equals Quantity Sold*

Point: Contribution margin (Sales 2 Variable expenses) is different from gross margin (Sales 2 Cost of sales).

ICEAGE COMPANY Income Statement (Variable Costing) For Year Ended December 31, 2013

Sales† (60,000 3 $40) . . . . . . . $2,400,000 Variable expenses Variable production costs (60,000 3 $15*) . . . . . . . . $900,000 Variable selling and administrative expenses (60,000 3 $2). . . . 120,000 1,020,000 Contribution margin . . . . . . . . . 1,380,000 Fixed expenses Fixed overhead . . . . . . . . . . . 600,000 Fixed selling and administrative expenses . . . 200,000 800,000 Net income . . . . . . . . . . . . . . . . $ 580,000

ICEAGE COMPANY Income Statement (Absorption Costing)

For Year Ended December 31, 2013

Sales† (60,000 3 $40) . . . . . . . . . . . . . $2,400,000 Cost of goods sold (60,000 3 $25**) . . 1,500,000 Gross margin . . . . . . . . . . . . . . . . . . . 900,000 Selling and administrative expenses [$200,000 1 (60,000 3 $2)]. . . . . . 320,000 Net income . . . . . . . . . . . . . . . . . . . . . $ 580,000

* ($4 DM 1 $8 DL 1 $3 VOH) ** ($4 DM 1 $8 DL 1 $3 VOH 1 $10 FOH) † Units produced equal 60,000; units sold equal 60,000.

A performance report that excludes fixed expenses and net income is a contribution margin report. Its bottom line is contribution margin.

Chapter 6 Variable Costing and Analysis 217

variable costing, expenses are grouped according to cost behavior—variable or fixed, and production or nonproduction. Under the traditional format of absorption costing, expenses are grouped according to function but not separated into variable and fixed components.

Exhibit 6.4 reveals that reported income is identical under absorption costing and variable costing when the number of units produced equals the number of units sold. Because variable costing results in expensing of fixed manufacturing overhead based on the number of units pro- duced (60,000 3 $10), and absorption costing results in expensing of fixed manufacturing over- head based on the number of units sold (also 60,000 3 $10), the net income is the same under either method when units produced equals units sold.

Exhibit 6.5 reorganizes the information from Exhibit 6.4 to show the assignment of costs to different expenses and assets under both absorption costing and variable costing. In this year, there are no units in ending inventory, so the finished goods inventory is $0 under both methods. When quantity produced equals quantity sold, there is no difference in total expenses reported on the income statement. Yet, there is a difference in what categories receive those costs. Ab- sorption costing assigns $1,500,000 to cost of goods sold compared to $900,000 for variable costing. The $600,000 difference is a period cost for variable costing.

Point: Contribution margin income statements prepared under variable costing are useful in performing cost- volume-profit analyses.

Units Produced Exceed Units Sold Exhibit 6.6 shows absorption costing and variable costing income statements for 2014. In 2014, 60,000 units were produced, which is the same as in 2013. However, only 40,000 units were sold, which means 20,000 units remain in ending inventory.

The income statements reveal that for 2014, income is $320,000 under absorption costing. Under variable costing, income is $120,000, which is $200,000 less than under absorption cost- ing. The cause of this $200,000 difference is due to the different treatment of fixed overhead under the two costing methods. Because variable costing expenses fixed manufacturing over- head (FOH) based on the number of units produced (60,000 3 $10), and absorption costing

EXHIBIT 6.5 Production Cost Assignment for 2013

Absorption Costing For Year 2013

Beginning finished goods inventory . . . . . . $ 0 Cost of goods manufactured Direct materials . . . . . . . . . . . . . . . . . . . . $240,000 Direct labor . . . . . . . . . . . . . . . . . . . . . . . 480,000 Variable manufacturing overhead . . . . . . 180,000 Fixed manufacturing overhead . . . . . . . . 600,000 1,500,000 Cost of goods available for sale . . . . . . . 1,500,000 Less: Ending finished goods inventory . . . 0 Cost of goods sold . . . . . . . . . . . . . . . . . $1,500,000

Variable Costing For Year 2013

Beginning finished goods inventory . . . . . . $ 0 Cost of goods manufactured Direct materials . . . . . . . . . . . . . . . . . . . . $240,000 Direct labor . . . . . . . . . . . . . . . . . . . . . . . 480,000 Variable manufacturing overhead . . . . . . 180,000 Fixed manufacturing overhead . . . . . . . . 0 900,000 Cost of goods available for sale . . . . . . . 900,000 Less: Ending finished goods inventory . . . 0 Cost of goods sold . . . . . . . . . . . . . . . . . 900,000 Period costs Fixed manufacturing overhead . . . . . . . . 600,000 Total costs . . . . . . . . . . . . . . . . . . . . . . . . . . $1,500,000

Manufacturing Margin Some managers compute manufacturing margin (also called production margin), which is sales less variable produc- tion costs. Some managers also require that internal income statements show this amount to highlight the impact of variable product costs on in- come. The contribution margin section of IceAge’s variable costing income statement would appear as follows (compare this to Exhibit 6.4).

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,400,000 Variable production costs . . . . . . . . . . . . 900,000 Manufacturing margin . . . . . . . . . . . . . . . 1,500,000 Variable selling & admin. exp. . . . . . . . . . 120,000 Contribution margin . . . . . . . . . . . . . . . . $1,380,000 ■

Decision Insight

©Steve Mason/Getty Images

218 Chapter 6 Variable Costing and Analysis

expenses FOH based on the number of units sold (40,000 3 $10), net income is lower under variable costing by $200,000 (20,000 units 3 $10).

Under variable costing, the entire $600,000 fixed overhead cost is treated as an expense in computing 2014 income. Under absorption costing, the fixed overhead cost is allocated to each unit of product at the rate of $10 per unit (from Exhibit 6.3). When production exceeds sales by 20,000 units (60,000 versus 40,000), the $200,000 ($10 3 20,000 units) of fixed overhead cost allocated to these 20,000 units is included in the cost of ending inventory (see Exhibit 6.7). This means that $200,000 of fixed overhead cost incurred in 2014 is not expensed until future years, when it is reported in cost of goods sold as those products are sold. Consequently, income for 2014 under absorption costing is $200,000 higher than income under variable costing. Even though sales (of 40,000 units) and the number of units produced (totaling 60,000) are the same under both costing methods, net income differs greatly due to the treatment of fixed overhead.

EXHIBIT 6.6 Income for 2014—Quantity Produced Exceeds Quantity Sold

ICEAGE COMPANY Income Statement (Absorption Costing)

For Year Ended December 31, 2014

Sales† (40,000 3 $40) . . . . . . . . . . . . . . . $1,600,000 Cost of goods sold (40,000 3 $25**). . . 1,000,000 Gross margin . . . . . . . . . . . . . . . . . . . . . 600,000 Selling and administrative expenses [$200,000 1 (40,000 3 $2)] . . . . . . . 280,000 Net income . . . . . . . . . . . . . . . . . . . . . . . $ 320,000

* ($4 DM 1 $8 DL 1 $3 VOH) ** ($4 DM 1 $8 DL 1 $3 VOH 1 $10 FOH) † Units produced equal 60,000; units sold equal 40,000.

ICEAGE COMPANY Income Statement (Variable Costing) For Year Ended December 31, 2014

Sales† (40,000 3 $40) . . . . . . . . $1,600,000 Variable expenses Variable production costs (40,000 3 $15*) . . . . . . . . $600,000 Variable selling and administrative expenses (40,000 3 $2). . . . 80,000 680,000 Contribution margin . . . . . . . . . 920,000 Fixed expenses Fixed overhead . . . . . . . . . . . 600,000 Fixed selling and administrative expense . . . . 200,000 800,000 Net income . . . . . . . . . . . . . . . . $ 120,000

Exhibit 6.7 reorganizes the information from Exhibit 6.6 to show the assignment of costs to different expenses and assets under both absorption costing and variable costing. When quantity produced exceeds quantity sold, there is a difference in total expenses. Under absorption cost- ing, cost of goods sold is $200,000 lower than the total costs ($1,200,000) under variable cost- ing. As a result, income (and ending finished goods inventory) under absorption costing is $200,000 greater than under variable costing because of the fixed overhead cost allocated to ending inventory (asset) under absorption costing.

EXHIBIT 6.7 Production Cost Assignment for 2014

Variable Costing For Year 2014

Beginning finished goods inventory . . . . . $ 0 Cost of goods manufactured Direct materials . . . . . . . . . . . . . . . . . . . $240,000 Direct labor . . . . . . . . . . . . . . . . . . . . . . 480,000 Variable manufacturing overhead . . . . . 180,000 Fixed manufacturing overhead . . . . . . . 0 900,000 Cost of goods available for sale . . . . . . 900,000 Less: Ending finished goods inventory . . 300,000** Cost of goods sold . . . . . . . . . . . . . . . . 600,000 Period costs Fixed manufacturing overhead . . . . . . . 600,000 Total costs . . . . . . . . . . . . . . . . . . . . . . . . . $1,200,000

Absorption Costing For Year 2014

Beginning finished goods inventory . . . . . . $ 0 Cost of goods manufactured Direct materials . . . . . . . . . . . . . . . . . . . . $240,000 Direct labor . . . . . . . . . . . . . . . . . . . . . . . 480,000 Variable manufacturing overhead . . . . . . 180,000 Fixed manufacturing overhead . . . . . . . . 600,000 1,500,000 Cost of goods available for sale . . . . . . . 1,500,000 Less: Ending finished goods inventory . . . 500,000* Cost of goods sold . . . . . . . . . . . . . . . . . $1,000,000

* 20,000 units 3 $25 per unit ** 20,000 units 3 $15 per unit

Chapter 6 Variable Costing and Analysis 219

EXHIBIT 6.8 Income for 2015—Quantity Produced Is Less Than Quantity Sold

ICEAGE COMPANY Income Statement (Variable Costing) For Year Ended December 31, 2015

Sales† (80,000 3 $40) . . . . . . . . . $3,200,000 Variable expenses Variable production costs (80,000 3 $15**) . . . . . . . . $1,200,000 Variable selling and administrative expenses (80,000 3 $2) . . . . . . . . . . . . 160,000 1,360,000 Contribution margin . . . . . . . . . . 1,840,000 Fixed expenses Fixed overhead . . . . . . . . . . . . 600,000 Fixed selling and administrative expense . . . . . . . . . . . . . . . . 200,000 800,000 Net income . . . . . . . . . . . . . . . . . $1,040,000

* ($4 DM 1 $8 DL 1 $3 VOH) ** ($4 DM 1 $8 DL 1 $3 VOH 1 $10 FOH) † Units produced equal 60,000; units sold equal 80,000.

ICEAGE COMPANY Income Statement (Absorption Costing)

For Year Ended December 31, 2015

Sales† (80,000 3 $40) . . . . . . . . . . . . . . . $3,200,000 Cost of goods sold (80,000 3 $25*). . . 2,000,000 Gross margin . . . . . . . . . . . . . . . . . . . . . 1,200,000 Selling and administrative expenses [$200,000 1 (80,000 3 $2)] . . . . . . . 360,000 Net income . . . . . . . . . . . . . . . . . . . . . . . $ 840,000

EXHIBIT 6.9 Production Cost Assignment for 2015

Specifically, ending inventory in 2014 under absorption costing was $500,000 (20,000 units 3 $25) whereas it was only $300,000 (20,000 units 3 $15) under variable costing—see Exhibit 6.7. Consequently, when that inventory is sold in 2015, that $200,000 difference in ending inventory is included in cost of goods sold under absorption costing. Thus, the 2015 income under absorption costing is $200,000 less than the income under variable costing. That inventory cost difference flows through cost of goods sold and then to income.

Absorption Costing For Year 2015

Beginning finished goods inventory . . . . . . $ 500,000* Cost of goods manufactured Direct materials . . . . . . . . . . . . . . . . . . . . $240,000 Direct labor . . . . . . . . . . . . . . . . . . . . . . . 480,000 Variable manufacturing overhead . . . . . . 180,000 Fixed manufacturing overhead . . . . . . . . 600,000 1,500,000 Cost of goods available for sale . . . . . . . 2,000,000 Less: Ending finished goods inventory . . . 0 Cost of goods sold . . . . . . . . . . . . . . . . . $2,000,000

Variable Costing For Year 2015

Beginning finished goods inventory . . . . . . $ 300,000** Cost of goods manufactured Direct materials . . . . . . . . . . . . . . . . . . . . $240,000 Direct labor . . . . . . . . . . . . . . . . . . . . . . . 480,000 Variable manufacturing overhead . . . . . . 180,000 Fixed manufacturing overhead . . . . . . . . 0 900,000 Cost of goods available for sale . . . . . . . 1,200,000 Less: Ending finished goods inventory . . . 0 Cost of goods sold . . . . . . . . . . . . . . . . . 1,200,000 Period costs Fixed manufacturing overhead . . . . . . . . 600,000 Total costs . . . . . . . . . . . . . . . . . . . . . . . . . . $1,800,000

* 20,000 units 3 $25 per unit ** 20,000 units 3 $15 per unit

Units Produced Are Less Than Units Sold Exhibit 6.8 shows absorption costing and variable costing income statements for 2015. In 2015, IceAge produced 60,000 units and sold 80,000 units. Thus, IceAge produced 20,000 units fewer than it sold. This means IceAge sold all that it produced during the period, and it sold all of its beginning finished goods inventory. IceAge’s income is $840,000 under absorption costing, but it is $1,040,000 under variable costing.

Point: IceAge can sell more units than it produced in 2015 because of inventory carried over from 2014.

The cause of this $200,000 income difference lies with the treatment of fixed overhead. Begin- ning inventory in 2015 under absorption costing included $200,000 of fixed overhead cost incurred in 2014, which is assigned to cost of goods sold in 2015 under absorption costing. Because variable costing expenses fixed manufacturing overhead (FOH) based on the number of units produced (60,000 3 $10), and absorption costing expenses FOH based on the number of units sold (80,000 3 $10), net income is higher under variable costing by $200,000 (20,000 units 3 $10).

Exhibit 6.9 reorganizes the information from Exhibit 6.8 to show the assignment of costs to different expenses and assets under both absorption costing and variable costing. When quantity produced is less than quantity sold, there is a difference in total costs assigned.

220 Chapter 6 Variable Costing and Analysis

Summarizing Income Reporting Income reported under both variable costing and absorption costing for the years 2013 through 2015 for IceAge is summarized in Exhibit 6.10. We see that total income is $1,740,000 for this time period for both methods. Further, income under absorption costing and that under variable costing differ whenever the quantity produced and the quantity sold differ. These differences in income are due to the different timing with which fixed overhead costs are reported in income under the two methods. Specifically, income under absorption costing is higher when more units are produced relative to units sold and is lower when fewer units are produced than are sold.

Units Units Income under Income under Income Produced Sold Absorption Costing Variable Costing Differences

2013 . . . . . . . . . 60,000 60,000 $ 580,000 $ 580,000 $ 0 2014 . . . . . . . . . 60,000 40,000 320,000 120,000 200,000 2015 . . . . . . . . . 60,000 80,000 840,000 1,040,000 (200,000) Totals . . . . . . . . 180,000 180,000 $1,740,000 $1,740,000 $ 0

EXHIBIT 6.10 Summary of Income Reporting

Point: In our illustration the company produces the same number of units (60,000) each year. We provide an example with varying yearly production levels in the Comprehensive Need-To-Know at the end of the chapter.

ZBest Mfg. reports the following data for 2015.

Computing Income under Absorption and Variable Costing

NEED-TO-KNOW 6-2

P2

1. Prepare an income statement for 2015 under absorption costing. 2. Prepare an income statement for 2015 under variable costing.

Solution

Direct materials cost . . . . . $6 per unit Units produced . . . . . . . . . . . . . . . . . . . . . . . 20,000 units Direct labor cost . . . . . . . . $11 per unit Units sold . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,000 units Variable overhead cost . . . $3 per unit Variable selling and administrative expenses . . $2 per unit Fixed overhead . . . . . . . . . $680,000 per year Fixed selling and administrative expenses. . . . $112,000 per year Sales price . . . . . . . . . . . . . $80 per unit

In our illustration using IceAge, the total number of units produced over 2013–2015 was exactly equal to the number of units sold over that period. This meant that the difference be- tween absorption costing income and variable costing income for the total three-year period is zero. In reality, it is unusual for production and sales quantities to exactly equal each other over such a short period of time. This means that we normally continue to see differences in income for these two methods extending over several years.

QC2

Do More: QS 6-3, QS 6-4, E 6-3, E 6-4, E 6-5.

ZBEST MFG. Income Statement (Variable Costing) For Year Ended December 31, 2015

Sales (14,000 3 $80) . . . . . . . . . $1,120,000 Variable expenses Variable production costs (14,000 3 $20)† . . . . . . . . . $280,000 Variable selling and admin. expenses**. . . . . . . . 28,000 308,000 Contribution margin . . . . . . . . . . 812,000 Fixed expenses Fixed overhead . . . . . . . . . . . . 680,000 Fixed selling and admin. expenses . . . . . . . . . . . . . . . 112,000 792,000 Net income . . . . . . . . . . . . . . . . . $ 20,000

* $6 DM 1 $11 DL 1 $3 VOH 1 $20 FOH ($680,000y20,000) 5 $54 per unit

** 14,000 3 $2 per unit. † $6 DM 1 $11 DL 1 $3 VOH 5 $20 per unit

ZBEST MFG. Income Statement (Absorption Costing)

For Year Ended December 31, 2015

Sales (14,000 3 $80) . . . . . . . . . . . . . . . $1,120,000 Cost of goods sold (14,000 3 $54)* . . . 756,000 Gross margin . . . . . . . . . . . . . . . . . . . . . 364,000 Selling and admin. expenses [$112,000 1 (14,000 3 $2)] . . . . . . . 140,000 Net income . . . . . . . . . . . . . . . . . . . . . . . $ 224,000

The difference in income between the two methods ($204,000) can be computed as the 6,000 units added to ending inventory 3 $34 FOH per unit.

Chapter 6 Variable Costing and Analysis 221

Converting Income under Variable Costing to Absorption Costing Companies commonly use variable costing for internal reporting and business decisions, and they use absorption costing for external reporting and tax reporting. For companies concerned about the cost of maintaining two costing systems, it is comforting to know that we can readily convert reports under variable costing to those using absorption costing.

Income under variable costing is restated to that under absorption costing by adding the fixed overhead cost in ending inventory and subtracting the fixed overhead cost in beginning inventory. Exhibit 6.11 shows the formula for this calculation.

P3 Convert income under variable costing to the absorption cost basis.

EXHIBIT 6.11 Formula to Convert Variable Costing Income to Absorption Costing

Income under 5 Income under 1 Fixed overhead cost 2 Fixed overhead cost absorption costing variable costing in ending inventory in beginning inventory

Using IceAge’s data, in 2014, absorption costing income was $200,000 higher than variable costing income. The $200,000 difference was because the fixed overhead cost incurred in 2014 was allocated to the 20,000 units of ending inventory under absorption costing (and not ex- pensed in 2014 under absorption costing). On the other hand, the $200,000 fixed overhead costs (along with all other fixed costs) were expensed in 2014 under variable costing.

Exhibit 6.12 shows the computations for restating income under the two costing methods. To restate variable costing income to absorption costing income for 2014, we must add back the fixed overhead cost deferred in (ending) inventory. Similarly, to restate variable costing in- come to absorption costing income for 2015, we must deduct the fixed overhead cost recog- nized from (beginning) inventory, which was incurred in 2014, but expensed in the 2015 cost of goods sold when the inventory was sold.

2013 2014 2015

Variable costing income (Exhibit 6.10) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $580,000 $120,000 $1,040,000 Add: Fixed overhead cost deferred in ending inventory (20,000 3 $10) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 200,000 0 Less: Fixed overhead cost recognized from beginning inventory (20,000 3 $10) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 0 (200,000) Absorption costing income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $580,000 $320,000 $ 840,000

EXHIBIT 6.12 Converting Variable Costing Income to Absorption Costing Income

COMPARING VARIABLE COSTING AND ABSORPTION COSTING This section compares the roles of absorption and variable costing in managers’ business decisions.

Planning Production Production planning is an important managerial function. Producing too much leads to excess inventory, which in turn leads to higher storage and financing costs, and to greater risk of prod- uct obsolescence. On the other hand, producing too little can lead to lost sales and customer dissatisfaction.

Production levels should be based on reliable sales forecasts. However, overproduction and inventory buildup can occur because of how managers are evaluated and rewarded. For instance, many companies link manager bonuses to income computed under absorption costing because this is how income is reported to shareholders (per GAAP).

To illustrate how a reward system can lead to overproduction under absorption costing, let’s use IceAge’s 2013 data with one change: assume that its manager decides to produce 100,000 units instead of 60,000. Since only 60,000 units are sold, the 40,000 units of excess production will be stored in ending finished goods inventory.

The left side of Exhibit 6.13 shows the unit cost when 60,000 units are produced (same as Exhibit 6.3). The right side shows unit cost when 100,000 units are produced. The exhibit is prepared under absorption costing for 2013.

C1 Describe how absorption costing can result in overproduction.

222 Chapter 6 Variable Costing and Analysis

Total production cost per unit is $4 less when 100,000 units are produced. Specifically, cost per unit is $21 when 100,000 units are produced versus $25 per unit at 60,000 units. The reason for this difference is because the company is spreading the $600,000 fixed overhead cost over more units when 100,000 units are produced than when 60,000 units are produced.

The difference in cost per unit impacts income reporting. Exhibit 6.14 presents the 2013 in- come statement under absorption costing for the two alternative production levels.

EXHIBIT 6.13 Unit Cost under Absorption Costing for Different Production Levels

Absorption Costing Absorption Costing When 60,000 Units Are Produced When 100,000 Units Are Produced

Direct materials cost . . . . . . . . . . . . $ 4 per unit Direct materials cost . . . . . . . . . . . . . . $ 4 per unit Direct labor cost . . . . . . . . . . . . . . . . 8 per unit Direct labor cost . . . . . . . . . . . . . . . . . 8 per unit Variable overhead cost . . . . . . . . . . . 3 per unit Variable overhead cost . . . . . . . . . . . . . 3 per unit Total variable cost . . . . . . . . . . . . . . . 15 per unit Total variable cost . . . . . . . . . . . . . . . . 15 per unit Fixed overhead Fixed overhead ($600,000/60,000 units) . . . . . . . . 10 per unit ($600,000/100,000 units) . . . . . . . . 6 per unit Total product cost . . . . . . . . . . . . . . $25 per unit Total product cost . . . . . . . . . . . . . . . . $21 per unit

EXHIBIT 6.14 Income under Absorption Costing for Different Production Levels

ICEAGE COMPANY Income Statement (Absorption Costing)

For Year Ended December 31, 2013 [60,000 Units Produced; 60,000 Units Sold]

Sales (60,000 3 $40) . . . . . . . . . . . . . . . . $2,400,000 Cost of goods sold (60,000 3 $25) . . . . . 1,500,000 Gross margin . . . . . . . . . . . . . . . . . . . . . . 900,000 Selling and administrative expenses Variable (60,000 3 $2) . . . $120,000 Fixed . . . . . . . . . . . . . . . . . 200,000 320,000 Net income . . . . . . . . . . . . . $ 580,000

ICEAGE COMPANY Income Statement (Absorption Costing)

For Year Ended December 31, 2013 [100,000 Units Produced; 60,000 Units Sold]

Sales (60,000 3 $40) . . . . . . . . . . . . . . . . $2,400,000 Cost of goods sold (60,000 3 $21) . . . . . 1,260,000 Gross margin . . . . . . . . . . . . . . . . . . . . . . 1,140,000 Selling and administrative expenses Variable (60,000 3 $2) . . $120,000 Fixed . . . . . . . . . . . . . . . . 200,000 320,000 Net income . . . . . . . . . . . . $ 820,000

Common sense suggests that because the company’s variable cost per unit, total fixed costs, and sales are identical in both cases, merely producing more units and creating excess ending inventory should not increase income. Yet, as we see in Exhibit 6.14, income under absorption costing is $240,000 greater if management produces 40,000 more units than necessary and builds up ending inventory. The reason is that $240,000 of fixed overhead (40,000 units 3 $6) is assigned to ending inventory instead of being expensed as cost of goods sold in 2013. This shows that under absorption costing, a manager can report increased income merely by produc- ing more and disregarding whether the excess units can be sold or not.

Manager bonuses are tied to income computed under absorption costing for many compa- nies. Accordingly, these managers may be enticed to increase production that increases income and their bonuses. This incentive problem encourages inventory buildup, which leads to in- creased costs in storage, financing, and obsolescence. If the excess inventory is never sold, it will be disposed of at a loss.

The manager incentive problem can be avoided when income is measured using variable costing. To illustrate, Exhibit 6.15 reports income under variable costing for the same produc- tion levels used in Exhibit 6.14. This demonstrates that managers cannot increase income under variable costing by merely increasing production without increasing sales.

Why is income under absorption costing affected by the production level when that for vari- able costing is not? The answer lies in the different treatment of fixed overhead costs for the two methods. Under absorption costing, fixed overhead per unit is lower when 100,000 units are produced than when 60,000 units are produced, and then fixed overhead cost is allocated to more units—recall Exhibit 6.13. If those excess units produced are not sold, the fixed overhead cost allocated to those units is not expensed until a future period when those units are sold.

Chapter 6 Variable Costing and Analysis 223

Reported income under variable costing, on the other hand, is not affected by production level changes because all fixed production costs are expensed in the year when incurred. Under variable costing, companies increase reported income by selling more units—it is not possible to increase income just by producing more units and creating excess inventory.

ICEAGE COMPANY Income Statement (Variable Costing) For Year Ended December 31, 2013

[60,000 Units Produced; 60,000 Units Sold]

Sales (60,000 3 $40) . . . . . . . . . $2,400,000 Variable expenses Variable production costs (60,000 3 $15) . . . . . . . . . . $900,000 Variable selling and administrative expenses (60,000 3 $2) . . . . . . . . . . . 120,000 1,020,000 Contribution margin . . . . . . . . . . 1,380,000 Fixed expenses Fixed overhead . . . . . . . . . . . . 600,000 Fixed selling and administrative expense . . . . . . . . . . . . . . . . 200,000 800,000 Net income . . . . . . . . . . . . . . . . . $ 580,000

ICEAGE COMPANY Income Statement (Variable Costing) For Year Ended December 31, 2013

[100,000 Units Produced; 60,000 Units Sold]

Sales (60,000 3 $40) . . . $2,400,000 Variable expenses Variable production costs (60,000 3 $15) . . . $900,000 Variable selling and administrative expenses (60,000 3 $2) . . . . 120,000 1,020,000 Contribution margin . . . 1,380,000 Fixed expenses Fixed overhead . . . . . 600,000 Fixed selling and administrative expenses . . . . . . . . 200,000 800,000 Net income . . . . . . . . . . $ 580,000

EXHIBIT 6.15 Income under Variable Costing for Different Production Levels

Production Manager Your company produces and sells MP3 players. Due to competition, your company projects sales to be 35% less than last year. In a recent meeting, the CEO expressed concern that top executives may not receive bonuses because of the expected sales decrease. The controller suggests that if the company continues to produce as many units as last year, reported income might achieve the level for bonuses to be paid. Should your company produce excess inventory to maintain income? What ethical issues arise? ■ [Answers follow the chapter’s Summary.]

Decision Ethics

Setting Prices Setting prices for products and services is one of the more complex and important managerial decisions. Although many factors impact pricing, cost is a crucial factor. Cost information from both absorption costing and variable costing can aid managers in pricing.

Over the long run, prices must be high enough to cover all costs, including variable costs and fixed costs, and still provide an acceptable return to owners. For this purpose, absorption cost information is useful because it reflects the full costs that sales must exceed for the company to be profitable. We can use a three-step process to determine product selling prices:

Step 1: Determine the product cost per unit using absorption costing. Step 2: Determine the target markup on product cost per unit. Step 3: Add the target markup to the product cost to find the target selling price.

To illustrate, consider IceAge. Under absorption costing, its product cost is $25 per unit (from Exhibit 6.3). IceAge’s management must then determine a target markup on this product cost. This target markup could be based on industry averages, prices that have been charged in the past, or other information. In addition, this markup must be set high enough to cover selling and administrative expenses (both variable and fixed) that are excluded from product costs. In this example, IceAge targets a markup of 60% of absorption cost. With that information, the company computes a target selling price as in Exhibit 6.16.

P4 Determine product selling price based on absorption costing.

224 Chapter 6 Variable Costing and Analysis

IceAge can use this target selling price as a starting point in setting prices. Management must also consider the level of competition in its industry and customer preferences. If customers are not willing to pay $40 per unit, IceAge must either lower its target markup or find ways to re- duce its costs.

While absorption cost information is useful in setting long-run prices, it can lead to mislead- ing decisions in analyzing special orders. We show how variable cost information can be used to analyze special order decisions in the Decision Analysis at the end of the chapter.

Controlling Costs Every company strives to control costs to be competitive. An effective cost control practice is to hold managers responsible only for their controllable costs. A cost is controllable if a manager has the power to determine or at least markedly affect the amount incurred. Uncontrollable costs are not within the manager’s control or influence. For example, direct materials cost is controllable by a production supervisor. On the other hand, costs related to production capacity are not controllable by that supervisor as that supervisor does not have authority to change fac- tory size or add new machinery. Generally, variable production costs and fixed production costs are controlled at different levels of management. Similarly, variable selling and administrative costs are usually controlled at a level of management different from that which controls fixed selling and administrative costs.

Under absorption costing, both variable production costs and fixed production costs are in- cluded in product cost. This makes it difficult to evaluate the effectiveness of cost control by different levels of managers. Variable costing separates the variable costs from fixed costs and, therefore, makes it easier to identify and assign control over costs.

Decisions to change a company’s fixed costs are usually assigned to higher-level managers. This is different from most variable costs that are assigned to lower-level managers and supervi- sors. When we separately report variable and fixed cost elements, as is done with an income statement in the contribution format, it highlights the impact of each cost element for income. This makes it easier for us to identify problem areas and to take cost control measures by ap- propriate levels of management. This approach is also useful in evaluating the performance of managers of different segments within a company.

EXHIBIT 6.16 Determining Selling Price with Absorption Costing

Step 1 Absorption cost per unit (from Exhibit 6.3) . . . . . . . . . . $25 Step 2 Target markup per unit ($25 3 60%) . . . . . . . . . . . . . . . 15 Step 3 Target selling price per unit . . . . . . . . . . . . . . . . . . . . . . . $40

Internal Auditor Your company uses absorption costing for preparing its GAAP-based income statement and balance sheet. Management is disappointed because its external auditors are requiring it to write off an inventory amount because it exceeds what the company could reasonably sell in the foreseeable future. Why would man- agement produce more than it sells? Why would management be disappointed about the write-off? ■ [Answers follow the chapter’s Summary.]

Decision Maker

CVP Analysis The previous chapter discussed cost-volume-profit (CVP) analysis for making managerial deci- sions. If the income statement is prepared under variable costing and presented in the contribu- tion format, the data needed for CVP analysis are readily available. However, if the income statement is prepared under absorption costing, the data needed for CVP analysis are not readily available. Thus, if absorption costing is used, substantial effort is needed to reclassify cost data in order to conduct CVP analysis.

Limitations of Reports Using Variable Costing An important generally accepted accounting principle is that of matching. Most managers interpret the matching principle as expensing all manufacturing costs, both variable and

Chapter 6 Variable Costing and Analysis 225

fixed, in the period when the related product is sold rather than when costs are incurred. Thus, and despite the many useful applications and insights provided by variable cost re- ports, absorption costing is the only acceptable basis for external reporting under both U.S. GAAP and IFRS. Also, as we discussed, top executives are often awarded bonuses based on income computed using absorption costing. For income tax purposes, absorption costing is the only acceptable basis for filings with the Internal Revenue Service (IRS) under the Tax Reform Act of 1986. These realities contribute to the widespread use of absorption costing by companies.

Variable Costing for Service Firms Although this chapter’s examples used data for a manufacturer, variable costing also applies to service companies. Since service companies do not produce inventory, the differences in income from absorption and variable costing shown for a manufacturer do not apply. Still, a focus on variable costs can be useful in managerial decisions for service firms. One example is “special order” pricing for airlines when they sell tickets a day or so before a flight at deeply discounted prices. Provided the discounted price exceeds variable costs, such sales increase contribution margin and net income.

QC3

Pricing Special Orders Decision Analysis

A1 Use variable costing in pricing special orders.

Over the long run, prices must cover all fixed and variable costs. Over the short run, however, fixed pro- duction costs such as the cost to maintain plant capacity do not change with changes in production levels. With excess capacity, increases in production levels would increase variable production costs, but not fixed costs. This implies that while managers try to maintain the long-run price on existing orders, which covers all production costs, managers should accept special orders provided the special order price ex- ceeds variable cost. To illustrate, let’s return to the data of IceAge Company. Recall that its variable production cost per unit is $15 and its total production cost per unit is $25 (at production level of 60,000 units). Assume that it receives a special order for 1,000 pairs of skates at an offer price of $22 per pair from a foreign skating school. This special order will not affect IceAge’s regular sales and its plant has excess capacity to fill the order.

U.S. multinational companies must change their business pro- cesses when moving their operations to international locations. These changes can impact the company’s cost structure. For example, both McDonald’s and Yum Brands offer delivery services in major international cities like Beijing (China) and Seoul (South Korea). Cities like these are heavily populated and real estate costs are high. These factors discourage the building of drive-through facilities, which would increase fixed overhead costs. Fixed overhead costs also fall as these compa- nies process more orders over the Internet and thus build fewer call centers. As fixed overhead costs decrease, the difference in net income that would result from applying variable costing versus absorption costing also decreases.

Sustainability and Accounting Happy Family Brands’s focus on sustainability extends beyond organic raw materials to the packaging of its products. Many of the com- pany’s packaging materials are made from recyclable materi- als. Such materials increase variable costs but are consistent with the company’s philosophy.

GLOBAL VIEW

©Krzystztof Dydynski/Getty Images/Lonely Planet Images

Navaroli Company began operations on January 5, 2014. Cost and sales information for its first two cal- endar years of operations are summarized below.

COMPREHENSIVE

NEED-TO-KNOW

226 Chapter 6 Variable Costing and Analysis

Drawing on absorption costing information, we observe that cost is $25 per unit and that the special order price is $22 per unit. These data would suggest that management reject the order as it would lose $3,000, computed as 1,000 units at $3 loss per pair ($22 2 $25). However, closer analysis suggests that this order should be accepted. This is because the $22 order price exceeds the $15 variable cost of the product. Specifically, Exhibit 6.17 reveals that the incremental revenue from accepting the order is $22,000 (1,000 units at $22 per unit), whereas the incremental produc- tion cost of the order is $15,000 (1,000 units at $15 per unit) and the incremental variable selling and ad- ministrative cost is $2,000 (1,000 units at $2 per unit). Thus, both its contribution margin and net income would increase by $5,000 from accepting the order. Variable costing reveals this profitable opportunity while absorption costing hides it.

Point: Use of relevant costs in special order and other manage- rial decisions is covered more extensively in a later chapter.

EXHIBIT 6.17 Computing Incremental Income for a Special Order

Rejecting Special Order Accepting Special Order

Incremental sales . . . . . . . . . $ 0 Incremental sales (1,000 3 $22) . . . . . . . . . . . . . . . . . . . . . . $22,000 Incremental costs . . . . . . . . 0 Incremental costs Variable production cost (1,000 3 $15) . . . . . . . . . . . . . . 15,000 Variable selling and admin. expense (1,000 3 $2) . . . . . . . 2,000 Incremental income . . . . . . $ 0 Incremental income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,000

The reason for increased income from accepting the special order lies in the different behavior of variable and fixed production costs. We see that if the order is rejected, only variable costs are saved. Fixed costs, on the other hand, do not change in the short run regardless of rejecting or accepting this order. Since in- cremental revenue from the order exceeds incremental costs (only variable cost in this case), accepting the special order increases company income.

Point: Fixed overhead costs won’t increase when these ad- ditional units are sold because the company already has the capacity.

Manufacturing costs Production and sales data Direct materials . . . . . . . . . . . . . . . . . . $80 per unit Units produced, 2014 . . . . . . . . . . . 200,000 units Direct labor . . . . . . . . . . . . . . . . . . . . . $120 per unit Units sold, 2014 . . . . . . . . . . . . . . . . 140,000 units Factory overhead costs for the year Units in ending inventory, 2014 . . . 60,000 units Variable overhead . . . . . . . . . . . . . . $30 per unit Units produced, 2015 . . . . . . . . . . . 80,000 units Fixed overhead. . . . . . . . . . . . . . . . . $14,000,000 Units sold, 2015 . . . . . . . . . . . . . . . . 140,000 units Nonmanufacturing costs Units in ending inventory, 2015 . . . 0 units Variable selling and administrative . . . $10 per unit Sales price per unit . . . . . . . . . . . . . $600 per unit Fixed selling and administrative . . . . . $ 8,000,000

Required

1. Prepare an income statement for the company for 2014 under absorption costing. 2. Prepare an income statement for the company for 2014 under variable costing. 3. Explain the source(s) of the difference in reported income for 2014 under the two costing methods. 4. Prepare an income statement for the company for 2015 under absorption costing. 5. Prepare an income statement for the company for 2015 under variable costing. 6. Prepare a schedule to convert variable costing income to absorption costing income for each of the

years 2014 and 2015. Use the format in Exhibit 6.12.

Chapter 6 Variable Costing and Analysis 227

PLANNING THE SOLUTION Set up a table to compute the unit cost under the two costing methods (refer to Exhibit 6.3). Prepare an income statement under both of the two costing methods (refer to Exhibit 6.6). Consider differences in the treatment of fixed production costs for the income statement to answer re-

quirements 3 and 6.

SOLUTION Before the income statement for 2014 is prepared, unit costs for 2014 are computed under the two costing methods as follows.

Production Cost Per Unit

Absorption Costing Variable Costing

Direct materials . . . . . . . . . . . . . . . . . . . . $ 80 $ 80 Direct labor. . . . . . . . . . . . . . . . . . . . . . . . 120 120 Overhead Variable overhead . . . . . . . . . . . . . . . . . 30 30 Fixed overhead* . . . . . . . . . . . . . . . . . . 70 — Total production cost per unit . . . . . . . . $300 $230

*Fixed overhead per unit 5 $14,000,000 4 200,000 units 5 $70 per unit.

NAVAROLI COMPANY Income Statement (Absorption Costing)

For Year Ended December 31, 2014

Sales (140,000 3 $600) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $84,000,000 Cost of goods sold (140,000 3 $300) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42,000,000 Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42,000,000 Selling and administrative expenses ($1,400,000 1 $8,000,000) . . . . . . . . . 9,400,000 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $32,600,000

NAVAROLI COMPANY Income Statement (Variable Costing) For Year Ended December 31, 2014

Sales (140,000 3 $600) . . . . . . . . . . . . . . . . . . . . . . . . . . . $84,000,000 Variable expenses Variable production costs (140,000 3 $230) . . . . . . . . . $32,200,000 Variable selling and administrative costs. . . . . . . . . . . . . 1,400,000 33,600,000 Contribution margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,400,000 Fixed expenses Fixed overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,000,000 Fixed selling and administrative . . . . . . . . . . . . . . . . . . . 8,000,000 22,000,000 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $28,400,000

3. Income under absorption costing is $4,200,000 more than that under variable costing even though sales are identical for each. This difference is due to the different treatment of fixed overhead cost. Under variable costing, the entire $14,000,000 of fixed overhead is expensed on the 2014 income statement. However, under absorption costing, $70 of fixed overhead cost is allocated to each of the 200,000 units produced. Since there were 60,000 units unsold at year-end, $4,200,000 (60,000 units 3 $70 per unit) of fixed overhead cost allocated to these units will be carried on its balance sheet in ending inventory. Consequently, reported income under absorption costing is $4,200,000 higher than variable costing income for the current period.

1. Absorption costing income statement for 2014.

2. Variable costing income statement for 2014.

228 Chapter 6 Variable Costing and Analysis

Before the income statement for 2015 is prepared, unit costs for production in 2015 are computed under the two costing methods as follows.

4. Absorption costing income statement for 2015.

NAVAROLI COMPANY Income Statement (Absorption Costing)

For Year Ended December 31, 2015

Sales (140,000 3 $600) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $84,000,000 Cost of goods sold From beginning inventory (60,000 3 $300) . . . . . . . . . . . . . . . . . . . . . . . $18,000,000 Produced during the year (80,000 3 $405) . . . . . . . . . . . . . . . . . . . . . . . 32,400,000 50,400,000 Gross margin. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33,600,000 Selling and administrative expenses ($1,400,000 1 $8,000,000) . . . . . . . . . 9,400,000 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $24,200,000

5. Variable costing income statement for 2015.

NAVAROLI COMPANY Income Statement (Variable Costing) For Year Ended December 31, 2015

Sales (140,000 3 $600) . . . . . . . . . . . . . . . . . . . . . . . . . . . $84,000,000 Variable expenses Variable production costs (140,000 3 $230) . . . . . . . . . $32,200,000 Variable selling and administrative costs. . . . . . . . . . . . . 1,400,000 33,600,000 Contribution margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,400,000 Fixed expenses Fixed overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,000,000 Fixed selling and administrative . . . . . . . . . . . . . . . . . . . 8,000,000 22,000,000 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $28,400,000

6. Conversion of variable costing income to absorption costing income.

2014 2015

Variable costing income. . . . . . . . . . . . . . . . . . . . . . . . . . . . $28,400,000 $28,400,000 Add: Fixed overhead cost deferred in ending inventory (60,000 3 $70) . . . . . . . . . . . . . 4,200,000 0 Less: Fixed overhead cost recognized from beginning inventory (60,000 3 $70) . . . . . . . . 0 (4,200,000) Absorption costing income . . . . . . . . . . . . . . . . . . . . . . . . . $32,600,000 $24,200,000

Production Cost Per Unit

Absorption Costing Variable Costing

Direct materials . . . . . . . . . . . . . . . . . . . . $ 80 $ 80 Direct labor. . . . . . . . . . . . . . . . . . . . . . . . 120 120 Overhead Variable overhead . . . . . . . . . . . . . . . . . 30 30 Fixed overhead* . . . . . . . . . . . . . . . . . . 175 Total production cost . . . . . . . . . . . . . . . . $405 $230

*Fixed overhead per unit 5 $14,000,000y80,000 units 5 $175 per unit.

Point: Total income across the two years equals $56,800,000 under both costing methods. This is because the total number of units produced over these two years equals the total number of units sold over these two years.

Chapter 6 Variable Costing and Analysis 229

Absorption costing (also called full costing)

Contribution format Contribution margin income statement Controllable costs

Fixed overhead cost deferred in inventory

Fixed overhead cost recognized from inventory

Manufacturing margin

Uncontrollable costs Variable costing (also called direct or

marginal costing)

Key Terms

C1 Describe how absorption costing can result in overpro-duction. Under absorption costing, fixed overhead costs are allocated to all units including both units sold and units in ending inventory. Consequently, expenses associated with the fixed overhead allocated to ending inventory are deferred to a future period. As a result, the larger ending inventory is, the more overhead cost is deferred to the future, and the greater cur- rent period income is.

A1 Use variable costing in pricing special orders. Over the short run, fixed production costs such as cost of maintain- ing plant capacity do not change with changes in production levels. When there is excess capacity, increases in production levels would only increase variable costs. Thus, managers should accept special orders as long as the order price is greater than the variable cost. This is because accepting the special order would increase only variable costs.

P1 Compute unit cost under both absorption and variable costing. Absorption cost per unit includes direct materials, direct labor, and all overhead, whereas variable cost per unit in- cludes direct materials, direct labor, and only variable overhead.

P2 Prepare and analyze an income statement using ab-sorption costing and using variable costing. The vari- able costing income statement differs from the absorption

costing income statement in that it classifies expenses based on cost behavior rather than function. Instead of gross margin, the variable costing income statement shows contribution margin. This contribution margin format focuses attention on the rela- tion between costs and sales that is not evident from the absorp- tion costing format. Under absorption costing, some fixed overhead cost is allocated to ending inventory and is carried on the balance sheet to the next period. However, all fixed costs are expensed in the period incurred under variable costing. Consequently, absorption costing income is generally greater than variable costing income if units produced exceed units sold, and conversely.

P3 Convert income under variable costing to the absorp-tion cost basis. Variable costing income can be adjusted to absorption costing income by adding the fixed cost allocated to ending inventory and subtracting the fixed cost previously allocated to beginning inventory.

P4 Determine product selling price based on absorption costing. Target selling prices can be determined by adding a markup to the total product cost under absorption costing. The markup should be enough to cover selling and administrative expenses, provide for a target profit, and yield a competitive price.

Summary

Production Manager Under absorption costing, fixed pro- duction costs are spread over all units produced. Thus, fixed cost for each unit will be lower if more units are produced because the fixed cost is spread over more units. This means the company can increase income by producing excess units even if sales re- main constant. With sales lagging, producing excess inventory leads to increased financing cost and inventory obsolescence. Also, producing excess inventory to meet income levels for bo- nuses harms company owners and is unethical. You must discuss this with the appropriate managers.

Internal Auditor If manager bonuses are tied to income, they would have incentives to increase income for personal gain. If absorption costing is used to determine income, management can reduce current period expenses (and raise income) with over- production, which shifts fixed production costs to future periods. This decision fails to consider whether there is a viable market for all units that are produced. If there is not, an auditor can con- clude that the inventory does not have “future economic value” and pressure management to write it off. Such a write-off reduces income by the cost of the excess inventory.

Guidance Answers to Decision Maker and Decision Ethics

230 Chapter 6 Variable Costing and Analysis

Icon denotes assignments that involve decision making.

1. What costs are normally included in product costs under variable costing?

2. What costs are normally included in product costs under absorption costing?

3. When units produced exceed units sold for a reporting period, would income under variable costing be greater than, equal to, or less than income under absorption cost- ing? Explain.

4. Describe how the following items are computed: a. Gross margin, and b. Contribution margin.

5. How can absorption costing lead to incorrect short-run pricing decisions?

6. What conditions must exist to achieve accurate short-run pricing decisions using variable costing?

7. Describe the usefulness of variable costing for control- ling company costs.

8. Describe how use of absorption costing in determining income can lead to overproduction and a buildup of inven- tory. Explain how variable costing can avoid this same problem.

9. What are the major limitations of variable costing?

10. Google uses variable costing for several business decisions. How can variable costing income statements be converted to absorp- tion costing?

11. Explain how contribution margin analysis is useful for managerial decisions and performance evaluations.

12. Samsung’s managers rely on re- ports of variable costs. How can variable costing reports prepared using the contribution margin format help managers in computing break-even vol- ume in units?

13. Assume that Apple has received a special order from a retailer for 1,000 specially out- fitted iPads. This is a one-time order, which will not require any additional capacity or fixed costs. What should Apple consider when determining a selling price for these iPads?

14. How can Samsung use variable costing to help better understand its operations and to make better pricing decisions?

Discussion Questions

GOOGLE

Samsung

Samsung

APPLE

Multiple Choice Quiz Answers at end of chapter

Answer questions 1 and 2 using the following company data.

1. Product cost per unit under absorption costing is: a. $11 d. $15 b. $12 e. $16 c. $14

2. Product cost per unit under variable costing is: a. $11 d. $15 b. $12 e. $16 c. $14

3. Under variable costing, which costs are included in product cost? a. All variable product costs, including direct materials,

direct labor, and variable overhead.

Units produced . . . . . . . . . . . . . . . . . . . . . . . . . 1,000 Variable costs Direct materials . . . . . . . . . . . . . . . . . . . . . . . $3 per unit Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . $5 per unit Variable overhead. . . . . . . . . . . . . . . . . . . . . . $3 per unit Variable selling and administrative . . . . . . . . . $1 per unit Fixed overhead. . . . . . . . . . . . . . . . . . . . . . . . $3,000 total Fixed selling and administrative . . . . . . . . . . . $1,000 total

b. All variable and fixed allocations of product costs, in- cluding direct materials, direct labor, and both variable and fixed overhead.

c. All variable product costs except for variable overhead.

d. All variable and fixed allocations of product costs, ex- cept for both variable and fixed overhead.

4. The difference between product cost per unit under absorption costing as compared to that under variable costing is: a. Direct materials and direct labor. b. Fixed and variable portions of overhead. c. Fixed overhead only. d. Variable overhead only.

5. When production exceeds sales, which of the following is true? a. No change occurs to inventories for either absorption

costing or variable costing methods. b. Use of absorption costing produces a higher net income

than the use of variable costing. c. Use of absorption costing produces a lower net income

than the use of variable costing. d. Use of absorption costing causes inventory value to

decrease more than it would through the use of variable costing.

Chapter 6 Variable Costing and Analysis 231

Refer to Vijay Company’s data in QS 6-1. Compute its production cost per unit under variable costing. QS 6-2 Computing unit cost under variable costing P1

Refer to the information about Ramort Company in QS 6-5. If Ramort doubles its production to 40,000 units while sales remain at the current 20,000-unit level, by how much would the company’s gross margin increase or decrease under absorption costing?

QS 6-6 Absorption costing and gross margin P2

Refer to the information about Ramort Company in QS 6-5. Compute contribution margin under variable costing.

QS 6-7 Variable costing and contribution margin P2

Refer to the information about Ramort Company in QS 6-5. If Ramort doubles its production to 40,000 units while sales remain at the current 20,000-unit level, by how much would the company’s contribution margin increase or decrease under variable costing?

QS 6-8 Variable costing and contribution margin P2

Aces Inc., a manufacturer of tennis rackets, began operations this year. The company produced 6,000 rackets and sold 4,900. Each racket was sold at a price of $90. Fixed overhead costs are $78,000 and fixed selling and administrative costs are $65,200. The company also reports the following per unit costs for the year. Prepare an income statement under variable costing.

QS 6-3 Variable costing income statement P2

Variable production costs . . . . . . . . . . . . . . . . . . . . . . . $25.00 Variable selling and administrative expenses . . . . . . . . . 2.00

Ramort Company reports the following cost data for its single product. The company regularly sells 20,000 units of its product at a price of $60 per unit. Compute gross margin under absorption costing.

QS 6-5 Absorption costing and gross margin

P2Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . $10 per unit Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $12 per unit Overhead costs for the year Variable overhead. . . . . . . . . . . . . . . . . . . . . . . $3 per unit Fixed overhead per year . . . . . . . . . . . . . . . . . $40,000 Selling and adminstrative costs for the year Variable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2 per unit Fixed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $65,200 Normal production level (in units) . . . . . . . . . . . 20,000 units

Aces Inc., a manufacturer of tennis rackets, began operations this year. The company produced 6,000 rackets and sold 4,900. Each racket was sold at a price of $90. Fixed overhead costs are $78,000 and fixed selling and administrative costs are $65,200. The company also reports the following per unit costs for the year. Prepare an income statement under absorption costing.

QS 6-4 Absorption costing income statement P2

Variable production costs . . . . . . . . . . . . . . . . . . . . . . . $25.00 Variable selling and administrative expenses . . . . . . . . . 2.00

QUICK STUDY

QS 6-1 Computing unit cost under absorption costing

P1

Vijay Company reports the following information regarding its production costs. Compute its production cost per unit under absorption costing.

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . $10 per unit Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $20 per unit Overhead costs for the year Variable overhead . . . . . . . . . . . . . . . . . . . . . . . $10 per unit Fixed overhead . . . . . . . . . . . . . . . . . . . . . . . . . $160,000 Units produced . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 units

232 Chapter 6 Variable Costing and Analysis

QS 6-9 Computing manufacturing margin P2

D’Souza Company sold 10,000 units of its product at a price of $80 per unit. Total variable cost is $50 per unit, consisting of $40 in variable production cost and $10 in variable selling and administrative cost. Compute the manufacturing (production) margin for the company under variable costing.

QS 6-10 Computing contribution margin P2

D’Souza Company sold 10,000 units of its product at a price of $80 per unit. Total variable cost is $50 per unit, consisting of $40 in variable production cost and $10 in variable selling and administrative cost. Compute the contribution margin.

QS 6-12 Converting variable costing income to absorption costing income

P3

Ming Company had net income of $772,200 based on variable costing. Beginning and ending inventories were 7,800 units and 5,200 units, respectively. Assume the fixed overhead per unit was $3.00 for both the beginning and ending inventory. What is net income under absorption costing?

QS 6-13 Converting variable costing income to absorption costing income

P3

Mortech had net income of $250,000 based on variable costing. Beginning and ending inventories were 50,000 units and 48,000 units, respectively. Assume the fixed overhead per unit was $0.75 for both the beginning and ending inventory. What is net income under absorption costing?

QS 6-14 Converting variable costing income to absorption costing income P3

Hong Co. had net income of $386,100 under variable costing. Beginning and ending inventories were 2,600 units and 3,900 units, respectively. Fixed overhead cost was $4.00 per unit for both the beginning and ending inventory. What is net income under absorption costing?

QS 6-15 Converting variable costing income to absorption costing income P3

E-Com had net income of $130,000 under variable costing. Beginning and ending inventories were 1,200 units and 4,900 units, respectively. Fixed overhead cost was $2.50 per unit for both the beginning and end- ing inventory. What is net income under absorption costing?

1. Convert this company’s variable costing income statement to an absorption costing income statement. 2. Explain the difference in income between the variable costing and absorption costing income statement.

QS 6-11 Converting variable costing income to absorption costing

P3

Diaz Company reports the following variable costing income statement for its single product. This com- pany’s sales totaled 50,000 units, but its production was 80,000 units. It had no beginning finished goods inventory for the current period.

DIAZ COMPANY Income Statement (Variable Costing)

Sales (50,000 units 3 $60 per unit) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,000,000 Variable expenses Variable manufacturing expense (50,000 units 3 $28 per unit) . . . . . . . . . . . . 1,400,000 Variable selling and admin. expense (50,000 units 3 $5 per unit) . . . . . . . . . . 250,000 Total variable expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,650,000 Contribution margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,350,000 Fixed expenses Fixed overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320,000 Fixed selling and administrative expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160,000 Total fixed expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 480,000 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 870,000

Chapter 6 Variable Costing and Analysis 233

1. Compute the company’s total production cost per unit if 12,500 units had been produced. 2. Why might a manager of a company using absorption costing produce more units than can currently

be sold?

Under absorption costing a company had the following per unit costs when 10,000 units were produced. QS 6-16 Absorption costing and overproduction

C1 Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2 Direct material . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 Variable overhead. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 Total variable cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 Fixed overhead ($50,000/10,000 units) . . . . . . . . . . . . . . . . . . . . 5 Total production cost per unit . . . . . . . . . . . . . . . . . . . . . . . . . . . $14

A manufacturer reports the following information on its product. Compute the target selling price per unit under absorption costing.

QS 6-17 Absorption costing and product pricing

P4Direct materials cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . $50 per unit Direct labor cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $12 per unit Variable overhead cost . . . . . . . . . . . . . . . . . . . . . . . . . . . $6 per unit Fixed overhead cost. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2 per unit Target markup . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40%

Exercise 6-2 Computing unit and inventory costs under variable costing P2

Refer to the information in Exercise 6-1. Assume instead that Trio Company uses variable costing. 1. Compute the cost per unit using variable costing. 2. Determine the cost of ending finished goods inventory using variable costing. 3. Determine the cost of goods sold using variable costing.

Check (1) Variable cost per unit, $35

QS 6-18 Special order pricing

C2

Li Company produces a product that sells for $84 per unit. A customer contacts Li and offers to purchase 2,000 units of its product at a price of $68 per unit. Variable production costs with this order would be $30 per unit, and variable selling expenses would be $18 per unit. Assuming that this special order would not require any additional fixed costs, and that Li has sufficient capacity to produce the product without af- fecting regular sales, explain to Li’s management why it might be a good decision to accept this special order.

EXERCISES

Exercise 6-1 Computing unit and inventory costs under absorption costing

P1

Trio Company reports the following information for the current year, which is its first year of operations.

1. Compute the cost per unit using absorption costing. 2. Determine the cost of ending finished goods inventory using absorption costing. 3. Determine the cost of goods sold using absorption costing.

Check (1) Absorption cost per unit, $43

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $15 per unit Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $16 per unit Overhead costs for the year Variable overhead. . . . . . . . . . . . . . . . . . . . . . . . . . $ 80,000 per year Fixed overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . $160,000 per year Units produced this year . . . . . . . . . . . . . . . . . . . . . . 20,000 units Units sold this year . . . . . . . . . . . . . . . . . . . . . . . . . . 14,000 units Ending finished goods inventory in units . . . . . . . . . 6,000 units

234 Chapter 6 Variable Costing and Analysis

Exercise 6-3 Income reporting under absorption costing and variable costing

P2

Sims Company, a manufacturer of tablet computers, began operations on January 1, 2015. Its cost and sales information for this year follows.

Manufacturing costs Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . $40 per unit Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $60 per unit Overhead costs for the year Variable overhead. . . . . . . . . . . . . . . . . . . . . . . $3,000,000 Fixed overhead . . . . . . . . . . . . . . . . . . . . . . . . $7,000,000 Selling and administrative costs for the year Variable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 770,000 Fixed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,250,000 Production and sales for the year Units produced . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 units Units sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70,000 units Sales price per unit . . . . . . . . . . . . . . . . . . . . . . . $350 per unit

1. Prepare an income statement for the year using variable costing. 2. Prepare an income statement for the year using absorption costing. 3. Under what circumstance(s) is reported income identical under both absorption costing and variable

costing?

Check (1) Variable costing income, $3,380,000

Exercise 6-5 Absorption costing and variable costing income statements

P2

Rey Company’s single product sells at a price of $216 per unit. Data for its single product for its first year of operations follow. Prepare an income statement for the year assuming (a) absorption costing and (b) variable costing.

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . $20 per unit Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . $28 per unit Overhead costs Variable overhead . . . . . . . . . . . . . . . . . . . . . $ 6 per unit Fixed overhead per year . . . . . . . . . . . . . . . $160,000 per year Selling and administrative expenses Variable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 18 per unit Fixed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $200,000 per year Units produced (and sold) . . . . . . . . . . . . . . . . 20,000 units

Exercise 6-4 Variable costing income statement

P2

Kenzi Kayaking, a manufacturer of kayaks, began operations this year. During this first year, the company produced 1,050 kayaks and sold 800 at a price of $1,050 each. At this first year-end, the company reported the following income statement information using absorption costing.

Additional Information

a. Production cost per kayak totals $500, which consists of $400 in variable production cost and $100 in fixed production cost—the latter amount is based on $105,000 of fixed production costs allocated to the 1,050 kayaks produced.

b. The $230,000 in selling and administrative expense consists of $75,000 that is variable and $155,000 that is fixed.

1. Prepare an income statement for the current year under variable costing. 2. Explain the difference in income between the variable costing and absorption costing income statement.

Sales (800 3 $1,050) . . . . . . . . . . . . . . . . . . . . . . . . . . . . $840,000 Cost of goods sold (800 3 $500) . . . . . . . . . . . . . . . . . 400,000 Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 440,000 Selling and administrative expenses . . . . . . . . . . . . . . . . 230,000 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $210,000

Chapter 6 Variable Costing and Analysis 235

1. Prepare this company’s income statement for its first month of operations under absorption costing. 2. Explain the difference in income between the variable costing and absorption costing income statement.

Hayek Bikes prepares the income statement under variable costing for its managerial reports, and it pre- pares the income statement under absorption costing for external reporting. For its first month of opera- tions, 375 bikes were produced and 225 were sold; this left 150 bikes in ending inventory. The income statement information under variable costing follows.

Exercise 6-6 Absorption costing income statement

P2

Polarix is a retailer of ATVs (all-terrain vehicles) and accessories. An income statement for its Consumer ATV Department for the current year follows. ATVs sell for $3,800 each. Variable selling expenses are $270 per ATV. The remaining selling expenses are fixed. Administrative expenses are 40% variable and 60% fixed. The company does not manufacture its own ATVs; it purchases them from a supplier for $1,830 each.

Exercise 6-8 Contribution margin format income statement

P2

POLARIX Income Statement—Consumer ATV Department

For Year Ended December 31, 2015

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . $646,000 Cost of goods sold . . . . . . . . . . . . . . . 311,100 Gross margin . . . . . . . . . . . . . . . . . . . . 334,900 Operating expenses Selling expenses . . . . . . . . . . . . . . . . $135,000 Administrative expenses . . . . . . . . . 59,500 194,500 Net income . . . . . . . . . . . . . . . . . . . . . $140,400

1. Prepare an income statement for this current year using the contribution margin format. 2. For each ATV sold during this year, what is the contribution toward covering fixed expenses and earn-

ing income? Check (2) $1,560

Sales (225 3 $1,600) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $360,000 Variable production cost (225 3 $625) . . . . . . . . . . . . . . . . . . . . . . . . 140,625 Variable selling and administrative expenses (225 3 $65) . . . . . . . . . . 14,625 Contribution margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204,750 Fixed overhead cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56,250 Fixed selling and administrative expense . . . . . . . . . . . . . . . . . . . . . . . 75,000 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 73,500

Oak Mart, a producer of solid oak tables, reports the following data from its second year of business. Exercise 6-7 Income reporting under absorption costing and variable costing

P2

1. Prepare the current year income statement for the company using variable costing. 2. Prepare the current year income statement for the company using absorption costing. 3. Explain any difference between the two income numbers under the two costing methods in parts 1 and 2.

Check (2) Absorption costing income, $8,749,000

Sales price per unit . . . . . . . . . . . . . . $320 per unit Units produced this year . . . . . . . . . . 115,000 units Units sold this year . . . . . . . . . . . . . . 118,000 units Units in beginning-year inventory . . . 3,000 units Beginning inventory costs Variable (3,000 units 3 $135) . . . . $405,000 Fixed (3,000 units 3 $80) . . . . . . . 240,000 Total . . . . . . . . . . . . . . . . . . . . . . . . $645,000

Manufacturing costs this year Direct materials . . . . . . . . . . . . . . . . . . $40 per unit Direct labor . . . . . . . . . . . . . . . . . . . . . $62 per unit Overhead costs this year Variable overhead. . . . . . . . . . . . . . . $3,220,000 Fixed overhead . . . . . . . . . . . . . . . . $7,400,000 Selling and adminstrative costs this year Variable . . . . . . . . . . . . . . . . . . . . . . . . $1,416,000 Fixed . . . . . . . . . . . . . . . . . . . . . . . . . . 4,600,000

236 Chapter 6 Variable Costing and Analysis

Exercise 6-10 Computing absorption costing income

P3

A manufacturer reports the information below for three recent years. Compute income for each of the three years using absorption costing.

Year 1 Year 2 Year 3

Variable costing income . . . . . . . . . . . . . . . . . . . . . $110,000 $114,400 $118,950 Beginning finished goods inventory (units) . . . . . . 0 1,200 700 Ending finished goods inventory (units) . . . . . . . . 1,200 700 800 Fixed manufacturing overhead per unit . . . . . . . . . $ 2.50 $ 2.50 $ 2.50

Exercise 6-9 Income statement under absorption costing and variable costing

P1 P2

Cool Sky reports the following costing data on its product for its first year of operations. During this first year, the company produced 44,000 units and sold 36,000 units at a price of $140 per unit.

1. Assume the company uses absorption costing. a. Determine its product cost per unit. b. Prepare its income statement for the year under absorption costing.

2. Assume the company uses variable costing. a. Determine its product cost per unit. b. Prepare its income statement for the year under variable costing.

Check (1a) Absorption cost per unit, $102

(2a) Variable cost per unit, $90

Manufacturing costs Direct materials per unit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $60 Direct labor per unit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $22 Variable overhead per unit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $8 Fixed overhead for the year. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $528,000 Selling and administrative costs Variable selling and administrative cost per unit . . . . . . . . . . . . . . . . . . . . . . $11 Fixed selling and administrative cost per year . . . . . . . . . . . . . . . . . . . . . . . . $105,000

Exercise 6-11 Absorption costing and product pricing

P4

Sirhuds Inc., a maker of smartwatches, reports the information below on its product. The company uses absorption costing and has a target markup of 40% of absorption cost per unit. Compute the target selling price per unit under absorption costing.

Direct materials cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $100 per unit Direct labor cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $30 per unit Variable overhead cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $8 per unit Fixed overhead cost. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $600,000 per year Variable selling and administrative expenses . . . . . . . . . . . . . . . . . . . $3 per unit Fixed selling and administrative expenses . . . . . . . . . . . . . . . . . . . . $120,000 per year Expected production (and sales) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000 units per year

Exercise 6-12 Absorption costing and overproduction

C1

Jacquie Inc. reports the following annual cost data for its single product.

Normal production and sales level . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000 units Sales price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $56.00 per unit Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $9.00 per unit Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $6.50 per unit Variable overhead. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $11.00 per unit Fixed overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $720,000 in total

If Jacquie increases its production to 80,000 units, while sales remain at the current 60,000-unit level, by how much would the company’s gross margin increase or decrease under absorption costing? Assume the company has idle capacity to double current production.

Chapter 6 Variable Costing and Analysis 237

A recent annual report for McDonald’s reports the following operating income for its United States and Europe geographic segments:

Exercise 6-16 Analyzing income growth

P2

Required

1. Is operating income growing faster in the United States or in the Europe segment? Explain. 2. Is the difference in operating income growth due to the use of different costing methods (absorption or

variable costing) in the two geographic segments? Explain.

In $ millions 2013 2012

United States . . . . . . . . . . . . . $3,779 $3,750 Europe . . . . . . . . . . . . . . . . . . 3,371 3,196

The hotel manager received an offer to hold the local Bikers’ Club annual meeting at the hotel in March, which is the hotel’s low season with an occupancy rate of under 50%. The Bikers’ Club would reserve 50 suites for three nights if the hotel could offer a 50% discount, or a rate of $125 per night. The hotel man- ager is inclined to reject the offer because the cost per suite per night is $140. Prepare an analysis of this offer for the hotel manager. Explain (with supporting computations) whether the offer from the Bikers’ Club should be accepted or rejected.

Grand Garden is a luxury hotel with 150 suites. Its regular suite rate is $250 per night per suite. The ho- tel’s cost per night is $140 per suite and consists of the following.

Exercise 6-13 Variable cost analysis for a services company

A1Variable direct labor and materials cost . . . . $ 30 Fixed cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110 Total cost per night per suite . . . . . . . . . . . . . $140

The hotel manager received an offer to hold the Junior States of America (JSA) convention at the hotel in February, which is the hotel’s low season with an occupancy rate of under 45%. JSA would reserve 100 rooms for four nights if the hotel could offer a 50% discount, or a rate of $150 per night. The hotel man- ager is inclined to reject the offer because the cost per room per night is $165. Prepare an analysis of this offer for the hotel manager. Explain (with supporting computations) whether the offer from JSA should be accepted or rejected.

Empire Plaza Hotel is a luxury hotel with 400 rooms. Its regular room rate is $300 per night per room. The hotel’s cost is $165 per night per room and consists of the following.

Exercise 6-14 Variable cost analysis for a services company

A1Variable direct labor and materials cost . . . . $ 40 Fixed cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125 Total cost per night per room. . . . . . . . . . . . $165

MidCoast Airlines provides charter airplane services. In October of this year, the company was operating at 60% of its capacity when it received a bid from the local community college. The college was organiz- ing a Washington, D.C., trip for its international student group. The college budgeted only $30,000 for round-trip airfare. MidCoast Airlines normally charges between $50,000 and $60,000 for such service. MidCoast determined its cost for the round-trip flight to Washington to be $44,000, which consists of the following:

Exercise 6-15 Variable costing for services

A1

Although the manager at MidCoast supports the college’s educational efforts, she could not justify accept- ing the $30,000 bid for the trip given the projected $14,000 loss. Still, she decides to consult with you, an independent financial consultant. Do you believe the airline should accept the bid from the college? Prepare a memorandum, with supporting computations, explaining why or why not.

Variable cost. . . . . . . . . . . . . . . . . . . . . . . $15,000 Fixed cost (allocated). . . . . . . . . . . . . . . . 29,000 Total cost . . . . . . . . . . . . . . . . . . . . . . . . . $44,000

238 Chapter 6 Variable Costing and Analysis

Additional Information

a. Sales and production data for these first two years follow.

b. Variable cost per unit and total fixed costs are unchanged during 2014 and 2015. The company’s $31 per unit product cost consists of the following.

c. Selling and administrative expenses consist of the following.

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5 Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 Variable overhead. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 Fixed overhead ($300,000y30,000 units) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 Total product cost per unit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $31

2014 2015

Variable selling and administrative expenses ($2.50 per unit) . . . . . . . . . . . . . $ 50,000 $100,000 Fixed selling and administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 240,000 240,000 Total selling and administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $290,000 $340,000

Required

1. Prepare income statements for the company for each of its first two years under variable costing. 2. Explain any difference between the absorption costing income and the variable costing income for

these two years.

Check (1) 2014 net loss, $(90,000)

2014 2015

Units produced . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000 30,000 Units sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 40,000

Problem 6-2A Variable costing income statement and conversion to absorption costing income

P2 P3

Trez Company began operations this year. During this first year, the company produced 100,000 units and sold 80,000 units. The absorption costing income statement for this year follows.

Sales (80,000 units 3 $50 per unit) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,000,000 Cost of goods sold Beginning inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 0 Cost of goods manufactured (100,000 units 3 $30 per unit) . . . . . . . . . 3,000,000 Cost of goods available for sale. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000,000 Ending inventory (20,000 3 $30) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600,000 Cost of goods sold. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,400,000 Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,600,000 Selling and administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 530,000 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,070,000

PROBLEM SET A

Problem 6-1A Variable costing income statement and conversion to absorption costing income (two consecutive years)

P2 P3

Dowell Company produces a single product. Its income statements under absorption costing for its first two years of operation follow.

2014 2015

Sales ($46 per unit) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $920,000 $1,840,000 Cost of goods sold ($31 per unit) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 620,000 1,240,000 Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000 600,000 Selling and administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 290,000 340,000 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 10,000 $ 260,000

Chapter 6 Variable Costing and Analysis 239

Additional Information

a. Selling and administrative expenses consist of $350,000 in annual fixed expenses and $2.25 per unit in variable selling and administrative expenses.

b. The company’s product cost of $30 per unit is computed as follows.

Required

1. Prepare an income statement for the company under variable costing. 2. Explain any difference between the income under variable costing (from part 1) and the income reported

above.

Check (1) Variable costing income, $890,000

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5 per unit Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $14 per unit Variable overhead. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2 per unit Fixed overhead ($900,000y100,000 units) . . . . . . . . . . . . . . . . $9 per unit

Blazer Chemical produces and sells an ice-melting granular used on roadways and sidewalks in winter. It annually produces and sells about 100 tons of its granular. In its nine-year history, the company has never reported a net loss. However, because of this year’s unusually mild winter, projected demand for its product is only 60 tons. Based on its predicted production and sales of 60 tons, the company projects the following income statement (under absorption costing).

Problem 6-3A Income reporting, absorption costing, and managerial ethics

P2 C1

Its product cost information follows and consists mainly of fixed cost because of its automated produc- tion process requiring expensive equipment.

Selling and administrative expenses consist of variable selling and administrative expenses of $310 per ton and fixed selling and administrative expenses of $300,000 per year. The company’s president is concerned about the adverse reaction from its creditors and shareholders if the projected net loss is reported. The op- erations manager mentions that since the company has large storage capacity, it can report a net income by keeping its production at the usual 100-ton level even though it expects to sell only 60 tons. The president was puzzled by the suggestion that the company can report income by producing more without increasing sales.

Required

1. Can the company report a net income by increasing production to 100 tons and storing the excess production in inventory? Your explanation should include an income statement (using absorption cost- ing) based on production of 100 tons and sales of 60 tons.

2. Should the company produce 100 tons given that projected demand is 60 tons? Explain, and also refer to any ethical implications of such a managerial decision.

Sales (60 tons at $21,000 per ton) . . . . . . . . . . . . . . . . . . . . . . $1,260,000 Cost of goods sold (60 tons at $16,000 per ton) . . . . . . . . . . 960,000 Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000 Selling and administrative expenses . . . . . . . . . . . . . . . . . . . . . 318,600 Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (18,600)

Variable direct labor and material costs per ton . . . . . . . . . . . . . . $ 3,500 Fixed cost per ton ($750,000 4 60 tons) . . . . . . . . . . . . . . . . . . . . 12,500 Total product cost per ton . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $16,000

PROBLEM SET B

Problem 6-1B Variable costing income statement and conversion to absorption costing income (two consecutive years)

P2 P3

Azule Company produces a single product. Its income statements under absorption costing for its first two years of operation follow.

2014 2015

Sales ($35 per unit) . . . . . . . . . . . . . . . . . . . . . . $1,925,000 $2,275,000 Cost of goods sold ($26 per unit) . . . . . . . . . . 1,430,000 1,690,000 Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . 495,000 585,000 Selling and administrative expenses . . . . . . . . . 465,000 495,000 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 30,000 $ 90,000

240 Chapter 6 Variable Costing and Analysis

Additional Information

a. Sales and production data for these first two years follow:

b. Its variable cost per unit and total fixed costs are unchanged during 2014 and 2015. Its $26 per unit product cost consists of the following.

c. Its selling and administrative expenses consist of the following.

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4 Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 Variable overhead. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 Fixed overhead ($480,000/60,000 units) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 Total product cost per unit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $26

2014 2015

Variable selling and administrative expenses ($3 per unit) . . . . . . . . . . . . . . . . $165,000 $195,000 Fixed selling and administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000 300,000 Total selling and administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $465,000 $495,000

Required

1. Prepare this company’s income statements under variable costing for each of its first two years. 2. Explain any difference between the absorption costing income and the variable costing income for

these two years.

Check (1) 2014 net loss, $(10,000)

2014 2015

Units produced . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000 60,000 Units sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55,000 65,000

Problem 6-2B Variable costing income statement and conversion to absorption costing income

P2 P3

E’Lonte Company began operations this year. During this first year, the company produced 300,000 units and sold 250,000 units. Its income statement under absorption costing for this year follows.

Sales (250,000 units 3 $18 per unit) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,500,000 Cost of goods sold Beginning inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 0 Cost of goods manufactured (300,000 units 3 $7.50 per unit) . . . . . . . 2,250,000 Cost of goods available for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,250,000 Ending inventory (50,000 3 $7.50) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 375,000 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,875,000 Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,625,000 Selling and administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,200,000 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 425,000

Additional Information

a. Selling and administrative expenses consist of $1,200,000 in annual fixed expenses and $4 per unit in variable selling and administrative expenses.

b. The company’s product cost of $7.50 per unit is computed as follows.

Required

1. Prepare the company’s income statement under variable costing. 2. Explain any difference between the company’s income under variable costing (from part 1) and the

income reported above.

Check (1) Variable costing income, $350,000

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2.00 per unit Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2.40 per unit Variable overhead. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1.60 per unit Fixed overhead ($450,000y300,000 units) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1.50 per unit

Chapter 6 Variable Costing and Analysis 241

Chem-Melt produces and sells an ice-melting granular used on roadways and sidewalks in winter. The company annually produces and sells about 300,000 pounds of its granular. In its ten-year history, the company has never reported a net loss. Because of this year’s unusually mild winter, projected demand for its product is only 250,000 pounds. Based on its predicted production and sales of 250,000 pounds, the company projects the following income statement under absorption costing.

Problem 6-3B Income reporting, absorption costing, and managerial ethics

P2 C1

Its product cost information follows and consists mainly of fixed production cost because of its automated production process requiring expensive equipment.

The company’s selling and administrative expenses are all fixed. The president is concerned about the adverse reaction from its creditors and shareholders if the projected net loss is reported. The controller sug- gests that since the company has large storage capacity, it can report a net income by keeping its production at the usual 300,000-pound level even though it expects to sell only 250,000 pounds. The president was puzzled by the suggestion that the company can report a profit by producing more without increasing sales.

Required

1. Can the company report a net income by increasing production to 300,000 pounds and storing the excess production in inventory? Your explanation should include an income statement (using absorp- tion costing) based on production of 300,000 pounds and sales of 250,000 pounds.

2. Should the company produce 300,000 pounds given that projected demand is 250,000 pounds? Explain, and also refer to any ethical implications of such a managerial decision.

Sales (250,000 lbs. at $8 per lb.) . . . . . . . . . . . . . . . . . . . . . . . . $2,000,000 Cost of goods sold (250,000 lbs. at $6.80 per lb.) . . . . . . . . . . 1,700,000 Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000 Selling and administrative expenses. . . . . . . . . . . . . . . . . . . . . . 450,000 Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (150,000)

Variable direct labor and materials costs per pound . . . . . . . . . . . . . $2.00 Fixed production cost per pound ($1,200,000y250,000 lbs.) . . . . . . 4.80 Total product cost per pound . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $6.80

The selling expenses related to these workstations follow.

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $800 per unit Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $400 per unit Variable overhead. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $100 per unit Fixed overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $24,000 per year

Variable selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . . $50 per unit Fixed selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,000 per year

SERIAL PROBLEM Business Solutions

P2 P3

(This serial problem began in Chapter 1 and continues through most of the book. If previous chapter seg- ments were not completed, the serial problem can begin at this point. It is helpful, but not necessary, to use the Working Papers that accompany the book.)

SP 6 Santana Rey expects sales of her line of computer workstation furniture to equal 300 workstations (at a sales price of $3,000) for 2016. The workstations’ manufacturing costs include the following.

Santana is considering how many workstations to produce in 2016. She is confident that she will be able to sell any workstations in her 2016 ending inventory during 2017. However, Santana does not want to overproduce as she does not have sufficient storage space for many more workstations.

Required

1. Compute Business Solutions’s absorption costing income assuming a. 300 workstations are produced. b. 320 workstations are produced.

[continued on next page]

242 Chapter 6 Variable Costing and Analysis

2. Compute Business Solutions’s variable costing income assuming a. 300 workstations are produced. b. 320 workstations are produced.

3. Explain to Santana any differences in the income figures determined in parts 1 and 2. How should Santana use the information from parts 1 and 2 to help make production decisions?

REPORTING IN ACTION P2

Beyond the Numbers

BTN 6-1 Apple’s ending inventory amounts (in $ millions) are shown below:

Required

1. Assume Apple uses variable costing for some of its internal reports. For each of the years 2013 and 2012, would net income based on variable costing be higher, lower, or no different from net income based on absorption costing? Explain.

2. Assume Apple is considering implementing a just-in-time (JIT) inventory system. Would a JIT system increase, decrease, or have no effect on differences in net income between absorption costing and vari- able costing? Explain.

APPLE

BTN 6-2 Apple offers repair service on its products. Assume that Google wants to offer in-home and online services for computer repair and support.

Required

1. What are some of the costs that Google must consider when deciding to offer these additional com- puter services? Are these costs different from what Apple must consider when offering additional new types of repair and support services?

2. Would variable or absorption costing be more useful to Google in analyzing whether repair and sup- port services are profitable?

APPLE

COMPARATIVE ANALYSIS P2

GOOGLE

BTN 6-3 FDP Company produces a variety of home security products. Gary Price, the company’s president, is concerned with the fourth quarter market demand for the company’s products. Unless something is done in the last two months of the year, the company is likely to miss its earnings expectation of Wall Street analysts. Price still remembers when FDP’s earnings were below analysts’ expectation by two cents a share three years ago, and the company’s share price fell 19% the day earnings were announced. In a recent meeting, Price told his top management that something must be done quickly. One proposal by the marketing vice president was to give a deep discount to the company’s major customers to increase the company’s sales in the fourth quar- ter. The company controller pointed out that while the discount could increase sales, it may not help the bot- tom line; to the contrary, it could lower income. The controller said, “Since we have enough storage capacity, we might simply increase our production in the fourth quarter to increase our reported profit.”

Required

1. Gary Price is not sure how the increase in production without a corresponding increase in sales could help boost the company’s income. Explain to Price how reported income varies with respect to production level.

2. Is there an ethical concern in this situation? If so, which parties are affected? Explain.

ETHICS CHALLENGE C1

BTN 6-4 Mertz Chemical has three divisions. Its consumer product division faces strong competition from companies overseas. During its recent teleconference, Ryan Peterson, the consumer product division manager, reported that his division’s sales for the current year were below its break-even point. However, when the division’s annual reports were received, Billie Mertz, the company president, was surprised that the consumer product division actually reported a profit of $264,000. How could this be possible?

Required

Assume that you work in the corporate controller’s office. Write a half-page memorandum to the president explaining how the division can report income even if its sales are below the break-even point.

COMMUNICATING IN PRACTICE P3

2013 2012 2011

Ending inventory . . . . . . . . . $1,764 $791 $776

Chapter 6 Variable Costing and Analysis 243

TAKING IT TO THE NET P2

BTN 6-5 This chapter discussed the variable costing method and how to use variable costing information to make various business decisions. We also can find several websites on variable costing and its business applications.

Required

1. Review the website of Value Based Management at ValueBasedManagement.net. Identify and print the site page on the topic of variable costing (valuebasedmanagement.net/methods_variable_costing.html).

2. What other phrases are used in practice for variable costing? 3. According to this website, what are the consequences of variable costing for profit calculation?

BTN 6-6 This chapter identified several decision contexts in which managers use product cost information.

Required

Break into teams and identify at least one specific decision context in which absorption costing information is more relevant than variable costing information and at least one decision context in which variable cost- ing information is more relevant than absorption costing. Be prepared to discuss your answers in class.

TEAMWORK IN ACTION P4

BTN 6-7 Happy Family Brands, which was launched by entrepreneur Shazi Visram, produces high- quality organic foods for babies, young children, and adults.

Required

1. The founder of Happy Family Brands uses variable costing in her business decisions. If Happy Family Brands used absorption costing, would you expect the company’s income to be more, less than, or about the same as its income measured under variable costing? Explain.

ENTREPRENEURIAL DECISION

P3

BTN 6-8 Visit a local hotel and observe its daily operating activities. The costs associated with some of its activities are variable while others are fixed with respect to occupancy levels.

Required

1. List cost items that are likely variable for the hotel. 2. List cost items that are likely fixed for the hotel. 3. Compare the fixed cost items with variable cost items. Rank costs within each category based on

your perception of which ones you believe are the larger. 4. Based on your observations and the answers to parts 1 through 3, explain why many hotels offer

discounts as high as 50% or more during their low occupancy season.

HITTING THE ROAD A1

BTN 6-9 Assume that Samsung (Samsung.com) is considering offering a service similar to Apple’s iTunes music download store. However, instead of developing the division internally, Samsung is consid- ering buying a company that already offers such services.

Required

Would absorption or variable costing be most useful to Samsung in evaluating whether to acquire an existing business that provides services similar to iTunes? Explain.

GLOBAL DECISION P2

Samsung APPLE

ANSWERS TO MULTIPLE CHOICE QUIZ

1. c; $14, computed as $3 1 $5 1 $3 1 ($3,000y1,000 units). 2. a; $11, computed as $3 1 $5 1 $3 (consisting of all variable product

costs).

3. a 4. c 5. b

Chhappter Preview

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Master Budgets and Performance Planning

Learningg Objjectivvvev s

CONCEPTUAL C1 Describe the benefits of budgeting and

the process of budget administration.

C2 Describe a master budget and the process of preparing it.

ANALYTICAL A1 Analyze expense planning using

activity-based budgeting.

PROCEDURAL P1 Prepare the operating budget

components of a master budget—for a manufacturing company.

P2 Prepare a cash budget.

P3 Prepare budgeted financial statements.

P4 Appendix 7A—Prepare each component of a master budget and link each to the budgeting process—for a merchandising company.

THE MASTER BUDGET

C2 Budget components P1 Operating budgets—including

sales; production; selling; administrative

Direct materials budget

Direct labor budget

Factory overhead budget

Capital expenditures budget

P2 Cash budget

BUDGETED FINANCIAL STATEMENTS

P3 Budgeted income statement Budgeted balance sheet

Using the master budget

A1 Activity-based budgeting P4 Appendix: Master budget—

merchandiser

BUDGET PROCESS AND ADMINISTRATION

C1 Budgeting as a management tool

Benefits of budgeting

Budgeting and human behavior

Budget reporting and timing

Budget committee

“Success is a path . . . you determine how long it is”

—Daniel Gómez Iñiguez

And, the company continues to plan for more growth—into

the United States and ultimately a listing on the Mexican stock

exchange.

Sources: Solben website, January 2015; billionsuccess.com interview, July 21, 2012; Mother Nature Network, April 27, 2012; news.niagara.edu, November 15, 2012

245

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MONTERREY, MEXICO—To fulfill requirements for his high

school degree, Daniel Gómez Iñiguez completed a project on

how to make biodiesel fuel from vegetable oil and animal

fats. “Searching the Internet, I realized it is real easy to make

biodiesel at your home,” explains Daniel. As Daniel’s interest

in making biodiesel grew, he expanded his knowledge by tak-

ing college courses on biodiesel production and joining an

informal biodiesel club. His efforts led to connections with

three partners—Guillermo Colunga, Antonio Lopez, and

Maurico Pareja—and the group started Solben, a company

that sells technology for biodiesel production.

Like most entrepreneurs, the partners faced challenges in

getting their business going. “We regularly entered entrepre-

neurship competitions, knowing we had no chance to win,”

admits Daniel. “The competitions wanted business plans and

budgets, and we didn’t have those. But we learned something

every time.” This continual learning enabled the company to

find a niche by developing technology that can be effective in

a developing economy. “Large plants are costly to build and

expensive to operate,” says Daniel, “but most homegrown

systems produce low-quality fuel. Our system makes high-

quality fuel, even at small volumes, and it is modular, so the

plant can grow as demand grows.”

As Solben grew, budgeting and the budgeting process be-

came increasingly important. Daniel explains that budgets

help formalize business plans and goals and help direct and

monitor employees. Budgeted income statements enable

managers to assess how changes in materials, labor, and

overhead impact the bottom line. As Solben expanded its

sales and its work force grew, the partners began developing

more formal plans and budgets. “Budgeting gives us a plan of

where we want to go,” asserts Daniel. “Still, we must never

stop learning and adapting our plans.” Although budgets are

expressed in monetary terms, Daniel says that “money is not

the only way to measure success. Success is based on the

number of people you can impact in a positive way.”

Daniel offers advice for budding entrepreneuers. “Do some-

thing you are really passionate about. And don’t be afraid

of failure. Failure is positive if you learn from it. Always keep

learning.” In Solben’s case, this emphasis on learning has led to

sales of over $3 million in a recent year, and an over 85 percent

share of Mexico’s market for biodiesel technology production.

Full of Energy

246 Chapter 7 Master Budgets and Performance Planning

BUDGET PROCESS AND ADMINISTRATION Budgeting as a Management Tool An important management objective in large companies is to ensure that activities of all depart- ments contribute to meeting the company’s overall goals. This requires coordination. Budgeting helps to achieve this coordination. The budgeting process coordinates the activities of various departments to meet the company’s overall goals.

Most companies prepare long-term strategic plans spanning 5 to 10 years. They then fine- tune them in medium-term and short-term plans. Long-term strategic plans provide a road map for the future about potential opportunities such as new products, markets, and investments. Medium- and short-term plans are more operational and translate strategic plans into actions. These action plans are fairly concrete and consist of defined objectives and goals.

Short-term financial plans are called budgets and typically cover a one-year period. A budget is a formal statement of a company’s future plans. It is usually expressed in monetary terms because the economic or financial aspects of the business are the primary factors driving man- agement’s decisions. All managers should be involved in budgeting, the process of planning future business actions and expressing them as formal plans. Managers who participate in a budgeting process increase the likelihood of both personal and company success.

Benefits of Budgeting Budgets help fulfill the key managerial functions of planning and controlling. There are several benefits to having a written budget:

A budget focuses on the future opportunities and threats to the organization. This focus on the future is important, because the daily pressures of operating an organization can divert management’s attention to planning. The budgeting system counteracts this tendency by for- malizing the planning process and demanding input. Budgeting makes planning an explicit management responsibility.

The control function requires management to evaluate (benchmark) operations against some norm. Since budgeted performance takes into account important company, industry, and eco- nomic factors, a comparison of actual to budgeted performance provides an effective moni- toring and control system. This evaluation assists management in identifying problems and taking corrective actions if necessary.

An important management objective in large companies is to ensure that the activities of all departments contribute to meeting the company’s overall goals. This requires coordination. Budgeting helps to achieve this coordination across departments.

A written budget is an effective way to communicate management’s specific action plans to all employees. When plans are not written down, conversations can lead to uncertainty and confusion among employees.

Budgets can be used to motivate employees. Budgeted performance levels can provide goals for employees to attain or even exceed. Many companies provide incentives, like cash bo- nuses, for employee performance that meets or exceeds budget goals.

C1 Describe the benefits of budgeting and the process of budget administration.

Decision Insight

Incentive Pay Budgets are important in determining managers’ pay. A recent survey shows that 82% of large companies tie managers’ bonus payments to beating budget goals. For these companies, bonus payments are frequently more than 20% of total manager pay. ■

Budgeting and Human Behavior Budgets provide standards for evaluating performance and can affect the attitudes of employees evaluated by them. Budgeting can be used to create a positive effect on employees’ attitudes, but it can also create negative effects if not properly applied. Budgeted levels of performance, for instance, must be realistic to avoid discouraging employees. Personnel who will be evaluated should be consulted and involved in preparing the budget to increase their commitment to