>Sheet Maximization has been populated in Cells A to H of Q 1. Assuming the company operates months of the year convert the information from Project 2 to annual information for both Standard and Deluxe Boxes.
22
( obtain from Project 2)
12 Boxes sold per month in millions
/unit
VC Costs (FC+VC)
(millions)
0.00
$ 10.00 0.00
$ 50.00 20.00
$ 600.00 0
0
$ – 0 0
$ – 0 $ – 0 $ – 0 .60
$ – 0 $ – 0 .80
$ – 0 $ – 0 $ – 0 $ – 0 $ – 0 $ – 0 $ – 0 $ – 0 .60
$ – 0 $ – 0 $ – 0 12 Price Annual Revenue (millions) Annual VC (millions) Annual FC (millions) Annual Total Costs (millions) $ 30.00 $ 22.00 $ 47.30 $ 47.25 and 1.5 Million Deluxe Boxes per month. With environmental concerns over the use of the materials and techniques to make the Deluxe Boxes the company director is concerned over its longterm feasibility. The marketing manager is convinced that under the current cost allocation Deluxe boxes is the highest contributor to company gross profit. How much profit is made on each product ? Also calculate the Gross Profit percentage for each product. HINT Use the annual information calculated in to complete Question 2. Complete the grey spaces
per month )
9 10.5 18 $ (in millions) $ (in millions) 9 1.5 10.5 108 18 126 Millions Millions below. How much overhead would be allocated to Standard and Deluxe Boxes ( in total and per unit) using this method? Show all supporting calculations. Complete the grey spaces
of Drivers
1,000 Labour Hours 1,000.00 9,000.00 108 18 Question 1 Less: Variable Costs Less: Fixed Costs Box.
18.00 15 Sales Contribution Profit Question 2 18 Total Contribution Profit % Contribution Fixed Costs Project
3 Questions – Report Template
Instructions: Answer the five questions below. They focus entirely on improving the EBITDA of Largo Global Inc. (LGI) based on the information provided in the Excel workbook. Provide support for your reasoning from the readings in Project 3, Step 1, and the discussion in Project 3, Step 3. Be sure to cite your sources in APA 7th ed. style. Provide a detailed response below each question. Use 12-point font and double spacing. Maintain the existing margins in this document. Your final Word document, including the questions, should not exceed 5 pages. Include a title page in addition to the five pages. Any tables and graphs you choose to include are excluded from the five-page limit. Name your document as follows: P3_Final_lastname_Report_date. You must address all five questions and make full use of the information on all tabs. You are strongly encouraged to exceed the requirements by refining your analysis. Consider other tools and techniques that were discussed in the required and recommended reading for Project 3. This means adding an in-depth explanation of what happened in the year for which data was provided to make precise recommendations to LGI.
Title Page Name Course and section number Faculty name Submission date
Questions:
1. How much of the costs were allocated between the standard and deluxe models of the product? Is the marketing manager correct that LGI is making significant margins on the Deluxe Loot Box? Please elaborate on your answer and include evidence from Tab 1 of the Excel workbook. [insert your answer here] 2. The IT manager indicated that splitting the costs, as you have done in the calculations performed in Tab 2, does nothing to improve the bottom line. She said: “The amounts are relatively small and as it all comes from the same pot in the end, there is no need to split the costs, it just creates additional coding categories for the system.” Explain why the calculation performed in Tab 2 is important. In your discussions, also indicate the benefit of accurate costing when trying to improve profit margins. [insert your answer here] 3. Based on the calculations in Tab 3 using ABC, comment on the profits made for each product type. Explain in your report why this has changed under ABC costing. Also indicate which one of the two systems; that is, historical cost or ABC, provides the best answers for decision making to improve cost management to improve EBITDA. [insert your answer here] 4. The marketing manager suggested that to improve EBITDA and increase sales volume, the Deluxe Loot Box should be sold at the same margin as the Standard Loot Box. Base your answers on the ABC calculations performed in Tab 3 to indicate how much Largo will need to charge for the Deluxe Loot Box. Indicate how many Deluxe Loot Boxes the company will have to sell at the new price to break even. Discuss whether changing the price is a viable option for Largo. Provide evidence from the Excel workbook, Tab 4. [insert your answer here] 5. If Largo Global Inc. is unable to sell the Deluxe Loot Box for more than $27.86, discuss possible alternatives. Doing the same thing LGI is already doing is not an option; you must suggest how to improve EBITDA. Discuss the facts that should be considered in determining whether manufacturing the Loot Boxes in-house could lead to a price reduction. No calculations are required for Question 5 [insert your answer here] >Instructions
Largo Global Inc. is a fictious firm that is will be used to allow you to understand the market forces of supply and demand as they impact a company as well as the industry in which the company operates. The company produces two types of boxes, a Standard box and a Deluxe box. These boxes are also produced by many other companies. after reading the instructions, you will chart the supply and demand curves for the two different boxes. In tab 2 you will focus on the price elasticity of demand for these two products. In tab 3 you will determine at what price the company can maximize the profitability of both boxes. 1. In step 2, you will complete this Excel file by placing your answers to the questions in the boxes provided. You may submit this file as the Milestone submission so you can receive feedback on the accuracy of your calculations. 20. Each team member will have three deliverables for the project. First, each team member will complete the Excel spreadsheet. Second, each team member will serve as the team’s primary respondent for one of the five topics and will answer all questions for that topic. Third, team members will serve as the secondary respondent to one of the five topics and submit their answers to the primary for that topic. The primary respondent will coordinate the answers for that topic and submit them to the editor for the team’s Word file. Once the faculty member’s feedback is provided, the primaries will coordinate any changes to the team’s answers to the topic questions. per box
.00
2 1 0.6 0.8 0.4 0.2 1 0.1 0.740 Future Supply and Demand for cardboard boxes 2 0.3 0
0.4 1.6 0.5 0
1.4 0.6 1.2 0.7 0
1 0.8 0.8 0.9 0
0.6 1 0.4 1.1 0
0.2 1.2 0.1 Given: 0
0.872 Future Supply & Demand for Standard Boxes Daily US supply of Standard boxes (in billions of boxes per day) 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 1. 00000000000001 17 17.2 17.399999999999999 17.600000000000001 17.8 18 18.2 18.399999999999999 18.600000000000001 18.8 19 Daily US demand of Standard boxes (in billions of boxes per day) 2 1.8 1.6 1.4 1.2 1 0.8 0.6 0.4 0.2 0.1 17 17.2 17.399999999999999 17.600000000000001 17.8 18 18.2 18.399999999999999 18.60000000 0000001 18.8 19 Billions of Boxes per Day Price per Box Future Supply & Demand for Deluxe Boxes Daily US demand of Deluxe boxes (in billions of boxes per day) 2 1.8 1.6 1.4 1.2 1 0.8 0.6 0.4 0.2 0.1 30 29.5 29 28.5 28 27.5 27 26.5 26 25.5 25 Daily US supply of Deluxe boxes (in billions of boxes per day) 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 1.1000000000000001 1.2 1.3 30 29.5 29 28.5 28 27.5 27 26.5 26 25.5 25 Billions of Boxes per Day Price per Box 1. Based on the information provided in Table 1, create a chart in the space below showing the supply and demand curves for the number of Standard boxes in the United States per day. This information is helpful in knowing how many boxes to produce. After you have examined the graph below, identify the price and quantity at which market equilibrium exists.
2. Based on the information provided in Table 2, create a chart in the space below showing the supply and demand curves for the number of Deluxe boxes in the United States per day. This information is helpful in knowing how many boxes to produce. After you have examined the graph below, identify the price and quantity at which market equilibrium exists. ity
Price % change 8%
98%
Price $ 10.00 $ 10.00 $ 10.00 Quantity Price 17.60 New % change % change Elasticity of Demand 5
Elasticity: Price Elastic Price Revenue (millions) Variable Cost per cardboard box Variable Cost (millions) Fixed cost per month (millions) Monthly Profit (millions) 9.5 $ 18.40 $ 174.80 $ 10.00 $ 95.00 $ 10.00 $ 105.00 $ 69.80 $ 10.00 $ 105.00 $ 10.00 $ 69.80 Quantity Price 5
$28.00 Original $29.00 New % change % change Elasticity of Demand .793%
Elasticity: Price Elastic )
Price Revenue (millions) Variable Cost (millions) Fixed cost per month (millions) Total Cost (Millions) Monthly Profit (millions) $28.00 $ 10.00 00
$ 10.00 0
$ 3.00 00
Quantity Price $27.00 New % change % change Elasticity of Demand Elasticity: Price Elastic Price Revenue (millions) Variable Cost per metal box Variable Cost (millions) Fixed cost per month (millions) Total Cost (Millions) Monthly Profit (millions) 1.35 $29.00 $ 39.15 $ 10.00 $ 3.00 $ 22.65 $ 10.00 $ 16.50 $ 3.00 00
Price Elastic 1. Last month the company sold 10 million of their Standard boxes at an average price of $18.00 per box. This week the company raised the average price to $18.40 per box. The company sold 9.5 million boxes for the month. The variable cost per unit is $10 and the fixed costs are $10 million per month. 2. After reviewing last month’s results, the company decided to lower the price of a Standard box to $17.60. After this change, the volume sold increased to 10.5 million boxes for the month. 3. Last month the company sold 1.55 million Deluxe boxes at an average price of $28 per box. This month the company raised the price to $29 and sold 1.35 million boxes. The variable cost per unit is $10 and the fixed costs are $3 million per month. 4. After reviewing the last results, the company decided to lower the price to $27 and sold 1.65 million boxes for the month.1
In this Project you will analyse managerial and costing information to improve the company’s EBITDA. You will use what you have learned about cost behavior and apply activity-based costing and cost-volume-profit analysis to make recommendations about LGI’s operational productivity. Use Information you calculated in project 2 Tab 3
Profit
12
1
10
Question 1
Profit Maximization
Standard Boxes
Quantity
Price
Revenue
VC
FC / per month (millions)
Total
Daily profit (revenue -all costs)
Annual Revenue (millions)
Annual VC (millions)
Annual FC (millions)
Annual
Total Costs
Annual Profit
5
$ 22.00
$
11
$ 10.00
$ 50.00
$
6
$ 1,320.00
$ 600.00
$ 120.00
$
7
5.5
$ 2
1.6
$ – 0
6
$ 2
1.2
6.5
$ 20.
8
7
$ 20.40
7.5
$ 20.00
8
$ 1
9
8.5
$ 19.20
9
$
18
9.5
$ 18.40
10
$
18.00
10.5
$ 17.60
11
$ 17.20
1
1.5
$ 16.80
12
$ 16.40
12.5
$ 16.00
13
$
15
13.5
$ 15.20
14
$ 14.80
Profit Maximization
Deluxe Boxes
Deluxe boxes sold per month (millions)
Revenue (price x volume)
Variable Cost per standard box
Variable Cost (cost per unit x volume)
Fixed cost per month (millions)
Total Cost (Fixed + Variable)
Daily Profit (revenue – all costs)
Annual Profit (millions)
1
$ 30.00
1.2
$ 29.50
$ 35.40
1.35
$ 29.00
$ 39.15
1.5
$ 28.50
$ 42.75
1.55
$ 28.00
$ 43.40
1.6
$ 27.50
$ 44.00
1.65
$ 27.00
$ 44.55
1.7
$ 26.50
$ 45.05
1.75
$ 26.00
$ 45.50
1.8
$ 25.50
$ 45.90
1.85
$ 25.00
$ 46.25
1.9
$ 24.50
$ 46.55
1.95
$ 24.00
$ 46.80
2
$ 23.50
$ 47.00
2.05
$ 23.00
$ 47.15
2.1
$ 22.50
$ 47.25
2.15
$ 47.30
2.2
$ 21.50
2.25
$ 21.00
Question 2
The Company currently operates by selling 9 Million
Standard Boxes
Question 1
Standard Boxes Deluxe Boxes Total
Number Of Boxes (in
Millions
1,5
Volume per year ( millions)
108
126
$ (in millions)
Revenue
Less:
Variable Costs
Marginal
Contribution
Less:
Fixed Costs
Profit
Profit
%
Sheet2
Question 1
A new intern at the company believes that fixed cost based and allocated on a daily basis is incorrect and suggests allocating the Fixed Costs between Standard and Deluxe Boxes Based on the number of boxes sold. How much costs are allocated to each product based on the method suggested by the intern? To prove s/he point the intern also calculated the profit percentage. Complete the grey spaces
Standard Boxes Deluxe Boxes Total
Volumes (per Month)
Volumes per year ( millions)
Total Fixed Costs (Millions- from Tab1)
New Profit
Sales
Less VC
Contribution Margin
Less Fixed Costs
Operting Profit
Profit %
Sheet3
Question 1
LGI’s production managers recently attended a course at UMGC where they learned about ABC costing. They propose allocating the total fixed costs between Standard and Deluxe boxes based on this method . They collected information about the cost drivers and the break up of the total costs in
Table 1
Table 1
Manufacturing overhead
$ Amount
Cost driver
Standard Box
Deluxe Box
Totals
Cost of
Deluxe Boxes
Cost of Deluxe Boxes
Total Cost Check (must agree to Column B7:B14)
Depreciation
$47.00
Square feet
7,000
80,000
Maintenance
$50.00
Direct
Labour Hours
1,000
9,000
Purchase order processing
$9
Number of purchases orders
500
4,500
Inspection
$34
Number of employees
6000
Indirect Materials
$5.00
1,000.00
9,000.00
Supervision
$7.00
#of inspections
200
800
Supplies
$4.00
Units manufactured
Total Allocated costs
$156.00
Number of boxes per year
Allocated Cost per Box
Deluxe Boxes Deluxe Boxes Total
Sales
Contribution
Profit
Profit %
Sheet4
Question 1
The sustainability manager is concerned about the long term sustainability implications of Deluxe boxes on the environment and suggest changing to sustainable materials for the production of a
Sustainable Deluxe
If the company switches to their current quantity of Deluxe Boxes sold to Sustainable Deluxe Boxes there will be some cost implications.
The Sustainable Deluxe Boxes could be made cheaper, and the sustianability manager believes that the company could bring down the selling price to $15 per box which would entice current Deluxe Box customers to accept the switch over. The new Sustainable Deluxe Boxes will attract 60% of total fixed costs calculated for the Deluxe Boxes under the ABC method. The number of boxes sold will not be affected by this new selling price, as the company will in future have to do marketing to sell more boxes at the lower price. Calculate the new Gross profit and profit percentage. Complete the grey spaces
Standard Boxes Sustainable Deluxe Total
Quantity
108.00
126.00
Sellin price per unit
$ 18.80
VC
Fixed Costs
GP %
The manager is concerned about the massive reduction in profit from the Sustainable Deluxe Boxes but realizes that because of the change in materials, they will no longer be able to charge the price of $18 per box. The manager wants to achieve at least the same profit percentage for the deluxe boxes as they have on standard boxes. How much additional profit are they requiring? Complete the grey spaces.
Required profit
See Tab 3
Less: Existing profit
See Q 1 above
Equals: Difference in additional profit required
Question 3
Work out the percentage that they should mark up on the costs to achieve the same profit % as for the standard boxes. Complete the grey spaces
%
Sales
Less Required GP%
Equals: Mark up percentage on cost
Question 4
Use the percentage calculated in Question 3 to determine how much the company should charge per product to reach the same profit percentage as for the standard boxes . Assume the company can still sell the same quantity of the Sustainable Deluxe Boxes as for the Deluxe Boxes. Complete the grey spaces
Totals
Variable Costs
Fixed Cost
Total Costs
Sales
Units sold
Sales Price per unit
Question 5
Prove that your calculation in Q 4 is correct. Complete the grey boxes.
Proof:
Per Unit
Sales $ – 0
Less VC 12
Fixed Costs
Net Profit
Question 5
The marketing manger is concerned that the change could havea significant impact on sales as ciustomers may see the sustaiable boxes as an inferiror product for which they still have to pay only a little bit less than the orginal price of the Deluxe Boxes. How many boxes would the company have to sell to break even on the new Sustainabale Deluxe Boxes based on the new selling price? Complete the grey boxes.
$ Totals
Selling price
Less: Variable costs
Breakeven Quantity
BreakEven Value
2
In Project 2, you will learn about how to apply the tenets of microeconomics to improve the company’s profitability. In tab
1
Follow these steps to complete Project 2:
2. In step 3, you will answer the questions provided in the Word file for this project that will guide/give direction to your analysis. These questions will constitute the core of your report where you will be asked to make key recommendations.
Project 2 is the team assignment in MBA 6
All team members must submit their three deliverables in order to receive a grade for the project. Your faculty member will let you know how you will submit your deliverables as well as the team’s consolidated Word file which will be graded.
Tab 1 – Supply and Demand Graph
Table 1
Future Supply and Demand for cardboard boxes
Price
Daily US demand of Standard boxes (in billions of boxes per day)
Daily US supply of Standard boxes (in billions of boxes per day)
$1
7
0.1
$17.20
1.
8
0.2
$17.40
1.6
0.3
$
17.60
1.4
0.4
$17.80
1.2
0.
5
$
18.00
0.6
$18.20
0.8
0.7
$
18.40
$18.60
0.
9
$18.80
$19.00
1.1
Question 1:
Create a Supply and Demand Chart for the Standard box below
Given:
Demand Slope
y=-.977x+18.6
Supply Slope
y=.5x-8.4
solve for value of x at intersect
-.977x+18.6=.5x-8.4
add 8.4
-.977x+27=.5x
add .977x
27=1.477x
divide by 1.477
18.280
solve for Y
y=.5(18.28)-8.4
0.740
y=-.977(18.28)+18.6
Equilibrium:
.74 Billion boxes per day, at a price of $18.28 per box
Table 2
Price per box
Daily US demand of Deluxe boxes (in billions of boxes per day)
Daily US supply of Deluxe boxes (in billions of boxes per day)
$30.00
$2
9.5
1.8
$29.00
$2
8.5
$28.00
$2
7.5
$27.00
$2
6.5
$26.00
$2
5.5
$25.00
1.3
Question 2:
Create a Supply and Demand Chart for the deluxe box below
Demand Slope
y=.391x-9.74
Supply Slope
y=-.2x+6.3
solve for value of x at intersect
.391x-9.74=-.2x+6.3
add 9.74
.391x=-.2x+16.04
add .2x
.591x=16.04
divide by .4
11
27.
14
solve for Y y=-.2x+6.3
0.872
y=.391(27.14)-9.74
Equilibrium:
.87 Billion Boxes per Day, at a price of $27.14 per box
10
Tab 2 –
Price Elastic
Price Elasticity
Quantity
10 18.00
Original
9.5 18.40
New
% change
Elasticity of Demand
-5.
12
2.1
2.33
Elasticity:
Price Elastic
By how much did revenues increase or decrease as a result of the change in price?
$ (5.20)
By how much did profits increase or decline?
$ (0.20)
Standard Boxes sold per monthly (millions)
Revenue (millions)
Variable Cost per cardboard box
Variable Cost (millions)
Fixed cost per month (millions)
Total Cost (millions)
Monthly Profit (millions)
10
$ 18.00
$ 180.00
$ 10.00
$ 100.00
$ 110.00
$ 70.00
9.5
$ 18.40
$ 174.80
$ 95.00
$ 105.00
$ 69.80
9.5 18.40 Original
10.5
10.000%
-4.444%
2.2
By how much did revenues increase or decrease as a result of the change in price?
$ (0.80)
By how much did profits increase or decline?
$ – 0
Standard Boxes sold per month (millions)
Total Cost (Millions)
10.5
$ 17.60
$ 184.80
$ 115.00
1.5
1.35
–
13
3.509%
3.93
By how much did revenues increase or decrease as a result of the change in price?
$ (4.25)
By how much did profits increase or decline?
$ (
2.25
Deluxe boxes sold per month (millions)
Variable Cost per metal box
1.55
$ 43.40
$ 15.50
$ 3.00
$ 18.50
$ 24.90
1.35 $29.00
$ 39.15
$
13.5
$ 16.50
$ 22.65
1.35 $29.00 Original
1.65
20.000%
-7.143%
2.80
By how much did revenues increase or decrease as a result of the change in price?
$ 5.40
By how much did profits increase or decline?
$ 2.40
Deluxe boxes sold per month (millions)
$ 13.50
$ 16.5000
1.65 $27.00
$ 44.55
$ 19.50
$ 25.05
Select One
Price Inelastic
Unit Price Elastic
What is the price elasticity of demand?
Can the demand be characterized as price elastic, price inelastic, or neither?
By how much did revenues increase or decrease as a result of the change in price?
By how much did profits increase or decline?
What is the price elasticity of demand?
Can the demand be characterized as price elastic, price inelastic, or neither?
By how much did revenues increase or decrease as a result of the change in price?
By how much did profits increase or decline?
What is the price elasticity of demand?
Can the demand be characterized as price elastic, price inelastic, or neither?
By how much did revenues increase or decrease as a result of the change in price?
By how much did profits increase or decline?
What is the price elasticity of demand?
Can the demand be characterized as price elastic, price inelastic, or neither?
By how much did revenues increase or decrease as a result of the change in price?
By how much did profits increase or decline? Tab 3 –
| Standard boxes sold per month (millions) | Revenue (price x volume) | Variable Cost per standard box | Variable Cost (cost per unit x volume) | Total Cost (Fixed + Variable) | Monthly Profit (revenue – all costs) | MR | MC | Difference | |||||||||||||||||
| $ 22.00 | $ 50.00 | $ 10.00000 | $ 60.00 | ||||||||||||||||||||||
| $ 21.60 | $ 118.80 | $ 55.00 | $ 65.00 | $ 53.80 | $ 7.60 | ||||||||||||||||||||
| $ 21.20 | $ 127.20 | $ 70.0000 | $ 57.20 | $ 16.80 | $ 6.80 | ||||||||||||||||||||
| $ 20.80 | $ 135.20 | $ 75.00 | $ 60.20 | $ 16.00 | $ 6.00 | ||||||||||||||||||||
| $ 20.40 | $ 142.80 | $ 80.00 | $ 62.80 | $ 15.20 | $ 5.20 | ||||||||||||||||||||
| $ 20.00 | $ 150.00 | $ 85.00 | $ 14.40 | $ 4.40 | |||||||||||||||||||||
| $ 19.60 | $ 156.80 | $ 90.00 | $ 66.80 | $ 13.60 | $ 3.60 | ||||||||||||||||||||
| $ 19.20 | $ 163.20 | $ 95.0000 | $ 68.20 | $ 12.80 | $ 2.80 | ||||||||||||||||||||
| $ 18.80 | $ 169.20 | $ 100.0000 | $ 69.20 | $ 12.00 | $ 2.00 | ||||||||||||||||||||
| $ 105.0000 | $ 11.20 | $ 1.20 | |||||||||||||||||||||||
| $ 110.0000 | $ 10.40 | $ 0.40 | |||||||||||||||||||||||
| $ 115.0000 | $ 9.60 | $ (0.40) | |||||||||||||||||||||||
| $ 17.20 | $ 189.20 | $ 120.00 | $ 8.80 | $ (1.20) | |||||||||||||||||||||
| 11.5 | $ 193.20 | $ 125.00 | $ 8.00 | $ (2.00) | |||||||||||||||||||||
| $ 16.40 | $ 196.80 | $ 130.00 | $ 7.20 | $ (2.80) | |||||||||||||||||||||
| 12.5 | $ 200.00 | $ 135.00 | $ 6.40 | $ (3.60) | |||||||||||||||||||||
| $ 15.60 | $ 202.80 | $ 140.00 | $ 5.60 | $ (4.40) | |||||||||||||||||||||
| $ 205.20 | $ 145.0000 | $ 4.80 | |||||||||||||||||||||||
| $ 14.80 | $ 207.20 | $ 150.0000 | $ 4.00 | $ (6.00) | |||||||||||||||||||||
| Standard Boxes priced at $18 | |||||||||||||||||||||||||
| $ 30.00 | $ 3.00000 | $ 13.00 | $ 17.00 | ||||||||||||||||||||||
| $ 29.50 | $ 35.40 | $ 15.00 | $ 27.00 | ||||||||||||||||||||||
| $ 29.00 | $ 25.00 | ||||||||||||||||||||||||
| $ 28.50 | $ 42.75 | $ 18.0000 | $ 24.75 | $ 24.00 | $ 14.00 | ||||||||||||||||||||
| $ 28.00 | |||||||||||||||||||||||||
| $ 27.50 | $ 44.00 | $ 19.00 | |||||||||||||||||||||||
| $ 11.00 | $ 1.00 | ||||||||||||||||||||||||
| 1.7 | $ 26.50 | $ 45.05 | $ 20.0000 | ||||||||||||||||||||||
| 1.75 | $ 26.00 | $ 45.50 | $ 17.50 | $ 20.50 | $ 9.00 | $ (1.00) | |||||||||||||||||||
| $ 25.50 | $ 45.90 | $ 21.00 | |||||||||||||||||||||||
| 1.85 | $ 46.25 | $ 21.50 | $ 7.00 | $ (3.00) | |||||||||||||||||||||
| 1.9 | $ 24.50 | $ 46.55 | $ 22.0000 | $ 24.55 | $ (4.00) | ||||||||||||||||||||
| 1.95 | $ 46.80 | $ 22.50 | $ 24.30 | $ 5.00 | $ (5.00) | ||||||||||||||||||||
| $ 23.50 | $ 47.00 | $ 23.00 | |||||||||||||||||||||||
| 2.05 | $ 47.15 | $ 23.5000 | $ 23.65 | $ (7.00) | |||||||||||||||||||||
| $ 47.25 | $ 24.0000 | $ 23.25 | $ (8.00) | ||||||||||||||||||||||
| 2.15 | $ 47.30 | $ 24.5000 | $ 22.80 | $ (9.00) | |||||||||||||||||||||
| $ 25.0000 | $ 22.30 | $ (10.00) | |||||||||||||||||||||||
| $ 25.5000 | $ 21.75 | $ (11.00) | |||||||||||||||||||||||
| Deluxe Boxes priced at $26.50 |
1. The company views its goal as profit maximization. Complete the table to the right to approximate the profit-maximizing price for the Standard boxes.
What is the closest price that will help the company maximize the profit on Standard boxes?
2. The company views its goal as profit maximization. Complete the table to the right to approximate the profit-maximizing price for the Deluxe boxes.
What is the closest price that will help the company maximize the profit on Deluxe boxes?
Project 3: Costing and Cost Allocations
Start Here
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Transcript
Scenario
In your last business report, you recommended a strategic decision about the revenue target to make LGI competitive. In Project 3, you will help LGI’s leadership move the company forward on a path toward a sustainable future. The company needs to restore the confidence of shareholders and other stakeholders by maintaining a satisfactory level of operating performance.
LGI, like all companies, needs robust earnings before interest, taxes, depreciation, and amortization (EBITDA). In other words, earnings must be sufficient to cover LGI’s investing activities, debt service, and taxes—with a healthy profit left for reinvestment and distributions to stockholders
Your Project 3 business report will focus on strengthening EBITDA. To do this, you will analyze LGI’s cost structure and determine how to increase productivity. These tasks are prerequisites for identifying a future investment (Project 4) and how to finance it (Project 5).
Competencies
Your work will be evaluated using the competencies listed below.
· 3.1: Identify numerical or mathematical information that is relevant in a problem or situation.
· 3.2: Employ mathematical or statistical operations and data analysis techniques to arrive at a correct or optimal solution.
· 3.3: Analyze mathematical or statistical information, or the results of quantitative inquiry and manipulation of data.
· 10.3: Determine optimal financial decisions in pursuit of an organization’s goals.
· 10.5: Develop operating forecasts and budgets and apply managerial accounting techniques to support strategic decisions.
Project 3: Costing and Cost Allocations
Step 1: Prepare for the Project
For the next two weeks, you will focus on the specific actions LGI can take to strengthen its EBITDA. You will analyze cost-volume-profit, pricing decisions, and activity-based costing.
Log into O’Reilly by following these instructions
before accessing the chapters and completing the required reading.
Required Reading
Davis, C. E. & Davis, E. (2011).
Managerial Accounting
. Wiley.
Chapter 3: Cost-Volume-Profit Analysis and Pricing Decisions
· Section 3.1 to 3.3
Chapter 7: Activity-Based Costing and Activity-Based Management
· Sections 7.1–7.2
Recommended Reading
Chapter 2: Cost Behavior and Cost Estimation
· Sections 2.1–2.3
Project 3: Costing and Cost Allocations
Step 2: Review and Practice
Using the
Project 3 Review and Practice Guide
, review EBITDA and cost structures to set LGI on the path toward a sustainable future. Then apply what you have learned by completing the exercises and problems referenced in the Project 3 Review and Practice Guide.
You must review the guide and do the practice exercises and problems so that you
· are prepared to have informed discussions with your team about LGI’s income statement,
· understand what the cost data reveal about operational efficiency, and
· can use this information to make recommendations for improvements.
Complete this review and practice by the end of Week 5.
Review and Practice
You must complete the review and practice content to participate in the discussion in Step 3.
Project 3 Review and Practice Guide
Project 3: Costing and Cost Allocations
Step 3: Participate in the Required Project 3 Discussion
SolStock / E+ / Getty Images
You have finished reviewing the material and performing the exercises, but you have some questions. Participate in the Project 3 class discussion. Respond to the two questions below by posting in the discussion; then, respond to two of your classmates’ discussion posts by the end of the week.
Discussion
Answer the following questions:
1. Discuss the concepts that were most challenging for you in the readings and review material. How did the practice exercises help clarify these?
2. What did you learn that will help you analyze LGI’s cost structure to increase its productivity and put the company on a path to a sustainable future?
Before you participate in the discussion activity see
MBA discussion guidelines
.
Project 3: Costing and Cost Allocations
Step 4: Complete the Analysis Calculation for Project 3
Your team has provided you with an Excel workbook containing LGI’s financials. You will use the workbook to
· Determine how LGI can strengthen EBITDA
· Discover ways for LGI to increase productivity
· Perform cost calculations in the worksheets
Complete the analysis calculation for the project:
· Download the
Project 3 Excel Workbook
, click the Instructions tab, and read the instructions.
· Calculate and evaluate costs using the worksheets.
· If you would like instructor feedback on this step, follow the instructions in the box below to submit your Excel file to the Assignments folder as a milestone by the end of Week 5. This is optional. If you choose to submit the milestone, you will receive instructor feedback you may use to make corrections before submitting your final Project 3. To distinguish the milestone submission from the file you will submit in Step 5, label your file as follows: P3_milestone_lastname_Calculation_date
Take Action
Submit your assignment to your instructor for review and feedback.
Follow these steps to access the assignment:
· Click My Tools in the top navigation bar.
· Click Assignments.
· Select the relevant assignment.
· You should use the comments your instructor made about your optional milestone submission to revise your calculations as needed. Next, proceed to Step 5, where you will answer questions about your analysis, make recommendations for the client, and compile and submit your final report.
Project 3: Costing and Cost Allocations
Step 5: Prepare the Analysis Report for Project 3
Chalirmpoj Pimpisarn / iStock/Getty Images Plus / Getty Images
You have developed an in-depth understanding of LGI’s operating efficiency related to costing and the impact on EBITDA. You feel confident that your target revenue combined with a better mix of fixed and variable costs will positively boost LGI’s productivity, providing the company with a competitive edge. LGI will finally be on a path toward a sustainable future. Answer the questions in the
Project 3 Questions – Report Template
document. Prepare your analysis report including recommendations for how the company can improve its financial situation.
Complete the analysis report for the project:
· Download the Project 3 Questions – Report Template
· Read the instructions.
· Answer all the questions.
· Include your recommendations.
· Submit the analysis report (Word document) and analysis calculation (Excel file) to the Assignments folder as your final deliverable at the end of Week 6. Label your files as follows:
· P3_Final_lastname_Report_date x
· P3_Final_lastname_Calculation_date.xlsx
Check Your Evaluation Criteria
Before you submit your assignment, review the competencies below, which your instructor will use to evaluate your work. A good practice would be to use each competency as a self-check to confirm you have incorporated all of them. To view the complete grading rubric, click My Tools, select Assignments from the drop-down menu, and then click the project title.
· 3.1: Identify numerical or mathematical information that is relevant in a problem or situation.
· 3.2: Employ mathematical or statistical operations and data analysis techniques to arrive at a correct or optimal solution.
· 3.3: Analyze mathematical or statistical information, or the results of quantitative inquiry and manipulation of data.
· 10.3: Determine optimal financial decisions in pursuit of an organization’s goals.
· 10.5: Develop operating forecasts and budgets and apply managerial accounting techniques to support strategic decisions.
COST-VOLUME-PROFIT ANALYSIS AND PRICING DECISIONS..
After studying this chapter, you should be able to meet the following learning objectives (LO)
.
1.
Calculate the breakeven point in units and sales dollars. (Unit 3.1)
2
. C
alculate the level of activity required to meet a target income. (Unit 3.2)
3. Determine the effects of changes in sales price, cost, and volume on operating income. (Unit 3.2)
4. D
efine operating leverage and explain the risks associated with the tradeoff between variable and fixed costs. (Unit 3.2)
5. C
alculate the multiproduct breakeven point and level of activity required to meet a target income. (Unit 3.3)
6. D
efine markup and explain cost-plus pricing. (Unit 3.4)
7
. Explain target costing and calculate a target cost. (Unit 3.4)
The Pitch
Martin Keck, vice president for sales at Universal Sports Exchange, was talking with his sales team at the monthly sales meeting. “As you know, the company missed its sales target last year. We were expecting to sell 10% more jerseys than we did. And we all saw the effect that the lower sales level had on our bottom line. When we miss our sales targets, it affects what everyone else in the company can accomplish because they count on us to generate revenue.”
Sarah Yardley, one of the company’s top salespeople, had been listening intently as Martin discussed the concept of cost behavior. “I think I understand all this talk about cost behavior,” she said, “but I’m still not sure how it plays into my decisions.”
“Sarah,” Martin replied, “we have to use our knowledge of cost behaviors to predict what effect our decisions will have on the bottom line. We know when it is advantageous to, say, initiate a new advertising campaign instead of reducing prices, but to persuade the president and the CFO, we need to have more convincing data, and that includes the financial impact of our decisions. In fact, I’ll be meeting with the president and CFO next week to discuss the relative merits of a $50,000 advertising campaign and a 10% reduction in sales price. You can be sure that I’ll know the financial impact of each alternative before I walk into the meeting.”
Decisions like this one come up frequently in business. Managers of a start-up company want to know how much they will have to sell before they generate a profit. Managers of a company that has been in business for years want to know whether they should pass their
increase
d costs on to customers in the form of a price increase. And in a highly competitive industry, managers of another company want to know what will happen to income if they meet a competitor’s lower price or offer a coupon to increase sales volume. Knowing how these changes will affect a company’s income will help managers to decide which alternatives to implement.
UNIT 3.1 Breakeven Analysis
GUIDED UNIT PREPARATION
Answering the following questions while you read this unit will guide your understanding of the key concepts found in the unit. The questions are linked to the learning objectives presented at the beginning of the chapter.
1. What does it mean to break even? LO 1
2. If a product’s variable cost per unit increases while the selling price and fixed costs remain constant, what will happen to the breakeven point? LO 1
3. How do you calculate the breakeven point in units? In dollars? LO 1
4. What actions can a company take to reduce its breakeven point? LO 1
5. What is the margin of safety? How is it calculated? LO 1
A common question for managers, particularly of start-up ventures, is, “How long will it take us to earn a profit?” Stated another way, what these managers are really asking is, “When will we break even?” Knowing the breakeven point helps managers evaluate the desirability and profitability of various business opportunities.
1
The Breakeven Point
As managers evaluate business opportunities, they examine many factors, including profitability. But before a business can generate a profit, it must generate sufficient revenue to cover all of its expenses. In other words, the business must reach its breakeven point. At the breakeven point, sales revenue is exactly equal to total expenses, and there is no profit or loss. There is only one level of sales at which this relationship is true. Thus, the breakeven point can be calculated using the profit equation. To find the breakeven point, set the standard profit equation equal to zero, let x equal the number of units needed to break even, and then solve for x, as shown in the following equation.
As
Exhibit 3-1
shows, Universal Sports Exchange, one of C&C Sports’ customers, reported operating income of $42,000 for fiscal year 2010. Using the information in Universal’s income statement, let’s calculate Universal’s breakeven point in jerseys using the profit equation above.
EXHIBIT 3-1 Universal Sports Exchange’s contribution format income statement.
In Step (1) we put everything into “constant” form—sales price per unit, variable cost per unit, and total fixed expenses. We set the number of jerseys equal to x because that is what we want to know—the number of jerseys that must be sold to break even. Step (2) shows that we could have started the calculation with the $4 contribution margin per unit, skipping Step (1). Step (3) reveals an essential relationship: At the breakeven point, the total contribution margin equals total fixed expenses. In Step (4), we solved the breakeven question: 42,000 jerseys must be sold to break even.
We can use our definition of the contribution margin as a shortcut to finding the breakeven point. Since the contribution margin is the amount that is available to cover fixed expenses and provide a profit ($0 in the breakeven case), we can use the following formula to calculate the breakeven point in units:
Notice that this formula is just a restatement of the mathematical operations made between Steps (3) and (4).
Sometimes it is useful to know the breakeven point in terms of sales dollars rather than units. If we know the breakeven point in units, we can simply multiply it by the sales price per unit: $20 × 42,000 = $840,000. Alternatively, we could use the contribution margin ratio and the profit relationships examined above, as in the following formula:
Reality Check—Who really uses breakeven analysis?
For the gallery to break even, only 400 people a day needed to view the exhibit.
Retail establishments and manufacturers have an obvious interest in breakeven analysis. But do organizations such as art galleries ever use the concept? Consider the Bellagio Gallery of Fine Art, housed in the Bellagio Casino in Las Vegas. With no permanent collection, the gallery must borrow works from museums and private collections. On January 30, 2004, Bellagio opened a show of 21 Monets on loan from the Museum of Fine Arts in Boston. Marc Glimcher, the man behind the show, guaranteed the museum at least $1 million for the loaned paintings. He estimated that for the gallery to break even, only 400 people a day, paying between $12 and $15 each, needed to view the exhibit. Since shows of works by Andy Warhol and Faberge had drawn over 150,000 visitors, this level of attendance did not appear to be out of reach.
When the exhibit closed on May 30, 2005 after a 16-month run, 450,000 people had visited the show. The average 1,000 visitors each day far exceeded the projected breakeven attendance. The show generated approximately $6 million in ticket sales, with more than $1 million going
back
to Boston’s Museum of Fine Arts. Following the show’s success, the gallery staged another show of Impressionist paintings from the museum, and other museums are expressing interest in showing their works at the Bellagio.
Sources: Fred A. Bernstein, “A Loan That Keeps on Paying,” The New York Times, March 30, 2005; Kristen Peterson, “Casino Handed Artistic Legacy,” Las Vegas Sun, February 8, 2008,
http://www.lasvegassun.com/news/2008/feb/08/casino-handed-artistic-legacy/
(accessed March 5, 2008); Steve Friess and Peter Plagens, “Show Me the Monet,” Newsweek, January 26, 2004, 60; Ken White, “Making an Impression, Las Vegas Review-Journal Neon, June 10, 2005,
http://www.reviewjournal.com/lvrj_home/2005/Jun-10-Fri-2005/weekly/2000819.html
(accessed March 5, 2008).
Breakeven Graphs
While calculating a breakeven point is useful, managers are also interested in the profits generated at other sales levels. A breakeven graph illustrates this relationship between sales revenue and expenses, allowing managers to view a range of results at a single glance.
Exhibit 3-2
shows Universal’s breakeven graph based on the company’s sales and expense information. Notice that the total sales revenue line intersects the y-axis at $0 and has a slope of $20: for every jersey sold, Universal takes in $20 of revenue. The fixed expense line intersects the y-axis at $168,000 and remains constant across all sales volumes. Even if no jerseys were sold, the company would incur fixed expenses of $168,000. The total cost line represents the sum of fixed and variable expenses, so it intersects the y-axis at $168,000 and increases at a rate (slope) of $16 per jersey. The point at which the total sales revenue line and the total expense line intersect is the breakeven point. Any level of sales to the left of the breakeven point represents an operating loss. Any level of sales to the right of the breakeven point represents operating income.
EXHIBIT 3-2 Breakeven graph for Universal Sports Exchange.
One of the activities managers like to engage in is called “what-if” analysis, or sensitivity analysis. “What if I could reduce fixed expenses—how would profits change?” Before we get into this type of analysis, let’s use Universal’s breakeven graph to think conceptually about these questions. What if fixed expenses
decrease
—how would the graph change? The fixed expense line would shift downward, as would the total expense line. The revenue line would remain unchanged, so the breakeven point would shift to the left, indicating that fewer jerseys would need to be sold to break even. And since neither sales nor variable costs changes, the contribution margin doesn’t change either. The end result: when expenses go down, operating profit goes up.
Think About It 3.1
Fill in the rest of the table
Margin of Safety
A company’s margin of safety is the difference between current sales and breakeven sales. It represents the volume of sales that can be lost before the company begins to lose money and can be measured in units or sales dollars.
Let’s calculate Universal’s margin of safety. From
Exhibit 3-1
we can calculate Universal’s current unit sales: $1,050,000 ÷ $20 sales price per jersey = 52,500 jerseys sold.
Universal is in good shape—it would have to lose 20% ($210,000 4 $1,050,000) of its sales before it started losing money.
UNIT 3.1 REVIEW
KEY TERMS
Breakeven point p. 82
Breakeven graph p. 84
Margin of safety p. 86
SELF STUDY QUESTIONS
1. LO 1 At the breakeven point, sales revenue and total contribution margin are equal.
True or False?
2. LO 1 Reese Manufacturing has a current breakeven point of 475,642 units. To reduce the breakeven point, Reese Manufacturing should
2. reduce the contribution margin.
2. increase fixed expenses.
2. reduce the sales price per unit.
2. increase the contribution margin.
1. LO 1 Jordan Graft Images sells framed prints of various college landmarks. Jordan purchases the prints from his supplier for $30 and sells them through his website for $65. Jordan’s fixed expenses are $89,250. What is Jordan’s breakeven point in units?
3. 940
3. 1,373
3. 2,550
3. 2,975
1. LO 1 Deaton, Inc., sells computer backpacks. The company purchases the backpacks from its supplier for $15 and sells them to office supply stores for $2
5. D
eaton’s fixed expenses are $100,000. What is Deaton’s breakeven point in sales dollars?
4. $100,000
4. $166,667
4. $175,000
4. $250,000
1. LO 1 Conrad Steel sells bridge supports. Currently, the company’s sales revenue is $5,000,000. If Conrad’s controller has calculated the company’s breakeven point to be $3,975,000, what is the company’s margin of safety?
5. $1,025,000
5. $2,950,000
5. $3,975,000
5. $5,000,000
UNIT 3.1 PRACTICE EXERCISE
Use this income statement to answer the questions that follow.
Required
1. What is the variable cost per unit?
2. What is the total fixed expense?
3. What is the contribution margin per unit?
4. What is the contribution margin ratio?
5. What is the breakeven point in units? In dollars?
6. What is the margin of safety in units? In dollars?
SELECTED UNIT 3.1 ANSWERS
Think About It 3.1
Self Study Questions
1. False
2. D
3. C
4. D
5. A
Unit 3.1 Practice Exercise
1. The two variable costs are cost of goods sold ($32 per unit) and shipping ($2 per unit), for a total variable cost per unit of $34.
2. The two fixed expenses are salaries ($800) and advertising ($400), for a total fixed expense of $1,200.
3. $50 − $34 = $16
4.
5.
(Notice that this amount also equals 75 units × $50.)
6. The margin of safety equals current sales minus breakeven sales. Before this calculation can be done in units, you must compute how many units the company is currently selling:
Margin of safety in units = 100 units − 75 units = 25 units
Margin of safety in dollars = $5,000 − $3,750 = $1,250 (Notice that this amount also equals 25 units × $50.)
UNIT 3.2 Cost-Volume-Profit Analysis
GUIDED UNIT PREPARATION
Answering the following questions while you read this unit will guide your understanding of the key concepts found in the unit. The questions are linked to the learning objectives presented at the beginning of the chapter.
1. How can managers use breakeven analysis to determine the level of sales needed to attain a specific level of income? LO 2
2. How can managers use CVP analysis to support their decision making? LO 3
3. What assumptions are made in CVP analysis? Do those assumptions invalidate the predictions managers make using CVP analysis? LO 3
4. Explain the concept of operating leverage. LO 4
Although managers often want to know how many units they need to sell to break even, they are more interested in finding out how they can generate a profit. Cost-volume-profit analysis, or CVP for short, helps managers assess the impact of various business decisions on company profits.
Target Operating Income
Managers frequently have an income target in mind when they plan business activities. They might want to know what it takes to make, say, $60,000 in operating income, or income before taxes. Calculating the level of sales required to meet that goal is easy if you know some basic information. You use the same profit equation you use to determine the breakeven point, but set profit equal to the target income. In Universal’s case, we would solve the problem as follows:
Recall from page 83 that Universal is already selling 52,500 jerseys. Although we can do the math to determine that the company will need to sell 4,500 additional jerseys to reach the target income of $60,000, managers must use their judgment in deciding if achieving this level of additional sales is likely.
With a simple adjustment, we can use our shortcut formulas from Unit 3.1 to answer the target income question:
Target Net Income
Suppose that instead of operating income, Universal’s managers want to know how many jerseys they must sell to make $42,000 in net income. Remember, net income is operating income less income taxes. Since the profit equation calculates operating income, we need to convert the desired net income to operating income. Universal’s income taxes are 30% of operating income. That means net income must be 70% of operating income. If we state this relationship mathematically, we can determine what operating income results in $42,000 net income:
Now we have the same operating income target—$60,000—as in the last section. From this point, we simply follow the steps described in that section to calculate the number of units needed to reach the target operating income.
From the preceding calculations, we can develop the following general formula for converting net income to operating income:
What-If Analysis
Managers often want to know what will happen to profit or other measures if costs or volume change. Recall that the profit equation includes sales revenue, variable expenses, and fixed expenses. If we know all but one of these variables, we can solve for the remaining unknown variable. Here are some questions that Universal’s managers might ask. As we answer these questions, refer back to
Exhibit 3-1
, which shows Universal’s contribution format income statement as of January 30, 2010. Remember that the company sold 52,500 jerseys that year.
What if C&C Sports were to raise the price of a baseball jersey by 5%?
The price Universal pays C&C Sports for each jersey is a variable cost, so we need to adjust the “constant” form of that cost, which is the $14.80 cost per jersey. A 5% increase from $14.80 would be $0.74, so the new cost of goods sold per jersey would be $14.80 + $0.74 = $15.54. The total variable cost per jersey would be $15.54 plus a $1.20 sales commission, or $16.74.
Since the variable cost per unit has gone up, the contribution margin per unit has gone down to $20 − 16.74 = $3.26. (We could just as easily reduce the original contribution margin per unit by the increase in variable costs: $4 − $0.74 = $3.26.) To calculate the new operating profit, we simply substitute this revised contribution margin into the profit formula:
If the cost of jerseys increases 5% and Universal sells the same number of jerseys as last year, but does not raise the price it charges, the company will report a much smaller profit.
How much would Universal need to raise the price of a baseball jersey to cover the increase in cost and earn the same operating profit as last year?
The solution to this problem isn’t as simple as adding $0.74 to the price because Universal pays a commission based on a percentage of sales revenue—6%, to be exact. Therefore, if the sales price per unit changes, so must the commission per unit. Solving for the sales price, SP, we find that the new price per jersey would need to be $20.79:
The new sales commission would be $20.79 X 0.06 = $1.247 per jersey, rounded up to $1.25. Therefore, the contribution margin per unit would be $20.79 − 15.54 − 1.25 = $4. Notice that this amount is the same as the original contribution margin. If Universal raised the price to $20.79 and the number of units sold remained the same, operating income would not change.
Think About It 3.2
If Universal were to raise the sales price of its baseball jersey by $0.79, would the number of units sold remain the same? What if the price were to rise by $5 to $25?
Refer back to the original situation. Assume Universal is considering a new advertising campaign that would cost $10,000. By how much would sales need to increase for the company to make the same operating income as last year?
Adding a new advertising campaign would increase fixed expenses to $178,000. This is a target income problem, and the target is last year’s operating income, $42,000 (see
Exhibit 3-1
on page 83):
So the answer to the question of how much sales would need to increase is:
WATCH OUT!
When volume changes, total sales revenue, total variable expenses, and total contribution margin all change. Students typically change total sales revenue but forget to change total variable expenses. The safest bet is to start with contribution margin per unit X sales volume to be sure to capture the change in total sales and variable expenses.
We could have considered this question in a different manner by asking how much additional contribution margin would be needed to cover the $10,000 in additional fixed expenses. The answer is $10,000. How much in additional sales does that amount imply? Since the contribution margin is 20% of sales, we simply divide the additional contribution margin needed by the contribution margin ratio:
Limitations of CVP Analysis
CVP analysis is a powerful tool for assessing the profit implications of various business decisions. However, the predictions provided by the analysis are only as good as the data they are based on. And when using CVP as a decision tool, we have to make several assumptions about the data. The primary assumptions we have made in our use of CVP in this unit are:
· All costs can be easily and accurately separated into fixed and variable categories.
· A linear relationship exists between total variable expenses and sales activity over the relevant range of interest.
· Total fixed expenses and variable costs per unit remain constant across all sales levels.
· Inventory is sold during the same period it is purchased or produced.
Even with these assumptions, managers find CVP to be a useful tool in evaluating business opportunities.
Cost Structure and Operating Leverage
Up to this point, we have considered the levels of variable and fixed costs to be given, changeable only by increases or decreases in cost. To some degree, however, firms can, over time, control the relative size of variable and fixed costs in order to establish a particular cost structure. Why would this cost structure matter to a company? Remember that variable costs are incurred only with some type of activity. For example, variable selling expenses are incurred only when sales are made, whereas fixed selling expenses are incurred regardless of the level of sales. Companies that carry a high level of fixed costs relative to variable costs are considered to have greater risk than companies with a high level of variable costs relative to fixed costs.
One measure that is directly affected by the company’s cost structure is operating leverage, or the change in operating income relative to a change in sales. A company with high operating leverage will experience a large percentage change in operating income as a result of a small percentage change in sales. Refer back to
Exhibit 3-1
, which shows Universal’s contribution format income statement. If sales were to increase by 10% ($105,000), the contribution margin would increase by 10% ($21,000), increasing operating income by $21,000. Compared to the original operating income of $42,000, that is a 50% increase in operating income! Of course, the bad news is that if sales were to decrease by 10%, operating income would decrease by 50%.
Another way to compute the expected change in operating income due to a change in sales volume at a given level of sales is to compute the degree of operating leverage.
Universal’s degree of operating leverage is 5, computed as follows:
That is why a 10% increase in sales due to sales volume (not due to a change in sales price) will increase operating income by 50%: a 10% increase in sales × 5 = a 50% increase in operating income.
Firms can manage their degree of operating leverage by converting variable costs to fixed costs, and vice versa. In a production facility, for example, welders who are paid by the hour (a variable cost) could be replaced by a welding machine (a fixed cost). In Universal’s case, managers could replace the sales commission (a variable cost) with a salary (a fixed cost).
Exhibit 3-3
compares Universal’s contribution format income statement for last year to what it would have looked like if the sales commission had been replaced with a salary.
The $63,000 in original sales commissions has been added to the original $116,500 fixed selling and marketing expenses, yielding new fixed selling and marketing expenses of $179,500. Notice that under the salary alternative, the contribution margin per unit has risen to $5.20. For every unit sold, Universal retains $1.20 more revenue to cover fixed expenses and contribute to profit.
Under the new salary alternative, as before, a 10% increase in sales ($105,000) will increase contribution margin by 10%, or $27,300. But the $27,300 added to operating income represents a 65% increase ($27,300 ÷ $42,000). The degree of operating leverage, then, has increased from a factor of 5 to a factor of 6.5 ($273,000 ÷ $42,000). With more fixed and fewer variable costs, the new cost structure creates a higher degree of operating leverage, and thus a higher degree of risk. The payoff is bigger when sales increase, but the downside is bigger when sales decrease.
EXHIBIT 3-3 Universal Sports Exchange’s contribution format income statement.
The profit–volume graph in
Exhibit 3-4
compares Universal’s profit over several sales levels under the two cost structures, one with a sales commission and the other with a sales salary. The point at which the profit line intersects the y-axis represents total fixed expenses—$168,000 under the commission scenario and $231,000 under the salary scenario. The point at which the profit line crosses the x-axis is the breakeven point, where profit equals zero. Under the commission scenario, only 42,000 jerseys must be sold to break even; under the salary scenario, 44,423 jerseys must be sold to break even. The difference in the breakeven points represents another type of risk related to operating leverage: As operating leverage rises, more jerseys must be sold to break even.
EXHIBIT 3-4 Profit-volume graph for Universal Sports Exchange.
Reality Check—Fixed versus variable costs
We believe that a simpler business model will better serve our customers and lower costs and is required in the demanding, competitive industry in which we operate today.
Circuit City Stores, Inc., is a good example of the double-edged sword of sales commissions, which affect both sales revenue and sales cost. Until early 2003, 60% of Circuit City’s sales force was paid on commission; the remaining 40% was paid on an hourly basis. In 2003, in an effort to control costs, Circuit City converted its commission-based employees to hourly salaries. Although many employees who had been paid on commission chose to accept an hourly rate, not all employees did. As a result, the company laid off 3,900 commission-based employees and hired 2,100 new hourly workers.
Unfortunately, many of the laid-off workers were among Circuit City’s best salespeople. One former salesman who had been with the company for more than five years had averaged about $28 per hour in commissions and other incentives. On four occasions he had been honored as one of the company’s top 200 salespeople. Why would Circuit City let him and others go when the results could be lower sales? In its 2003 annual report, Circuit City’s management stated that they had “changed the compensation structure in our stores, adapting to the preferences of today’s consumer as well as the industry’s new product trends. This change also was a major step towards simplifying our business. We believe that a simpler business model will better serve our customers and lower costs and is required in the demanding, competitive industry in which we operate today.”
And save money the company did—approximately $130 million in payroll costs in fiscal 200
4. A
fter a disappointing fiscal year 2004, the company’s sales and performance measures rebounded in 2005 and again in 2006.
But the switch in cost structure didn’t solve all the company’s wage issues. On March 28, 2007, Circuit City announced a “wage management initiative” that resulted in the termination of 3,400 of its highest paid salespeople in favor of new, lower paid, less experienced salespeople. The terminated employees were told, however, that they could reapply for their positions after ten weeks, but at the lower salary. Estimated savings to Circuit City? $250,000 over the next two years.
Again, this wasn’t enough savings to solve the company’s problems, as the firm declared bankruptcy and in January 2009 announced liquidation plans for all stores to close by March 31, 2009. On May 19, 2009, the brand was purchased by Systemax, Inc., and will be relaunched as an online retailer. With a significantly lower level of fixed costs than the brick-and-mortar version, perhaps this reincarnation will be successful.
Sources: David Carr, “Thousands Are Laid Off at Circuit City. What’s New?” The New York Times, April 2, 2007,
http://www.nytimes.com/2007/04/02/business/media/02carr.html
(accessed March 13, 2008); “Circuit City … The ReLaunch,”
http://www.circuitcity.com
(accessed May 22, 2009); “Circuit City Stores, Inc. Announces Additional Changes to Improve Financial Performance,” Circuit City Stores, Inc. news release, March 28, 2007,
http://newsroom.circuitcity.com/releasedetail.cfm?ReleaseID=235835
(accessed March 13, 2008); Parija B. Kavilanz, “Circuit City to Shut Down,” CNNMoney.com,
http://money.cnn.com/2009/01/16/news/companies/circuit_city/
(accessed May 22, 2009); David Lazarus, “Circuit City Firing Its Best Salesmen,” San Francisco Chronicle, February 12, 2003; Barry Willis, “Cutbacks at Circuit City,”Stereophile, February 9, 2003,
http://stereophile.com/news/11569/
(accessed February 23, 2006); Circuit City 2003 Annual Report; Circuit City 2004 Annual Report; Circuit City 2005 Annual Report; Circuit City 2006 Annual Report.
At 52,500 jersey sales, the point where the two profit lines cross, the two scenarios return equal profits. At lower sales levels, profit is higher under the commission scenario; at higher sales levels, profit is higher under the salary scenario. The choice of cost structure, then, is critical. Depending on the company’s sales volume, it can greatly affect profit.
Changing a company’s cost structure affects more than its operating leverage, however. It may have behavioral implications for the employees. In Universal’s case, the company paid sales commissions to encourage the sales staff to sell more units, to make more money both for themselves and for the company. When the sales commission is eliminated, so is the financial incentive for the sales staff to sell more. The Reality Check on page 94 describes what happened to Circuit City’s sales when managers dropped the sales commission.
Think About It 3.3
Assume you are running a new start-up company in which you have invested a good deal of money. What type of cost structure will you use to pay your sales staff—commission or salary? Why?
UNIT 3.2 REVIEW
KEY TERMS
Cost-volume-profit analysis (CVP) p. 88
Degree of operating leverage p. 92
Operating leverage p. 92
SELF STUDY QUESTIONS
1. LO 2 Pete’s Pretzel Stand sells jumbo pretzels for $2 each. Pete’s variable cost per pretzel is $0.50, and total fixed expenses are $3,000 per month. If Pete wants to earn a monthly operating income of $9,000, how many pretzels must he sell during the month?
1. 8,000
1. 6,000
1. 4,000
1. 2,000
1. LO 2 Marisol’s Parasols sells novelty umbrellas for $10 each. Marisol’s variable costs are $4 per unit, and her fixed expenses are $3,000 per month. If Marisol’s tax rate is 25%, how many umbrellas must Marisol sell each month if she wants to earn $9,000 in net income?
2. 500
2. 2,000
2. 2,500
2. 3,500
1. LO 3 All other things equal, a 20% increase in the number of units sold will yield a 20% increase in net income. True or False?
1. LO 3 All other things equal, an increase in the number of units sold will
4. increase operating income.
4. increase total variable expenses.
4. increase total contribution margin.
4. all of the above.
1. LO 3 Ellis McCormick and Elaine Sury are owners of MeetingKeeper, a company that sells personalized daily planners. Last month, the company sold 1,500 planners at a price of $6 per planner. Variable costs were $2.40 per unit; fixed expenses were $3,600. This month, Ellis and Elaine have decided to spend $2,000 to advertise in the local newspaper. They believe that the additional advertising will generate 25% more sales volume than last month. What will be this month’s operating income?
5. $3,150
5. $1,150
5. $775
5. ($1,100)
1. LO 4 All other things equal, a company can increase its operating leverage by converting commission-based salespeople to salaries. True or False?
1. LO 4 Dawson Enterprises’ current degree of operating leverage is 8. A planned promotion campaign is expected to increase sales by 15%. What is the expected increase in operating income?
7. 8%
7. 15%
7. 23%
7. 120%
1. LO 4 Festive Foods Caterers’ income statement for last month follows. What is Festive Foods’ degree of operating leverage?
8. 0.7
8. 3
8. 7
8. 10
UNIT 3.2 PRACTICE EXERCISE
Use this income statement and your calculations from the Unit 3.1 Practice Exercise to answer the following questions.
1. How many units would the company need to sell to earn $2,000 in operating income?
2. How many units would the company need to sell to earn $1,140 in net income if the tax rate is 25%?
3. B
y how much would operating income change with a 10% increase in units sold?
SELECTED UNIT 3.2 ANSWERS
Think About It 3.2
Kids who play baseball need baseball jerseys. The question is, will consumers continue to buy those jerseys from Universal, or will they go elsewhere? For an additional $0.79, Universal may not see much of a change in demand for its jerseys; the increase in price is less than 4%. At a $5 increase in price, however, consumers may look for a better deal somewhere else.
Think About It 3.3
You should offer a commission. A start-up company typically has little self-generated cash and few customers. Salaries would have to be paid no matter what, even if no sales were made. With a commission, the sales staff is paid only when the company earns revenue. Because many employees are not willing to bear the total risk of compensation tied to sales, some companies offer a combination of salary and commission (a mixed cost).
Self Study Questions
1. A
2. C
3. False
4. D
5. B
6. True
7. D
8. C
Unit 3.2 Practice Exercise
1. You know from the Unit 3.1 Practice Exercise that the contribution margin is $16/unit and total fixed expenses are $1,200. Now, use the target income formula to solve for the number of units:
2. First, you must convert net income to operating income:
3. First, you must compute the degree of operating leverage
Now, multiply the degree of operating leverage by the percentage change in the number of units sold to arrive at the change in operating income: 4 × 10% = 40% increase in operating income. Therefore, a 10% increase in unit sales results in a $160 (0.4 × $400) increase in operating income. This answer can also be calculated by multiplying the increase in the number of units sold (0.1 × 100 = 10) by the contribution margin per unit: 10 × $16 = $160
UNIT 3.3 Multiproduct CVP Analysis
GUIDED UNIT PREPARATION
Answering the following questions while you read this unit will guide your understanding of the key concepts found in the unit. The questions are linked to the learning objectives presented at the beginning of the chapter.
1. What is meant by the term sales mix? LO 5
2. How do you calculate the sales required to break even or achieve a target income in a multiproduct setting? LO 5
3. What assumption is required in multiproduct CVP analysis but is not necessary in single-product CVP analysis? LO 5
The CVP analyses you have conducted so far focus on decisions about a single product. While this type of analysis is useful in small start-up businesses and divisions with only a single product line, most companies produce or sell more than one type of product. Companies that sell multiple products need to know what results are required for the company, not individual products, to achieve certain targets. To solve this type of problem, managers must have a good grasp of the sales mix—that is, the sales of each product relative to total sales.
We will illustrate multiproduct CVP analysis with another retail sporting goods store—Landon Sports, one of Universal’s competitors. Landon sells the same baseball jerseys as Universal, but it also sells athletic shoes. Unit data for the jerseys and shoes are as follows:
Note that Landon prices its jerseys the same as Universal (to be competitive) and offers employees the same 6% commission on sales. The athletic shoes that Landon sells are priced higher than the jerseys, and they cost the company more to sell.
Last year, Landon sold 40,000 jerseys and 10,000 pairs of shoes, so the sales mix is four jerseys for every pair of shoes sold.
Exhibit 3-5
shows Landon’s income statement by product type and in total. Note that no fixed expenses are assigned to either jerseys or shoes. As long as the company keeps selling jerseys and shoes, the fixed expenses will not change, so they are deducted in total rather than allocated to the individual product lines.
EXHIBIT 3-5 Landon Sports’ income statement.
The profit formula for a company with multiple products (in this case, jerseys and shoes) and a specified sales mix is:
This equation can be expanded to accommodate as many products as the company sells.
Reality Check—What’s in the mix?
As Warner’s sales mix moves toward digital recordings, the amount of sales revenue required to break even will decrease
Warner Music Group is a leading player in the music industry. According to its 2005 annual report, the company seeks to “drive innovation within the industry by making the transition from a records and songs-based company to a music-based content company.” The company’s product lines include CDs, digital music, videos, and sheet music.
So how has this transition progressed? The company’s 2008 annual report stated, “We continue to transform our recorded music business within the music value chain, while broadening our revenue mix into growing areas of the music business.” Sales of digital music exploded between 2006 and 2008—up 79% during the period. And in 2008, digital revenue provided 17% of the company’s total revenues, up from 9.5% in 2006.
Because digital files do not require a case or printed materials, digital recordings cost less than CDs to manufacture. Moreover, there are no inventory storage costs for digital recordings, and distribution costs are much lower (there is no shipping cost for a downloaded digital file). Warner reports that two-thirds of online sales come from older releases, whose marketing costs are lower than those for new releases.
All these savings mean that the contribution margin ratio for digital recordings is much higher than that for CDs. While the sales price of a digital download is less than that of a CD, more of each sales dollar is available to cover fixed costs and provide a profit. As Warner’s sales mix moves more toward digital recordings, the amount of sales revenue required to break even will decrease. That’s how Warner was able to achieve higher income on lower sales revenue. Clearly, sales mix is an important consideration in decision making.
Sources: Rob Curran, “Warner Music’s Earnings Surge 92% on Digital Sales, Lower Costs,” The Wall Street Journal, February 15, 2006; “Warner Music Group Corp. Reports Fiscal First Quarter Results for the Period Ended December 31, 2005,” Warner Music Group news release, February 14, 2006,
http://investors.wmg.com/phoenix.zhtml?c=182480&p=irol-news
(accessed February 22, 2006); Warner Music Group 2008 Annual Report; Warner Music Group 2007 Annual Report; Warner Music Group 2005 Annual Report.
Landon Sports breaks even when:
The preceding equation has two unknowns and an infinite number of solutions. However, when we require that the sales mix is held constant, then we know the number of jerseys sold is four times the number of pairs of shoes sold. If we let x equal the number of pairs of shoes sold, we have the following equation and solution:
Breakeven in sales dollars is $1,000,000: $640,000 for jerseys ($20 × 32,000) and $360,000 ($45 × 8,000) for shoes.
WATCH OUT!
Do not split fixed expenses between the multiple products and try to come up with individual product breakeven points or target income points. This will result in units sold that do not adhere to the sales mix ratio.
The formula is easily adapted to target income problems. Suppose the CFO at Landon Sports wanted to know how many jerseys and pairs of shoes needed to be sold to earn $66,900 in operating income:
If the sales mix changes, so do the breakeven point and the other targets.
Exhibit 3-6
shows what Landon’s income statement would look like if Landon Sports still sold a total of 50,000 units, but the sales mix changed to 30,000 jerseys and 20,000 pairs of shoes (instead of 40,000 jerseys and 10,000 pairs of shoes). The company would make more money, even though it sold the same number of units as in the previous scenario because more of those units sold were shoes, which generate a higher contribution margin per unit.
EXHIBIT 3-6 Landon Sports’ revised income statement.
Let’s see what the breakeven point is with this new sales mix. Since sales of jerseys are 1.5 times the number of shoe sales , we will replace 4x from the original formula with 1.5x in the new formula:
Breakeven in sales dollars is $1,087,865: $435,140 for jerseys ($20 × 21,757) and $652,725 ($45 × 14,505) for shoes. More sales dollars are needed to break even and achieve other income targets relative to the original sales mix because, although the shoes have a higher contribution margin per unit than the jerseys ($6.30 compared to $4.00), the contribution margin ratio for shoes is lower than the contribution margin ratio for jerseys. That means that with this mix, less of each sales dollar is available after covering variable expenses to cover fixed expenses and profit.
Think About It 3.4
Consider Landon’s original sales mix of 40,000 jerseys and 10,000 shoes. In an effort to stimulate jersey sales, Landon has increased the sales commission paid on each jersey to 12.3%. The company believes that this move will generate additional sales of 10,000 jerseys, with no effect on shoe sales. How will this move alter Landon’s sales mix? How will it affect the breakeven point? Do you think this change is a good move?
Limitations of Multiproduct CVP Analysis
In Unit 3.2, you learned about the assumptions of CVP analysis, and all those assumptions apply in a multiproduct environment. However, there is another assumption that we make in a multiproduct environment: The sales mix can be determined and will remain constant.
UNIT 3.3 REVIEW
KEY TERMS
Sales mix p. 97
SELF STUDY QUESTIONS
1. LO 5 If a company sells more than one product, it cannot use CVP analysis to examine the effect of changes in costs on operating income. True or False?
2. LO 5 Which of the following is not a limiting assumption of multiproduct CVP analysis?
2. Fixed cost per unit remains constant within the relevant range.
2. A
ll variable cost relationships are linear with respect to activity.
2. All costs can be easily separated into variable and fixed categories.
2. The sales mix can be determined and remains constant over time.
1. LO 5 Blalock Training sells three online training courses in database programming skills. For every 12 people who take the introductory course, 5 take the intermediate course and 3 take the advanced course. Blalock’s CFO has calculated a breakeven point of 10,000 courses. How many of those 10,000 courses will be introductory?
3. 1,200
3. 6,000
3. 8,000
3. 10,000
1. LO 5 Montelone Images, a photography studio, sells two photo packages. The standard package has a contribution margin of $5, and the deluxe package has a contribution margin of $12. Montelone sells five standard packages for every one deluxe package. If fixed expenses total $74,000, how many standard and deluxe packages must be sold to break even?
4. 14,800 standard; 6,167 deluxe
4. 4,353 standard; 4,353 deluxe
4. 9,280 standard; 2,300 deluxe
4. 10,000 standard; 2,000 deluxe
1. LO 5 Assume a company sells 10,000 units –5,000 of product A and 5,000 of product B. Product A has a contribution margin of $6.00 per unit, while Product B has a contribution margin of $4.00 per unit. If the sales mix changes to 5,500 units of Product A and 4,500 units of product B, which of the following is true?
5. The company will make more money because more of the product with the higher contribution margin per unit is being sold.
5. It will take fewer total units to break even now that more of the product with the higher contribution margin per unit is being sold.
5. The breakeven point depends on the current sales volume as it effects the sales mix.
5. All of the above are true.
UNIT 3.3 PRACTICE EXERCISE
Hometown Bakery sells three types of doughnuts: glazed, jelly, and cake. The following table shows the sales price and variable costs for each type. The bakery incurs $300,000 a year in fixed expenses. Assume that it sells two glazed doughnuts for every one jelly doughnut and every one cake doughnut.
Required
1. How many doughnuts of each type will be sold at the breakeven point?
2. What amount of revenue would need to be generated by each type of doughnut for the company to earn $60,000 in operating income?
SELECTED UNIT 3.3 ANSWERS
Think About It 3.4
The new sales commission is expected to generate sales of an additional 10,000 jerseys. With total sales of 50,000 jerseys and 10,000 pairs of shoes, the new sales mix would be five jerseys for every one pair of shoes. The new contribution margin for jerseys would be:
Breakeven is now:
By lowering the contribution margin per unit of jerseys and shifting a greater percentage of sales to those jerseys, more jerseys and more shoes will have to be sold in order to break even.
Is this change a good move? An increase in the breakeven point creates more risk for the company, but it might be considered a good move if greater income can be generated. Since the number of shoes sold is expected to remain constant at 10,000, we only need to consider the contribution margin generated by the jerseys.
If the new commission strategy only generates an additional 10,000 jersey sales, then it is not a good move, since total contribution margin, and therefore operating income, decreases by $23,000.
Self Study Questions
1. False
2. A
3. B
4. D
5. D
Unit 3.3 Practice Exercise
1. ($0.15 × 2x) + ($0.05 × x) + ($0.13 × x) − $300,000 = $0
$0.48x = $300,000
x = 625,000 jelly doughnuts
x = 625,000 cake doughnuts
2x = 1,250,000 glazed doughnuts
2. ($0.15×2x)+($0.05×x)+($0.13×x) − $300,000=$60,000
$0.48x = $360,000
x = 750,000 jelly doughnuts × $0.50 = $375,000
x = 750,000 cake doughnuts × $0.40 = $300,000
2x = 1,500,000 glazed doughnuts × $0.35 = $525,000
UNIT 3.4 Pricing Decisions
GUIDED UNIT PREPARATION
Answering the following questions while you read this unit will guide your understanding of the key concepts found in the unit. The questions are linked to the learning objectives presented at the beginning of the chapter.
1. D
efine markup. How does a markup percentage differ from the gross margin percentage? LO 6
2. E
xplain cost-plus pricing. What are some flaws of cost-plus pricing? LO 6
3. Explain how competitors influence the price under cost-plus pricing. LO 6
4. Explain target costing. What alternatives does a company have if it cannot make a product at the target cost? LO 7
In this chapter you have learned how to calculate several pieces of information to assist managers in their decision making. For each calculation you were provided all the necessary inputs, such as the sales price, variable and fixed expenses, and sales demand. But knowing how to plug these inputs into an equation and “do the math” is not enough. As a manager, you will need to determine the prices, costs, and demand for products and services; they will not be provided to you.
In this unit you will learn about some of the decisions managers face in setting the price to charge for a product or service. As Noel Zeller, founder of Zelco Industries, maker of the “itty bitty” Booklight, put it, “Pricing is crucial to success—knowing how to price your merchandise so that you make an adequate profit. Most people starting out under-pricing their products. Why? Because they price them out on the basis of labor costs and what the components cost, and don’t go by the perceived value of the product.”
2
Influences on Price
From the customer’s perspective, the price paid for a product or service should reflect its value. From the company’s perspective, the price charged must be high enough to cover expenses and return a reasonable profit to the company. The customer wants to pay as little as reasonably possible, while the company wants to charge as much as reasonably possible. Where do those two perspectives meet?
Economic theory suggests that price and demand are inversely related: the higher the price, the lower the demand for a product. At lower prices, customers will demand (and purchase) a higher quantity of a product than they will at higher prices. The lower the price, however, the fewer units of product a company is willing to supply. How do companies decide what price to charge in order to make an acceptable profit and deliver the goods and services customers want?
The answer depends in part on the market for their products. While customers and costs influence prices, so does the level of competition in the marketplace. If two companies are selling the same product, why would a consumer pay a higher price to one than to the other? If the products are identical, they won’t. In a market in which many companies are selling the same product, each company will sell its product at the going market price, which is set by the supply of and demand for the product. These companies are “price takers”: Their production and sales decisions do not affect the price of their product. Producers of commodities such as corn, oil, and orange juice face this kind of market.
Since price takers can’t impact product prices, they must find other ways to earn a reasonable profit. The one profit-related factor they can influence is the cost to deliver their products or services to consumers. To reduce that cost, they must focus on operational efficiency. If the cost is too high, so that net income is low or negative, they may choose to leave the market altogether.
If a company is not a price taker, how do managers decide what price to set for a product or service? This is a difficult question, one we will not answer fully in this unit. However, there are some basic guidelines these companies can follow. Most important, to justify a higher price, a company must differentiate its product or service from that of competitors, so that customers believe it is different enough to warrant the higher price.
Why pay $50 for a haircut at a fancy salon instead of $8 at the local barbershop? Why pay more for a Lexus than a Kia? The difference depends on the customer’s desires and the seller’s ability to convince the customer that the product is or is not worth a higher price. The luxury of the Lexus certainly adds to the cost of producing it. Since the cost of producing the Lexus is higher than the cost of producing a Kia, Lexus will need to charge a higher price. It’s up to the customer to decide whether the higher price is worth it, and it’s up to Lexus to convince the consumer that it is.
In a perfect world, companies would understand the relationship between the price of their products and the demand for them. If they knew that information, they could figure out exactly which price would return the greatest income. Although it is possible to calculate this information—and you may be familiar with the economic theory behind these calculations—such information may be difficult or expensive to acquire. As an alternative, some companies rely on one of two methods: cost-plus pricing or target costing.
Cost-Plus Pricing
To be profitable over the long run, a company must sell its products or services at a price that will both cover its expenses and provide a profit. Cost-plus pricing adds an amount to the cost of the product or service to cover the company’s operating costs and contribute to its profit. The “plus” amount is often referred to as a markup, or the difference between the selling price and the cost of the product:
Look back at
Exhibit 3-1
(p. 83). Universal adds a $5.20 markup to the wholesale price (cost of goods sold) C&C Sports charges for baseball jerseys: $20.00 − $14.80 = $5.20. Most companies don’t think of their markups as dollar amounts, however. Instead, they express markups as a percentage of the cost:
Expressed as a percentage, Universal’s jersey markup is 35% of the cost of goods sold:
Because cost can be defined in different ways, it is important to identify the appropriate cost basis in communicating markups. Let’s look again at
Exhibit 3-1
. If Universal chooses to define cost as the total variable cost per unit rather than the cost of goods sold, then the markup percentage is 25% . If cost is defined as total cost (ignoring income taxes), then the markup percentage is 4.17% . Notice that as the cost base grows larger, the markup grows smaller. That is because as the cost base expands, fewer costs are left to be covered by the markup.
WATCH OUT!
All the different percentages that business people use can become confusing. In this chapter, you learned about markups as a percentage of cost. As a dollar amount, gross profit (Sales – Cost of Goods Sold) is the same as the markup on Cost of Goods Sold, but the gross margin percentage is not the same as the markup percentage.
For example, Universal Sports Exchange buys jerseys from C&C Sports for $14.80 and sells them for $20. The gross margin, or markup on the cost of goods sold, is $5.20. The gross margin percentage is 26% ($5.20 ÷ $20.00), but the markup percentage on the cost of goods sold is 35% ($5.20 ÷ $14.80).
To keep these concepts straight, remember that markups are always expressed as a percentage of cost. In contrast, financial ratios such as the gross margin percentage and the profit margin are based on sales. Finally, be sure you know what cost someone is referring to before you make a calculation. When in doubt, ask.
The markup percentages we just calculated are based on existing costs and prices. How can these markup percentages be used to set the prices of new products? Suppose that to remain competitive with Landon Sports, managers of Universal Sports Exchange have decided to start selling shoes. If Universal can purchase the shoes at the same average cost ($36) as Landon (refer back to Unit 3.3), what price should the company charge to maintain a 35% markup on the cost of goods sold, as for its jerseys? The answer is $48.60 ($36 1 (35% × $36)). But does it make sense to charge $48.60 for Universal’s shoes when customers can buy similar shoes from Landon for only $45? Only if Universal can convince customers that they are getting better shoes or better service than they would from Landon does a price of $48.60 make sense. Otherwise, Universal will need to meet Landon’s $45 price and settle for a 25% markup on cost of goods sold .
Although cost-plus pricing is a relatively simple approach to pricing, it has several flaws. First, the price a customer is willing to pay for a product or service should represent the value of that product or service to the customer. A markup based on cost does not represent the value to the customer. Instead, the markup represents the return to the seller. Similarly, cost-plus pricing implies that the cost of the seller’s operational inefficiencies should be borne by the customer. For example, Landon may be able to charge $45 for shoes because its operating costs are lower than Universal’s. If $45 provides Landon with enough return to cover operating costs and contribute to profits, should customers pay Universal more just because it has more costs to cover? No. It is not the customer’s responsibility to ensure that companies stay in business. Customers should be willing to pay a fair price for a product or service. Aside from the price, they will buy from the company that delivers the product or service they want, the way they want it.
Target Costing
The term target costing may not sound like a pricing strategy, yet it is just that. Whereas cost-plus pricing starts with the cost, target costing starts with the price customers are willing to pay. This method computes the desired markup and the maximum cost the company can incur to deliver a product or service at the market price.
Reality Check—Filling the tank empties the wallet
Two railroad operators, Union Pacific and Burlington Northern Santa Fe, earned $2.12 billion in surcharge revenue in 2005—more than 200% over 2004.
In the summer of 2006, crude oil prices climbed to over $70 a barrel. By July 2008, the price had soared to more than $145 per barrel, and consumers began to feel the pinch of higher oil prices at the gas pump, with the average price of gasoline topping out at $4.054 per gallon. But that wasn’t the only place where consumers saw prices rise. As oil prices rose, providers of goods and services sought to pass along their increased fuel costs to customers in order to protect their profit margins. While some companies simply raised prices, others added a “fuel surcharge.” American Airlines, Delta, and Air France rushed to add fuel surcharges to their ticket prices. Cruise lines, tour operators, florists, and delivery services, soon followed.
Fuel surcharges can be a significant source of revenue. Two railroad operators, Union Pacific and Burlington Northern Santa Fe, earned $2.12 billion in surcharge revenue in 2005—more than 200% over 2004. And the growth in these surcharges continued into 2007 and beyond. Interestingly, not all fuel surcharges are levied in the same way—some are fixed and others are variable. Lufthansa charged $118.71 per ticket on intercontinental flights in early 2008, for example, while UPS added a percentage-based surcharge. How were these surcharges calculated? Is it possible that some surcharges more than cover the additional fuel costs, providing additional profit as well?
For some companies, the surcharges may translate into permanent price increases, even if costs subsequently decline. Australia’s major airlines appear to have adopted fuel surcharges for the long run. Peter Gregg, CFO of Qantas, said that in a volatile fuel-pricing environment, he didn’t expect fuel surcharges to decrease, even though oil prices had begun to drop. In November 2008, American Airlines led an industry move to drop most fuel surcharges after oil prices declined. However, many of the fuel surcharges were simply absorbed into the base fare price, so the flying public did not see a reduction in the price it paid for air travel.
Sources: “Airlines Say Fuel Surcharges to Remain Despite Cheaper Oil,” Australian Associated Press Pty. Ltd. News feed, September 24, 2006; BNSF 2007 10-K; Rick Brooks, “More Businesses Slap on Fuel Fees,” The Wall Street Journal, May 4, 2006; Crude Oil Price History,
http://www.nyse.tv/crude-oil-price-history.htm
(accessed May 22, 2009); Lufthansa’s Fuel Surcharge Soars,” CNNMoney.com, March 10, 2008,
http://money.cnn.com/2008/03/10/news/international/bc.apfn.germany.lufthansa.ap/index.htm?section=money_latest
(accessed March 13, 2008); “Retail Gasoline Historical Prices,”
http://www.eia.doe.gov/oil_gas/petroleum/data_publications/wrgp/mogas_history.html
(accessed September 27, 2006); Gary Stoller, “Airlines’ Fuel Surcharges Fade, But Airlines Don’t,” USA Today, November 10, 2008,
http://www.usatoday.com/travel/flights/2008-11-10-fuel-surcharge-airfares_N.htm
(accessed May 22, 2009);
http://www.ups.com/content/us/en/resources/find/cost/fuel_surcharge.html
(accessed March 13, 2008).
Companies need to engage in target costing before introducing a new product. Suppose Bradley Textile Mills, one of C&C’s fabric suppliers, has developed a fabric that “breathes” better than all other fabrics currently on the market. Before Bradley begins to mass produce the new fabric, managers need to know what customers like C&C are willing to pay for it. Bradley’s marketing department, together with the product engineers, should conduct marketing surveys and demonstrations to assess customers’ interest in its product and the price they are willing to pay.
Let’s assume that Bradley’s market re
search
indicates that customers are willing to pay $4.50 per yard for the new fabric. That’s $0.50 more per yard than the price of the fabric Bradley currently produces. Let’s assume, too, that Bradley Textile Mills requires a 30% gross profit margin on all new products. A 30% gross margin on $4.50 would be $1.35, resulting in a target cost of goods sold of $3.15 ($4.50 − $1.35). At this point, the production engineers at Bradley Textile Mills need to figure out whether the new fabric can be made for $3.15 per yard. If it can’t, the company shouldn’t produce the new product because the market price will not provide the desired return.
Think About It 3.5
Why is it important to figure out the target cost before beginning production of a new product?
UNIT 3.4 REVIEW
KEY TERMS
Cost-plus pricing p. 104
Markup p. 104
Target costing p. 105
SELF STUDY QUESTIONS
1. LO 6 A markup percentage can be calculated as .
True or False?
2. LO 6 Which of the following affects the price a company charges under cost-plus pricing?
2. The cost of the product
2. Competitors’ prices
2. Desired gross margin percentage
2. b. and c. only
2. All of the above
1. LO 6 Dunn Family Auto Repairs offers several services ranging from tire patching to complete transmission rebuilding. Since labor is the main cost of these services, the company charges customers a markup on the worker’s wage rate. The most skilled workers earn $25 per hour; Dunn charges customers $40 per hour. If Dunn applies the same markup percentage to each worker, what price will the company charge for a worker who earns $15 per hour?
3. $20
3. $24
3. $30
3. $40
1. LO 7 The gross margin percentage and the markup percentage are essentially the same. True or False?
1. LO 7 Carpenter Western Wear is a retail clothing store in Lubbock, Texas. On average, the store earns a 40% gross margin on its merchandise. The owner, Carol Carpenter, wants to add jewelry to the sales mix. Carol believes that her customers won’t pay more than $50 for a bracelet. If she wants to maintain the same average gross margin, what is the maximum wholesale cost she should pay for bracelets?
5. $15
5. $20
5. $30
5. $35
UNIT 3.4 PRACTICE EXERCISE
Gorrells and Sunn builds high-quality homes ranging in price from $200,000 to $1 million. John Ellis, a local physician, has asked Gorrells and Sunn to show him some house plans. Dr. Ellis has selected a plan that calls for $300,000 in building materials, $180,000 in labor, and $40,000 in add-ons, but he doesn’t want to pay more than $575,000 for his home. Gorrells and Sunn typically prices its homes based on the total cost of construction plus 15%.
Required
1. What price would Gorrells and Sunn normally quote for this house plan?
2. What is the target cost Gorrells and Sunn would need to meet to sell the house for $575,000 at a 15% markup?
3. What could Gorrells and Sunn do to meet the target cost in part (2)?
SELECTED UNIT 3.4 ANSWERS
Think About It 3.5
When a company is ready to start producing a new product or offering a new service, new investments must be made. For example, new machinery might be purchased, new employees hired, or new office facilities rented. Because these costs are fixed, they will be difficult to reduce in the short run. In other words, once a company has committed to producing a new product or offering a new service, a vast majority of the costs are already incurred. If the product or service can’t command the price that the company expects and costs can’t be reduced, the company will end up earning less money than expected, and perhaps even losing money. If used effectively, target costing can help companies to avoid sinking money into unprofitable products or services.
Self Study Questions
1. True
2. E
3. B
4. False
5. C
Unit 3.4 Practice Exercise
· 1.
· 2.
· 3. Gorrells and Sunn will need to reduce its cost by $20,000 to build the house. The company could use lower-quality building materials or look for cheaper subcontractors to provide labor, though such cost reductions could impact the quality of the house and the company’s reputation. The builder could also work with Dr. Ellis to reduce the add-ons he has selected.
The Wrap-up
Martin Keck now knows how to present the financial implications of the $50,000 advertising campaign and a 10% price reduction.
The advertising campaign represents a $50,000 increase in fixed expenses. Since nothing else is changing, Martin determined that Universal will need to sell at least 12,500 additional jerseys to cover the additional fixed expense ($50,000 ÷ $4 contribution margin). That’s a 24% increase in sales volume just to earn the same net income that Universal earns without the extra advertising. Of course, if the campaign generates customer loyalty so that sales volume remains higher even after the advertising has been discontinued, then the company will benefit in the future.
A 10% price reduction results in a new sales price of $18 ($20 × 90%) and a new commission of $1.08 ($18 × 6%). The new contribution margin would be $2.12 ($18.00 − 14.80 − 1.08). To earn the same $210,000 contribution margin generated by the $20 price, the company would need to sell 99,057 jerseys ($210,000 ÷ $2.12), or 46,557 more jerseys than it sells now.
The worst case scenario for each of the alternatives would be no impact on current sales volume, as it is unlikely that either would reduce sales. If that were to occur, the company would lose $50,000 if it paid for the advertising campaign, but it would lose $98,700 [($4.00 − $2.12) × 52,500 jerseys] with the price reduction.
In making this decision, Martin must rely on his understanding of the industry and his company’s customers. Without the numbers, however, he wouldn’t know where to begin.
CHAPTER SUMMARY
In this chapter you learned some important terms and techniques that will be relevant throughout the rest of this book. Specifically, you should be able to meet the learning objectives set out at the beginning of the chapter:
1.
Calculate the breakeven point in units and sales dollars. (Unit 3.1)
The breakeven point is the level of sales at which sales revenue equals total expense and profit is $0. This point can be calculated in terms of units or sales revenue using either the profit equation or the contribution margin formula, as follows:
2.
Calculate the level of activity required to meet a target income. (Unit 3.2)
To calculate the sales level required to meet a certain level of operating income, use one of the following formulas. If you are working with a target level of net income, divide it by (1 minus the tax rate) to convert it to operating income before using one of the formulas.
3.
Determine the effects of changes in sales price, cost, and volume, on operating income. (Unit 3.2)
Using the following equations, you should be able to solve for any unknown factors that would help in evaluating the financial impact of certain managerial decisions.
Other relationships that you will find helpful in solving these problems include the contribution margin ratio (contribution margin divided by sales revenue) and the variable cost ratio (variable cost divided by sales revenue). The sum of the contribution margin ratio and the variable cost ratio is 1.
4.
Define operating leverage and explain the risks associated with the trade-off between variable and fixed costs. (Unit 3.2)
Operating leverage indicates the change in operating income that will result from a change in sales; it is directly affected by the ratio of fixed expenses to variable expenses. The degree of operating leverage at a particular level of sales can be calculated as follows:
Companies with relatively high contribution margins (meaning low variable costs) and high fixed expenses generate profits quickly once they pass the breakeven point. However, if their sales fall below the breakeven point, their losses mount quickly. To reduce the risk of covering fixed expenses, some companies prefer to carry high levels of variable costs, so that expenses are incurred only as products are sold.
5.
Calculate the multiproduct breakeven point and level of activity required to meet a target income. (Unit 3.3)
Companies that sell more than one product must consider their sales mix in order to solve breakeven and other problems. Holding the sales mix constant for n products, the breakeven point and target operating income can be calculated using the modified profit formula:
6.
Define markup and explain cost-plus pricing. (Unit 3.4)
A markup is the difference between the cost of a product or service and the price a company charges for it. The markup percentage can be calculated as
Cost-plus pricing begins with the cost of a product and adds a markup to determine the price to charge. The flaw in this method is that the resulting price does not reflect the value of the product to the customer. After the price has been calculated, managers must still compare it to the price of a comparable product or service. If the price is too high relative to competitors’ prices, the company is unlikely to be able to sell the product.
7.
Explain target costing and calculate a target cost. (Unit 3.4)
Target costing begins with the price a customer is willing to pay for a product or service and works backward to the maximum cost the company can incur to deliver the product or service to market. Assume, for example, that a company is considering a new product that marketing research suggests customers will pay no more than $25 for. If the company needs a 40% gross profit margin to cover its operating expenses and contribute to profit, then managers must be able to acquire or make the product for no more than $15: $25 − ($25 × 40%) = $15. If managers conclude that they can deliver the product for $15, then they should go ahead with the new venture. If they can’t, then they need to halt the project before the company sinks any more funds into it.
KEY TERMS
Breakeven graph (Unit 3.1)
Breakeven point (Unit 3.1)
Cost-plus pricing (Unit 3.4)
Cost-volume-profit analysis (CVP) (Unit 3.2)
Degree of operating leverage (Unit 3.2)
Margin of safety (Unit 3.1)
Markup (Unit 3.4)
Operating leverage (Unit 3.2)
Sales mix (Unit 3.3)
Target costing (Unit 3.4)
EXERCISES
3-1 Breakeven analysis (LO 1) Fashion Headwear, Ltd., operates a chain of exclusive ski hat boutiques in the western United States. The stores purchase several hat styles from a single distributor at $18 each. All other costs incurred by the company are fixed. Fashion Headwear, Ltd., sells the hats for $30 each.
Required
0. If fixed costs total $150,000 per year, what is the breakeven point in units? In sales dollars?
1. What is Fashion Headwear’s contribution margin ratio? Its variable cost ratio?
2. Assume that Fashion Headwear, Ltd., currently operates at a loss. What actions could managers take to lower the breakeven point and begin earning a profit?
3-2 Breakeven analysis (LO 1) Scott Confectionary sells its Stack-o-Choc candy bar for $0.80. The variable cost per unit for the candy bar is $0.45; total fixed costs are $175,000.
Required
0. What is the contribution margin per unit for the Stack-o-Choc candy bar?
1. What is the contribution margin ratio for the Stack-o-Choc candy bar?
2. What is the breakeven point in units? In sales dollars?
3. If an increase in chocolate prices causes the variable cost per unit to increase to $0.55, what will happen to the breakeven point?
3-3 Target operating income (LO 2) Three years ago, Marissa Moore started a business that creates and delivers holiday and birthday gift baskets to students at the local university. Marissa sells the baskets for $25 each, and her variable costs are $15 per basket. She incurs $12,000 in fixed costs each year.
Required
0. How many baskets will Marissa have to sell this year if she wants to earn $30,000 in operating income?
1. Last year, Marissa sold 4,000 baskets, and she believes that demand this year will be stable at 4,000 baskets. What actions could Marissa take if she wants to earn $30,000 in operating income by selling only 4,000 baskets? Be specific.
3-4 Target net income (LO 2) Marling Machine Works produces soft serve ice cream freezers. The freezers sell for $12,000, and variable costs total $8,200 per unit. Marling incurs $6,840,000 in fixed costs during the year. The company’s tax rate is 25%.
Required
How many freezers must Marling sell to generate net income of $3,420,000?
3-5 Breakeven analysis; target income (LO 1, 2) Reid Recreation Products sells the Amazing Foam Frisbee for $12. The variable cost per unit is $3; fixed costs are $36,000 per month.
Required
0. What is the annual breakeven point in units? In sales dollars?
1. How many frisbees must Reid sell to earn $18,000 in operating income?
2. What operating income must Reid earn to realize net income of $16,200, assuming that the company is in the 40% tax bracket?
3. How many frisbees must Reid sell to earn $16,200 in net income?
3-6 CVP analysis (LO 3) MathTot sells a learning system that helps preschool and elementary students learn basic math facts and concepts. The company’s income statement from last month is as follows:
Required
0. What is MathTot’s contribution margin ratio? Its variable cost ratio?
1. What is MathTot’s margin of safety?
2. If MathTot’s sales were to increase by $100,000 with
no change
in fixed expenses, by how much would net operating income increase?
3. MathTot’s managers have determined that variable costs per unit will increase by 16% beginning next month. To offset this increase in costs, they are considering a 10% increase in the sales price. Market research indicates that the price increase will result in a 2% decrease in the number of learning systems MathTot sells. What will be MathTot’s expected net operating income if the price increase is implemented?
3-7 CVP analysis (LO 3) Clarkson Computer Company distributes a specialized wrist support that sells for $30. The company’s variable costs are $12 per unit; fixed costs total $360,000 a year.
Required
0. If sales increase by $39,000 per year, by how much should operating income increase?
1. Last year, Clarkson sold 32,000 wrist supports. The company’s marketing manager is convinced that a 5% reduction in the sales price, combined with a $50,000 increase in advertising, will result in a 30% increase in sales volume over last year. Should Clarkson implement the price reduction? Why or why not?
3-8 Multiple-choice questions covering various topics; consider each scenario independently (LO 1, 3)
0. James Shaw owns several shaved ice stands that operate in the summer along the Outer Banks of North Carolina. His contribution margin ratio is 60%. If James increases his sales revenue by $25,000 without any increase in fixed cost, by how much will his operating income increase? (a) $25,000; (b) $15,000; (c) $10,000; (d) $5,000.
1. Which of these events will decrease a company’s breakeven point? (a) decrease in units sold; (b) increase in direct labor costs; (c) increase in sales price; (d) both (a) and (b).
2. Halloween, Inc., reported the following income statement data for February: Sales $150,000; Total costs $170,000; Loss ($ 20,000). The firm’s contribution margin percentage at its current selling price of $20 is 40%. What is the company’s total fixed cost? (a) $20,000; (b) $90,000; (c) $60,000; (d) $80,000.
3. Refer to the information in part (c). What would be the change in income if the company paid $6,000 for a special advertising campaign and increased sales by 1,000 units, at $20 per unit? (a) $2,000 increase; (b) $14,000 increase; (c) $4,000 decrease; (d) $6,000 decrease.
4. A company’s selling price is $50; its contribution margin ratio, 32%; its fixed costs, $200,000; and its income, $20,000. What is the company’s breakeven point in units? (a) 11,250; (b) 13,750; (c) 12,500; (d) cannot be determined.
3-9 Breakeven analysis; CVP analysis (LO 1, 3) Matoaka Monograms sells stadium blankets that have been monogrammed with high school and university emblems. The blankets retail for $40 throughout the country to loyal alumni of over 1,000 schools. Matoaka’s variable costs are 40% of sales; fixed costs are $120,000 per month.
Required
0. What is Matoaka’s annual breakeven point in sales dollars?
1. Matoaka currently sells 100,000 blankets per year. If sales volume were to increase by 15%, by how much would operating income increase?
2. Assume that variable costs increase to 45% of the current sales price and fixed costs increase by $10,000 per month. If Matoaka were to raise its sales price by 10% to cover these new costs, what would be the new annual breakeven point in sales dollars?
3. Assume that variable costs increase to 45% of the current sales price and fixed costs increase by $10,000 per month. If Matoaka were to raise its sales price 10% to cover these new costs, but the number of blankets sold were to drop by 5%, what would be the new annual operating income?
4. If variable costs and fixed costs were to change as in part (d), would Matoaka be better off raising its selling price and losing volume or keeping the selling price at $40 and selling 100,000 blankets? Why?
3-10 Breakeven analysis; target operating income; CVP graph (LO 1, 2, 3) Wimpee’s Hamburger Stand sells the Super Tuesday Burger for $3.00. The variable cost per hamburger is $1.75; total fixed cost per month is $25,000.
Required
0. How many hamburgers must Wimpee’s sell per month to break even?
1. How many hamburgers must Wimpee’s sell per month to make $6,000 in operating income?
2. Prepare a CVP graph for Wimpee’s.
3. Assuming that the most hamburgers Wimpee’s has ever sold in a month is 21,000, how likely is Wimpee’s to achieve a target operating income of $6,000? What actions could Wimpee’s manager take to increase the chances of reaching that target operating income?
3-11 Operating leverage (LO 4) Mary Smith sells gourmet chocolate chip cookies. The results of her last month of operations are as follows:
Required
0. What is Mary’s degree of operating leverage?
1. If Mary can increase sales by 10%, by how much will her operating income increase?
3-12 Conceptual breakeven; margin of safety; operating leverage (LO 1, 4) On March 1, 2004, Seagram Co. CEO Edgar Bronfman, Jr., purchased Warner Music Group for $2.6 billion. The next day he fired 1,000 salaried employees and reduced top executives’ salaries, slashing overhead costs by more than $250 million.
Required
0. What effect would these cuts have on Warner’s breakeven point? Explain.
1. What effect would these cuts have on Warner’s margin of safety? Explain.
2. What effect would these cuts have on Warner’s degree of operating leverage? Explain.
3-13 Breakeven analysis; multiproduct CVP analysis (LO 1, 5) Abado Profiles provides testing services to school districts that wish to assess students’ reading and mathematical abilities. In 2010 Abado evaluated 60,000 math tests and 20,000 reading tests. An income statement for 2010 follows.
Required
0. What is Abado’s breakeven point in sales dollars?
1. In an effort to raise the demand for reading tests, managers are planning to lower the price from $36 per test to $20 per test, the current price of the math test. They believe that doing so will increase the demand for reading tests to 60,000. Prepare a contribution format income statement reflecting Abado’s new pricing and demand structure.
2. What will be Abado’s breakeven point in sales dollars if this change is implemented? Do you recommend that Abado make the change?
3-14 Breakeven analysis; multiproduct CVP analysis (LO 1, 5) Kitchenware, Inc., sells two types of water pitchers, plastic and glass. Plastic pitchers cost the company $15 and are sold for $30. Glass pitchers cost $24 and are sold for $45. All other costs are fixed at $982,800 per year. Current sales plans call for 14,000 plastic pitchers and 42,000 glass pitchers to be sold in 2011.
Required
0. How many pitchers of each type must be sold to break even in 2011?
1. Kitchenware, Inc., has just received a sales catalog from a new supplier that is offering plastic pitchers for $13. What would be the new breakeven point if managers switched to the new supplier?
3-15 Markups; cost-plus pricing (LO 6) According to a December 19, 2005, BusinessWeek article, the gross margin for an Apple iPod can run as high as 25%.
Required
0. If the sales price for an iPod Nano is $249, what is the cost to make it, assuming a 25% gross margin?
1. If Apple were to reduce the cost of producing the iPod to $166, what would be the markup percentage at the $249 sales price?
2. If Apple were to reduce the cost of producing the iPod to $166, what would be the sales price at a 25% gross margin?
3-16 Markups; cost-plus pricing (LO 6) The following is Talley Company’s 2010 income statement.
Required
0. What is the markup percentage on cost of goods sold?
1. What is the markup percentage on total cost?
2. What is the gross margin percentage?
3. If the company wants to sell a new product that costs $42 wholesale while keeping the same markup structure, what will be the price of the new product?
3-17 Target costing (LO 7) Justin Allen, a product engineer for L’Oso Gaming, is designing a new electronic game. Market research indicates that gamers will pay $36 for the game.
Required
0. If L’Oso desires a 60% markup on production costs, what is the target cost for the new game?
1. Justin believes it will cost $24 per unit to produce the new game. What actions should he take next?
3-18 Cost-plus pricing; target costing (LO 6, 7) Pet Designs makes various accessories for pets. Their trademark product, PetBed, is perceived to be high quality but not extravagant, and is sold in a variety of pet stores. Wanda Foster, marketing manager, has convinced her boss that they are missing an important segment of the market. “We can increase the quality of the material and design and market PetBed to a higher-end clientele,” Wanda claims. “We won’t compete with our existing product. It’s win-win!”
PetBeds sell for $45 each. Wanda estimates the gross margin at $15. After working with production engineers and the marketing research team, Wanda has designed a bed that she believes the new market segment will pay $78 for. The production engineers and accountants believe it will cost about $58 to make.
Required
0. If Pet Designs uses cost-plus pricing and prices most products like the original PetBed, what should be the price of the high-end PetBed?
1. If Pet Designs wants to preserve the existing gross margin percentage, what is the target cost at a market price of $78?
2. B
ased on your answers to (a) and (b), what are Pet Designs’ alternatives?
PROBLEMS
3-19 Breakeven analysis; margin of safety (LO 1) The Robinson Company sells sports decals that can be personalized with a player’s name, a team name, and a jersey number for $5 each. Robinson buys the decals from a supplier for $1.50 each and spends an additional $0.50 in variable operating costs per decal. The results of last month’s operations are as follows:
Required
0. What is Robinson’s monthly breakeven point in units? In dollars?
1. What is Robinson’s margin of safety?
3-20 CVP analysis (LO 3) CB Markets imports and sells small bear-shaped piñatas. In planning for the coming year, the company’s owner is evaluating several scenarios. For each scenario under consideration, prepare a contribution margin income statement showing the anticipated operating income. Consider each scenario independently. Last year’s income statement is as follows:
Required
0. The sales price increases by 10% and sales volume decreases by 5%.
1. The sales price increases by 10% and variable cost per unit increases by 5%.
2. The sales price decreases by 10% and sales volume increases by 20%.
3. Fixed expenses increase by $20,000.
4. The sales price increases by 10%, variable cost per unit increases by 10%, fixed expenses increase by $25,000, and sales volume decreases by 10%.
3-21 CVP analysis (LO 3) SND, Inc., had the following results for 2010:
Prepare a new income statement for each of the following scenarios. Consider each scenario independently.
Prepare a new income statement for each of the following scenarios. Consider each scenario independently.
Required
0. Sales volume decreases by 10%.
1. The sales price increases by 5%.
2. Variable costs per unit increase by $1.50.
3. The sales price decreases to $18, and an additional 5,000 units are sold.
4. A new advertising campaign costing $75,000 increases sales volume by 15%.
5. Variable costs per unit increase by $2.00, the sales price per unit increases by $1.50, sales volume decreases by 2,500 units, and fixed expenses increase by $20,000.
3-22 CVP analysis (LO 3) Universal Sports Exchange has just received notice from C&C Sports that the cost of a baseball jersey will be increasing to $15.30 next year. In response to this increase, Universal is planning its sales and marketing campaign for the coming year. Managers have developed two possible plans and have asked you to evaluate them.
The first plan calls for passing on the entire $0.50 cost increase to customers through an increase in the sales price. Managers believe that $5,000 in additional advertising targeted directly to current customers will allow the sales force to reach the current year’s sales volume of 52,500 jerseys.
The second plan relies on a new advertising campaign that focuses on the sales price remaining the same as last year. The campaign would include a new database that offers more potential customers than Universal has had access to in the past. The cost of the campaign is expected to be $10,000. Managers believe that the campaign will be more successful in generating new sales than the current incentive-based sales and marketing plan. As a result, they want to reduce the sales commission from 6% to 4% of sales and increase sales salaries by $22,000. The campaign is expected to generate an additional 10% in sales volume.
Using the information in
Exhibit 3-1
(p. 83) as a starting point, complete the following questions.
Required
0. How much would operating income decrease if Universal did nothing to recover the increase in cost of goods sold, all other things equal?
1. Determine the expected operating income under each proposed sales and marketing plan.
2. Why does the first plan result in a reduction in operating income that is greater than the $5,000 advertising?
3. Which plan do you recommend to management? Why?
3-23 Breakeven; CVP analysis (LO 1, 3) W Promotions sells T-shirts imprinted with high school names and logos. Last year the shirts sold for $18 each, and variable costs were $5.40 per shirt. At this cost structure, the breakeven point was 20,000 shirts. However, the company actually earned $15,120 in net income.
This year, the company is increasing its price to $21 per shirt. Variable costs per shirt will increase by one-third, and fixed expenses will increase by $30,900. The tax rate will remain at 40%.
Required
0. Prepare a contribution format income statement for last year.
1. How many T-shirts must the company sell this year to break even?
2. How many T-shirts must the company sell this year in order to earn $28,980 in net income?
3-24 Breakeven; target income; CVP analysis (LO 1, 2, 3) Justin Lake operates a kiosk in downtown Chicago, at which he sells one style of baseball hat. He buys the hats from a supplier for $13 and sells them for $18. Justin’s current breakeven point is 15,000 hats per year.
Required
0. What is Justin’s current level of fixed costs?
1. Assume that Justin’s fixed costs, variable costs, and sales price were the same last year, when he made $14,000 in net income. How many hats did Justin sell last year, assuming a 30% income tax rate?
2. What was Justin’s margin of safety last year?
3. If Justin wants to earn $17,500 in net income, how many hats must he sell?
4. How many hats must Justin sell to break even if his supplier raises the price of the hats to $14 per hat?
5. What actions should Justin consider in response to his supplier’s price increase?
6. Justin has decided to increase his sales price to $20 to offset the supplier’s price increase. He believes that the increase will result in a 5% reduction from last year’s sales volume. What is Justin’s expected net income?
3-25 Breakeven analysis; target income; CVP analysis (CMA adapted) (LO 1, 2, 3) Delphi Company has developed a new product that will be marketed for the first time next year. The product will have variable costs of $16 per unit. Although the marketing department estimates that 35,000 units could be sold at $36 per unit, Delphi’s management has allocated only enough manufacturing capacity to produce a maximum of 25,000 units a year. The fixed costs associated with the new product are budgeted at $450,000 for the year. Delphi is subject to a 40% tax rate.
Required
0. How many units of the new product must Delphi sell in the next fiscal year to break even?
1. What is the maximum net income that Delphi can earn from sales of the new product in the next fiscal year?
2. Delphi’s managers have stipulated that they will not authorize production beyond the next fiscal year unless the after-tax profit from the new product is at least $75,000. How many units of the new product must be sold in the next fiscal year to ensure continued production?
3. Regardless of your answer in part (c), assume that more than the allowed production of 25,000 units will be required to meet the $75,000 net income target. Given the production constraint (maximum of 25,000 units available), what price must be charged to meet the target income and continue production past the next fiscal year?
4. Assume that the marketing manager thinks the price you calculated in part (d) is too high. What actions could the project manager take to help ensure production of the new product past the current fiscal year?
3-26 Target income; CVP analysis (CMA adapted) (LO 2, 3) Kipmar Company J produces a molded briefcase that is distributed to luggage stores. The following operating data for the current year has been accumulated for planning purposes.
Kipmar can produce 1.5 million cases a year. The projected net income for the coming year is expected to be $1.8 million. Kipmar is subject to a 40% income tax rate.
During the planning sessions, Kipmar’s managers have been reviewing costs and expenses. They estimate that the company’s variable cost of goods sold will increase 15% in the coming year and that fixed administrative expenses will increase by $150,000. All other costs and expenses are expected to remain the same.
Required
0. What amount of sales revenue will Kipmar need to achieve in the coming year to earn the projected net income of $1.8 million?
1. What price would Kipmar need to charge for the briefcase in the coming year to maintain the current year’s contribution margin ratio?
3-27 Operating leverage (LO 4) Picasso’s Pantry is a chain of arts and crafts stores. Results for the most recent year are as follows:
Required
0. What is Picasso’s Pantry’s degree of operating leverage?
1. If sales increase by 5%, what will the new operating income be?
2. Managers are considering changing Picasso’s cost structure by offering employees a commission on sales rather than a fixed salary. What effect would such a change have on the firm’s operating leverage?
3-28 Sales mix (LO 5) Starbucks, a company that has set out “to become the leading retailer and brand of coffee,” operates retail outlets in a variety of locations, including downtown office buildings, university campuses, and suburban malls. These retail outlets sell more than coffee and related beverages. The following chart shows the retail sales mix for 2005 and 2009.
Required
0. Discuss the effect that the change in sales mix might have had on Starbucks’ breakeven point and operating income.
1. Assume that equipment and accessories have a higher contribution margin ratio than food items. Was the decrease in the percentage of sales provided by equipment and accessories a desirable outcome in 2009?
2. Within the equipment and accessories line, do you think all products have the same contribution margin? Why or why not?
3-29 Breakeven analysis; multiproduct CVP analysis (CMA adapted) (LO 1, 4) Return to Problem 3-26. Kipmar Company’s managers are considering expanding the product line by introducing a leather briefcase. The new briefcase is expected to sell for $90; variable costs would amount to $36 per briefcase. If Kipmar introduces the leather briefcase, the company will incur an additional $300,000 per year in advertising costs. Kipmar’s marketing department has estimated that one new leather briefcase would be sold for every four molded briefcases.
Required
0. If managers decide to introduce the new leather briefcase, given the cost changes on the molded briefcase presented in Problem 3-26, how many units of each briefcase would be required to break even in the coming year? Cost of good sold for the molded briefacse is expected tobe $13.80 per unit.
1. After additional research, Kipmar’s marketing manager believes that if the price of the new leather briefcase drops to $66, it will be more attractive to potential customers. She also believes that at that price, the additional advertising cost could be cut to $177,600. These changes would result in sales of one molded briefcase for every three leather briefcases. Based on these circumstances, how many units of each briefcase would be required to break even in the coming year?
2. What additional factors should Kipmar’s managers consider before deciding to introduce the new leather briefcase?
3-30 Breakeven analysis; multiproduct CVP analysis (LO 1, 5) Herzog Industries sells two electrical components with the following characteristics. Fixed costs for the company are $200,000 per year.
Required
0. How many units of each product must Herzog Industries sell in order to break even?
1. Herzog’s vice president of sales has determined that due to market changes, the sales price of component XL-709 can be increased to $14.00 with no impact on sales volume. What will be Herzog’s new breakeven point in units?
2. Returning to the original information, Herzog’s vice president of marketing believes that spending $60,000 on a new advertising campaign will increase sales of component CD-918 to 80,000 units, without affecting the sales of product XL-709. How many units of each product must Herzog sell to break even under this new scenario?
3. The market changes referred to in part (b) indicate additional overall demand for component XL-709. Herzog’s vice president of marketing believes that if the company spends $60,000 to advertise component XL-709 rather than CD-918, as planned in part (c), the company will be able to sell a total of 50,000 units of XL-709 at the new price of $14.00. If the company must choose to advertise only one component, which component should receive the additional $60,000 in advertising?
3-31 General pricing; markups (LO 6) Taylor Pennington produces and sells leather briefcases. One day during lunch he complained to his friend Steven Green, an economist, that he was having trouble setting prices. When he raised his prices, demand went down as expected, but he could never predict how much demand would change. “I understand my costs quite well,” Taylor commented. “I can produce briefcases for $60 each, and I incur $350,000 in fixed costs each year. I think I could manage my business much better if I had a better idea of the demand for briefcases at different prices.” Steve said he would take a look at several years’ worth of sales data and try to estimate a demand curve for the briefcases. He came up with the following table:
Required
0. What price can be expected to result in the highest operating income?
1. What is the markup on variable cost at the price you selected in part (a)?
2. What is the markup on variable cost when the sales price is $200? $100?
3. What can you conclude about the value of cost-plus pricing compared to pricing based on a demand schedule?
3-32 Cost-plus pricing; target costing (LO 6, 7) Gail Sawyer has just started a new catering business in Dallas, Texas. Instead of establishing a fixed menu, she has decided to make whatever the customer wants until she knows how well different dishes will be received. Gail has been invited to bid on the rehearsal dinner for the wedding of the mayor’s son. If she wins the bid and gets the job, some of the most prominent people in Dallas will taste her food. She can’t get better advertising than that!
The mayor has decided on a menu of peanut soup, baby field greens salad with fresh mozzarella, grilled salmon, bacon-wrapped filet mignon, baby asparagus with hollandaise sauce, and white chocolate creme brulée. Gail estimates that the selected menu will require $30 of food per person. She has been quoting prices based on a 60% markup on food cost.
Required
0. What is the minimum price per person that Gail should quote for the job?
1. What price would Gail need to charge to achieve her desired 60% markup?
2. Assume the mayor has already received a bid of $45 per person and has told Gail that she will not pay more than that. If Gail agreed to a price of $45 per person for the desired menu, what markup would she realize?
3. If Gail met the lower price and took the job, what might be some potential consequences, both good and bad?
CASES
3-33 Operating leverage (LO 4) In 1999, Blue Nile, Inc., began selling diamonds and other fine jewelry over the Internet. Using an online retailing model, Blue Nile prices its diamonds at an average of 35% less than traditional bricks-and-mortar jewelers. In fewer than five years, the company had become the eighth-largest specialty jeweler in the United States. On May 20, 2004, Blue Nile went public with an initial stock offering priced at $20.50 per share. By the end of the day, shares were trading at $28.40. Before the end of the month, the share price had doubled, before closing at month’s end in the mid-$30s.
While traditional jewelers operate with gross margins of up to 50%, Blue Nile’s gross margin percentage for the year ended January 4, 2009 was just 20.3%. Yet the company remains competitive despite its lower gross margin. As of January 4, 2009, Blue Nile employed 170 full-time, 7 part-time employees, and 3 independent contractors. It leased its 24,000-square-foot corporate headquarters in Seattle, Washington, as well as an additional 27,000-square-foot fulfillment center in the United States and a 10,000-square-foot fulfillment center in Dublin, Ireland.
Compared to Blue Nile, Tiffany & Co., one of the world’s best-known in-store jewelers, is a giant. Tiffany & Co. opened its doors in New York City in 1837 and has since grown into an international operation. Regarded as one of the world’s premier jewelers, the company went public in 1987 at $1.92 per share and closed that day at $1.93 per share. A month later it was trading at $1.90 per share. Seventeen years later, on the day Blue Nile went public, Tiffany & Co. closed at $33.90 per share.
As of January 31, 2009, Tiffany & Co. employed approximately 9,000 people. The company owns a 124,000-square-foot headquarters building on Fifth Avenue in New York City, 42,000 square feet of which is devoted to a retail storefront. The company has 85 other stores in the United States and 120 more abroad. The average operating profit as a percentage of sales for the retail jewelry industry is 5%.
Selected income statement information for the two companies is as follows.
Required
0. How do Tiffany’s fixed costs compare to those of Blue Nile, Inc.?
1. How can Blue Nile, Inc., remain competitive with its 20.3n% gross margin percentage when Tiffany & Co. earns a 57.5% gross margin?
2. Which company do you believe has the greater operating leverage? Why?
3. In Tiffany & Co.’s 2003 Annual Report, management stated that gross margin had declined for several reasons, one of which was “changes in sales mix toward higher-priced, lower-margin diamond jewelry.” How would this shift have affected the company’s contribution margin?
4. On April 22, 2004,
Amazon.com
launched its online jewelry store. Which company’s cost structure do you think it resembles, Blue Nile’s or Tiffany’s? Why?
3-34 Comprehensive CVP analysis (LO 1, 2, 3, 5) “I’ll never understand this accounting stuff,” Blake Dunn yelled, waving the income statement he had just received from his accountant in the morning mail. “Last month, we sold 1,000 stuffed State University mascots and earned $6,850 in operating income. This month, when we sold 1,500, I thought we’d make $10,275. But this income statement shows an operating income of $12,100! How can I ever make plans if I can’t predict my income? I’m going to give Janice one last chance to explain this to me,” he declared as he picked up the phone to call Janice Miller, his accountant.
“Will you try to explain this operating income thing to me one more time?” Blake asked Janice. “After I saw last month’s income statement, I thought each mascot we sold generated $6.85 in net income; now this month, each one generates $8.07! There was no change in the price we paid for each mascot, so I don’t understand how this happened. If I had known I was going to have $12,100 in operating income, I would have looked more seriously at adding to our product line.”
Taking a deep breath, Janice replied, “Sure, Blake. I’d be happy to explain how you made so much more operating income than you were expecting.”
Required
0. Assume Janice’s role. Explain to Blake why his use of operating income per mascot was in error.
1. Using the following income statements, prepare a contribution margin income statement for March.
2. Blake plans to sell 500 stuffed mascots next month. How much operating income can Blake expect to earn next month if he realizes his planned sales?
3. Blake wasn’t happy with the projected income statement you showed him for a sales level of 500 stuffed mascots. He wants to know how many stuffed mascots he will need to sell to earn $3,700 in operating income. As a safety net, he also wants to know how many stuffed mascots he will need to sell to break even.
4. Blake is evaluating two options to increase the number of mascots sold next month. First, he believes he can increase sales by advertising in the University newspaper. Blake can purchase a package of 12 ads over the next month for a total of $1,200. He believes the ads will increase the number of stuffed mascots sold from 500 to 960. A second option would be to reduce the selling price. Blake believes a 10% decrease in the price will result in 1,000 mascots sold. Which plan should Blake implement? At what level of sales would he be indifferent between the two plans?
5. Just after Blake completed an income projection for 1,200 stuffed mascots, his supplier called to inform him of a 20% increase in cost of goods sold, effective immediately. Blake knows that he cannot pass the entire increase on to his customers, but thinks he can pass on half of it while suffering only a 5% decrease in units sold. Should Blake respond to the increase in cost of goods sold with an increase in price?
6. Refer back to the original information. Blake has decided to add stadium blankets to his product line. He has found a supplier who will provide the blankets for $32, and he plans to sell them for $55. All other variable costs currently incurred for selling mascots will be incurred for selling blankets at the same rate. Additional fixed costs of $350 per month will be incurred. He believes he can sell one blanket for every three stuffed mascots. How many blankets and stuffed mascots will Blake need to sell each month in order to break even?
3-35 Ethics and CVP analysis (LO 3) At 3:00 P.M. on Friday afternoon, Dan Murphy, vice president of distribution, rushed into Grace Jones’s office exclaiming, “This is the fourth week in a row we’ve filed a record number of claims against our freight carriers for products damaged in shipment. How can they all be that careless? At this rate, we’ll have filed over $150,000 in claims this year to replace damaged goods. Some of the freight carriers claim we’re their worst customer. Sure, we give them lots of business, but we’ve got the highest claims level.”
“That’s interesting,” replied Grace, the company’s CFO. “Last week Jeff and I were talking about the great cartons he just purchased for shipping our products. In fact, he had to get special permission to enter into a long-term contract with the company, so that it would provide us with the cartons at a reduced price. He prepared a great proposal outlining the increase in income we could expect based on the number of cartons we use per period and the cost savings per carton. His proposal for tying us into a long-term contract was accepted because he specifically addressed the need to maintain the quality that our customers have come to expect while at the same time improving the bottom line. If anything, I would have thought our claims would have been reduced, and that we would have started to save money by buying boxes in bulk. Why don’t you see if Jeff has any insights into the problem?”
Dan found Jeff in the coffee room early Monday morning. “Hey Jeff, we’ve been having lots of trouble lately with damage claims. Grace tells me you bought some new cartons for shipping. Do you think they could be causing the problem?”
“Gee, I hope not,” replied Jeff. “My evaluations have been awesome since I cut costs so dramatically. In fact, the product managers have been singing my praises since the variable costs of shipping went down and their contribution margins went up.”
“Well, I’ve got to figure this out,” said Dan, “because the freight companies are breathing down my neck, and they’ve threatened to quit paying our claims. The sales reps are all over me, too, because their customers are irritated at having to go through the claims process. They want their products delivered free of damage, the first time. Let me take a look at the cartons and see if I can figure out the problem.”
As Dan left the room, Jeff started to worry. Jeff was aware of the crush weight standards (i.e., the strength) of the company’s cartons. He decided to save the company some money by trying a carton with a slightly lower crush weight. Of course, the savings would also make Jeff look good at annual evaluation time, and this was important since he was up for a promotion. He had gotten such a great deal on the new cartons because his brother Marvin had just been named sales manager at a new carton manufacturing company. Jeff signed the long-term contract so that his brother would achieve a sizeable year-end bonus for exceeding his sales targets. Part of the bonus was a week-long trip for two to the Super Bowl, and Marvin promised Jeff he could go with him.
Wednesday morning Dan called Jeff and said, “I’ve been talking with our shipping department, and one of the guys figured out that the cartons on the bottom of the pallet seem to suffer the most damage. It turns out that the crush weight of the new cartons you purchased wasn’t as high as that of the old boxes. We’ve filed all those damage claims against our carriers, and the damage hasn’t been their fault at all. I guess you need to go back to purchasing the sturdier cartons.”
“Can’t do that for the next 15 months,” Jeff moaned. “We’re locked into a long-term contract.”
Required
0. Identify the ethical issues in this case.
1. What steps should Dan and Jeff take next?
2. What are the costs and benefits to the company for making an ethical decision?
ENDNOTES
1
. The following abbreviations will be used in equations throughout the chapter:
x = number of units
SP = sales price per unit
VC = variable cost per unit
FC = fixed expenses
OI = operating income
CM = contribution margin
2
. “Entrepreneurial Words of Wisdom,” American Way, July 15, 2004, 58.
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7
ACTIVITY-BASED COSTING AND ACTIVITY-BASED MANAGEMENT
After studying this chapter, you should be able to meet the following learning objectives (LO).
1. Classify activities as unit-level, batch-level, product-level, customer-level, or organization-level. (Unit 7.1)
2. Calculate activity-based product costs. (Unit 7.2)
3. Explain the difference between traditional product costs and activity-based product costs. (Unit 7.2)
4. Distinguish between value-added and non-value-added activities. (Unit 7.3)
5. Explain how information about activities can be used to make decisions. (Unit 7.3)
The Pitch
It was early in 2012, and C&C Sports’ managers were reeling from the recently released operating results for 2011. Selling more award jackets than budgeted should have increased C&C’s operating income, but that hadn’t happened. Instead, costs had skyrocketed (see
Chapter 6
). Direct material and direct labor costs were part of the problem, but other production costs had come in much higher than expected.
George Douglas, CEO, called a meeting of upper management to discuss the unexpected results. “We’ve never missed budgeted income by this much,” said Douglas. “I am more convinced than ever that we don’t understand what it costs to make our products,” CFO Claire Elliot replied. “You’re right,” Penny Townsley, production operations manager, chimed in, “but our production has been fairly stable for the last several years. As we’ve added more award jackets to the mix, operations have become more complex. I’ve been telling you all that making jackets isn’t the same as making pants and jerseys. I’m not saying that they’re a bad product line, but we have to do a lot more to make a jacket than we do for the other two products.”
“Selling the jackets is no easy job, either,” commented Jonathan Smith, vice president of marketing. “It takes a lot more time and advertising to complete a sale. Thank goodness the jackets are priced high enough to make it worthwhile. Apparently our competitors don’t want to go to as much trouble as we do. We’ve been hearing that our jackets are higher quality and less expensive than our competitors’. I’m convinced that we could sell even more jackets next year.”
“Well, we can’t just stop operations until we figure out this problem,” said George. “Let’s keep to our plan of improving cash flow and meeting sales targets, but let’s not sell any more jackets than we did last year until we know what’s going on. In the meantime, we need to find out why our costs have increased so dramatically.” The meeting adjourned with everyone still scratching their heads.
UNIT 7.1 Activity-Based Costing
GUIDED UNIT PREPARATION
Answering the following questions while you read this unit will guide your understanding of the key concepts found in this unit. The questions are linked to the learning objectives presented at the beginning of the chapter.
1. What is an activity? Provide some examples. LO 1
2. Define the following activity types and provide one example of each: LO 1
2. Unit-level activity
2. Batch-level activity
2. Product-level activity
2. Customer-level activity
2. Organization-level activity
1. What characteristics of an organization make it a good candidate to implement activity-based costing? When is activity-based costing not likely to benefit an organization? LO 1
In preceding chapters, you have learned how managers use product cost information to make a variety of decisions. But what happens if that product cost information is distorted? Managers may make poor decisions, and results may not occur as expected. That is what C&C Sports’ managers experienced when the company produced and sold more award jackets than budgeted. Revenue increased, but costs increased more than they expected, decreasing the company’s income. Apparently, award jackets cost more to produce than the managers realized.
Managers at Starn Tool & Manufacturing in Meadville, Pennsylvania, had a similar experience. The company’s product costing system did not reflect the way costs were actually incurred on the shop floor. As president and owner Bill Starn realized, some jobs that looked profitable were actually losing money, while others that looked unprofitable were making money. The company turned to activity-based costing. Now that managers better understand the costs the company incurs, job bidding is more accurate.
1
In this unit we will explore the differences between traditional, GAAP-based product costing (see
Chapter 4
) and activity-based costing.
Why Activity-Based Costing?
What leads a manager to question the accuracy of the reported costs of products or services? Typically, doubt arises when a company’s operating or financial results haven’t materialized as expected. At C&C Sports, higher revenue coupled with lower operating income suggested that award jackets might be more costly to produce than profitability reports showed. At other companies, the continual loss of business to a lower bidder, even when managers believe that their bid barely covers costs, might be the source of suspicion.
Recall from
Chapter 4
that direct materials and direct labor costs are directly traceable to products and services. Calculating the direct materials and direct labor costs that have been incurred to produce a product or deliver a service is relatively simple. If all costs could be traced directly to cost objects in this way, there would be no problem. Managers would know exactly how much it cost to produce a product or deliver a service. So if product costs have become a problem, nontraceable costs, such as manufacturing overhead, must be the source. The problem is the way that these manufacturing overhead costs are allocated to a product or service.
When direct materials and direct labor comprise the majority of product costs, manufacturing overhead allocation is not a major issue. But in recent decades, manufacturing overhead has increased in size relative to direct materials and direct labor. Armstrong Laing Group estimates that in the last 35 years, manufacturing overhead cost has more than doubled, climbing to approximately 40% of total product cost.
2
In that same period, direct labor cost has fallen by more than half, to approximately 10% of total product cost. With such a dramatic increase in manufacturing overhead cost, the choice of a method for allocating the cost has become an important managerial decision.
Activity-based costing (ABC) is a costing technique that assigns costs to cost objects such as products or customers, based on the activities those cost objects require. An activity is an event that consumes resources. Activities include tasks such as ordering materials, processing purchase orders, and setting up machines. When Oxford University Library Services implemented an ABC system, it identified activities such as ordering books from publishers, shelving and reshelving books, answering customer inquiries, and processing interlibrary loan requests.
3
A simple ABC model can have fewer than 20 activities; a complex model may include over 500 activities.
4
Frederick Taylor was the first to understand the importance of a business’s activities. In the early 1900s, Taylor examined workers’ jobs as a set of tasks, each of which had a standard completion time.
5
But his idea was slow to catch on. In The Practice of Management (1954), Peter Drucker lamented “To find out what activities are needed to attain the objectives of the business is such an obvious thing to do that it would hardly seem to deserve special mention. But analyzing the activities is as good as unknown to traditional theory.”
6
Activity-based costing did not gain widespread popularity until 1987, when Robin Cooper and Robert Kaplan discussed it in their article “How Cost Accounting Systematically Distorts Product Costs.”
7
By 2005, 55% of companies surveyed were actively using activity-based costing; another 32% were considering its adoption.
8
Exhibit 7-1
illustrates the basic concept of overhead usage in activity-based costing. A company incurs costs to obtain resources such as factories, machinery, and workers. Those resources are consumed by the activities performed that produce the product or deliver the service to the customer. With activity-based costing, the goal is to allocate a cost in a manner that reflects the amount of each resource consumed by the activities performed to produce a specific product. For example, C&C makes cash payments (a cost) to obtain a sewing machine (a resource) for use in sewing (an activity) the company’s pants, jerseys, and jackets (products).
EXHIBIT 7-1 Overhead usage in activity-based costing.
Let’s look at a simple example to illustrate the problem of manufacturing overhead cost allocation. C&C incurs costs to purchase and operate a forklift that moves bolts of fabric from the warehouse to the cutting department. In
Chapter 4
you learned that C&C applies manufacturing overhead to its products based on direct labor cost. Of a total $826,600 in direct labor costs, $440,000 is incurred to produce 183,500 pairs of pants, $127,400 to produce 66,500 jerseys, and $259,200 to produce 18,000 award jackets. Since pants have the highest direct labor cost, they are assigned the largest share of the manufacturing overhead costs related to the forklift. But does the cost of labor affect how often the forklift is used to move a pair of pants or a jacket? It takes one trip from the warehouse to deliver the fabric for a batch of pants and one trip to deliver the fabric for a batch of jackets. Use of the forklift, then, is related to the number of batches moved, not to the direct labor cost incurred.
Are manufacturing overhead costs a problem for all companies? Not necessarily. If a company produces products or delivers services that are very similar, or that consume resources in the same way, then analyzing the details associated with overhead is unlikely to offer greater precision in product costing. Likewise, if a company makes different products, but does so in a separate production facility for each product, there would be no confusion about which overhead costs are incurred for specific products. However, if a company produces products or delivers services that differ in complexity or in their consumption of common (overhead) resources, then greater attention to overhead and the activities that generate overhead costs could provide better cost information for decision making. Indicators that an activity-based costing analysis may be appropriate include the following.
9
· Bids for complex products are accepted, while bids for simple products are rejected.
· High-volume jobs show losses or minimal profits, while low-volume jobs show healthy profits.
· Bids for jobs that require “special” processing are always accepted.
· Some manufacturing departments run at capacity, whereas others have minimal operations.
Would an activity-based analysis that focused only on manufacturing overhead improve GAAP-based financial statements? No. Because the balances in inventory and cost of goods sold, the two accounts that contain product costs, are aggregate numbers, not much will be gained from shifting costs from one product to another (only to add them together again). But an activity-based analysis that focused on all costs to produce and deliver a product or service, not just the production costs, would enhance decision making. This means that the activity-based analysis would include selling and administrative activities and costs. For example, the total activity-based cost should include the cost to deliver a product to a customer.
Including these nonproduct costs in the activity-based costing analysis means that the resulting costs cannot be used for GAAP-based financial reporting of inventory or cost of goods sold. However, if a company wants to use activity-based costing for financial reporting, the approach can easily be adapted to comply with GAAP.
Analyzing the activities that consume manufacturing overhead, selling, and administrative resources is a time-consuming process. Therefore, managers need to decide what the information will be used for and whether the expected benefit from the new information will be worth the cost to gather it. Because the main reason for generating new information is to help managers make better decisions, we will focus our discussion on providing better product costing information for internal decision making.
Classification of Activities
All activities are not created equal. In an activity-based costing system, activities are classified into five categories: (1) unit-level; (2) batch-level; (3) product-level; (4) customer-level; and (5) organization-level. This classification recognizes that different activities consume resources differently and that different cost objects use activities differently.
Unit-level activities are performed for each individual unit of product. Since each unit of a particular product requires the same level of activity, each unit consumes the same amount of resources that provide that activity. The total level of activity performed varies proportionately with the number of units produced. At C&C Sports, providing electricity to run the sewing machines is a unit-level activity, since the amount of electricity used is a function of the number of units sewn.
Batch-level activities are performed all at once on groups, or batches, of products. Since the activity is based on the existence of the batch rather than on the number of units in the batch, a batch consumes the same amount of resources whether it contains 20 units or 2,000 units. At C&C Sports, pants are produced in batches of 50, jerseys in batches of 35, and jackets in batches of five. When production begins on pants, the forklift operator gathers enough fabric to make 50 pairs of pants and moves it from the raw materials warehouse to the cutting tables, all at once. The same is true for jerseys and jackets, except that the amount of fabric moved is enough to make 35 jerseys or five jackets, respectively. So even though the batches include fabric for ten times more pants than jackets, the cost of moving each batch is the same.
Think About It 7.1
If a batch of 5 jackets and a batch of 50 pants cost the same amount to move, what is the relative moving cost of one jacket compared to one pair of pants?
Product-level activities, also referred to as product-sustaining activities, are those that support the products or services a company provides. These activities are performed for the entire product line, regardless of how many units or batches are produced. At C&C Sports, creating a pattern for a new style of jersey is a product-level activity. When a product is eliminated, these activities are no longer performed.
Customer-level activities are performed for specific customers. For example, making a sales call and processing a sales order are customer-level activities. These activities, and the resources consumed to perform them, do not affect product costs. Rather, the resources are consumed to deliver customer support services, so the associated costs should be used to determine the cost to serve a particular customer. These activities are explored further in Focus on Customer Profitability Analysis.
Reality Check—At the center of activity
Plexus has built a profitable niche by producing a relatively high number of different products in numerous small batches
Understanding business activities is critical to understanding costs. Without such an understanding, a manager can unwittingly drive an organization into a financial tailspin.
One company that appears to understand how activities work is Plexus Corp., an assembler of electronic goods. Plexus has built a profitable niche by producing a relatively high number of different products in numerous small batches. This company takes on jobs that many larger companies find too small.
Understanding how resources are consumed by batch activities is essential to Plexus’s success. Each time the company changes from one small batch to the next, the production line must be retooled for the next product. Through careful facility arrangement and cross-training, Plexus has reduced the time required for such changeovers to as little as 30 minutes.
But just because an organization understands activities doesn’t mean that its customers do. Following a U.S. Postal Service rate increase for magazines in July 2007, some publishers showed a clear misunderstanding of the relationship between activities and resource consumption. In a Los Angeles Times editorial, they commented that “Rather than base rates on total weight and total number of pieces mailed, the new, complex formula is full of incentives that take into account packaging, shape, distance traveled and more.”
The incentives referred to in this quotation include a discounted rate for magazines that bear computer-readable mailing labels, which eliminate the need for human sorting, and a discount for dropping off magazines at a location closer to their final destination, which minimizes final delivery transportation cost. Basically, the new pricing structure is designed to charge for the resources consumed based on the activities performed. But apparently, some people don’t want to pay for what they get.
Sources: William M. Bulkeley, “Plexus Strategy: Smaller Runs of More Things,” The Wall Street Journal, October 8, 2003; Nate Guidry, “Magazines Brace for Higher Postage,” Pittsburgh Post-Gazette, July 10, 2007; Teresa Stack and Jack Fowler, “Magazines Feeling Postal Pinch,” Los Angeles Times, May 28, 2007.
Organization-level activities are required to provide productive capacity and to keep the business in operation. These activities do not provide identifiable benefits to specific products or services, but without them there would be no business. At C&C Sports, renting factory space and managing the organization (by the CEO or CFO, for example) are examples of organization-level activities that support the entire business. Regardless of how many units, batches, or products are produced or how many customers are served, these activities must continue. Therefore, the cost of the resources consumed by these activities should not be allocated to products or customers. Notice that this approach differs from GAAP-based product costing, in which costs such as factory rent are included as part of overhead and in the product costs that are used to prepare the financial statements.
Of the five categories of activities, only the first three are product- or service-related. Therefore, we will focus only on those activities in determining the resources that a product or service consumes.
Exhibit 7-2
compares the components of product cost used in traditional costing under GAAP-based financial reporting to the components used in internal decision making under activity-based costing.
EXHIBIT 7-2 Comparison of GAAP-based and activity-based product costs.
Although costs of the resources consumed by customer-level and organization-level activities can be allocated to products or services, determining a reasonable activity measure for use in allocating the costs would be difficult, and the information would not be helpful in decision making. Does that mean managers should ignore these costs? Absolutely not. Instead, managers need to find other ways of determining whether the benefits received from these resources are worth their cost.
Once a company has classified its activities and identified the related resources, managers may discover that some manufacturing overhead costs can be traced directly to products. A “traceable overhead cost” may sound like an oxymoron, because if a cost is traceable, it doesn’t need to be allocated. The problem is that companies will often aggregate any manufacturing costs that are not for direct materials or direct labor in manufacturing overhead without considering whether they are traceable. An example of a traceable manufacturing overhead cost at C&C Sports is the cost of operating the chenille machine. This cost, which totals $132,600 and includes depreciation and indirect materials, is directly traceable to the award jackets because the chenille machine is used only to produce award jackets, and should not be allocated to pants and jerseys.
Under GAAP-based product costing, selling and administrative costs are not allocated to products. However, under activity-based costing, these costs should be allocated to products if they are incurred to provide resources that are consumed by unit-level, batch-level, or product-level activities. As with manufacturing overhead costs, some selling and administrative costs may be directly traceable to products. At C&C Sports, three selling costs are traceable to products: shipping, commissions, and a portion of advertising costs. Shipping of $0.40 per unit and commissions of 5% of the sales price are unit-level costs that are easily assigned to products. Direct advertising costs include $85,000 to advertise award jackets and $20,000 each to produce a pants catalog and a jerseys catalog.
As we develop C&C Sports’ activity-based product costs, we will use budgeted information to establish performance standards.
Exhibits 7-3
and
7-4
show C&C Sports’ budgeted production and selling and administrative costs for 2011. This is the same information used to calculate the master budget in
Chapter 5
. The 2011 budget is based on the following estimated production and sales levels:
Since the number of units produced differs from the number of units sold, we will analyze production activities separately from selling and administrative activities.
EXHIBIT 7-3 2011 budgeted annual manufacturing overhead costs.
EXHIBIT 7-4 2011 budgeted annual selling and administrative costs.
UNIT 7.1 REVIEW
KEY TERMS
Activity p. 357
Activity-based costing p. 357
Batch-level activity p. 359
Customer-level activity p. 359
Organization-level activity p. 360
Product-level activity p. 359
Unit-level activity p. 359
SELF STUDY QUESTIONS
1. LO 1 Which of the following would be considered a unit-level activity?
1. Ordering direct materials
1. Making a sales call
1. Preparing the annual budget
1. Placing a UPC label on each package
1. LO 1 Mary’s Mix-ins makes custom ice cream by mixing various candies into vanilla and chocolate ice cream. Orders range in size from 1 to 5 quarts. After each order has been mixed and packed into one-quart containers, the mixing equipment must be cleaned. Cleaning the mixing equipment is an example of
2. a unit-level activity.
2. a batch-level activity.
2. a product-level activity.
2. an organization-level activity.
1. LO 1 Increasing the number of units in a batch will increase the batch-level costsassociated with the product. True or False?
1. LO 1 Which of the following would be considered a product-level activity?
4. Building a prototype of a product
4. Creating the company’s advertising campaign
4. Training warehouse employees
4. Organizing the annual sales meeting
1. LO 1 Which of the following would be considered a customer-level activity?
5. Ordering the direct materials used in all products
5. Cleaning the machines before beginning a production run
5. Making a sales call
5. Supervising production workers
UNIT 7.1 PRACTICE EXERCISE
Place an “X” in the column that corresponds to the type of activity level referred to in each scenario.
SELECTED UNIT 7.1 ANSWERS
Think About It 7.1
One jacket costs ten times more to move than one pair of pants. To illustrate, let’s say that the cost to move a batch is $100. For a batch of 50 pants, the cost would be $2 per pair ($100 ÷ 50 pairs). For a batch of 5 jackets, the cost would be $20 per jacket ($100 ÷ 5 jackets).
Self Study Questions
1. D
2. B
3. False
4. A
5. C
Unit 7.1 Practice Exercise
Place an “X” in the column that corresponds to the type of activity-level referred to in each scenario.
UNIT 7.2 Developing Activity-Based Product Costs
GUIDED UNIT PREPARATION
Answering the following questions while you read this unit will guide your understanding of the key concepts found in this unit. The questions are linked to the learning objectives presented at the beginning of the chapter.
1. What is an activity cost pool? LO 2
2. How are activity cost pool rates calculated? LO 2
3. How many overhead charges will a cost object have under an activity-based costing system? LO 2
4. How are product costs determined in an activity-based costing system? LO 2
5. Why are organization-level costs not allocated to products under activity-based costing? LO 2
6. What does using a “traditional” costing system mean in terms of overhead costs? LO 3
7. When a company switches from a traditional costing system to activity-based costing, overhead costs typically shift from the high-volume/low-complexity product to the low-volume/high-complexity product. Why is this the case? LO 3
Once a company has decided to implement an activity-based costing system, work begins to identify activities and the resources consumed by those activities. By completing the following five steps, a company can implement an activity-based costing system. To be successful, these efforts must have the full support of top management. Although the following discussion may make the process appear to be relatively easy, in reality it is a complex, time-consuming effort. Once the system is in place, however, decision makers will benefit from improved information.
Step 1: Identify Activities
The first step in developing activity-based product costs is to identify the activities performed in the organization. Think of activities as “verbs” that answer the question “What do you do?” If you had to answer the question, what might be some of your responses? “I study, I sleep, I eat.” Asking this question of employees is one way to determine the activities they perform; another is to observe what they do. Either way, this step is the most time-consuming part of implementing an activity-based costing system and the one that can generate the greatest error.
In addition to identifying the activities, you need to determine how much time employees spend performing each activity. Let’s go back to your answer to the question “What do I do?” While you might find it easy to list what you do, saying how much time you spend on each activity might be harder. For instance, the amount of time you spend studying probably varies each week, depending on what tests you have. The same is true for many employees; the time they spend on certain tasks varies from one month to the next. Nevertheless, employees must make such an estimate so that the resources consumed by the activities (that is, their salaries and other costs) can be calculated.
A critical question to ask during activity identification is “What level of detail does the company want to collect?” The greater the level of detail, the greater the chance of misclassifying some costs and activities. For example, instead of identifying “studying” as an activity, let’s say you provide greater detail, such as “studying accounting” or “studying economics.” You will likely misestimate the time you spend on each, although you may be fairly confident of the total time you spend studying. Of course, if you could make a detailed estimate without error, breaking “studying” down by your courses would provide better information. The same would be true of any activity costing system: the greater the error-free distinction between activities, the better the information.
As you identify activities, remember that once an activity has been defined, the time spent on that activity and the resources consumed by that activity must be tracked. Thus, defining activities in greater detail will require more monitoring. Will the benefits of defining more detailed activities outweigh the effort needed to monitor activity performance, and the resulting potential for error? To minimize both the cost of collecting the information and the potential for error, most companies that use activity-based costing systems combine related activities into one larger activity. For example, the activities in C&C Sports’ cutting department include layering fabric, laying out the pattern, cutting the fabric, collecting the cut pieces, and disposing of waste fabric. While C&C’s managers could have chosen to monitor the time spent on each of those activities, they chose instead to group them as a single cutting activity. Since all these activities are batch-level activities, combining them is not an issue. One caution, however: Activities from different categories (say, unit-level versus batch-level) should not be combined.
Step 2: Develop Activity Cost Pools
After all the activities have been identified and the appropriate level of detail has been selected, the activities are combined into activity cost pools based on their cost drivers. For example, C&C Sports’ managers determined that “moving materials from the storeroom to the cutting room” and “packing finished products” were both batch activities. Because pants, jerseys, and jackets are produced in batches, the number of batches produced determines the frequency of these warehousing and packaging activities and the resources consumed. Therefore, managers combined those two activities into one pool. After gathering all the relevant information about activities and their drivers, C&C Sports’ managers determined that the company had the following five activity pools:
10
Once the activity pools have been determined, manufacturing overhead costs can be assigned to them. This is referred to as a first-stage allocation because costs are assigned first to the activity pools before being assigned to cost objects.
Exhibit 7-5
shows the first-stage allocation of manufacturing overhead resources for C&C Sports. These allocations were based on employee estimates of time spent and the resources used to complete the activities. Notice that the $132,600 that relates to the chenille machine is not included in the costs allocated to the activity pools, since those costs are traceable directly to the jackets. All the remaining manufacturing overhead costs are allocated to the activity pools. Compare
Exhibit 7-5
to
Exhibit 7-3
to see that all the manufacturing overhead costs have been accounted for.
EXHIBIT 7-5 Step 2: Allocation of manufacturing overhead costs to activity pools.
Step 3: Calculate Activity Cost Pool Rates
After the manufacturing overhead costs have been assigned to activity cost pools, the next step in developing activity-based product costs is to calculate an activity rate for each cost pool. This calculation is similar to the predetermined overhead rate calculation under traditional job order costing (see
Chapter 4
):
Exhibit 7-6
shows the calculation of the four activity rates for C&C Sports. Let’s review the calculations. For product design, the activity cost totals $83,889 (see
Exhibit 7-5
). Since the number of product lines is the cost driver and C&C has three product lines (pants, jerseys, and jackets), the denominator is 3 product lines. The calculation of the activity rate is:
EXHIBIT 7-6 Step 3: Calculation of activity rates.
For warehousing/packaging, the activity cost totals $170,562. The number of batches produced is the cost driver for this activity pool. It is calculated as follows:
Given this number of batches, the activity rate for this pool is calculated as:
Think About It 7.2
Why would the batch size differ for the three product lines?
For cutting, the activity cost totals $147,108. The number of cuts is the cost driver for this activity pool; it is calculated as follows:
Given this number of cuts, the activity rate is calculated as:
Think About It 7.3
Refer to
Exhibit 7-5
to see what costs were allocated to the cutting pool. What specific costs might be included in the cutting pool?
WATCH OUT!
Always label the activity rate with the activity driver. Saying, for example, that the sewing activity rate is $2.40 is not sufficient; it is $2.40 per direct labor hour. With the activity driver included, you will know what to multiply therate by to calculate the allocated cost. To calculate the allocated cost for sewing, for example, you will know that you should multiply the $2.40 by the number of direct labor hours—not, say, the number of units produced.
Finally, for sewing, the activity cost totals $206,820. Direct labor hours is the cost driver for this activity pool, and it is calculated as follows:
Given this number of direct labor hours, the activity rate is calculated as:
Step 4:
Allocate Costs to Products or Services
With the activity rates calculated, you are ready to allocate the costs to products or services.
11
This calculation is similar to the calculation for applying overhead costs to products or services under traditional job order costing (see
Chapter 4
):
Exhibit 7-7
shows the cost allocations to the three products. Notice that each product has four allocations, one for each of the activity pools. Notice, too, that the activity rate column for each product is the same, since the activity rates are constant, regardless of the product that is consuming the resource. However, each product uses the activities to different degrees, and those differences in usage drive the differences in allocated costs. For example, the cutting cost allocated to pants is $2.60 × 14,680 cuts = $38,168; to award jackets, it is $84,240—why? The answer is that jackets require many more cuts than pants, even though the company makes fewer jackets than pants.
Let’s reconcile how the overhead costs from the first-stage allocation (see
Exhibit 7-5
) were allocated to the three products:
EXHIBIT 7-7 Step 4: Allocating activity costs to products.
All the overhead costs have been accounted for. When the overhead cost allocated to the award jackets is added to the chenille costs traced to the award jackets, the total overhead cost of the award jackets becomes $376,563. Notice that this amount is more than the overhead cost allocated to pants. Even though budgeted production called for only 18,000 jackets as compared to 183,500 pants, jacket production requires many more activities than pants production.
Step 5: Calculate Unit Product Costs
The last step in the preparation of activity-based costing data is to calculate the unit product cost. In Step 4 we calculated the total overhead allocated to each product. For decision-making purposes, we need to convert that amount to a unit cost by dividing the total overhead cost by the total number of units produced. For example, the overhead cost for a pair of pants would be $1.33 (rounded), calculated as
To calculate the total product cost per unit, we need to add the direct materials and direct labor costs to this overhead cost. The total activity-based cost for a pair of pants would be
Exhibit 7-8
shows the calculation of the total product costs and unit costs for all three products based on the budgeted production for 2011.
WATCH OUT!
With all the work they put into calculating overhead allocations, students sometimes forget the easiest part of calculating the total product cost—adding the direct materials and direct labor costs to overhead.
Reality Check—Can activity-based costing solve the FAA’s funding crisis?
Commercial passenger and freight carriers accounted for just 65.5% of all flights, yet they paid 91.4% of the funds contributed to the FAA.
A Boeing 737 can carry up to 190 passengers; a Gulfstream G450 carries a maximum of 19. But do the two planes make the same demands on air traffic controllers? That was the question being debated as the Federal Aviation Administration (FAA) sought renewal of its funding before a September 30, 2007 deadline.
In 2004, commercial passenger and freight carriers accounted for just 65.5% of all flights, yet they paid 91.4% of the funds contributed to the FAA. Business aviation, such as corporate jets and charters, accounted for 18.5% of all flights, yet those flights contributed only 4.9% of the FAA’s funds.
Why the difference in payments? It is built into the fee structure. In 2004, commercial passenger carriers paid a 7.5% tax on the price of each ticket, plus a $3.20 fee for each flight segment, a $14.20 fee for each international departure or arrival, and a 4.3¢-per-gallon fuel tax. Corporate carriers paid only 21.8¢ tax on each gallon of fuel. For a flight between Atlanta and Dallas, a commercial carrier would have been charged approximately $1,356 in fees; a business carrier would have paid only $161.
According to the FAA and others, this fee structure has nothing to do with the FAA’s resources, which are consumed in directing the flights from point to point. Each plane must take off and land, and each must be directed between takeoff and landing. But does a landing at a busy airport like Atlanta require the same resources as a landing at a smaller airport? Does a takeoff at a prime time like 5:00P.M. require the same resources as a takeoff at 11:00P.M.? What about a half-full plane versus a full plane?
Perhaps a close look at activity-based costing can help to solve the debate over the FAA’s funding. Developing a better understanding of how resources are consumed by activities may lead to a more equitable sharing of the costs of safe air travel.
Sources: GAO, “Observations on Potential FAA Funding Options,” September 2006,
http://www.gao.gov/highlights/d06973high
(accessed May 19, 2007); Laura Meckler, “Collision Course: Why Big Airlines Are Starting a Fight with Business Jets,” The Wall Street Journal, June 1, 2006; Chrisopher Palmeri, “Snarl in the Sky,” BusinessWeek, June 5, 2006, 26–29;
http://www.smartskies.org/LearningCenter/faa_funding/calculator.htm
(accessed May 19, 2007).
EXHIBIT 7-8 Step 5: Calculating unit product costs.
EXHIBIT 7-9 Comparison of traditional and activity-based costing.
Let’s compare the activity-based overhead allocation to C&C’s original allocation, based on direct labor dollars.
Exhibit 7-9
shows the manufacturing overhead costs allocated to each of the products under the two methods. Notice that the total amount of manufacturing overhead allocated to the products differs between the two methods—$1,033,250 under the traditional approach and $740,979 under the activity-based approach. The difference between the amount of manufacturing overhead allocated under the two methods is the $292,271 general overhead cost pool that was not allocated to products under activity-based costing.
Although the total amount of allocated overhead differs between the two methods, we can still compare the percentage of overhead allocated to each product. Notice where the big differences occur in
Exhibit 7-9
. Under the traditional costing method, pants were allocated 53.23% of manufacturing overhead, yet under activity-based costing, pants received just 33% of manufacturing overhead. The other major difference between the two methods was for award jackets, which were allocated 31.36% of total overhead under the traditional method and 50.82% under activity-based costing.
What caused the differences in the relative amount of manufacturing overhead allocated under the two methods to pants, a high-volume product, and jackets, a low-volume product? One obvious cause is the costs associated with the chenille machine. Under traditional costing, these costs were shared by all three products. However, under activity-based costing, these costs are traced directly to jackets, reducing the amount of overhead allocated to pants and increasing the amount of overhead allocated to jackets.
A second cause of the difference in costs results from the cutting operation. Jacket production required more cutting than pant production, even though C&C produced only one-tenth the number of jackets as pants. This shift in cost from a high-volume to a low-volume product is quite common in newly implemented activity-based costing systems. That is because low-volume products, like jackets, tend to use as many product-level activities as other products, while generating as many or more batch-level activities.
EXHIBIT 7-10 Activity-based costing at C&C Sports: An overview.
You have now learned the five steps of calculating product costs under activity-based costing.
Exhibit 7-10
summarizes the results of these steps for C&C Sports. Remember, however, that the product costs shown there include just direct materials, direct labor, and manufacturing overhead. To get a more accurate picture of total product costs, C&C will need to complete an activity-based analysis of selling and administrative costs.
UNIT 7.2 REVIEW
KEY TERMS
Activity cost pool p. 365
Activity rate p. 366
First-stage allocation p. 366
SELF STUDY QUESTIONS
1. LO 2 In an activity-based costing system, which of the following costs would most likely not be included in the allocation of overhead cost to products, but would instead be left in the “General” category?
1. Indirect materials
1. Factory rent
1. Equipment depreciation
1. Machine maintenance
1. LO 2 Managers of the Chadwick Company want to identify an appropriate cost driver for the quality control overhead cost pool. Which of the following would be the most appropriate choice?
2. Number of units produced
2. Number of quality engineers employed
2. Number of quality inspections performed
2. Number of returned units
1. LO 2 A firm produces and sells two products, SG8 and DY9. The following information relates to setup costs (a part of factory overhead) of $120,000.
Activity-based costing would allocate which of the following amounts of setup cost to each unit (rounded to the nearest dollar)?
1. LO 2 Walker Texas produces two kinds of recliners, Standard and Deluxe. Information about the two products follows.
Production costs are as follows:
The activity rate for the cost of moving and warehousing is:
4. $255 per batch.
4. $11.33 per unit.
4. $675 per batch.
4. $30 per unit.
1. LO 2 Refer to the information in question 4. Under activity-based costing, the total product cost per unit for the Deluxe recliner is:
5. $49.
5. $155.
5. $174.
5. $204.
1. LO 2 Refer to the information in question 4. Under activity-based costing, the total product cost per unit for the Standard recliner is:
6. $615,000.
6. $735,000.
6. $20.50.
6. $110.50.
1. LO 3 Under traditional costing systems, machine costs incurred specifically for one product might be allocated to all products. True or False?
1. LO 3 Activity-based costs can be higher than traditional product costs because of the inclusion of selling and administrative costs. True or False?
1. LO 3 In changing from a traditional costing system to an activity-based costing system, overhead costs tend to shift from high-volume standard products to low-volume premium products, because
9. companies usually make more premium products than standard products.
9. standard products use more total activities than premium products.
9. premium products use more total direct materials and direct labor than standard products.
9. premium products usually consume more activities per unit than standard products.
UNIT 7.2 PRACTICE EXERCISE
Babytime, Inc., manufactures two products, Piglets and Rattles. Piglets are the more complex of the two products, requiring more direct labor time and more machine time per unit than Rattles.
Manufacturing overhead is currently assigned to the products on the basis of direct labor hours. The company has gathered some activity information and is interested in the differences between its present costing method and activity-based costing. All overhead costs should be allocated to the products. The overhead cost pools and activity drivers are as follows:
Other product information is as follows:
Required
0. Using the traditional method of allocating overhead based on direct labor hours, compute the unit product cost of Rattles and Piglets:
0. Determine the overhead rate per direct labor hour.
1. Allocate overhead to each product based on the direct labor hours used by each.
2. Divide the total overhead allocated to each product by the number of products produced to obtain the overhead cost per unit.
3. Add the overhead cost per unit to the direct materials and direct labor costs per unit to obtain the unit product cost.
1. Using an activity-based costing approach, compute the unit product cost of Rattles and Piglets:
0. Determine the three activity rates.
1. Allocate overhead to each product based on the activity drivers used by each. Total the three activity allocations to arrive at the total overhead allocated to each product.
2. Divide the total overhead allocated to each product by the number of products produced to obtain the overhead cost per unit.
3. Add the overhead cost per unit to the direct materials and direct labor costs per unit to obtain the unit product cost.
2. Why do your answers to a(iv) and b(iv) differ? Be specific.
SELECTED UNIT 7.2 ANSWERS
Think About It 7.2
Something in the processing of the different products must require different batchsizes. In a clothing factory, fabric characteristics (for example, its thickness) determine how many units can be cut at one time. Cutting several units at once is more efficient and uses less labor than cutting units individually. However, the quality of the cut must be taken into consideration. C&C Sports’ production manager has likely determined the maximum number of units per batch so as to balance efficiency and quality.
Think About It 7.3
The three categories of costs allocated to the cutting pool were indirect labor, indirect materials, and other. Indirect labor is likely to include the costs of cleaning around the cutting tables and setting up various machines and tables for cutting. It would not include the labor cost of cutting the fabric—that is included in the direct labor cost of making various products (refer back to
Chapter 4
to see that cutting and sewing are direct labor costs). Indirect materials would include the knives and any other materials necessary to cut the fabric. It is difficult to say what “other” might include, since companies usethat category for a variety of items.
Self Study Questions
1. B
2. C
3. B
4. A
5. D
6. D
7. True
8. True
9. D
Unit 7.2 Practice Exercise
c. The unit product costs in a(iv) and b(iv) differ because of the activities consumed by each product. In the traditional system, with overhead cost allocated by direct labor hours, each rattle uses only 0.75 hours (30,000 hours ÷ 40,000 units), whereas each piglet requires 2 hours (20,000 hours ÷ 10,000 units). Because piglets use 2.667 times more direct labor hours than rattles, they are allocated 2.667 times the overhead cost ($20.08 = 2.667 3 $7.53). Under activity-based costing, resources are used by each product as shown in the following table:
In terms of setups, one piglet consumes 28 times the resources that one rattle does. Another way to think about this problem is that rattles are produced in batches of 100 (40,000 units ÷ 400 setups = 100 units per setup); piglets, on the other hand, are produced in batches of three or four. Therefore, each piglet consumes a much larger share of the setup cost than each rattle—more than its relative share of overhead based on direct labor hours. In terms of machine hours, each piglet consumes 9.6 times the resources that one rattle does. Again, each piglet consumes a much larger share of the machine operating cost than each rattle. Consumption of purchasing resources is almost the same for the two products.
UNIT 7.3 Activity-Based Management
GUIDED UNIT PREPARATION
Answering the following questions while you read this unit will guide your understanding of the key concepts found in this unit. The questions are linked to the learning objectives presented at the beginning of the chapter.
1. What is a value-added activity? Give an example. LO 4
2. What is a non-value-added activity? Give an example. LO 4
3. How do non-value-added activities affect product costs? LO 4
4. How does activity-based management allow managers to use information about activities to improve operations? LO 5
5. Raising the selling price of a product that is unprofitable based on activity-based costs is not always a good idea. What do managers need to evaluate before taking such an action? LO 5
What happens once product costs have been determined using activity-based costing? It’s up to managers to use the new information to make better-informed decisions. The process of using activity-based costing information to manage a business’s activities, and thus its costs, is called activity-based management.
Exhibit 7-11
shows the results of a recent survey concerning how companies use activity-based costing information. By far its greatest use is for product costing and cost control, but activity-based costing is also used to make decisions regarding pricing, customer profitability, distribution channel profitability, and process improvement. In this unit, we will explore how companies can use activity-based costing to manage their activities.
EXHIBIT 7-11 Primary use of activity-based costing.
Source: Activity Based Costing: How ABC Is Used in the Organization, Copyright 2005, SAS Institute Inc., Cary, NC, USA. All Rights Reserved. Reproduced with permission of SAS Institute Inc., Cary, NC.
Activity Management
Why is managing an organization’s activities so important? Let’s consider the case of a company that reduces costs by reducing the number of workers. If managers reduce the work force without considering the activities that employees perform, they will have done nothing to reduce the amount of work (the activities) that must be done. The remaining workers will face heavier workloads, which may decrease their job satisfaction and increase employee turnover. The company may end up having to pay overtime to meet its deadlines. In addition, customer satisfaction may fall as overworked employees miss deadlines and make more mistakes, causing product and service quality to decline. In reality, the company may see an increase in costs after the work force reduction. Cost reduction, then, will be more effective when it is implemented by managing the level of activity, and hence the required resources.
Furthermore, as a result of implementing activity-based costing, managers know the cost of performing the activities required to produce and sell products. Activity-based management focuses on using that information to identify activities that are non-value-added, and can therefore be eliminated without affecting the quality of products. Non-value-added activities are those activities that consume resources but do not contribute to the value of the product. Value-added activities are those activities that create the product the customer wants to buy. These categories—value-added or non-value-added—are defined from the customer’sperspective.
The customers who buy C&C Sports’ award jackets value the cutting, sewing, and chenille lettering that are built into the high-quality jackets. They don’t value activities such as moving materials, inspecting products, storing products, and setting up machines, which don’t contribute to the quality of the jackets. C&C’s customers deem these activities to be non-value-added. Consider inspection activities, for instance. Obviously, a company doesn’t want defective products to be shipped to the customer; the result would be an unhappy customer and the extra cost of replacing the defective merchandise. So why isn’t inspection a value-added activity? If the manufacturing process had occurred as it should have, there would be no defective products. Inspections would not be needed, and the cost incurred to conduct the inspections would be eliminated. So managers should focus on the manufacturing steps or material inputs that appear to be causing defects.
WATCH OUT!
Some activities may be non-value-added in one scenario but not in another. For example, inspecting a bicycle after it has gone through the production process is non-value-added. Inspection doesn’t improve the bicycle production process; it just catches mistakes. On the other hand, inspecting meat for compliance with FDA regulations is value-added. People are willing to pay for that extra assurance that the meat is safe to eat.
As non-value-added activities and their associated resources are eliminated, a company’s costs will decrease. The key to reducing costs through activity management is eliminating the resources associated with the reduced activities. Let’s assume that in the case of inspection costs, the company corrects the manufacturing process and eliminates the inspection process. If the inspectors (the resources) are not eliminated as well, the company will not have reduced total costs, even though the inspection activity has been eliminated.
Don’t think that non-value-added activities can be eliminated entirely—they can’t. Some activities, though they are non-value-added, are still essential to production or business operations. Materials, for example, must be moved from the warehouse into production, even though the moving doesn’t add value to the finished product. Managers can focus on decreasing the cost of these activities without affecting the quality of operations or of products and services, however.
Think About It 7.4
Identify the following activities in a bicycle production plant as value-added or non-value-added.
Process Improvement
One way to implement activity-based management is to take a fresh look at the activities performed in the organization to see if a business process can be changed so as to reduce costs. Process improvement is the examination of business processes to identify incremental changes that may reduce operating costs. Business process reengineering (BPR) is a managerial tool that focuses on improving the efficiency and effectiveness of an organization’s business processes through radical change.
C&C Sports’ managers took a look at the activities that emerged from the implementation of activity-based costing. They decided to focus first on warehousing and packaging activities because, for the most part, those activities are non-value-added. It seemed particularly strange to them that the cost driver for the activities was the number of batches produced, since there was no relationship between the size of the batch and the activities.
C&C’s products are produced in batches of different sizes based on how many items can be cut error-free at one time. For example, pants are cut in batches of 50 because their fabric is thin and few cuts are required. The pants fabric can be stacked fairly high and cut with very sharp knives. Jackets are cut in batches of five because their fabric is thick and slick, and cutting a taller stack of fabric results in uneven edges. Over the years, moving and packaging fabric and other raw materials in these same batch sizes became easier. When Chad Davis, vice president of operations, realized that the batch sizes were driving the costs of warehousing and packaging, he tasked production manager Penny Townsley to devise a more efficient, less expensive way to move raw materials into the factory.
Reassessment of Product Profitability
A company that is interested in maximizing profits will instruct its sales force to emphasize its most profitable products. It is probable that after completing an activity-based costing study, the company’s perception of its most profitable products will change.
Using activity-based costing, C&C Sports’ managers discovered that based solely on manufacturing costs, jackets were much more expensive to produce than they had thought, and pants were much less expensive to produce than thought. By expanding their activity-based costing exercise to include selling and administrative activities, they got an even better idea of the costs incurred to make and sell each product.
Exhibit 7-12
shows the calculation of C&C’s product margins using both the traditional costing method and activity-based costing.
EXHIBIT 7-12 C&C Sports’ product margins.
The top half of
Exhibit 7-12
shows the product margin calculation using traditional costing, based on the sales price per unit and the product cost per unit (see
Chapter 4
). These are the same numbers C&C Sports’ managers used to prepare the 2011 budget. Notice that award jackets were expected to generate the highest product margin at 38.30%. Based on this product margin, award jackets would account for over half of C&C’s total product margin, even though only 18,000 jackets were expected to be sold. Pants, on the other hand, have the lowest product margin, 17.75%. Even with selling 200,000 pairs, pants would account for only about 27% of C&C’s total product margin. With this information, it is not surprising that C&C’s president wanted to focus on increasing jacket sales. The bottom half of
Exhibit 7-12
tells a different story: Pants and jackets have similar product margins—17.92% for pants and 19.31% for jackets. And based on expected sales volumes, each generates about 42% of C&C’s total product margin.
What caused the change? Production costs differ between the two methods as activity-based costing matched resources consumed with the products that consume them. But the greatest difference between the two methods is including the selling and administrative costs under activity-based costing. We have omitted the specific calculation of selling and administrative costs in the interest of brevity, but the procedure is the same as that used to determine production costs. Note that selling and administrative expenses are exceptionally high for the award jackets because of the special advertising and extra administrative time needed to generate and process orders.
Think About It 7.5
If you calculate C&C’s total margin in panels A and B of
Exhibit 7-12
, you will get different numbers. Why? Using
Exhibit 7-4
, determine how much of C&C’s selling and administrative expense was not allocated to its products.
Implementing activity-based costing and obtaining the results reported in
Exhibit 7-12
didn’t make the award jackets more expensive to produce and sell. After all, nothing was done to change C&C’s operations. The only difference is that C&C Sports’ managers now have better information about what their products are contributing to the company’s bottom line. Clearly, these products are all “keepers.” Given that the only remaining costs not allocated to the products are general support costs, all three are covering their variable costs as well as some fixed costs, and are therefore contributing to the bottom line.
C&C’s managers now need to decide what to do with this information. If they want to increase their bottom line, they can either increase sales revenue or decrease costs. To increase sales revenue, they could either sell more units or increase their selling prices. Recall from
Chapter 6
that C&C has already increased its sales revenue by selling more jackets and jerseys. However, the increase in revenue didn’t translate into increased operating income because costs increased by a much higher amount. Raising the prices of pants and jerseys could be problematic. While the company touts the products’ exceptional quality, they functionally are not much different from those available from competitors. C&C’s award jackets, on the other hand, are perceived to be of higher quality and lower cost than other jackets. Therefore, pursuing a price increase for the jackets may be a reasonable strategy for increasing sales revenue.
Reality Check—Activity figures to the rescue
Even law enforcement agencies benefit from activity information.
Activity-based costing provides a wealth of information to decision makers. But how do those numbers figure into the organization’s daily life?
One large telecommunications company used activity-based information to investigate product profitability. After a close examination of processes, managers found that residential telephone maintenance costs differed in two service areas. It turned out that in one area, repairmen had a daily quota of repair calls to make. That quota was all that was expected of workers; there was no incentive for them to take on additional calls if they finished early. This practice resulted in higher service costs than those in the other area, where calls were assigned all day as they came in.
Consolidated Companies, Inc., used activity-based costing to evaluate the profitability of sales territories. Managers examined the average order size across territories. They found that territories with an average order size of less than $500 were not profitable, even when additional fees were charged for small orders. Through sales incentives and the elimination of some customers and services, managers increased the company’s annual profits by over $150,000.
Even law enforcement agencies benefit from activity information. Some have used activity-based budgeting to determine staffing budgets based on the types of crime committed, the number of officers required to respond to a particular type of crime, and the time officers take to provide service at the crime scene.
Even law enforcement agencies benefit from activity information. Some have used activitybased budgeting to determine staffing budgets based on the types of crime committed, the number of officers required to respond to a particular type of crime, and the time officers take to provide service at the crime scene.
Sources: Stephen Schulist, “Using ABC to Manage and Improve at CONCO Foods,” Journal of Corporate Accounting & Finance, 15, no. 3 (2004): 29-36; Jon M. Shane, “Activity-Based Budgeting: Creating a Nexus Between Workload and Costs,” FBI Law Enforcement Bulletin, 74, no. 6 (June 2005),
http://www.fbi.gov/filelink.html?file=/publications/leb/2005/june05leb
(accessed June 6, 2007); David Southiere, “Seeing Activity-Based Costs”,
http://www.cfoproject.com/documents.asp?d_ID=2076
(accessed June 6, 2007).
Activity-Based Budgeting
Activity-based costing and management aren’t the only ways a company can use information about activities to manage their operations. Activity-based budgeting is the practice of using activity-based costing information and knowledge about activities and resource consumption to prepare an organization’s budget.
Traditional budgeting often means applying a fixed percentage increase to last year’s budget. Any inefficiencies in the budget are simply carried forward from year to year. Under activity-based budgeting, the budget is based on the activities that will be performed to support the planned level of production. Knowing the activity-based cost of those activities, managers can include the appropriate level of resources in the budget. As the level of activities changes, the resources can be adjusted accordingly.
UNIT 7.3 REVIEW
KEY TERMS
Activity-based budgeting p. 381
Activity-based management p. 377
Business process reengineering p. 378
Non-value-added activity p. 377
Process improvement p. 378
Value-added activity p. 377
SELF STUDY QUESTIONS
1. LO 4 In a company that manufactures potato chips, which of the following is not a value-added activity?
1. Washing the potatoes
1. Peeling the potatoes
1. Frying the potatoes
1. Moving packages of chips to the warehouse
1. LO 4 Which of the following statements is not true of non-value-added activities?
2. If a manager is creative enough, all non-value-added activities can be eliminated completely.
2. An activity is defined as non-value-added from the customer’s perspective.
2. Activities can be considered non-value-added in some scenarios and value-added in others.
2. Eliminating non-value-added activities will not result in significant cost savings if the resources consumed by those activities are not eliminated.
1. LO 5 Activity-based management
3. is a by-product of activity-based costing.
3. typically results in the elimination of resources prior to the elimination of activities.
3. can be used to evaluate the profitability of distribution channels. d. results in the identification of value-added activities that can be eliminated.
1. LO 5 If under activity-based costing a manager realizes that the price of a product does not cover its activity-based cost, the best solution is to raise the price of the product. True or False?
1. LO 5 Which of the following is likely to generate the largest reduction in batch costs?
5. Increasing the size of a batch, which results in fewer batches
5. Eliminating specific batch costs, such as indirect materials used for machine setup
5. Both a and b are equally effective
5. Neither a nor b
UNIT 7.3 PRACTICE EXERCISE
Refer to your work on the Unit 7.2 Exercise. The managers at Babytime, Inc., were surprised that the activities associated with the production of Piglets were more extensive than they had imagined. They wondered if anything could be done to reduce the cost of producing Piglets.
Required
0. Compare the number of activities (setups, purchase orders, and machine hours) consumed per unit by Rattles and Piglets.
1. Identify whether each of the following activities is value-added or non-value-added. Explain your reasoning.
0. Setting up production machines
1. Preparing purchase orders
2. Operating production machines
2. For each of the activities you identified as non-value-added in part (b), indicate how managers might go about reducing the activity and the associated resources without affecting the quality of the product.
SELECTED UNIT 7.3 ANSWERS
Think About It 7.4
Think About It 7.5
The total margin is lower in panel B because a portion of the selling and administrative costs has been allocated to the products. Under the traditional costing method, selling and administrative costs are subtracted from the total gross margin, with no attempt to determine which products consume selling and administrative activities.
We can figure out how much selling and administrative cost was allocated to the products by multiplying the selling and administrative cost per unit by the number of units:
The total selling and administrative cost allocated to the three products was $846,160. Since the total selling and administrative cost (from
Exhibit 7-4
) was $1,138,912, we can conclude that $292,752 was not allocated to the products.
Self Study Questions
1. D
2. A
3. C
4. False
5. B
Unit 7.3 Practice Exercise
0. See the answer to Exercise 7-2, part (c).
1.
0. Setups are non-value-added. The activity consists of preparing machines to complete a production run, not of actually producing a product.
1. Preparing purchase orders is non-value-added. The activity consists of preparing paperwork (or electronic orders) with which to acquire materials and other production items.
2. Operating production machines is value-added. Running the machines produces the product.
2. Setups: Piglets are made in batches of three or four units at a time. A lot of time is likely to be wasted setting up the machines so frequently for so few items. Increasing the batch size would reduce the number of setups needed. Without additional information on the production process, it is difficult to say what the effect on quality might be. If the number of setups was decreased, some indirect materials automatically (for example, cleaning materials) would likely be saved. However, if the labor related to the setups was not either eliminated or redirected to a value-added activity, the company would not be able to reduce costs significantly.
Purchase orders: For both piglets and rattles, purchase orders have more to do with the company’s inventory management practices than with the products themselves. Given that 2,750 purchase orders are required to make 50,000 products, an average of only about 18 products’ worth of materials are ordered at one time. Still, decreasing the number of purchase orders by increasing the quantity of materials purchased at one time might increase the costs associated with storing and insuring inventory. Before changing the purchase order activity, the production manager should work with the purchasing manager to ensure that the best overall inventory management policy is implemented.
The Wrap-up
In the chapter opener, C&C Sports’ managers were confused by the 2011 operating results: Revenues had Increased but Income had gone down. They concluded that they must not understand what their products cost to produce. In fact, they were correct. After Implementing an activity-based costing system, they learned that award jackets were much more expensive to produce and sell than they had thought. Award jackets are more complicated to make, and they consume almost as many activities as pants, even though the company sells ten times more pants than jackets. C&C can probably raise the price of jackets because they are higher quality and less expensive than competitors’ jackets. Managers will also need to evaluate production and sales activities to identify and reduce non-value-added activities, which will reduce costs without compromising quality.
CHAPTER SUMMARY
In this chapter you learned that providing products and services to customers requires activities, and those activities consume organizational resources. Managers who understand the activities that are required to deliver products or services to the customer can make better decisions and obtain better operational and financial results for the organization. You should now be able to meet the objectives set out at the beginning of the chapter:
1.
Classify activities as unit-level, batch-level, product-level, customer-level, or organization-level.
Unit-level activities are performed for each individual unit. Since each unit of a particular product requires the same level of activity, each unit consumes the same amount of resources that provide for that activity. The total level of activity performed varies proportionately with the number of units produced.
Batch-level activities are performed on groups, or batches, of products at one time. Since the activity is based on the existence of the batch rather than on the number of units in the batch, a batch consumes the same quantity of resources whether it includes 20 units or 2,000 units.
Product-level activities, also referred to as product-sustaining activities, support the products or services provided by the company. These activities are performed for the entire product line, regardless of how many units or batches are produced.
Customer-level activities are performed for specific customers. These activities, and the resources consumed to perform them, do not affect product costs. Rather, the resources are consumed in the delivery of customer support services, and the associated costs are then used to determine the cost to serve a particular customer.
Organization-level activities are required to provide productive capacity and to keep the business in operation. Although these activities do not provide identifiable benefits to specific products or services, without them there would be no business.
2.
Calculate activity-based product costs.
Step 1: Identify activities.
Step 2: Develop activity cost pools.
Step 3: Calculate activity cost pool rates.
Step 4: Allocate costs to products or services.
Step 5: Calculate unit product costs.
3.
Explain the difference between traditional product costs and activity-based product costs.
The difference between traditional product costs and activity-based product costs lies in the way manufacturing overhead is allocated and in the inclusion of selling and administrative costs as a component of product cost. (Direct materials and direct labor costs do not differ between the two methods.) Activity-based product costs are based on the consumption of activities by each product rather than on consumption of the overhead base as in the traditional method.
4.
Distinguish between value-added and non-value-added activities.
Value-added activities are those activities that create the product or service the customer wants to buy. Non-value-added activities are those activities that consume resources but do not contribute to the product’s value.
5.
Explain how information about activities can be used to make decisions.
Activity-based management uses activity-based costing information to manage business activities. Decisions regarding pricing, customer profitability, distribution channel profitability, and process improvement can all benefit from the use of activity-based costing information.
KEY TERMS
· Activity (Unit 7.1)
· Activity-based budgeting (Unit 7.3)
· Activity-based costing (Unit 7.1)
· Activity-based management (Unit 7.3)
· Activity cost pool (Unit 7.2)
· Activity rate (Unit 7.2)
· Batch-level activity (Unit 7.1)
· Business process reengineering (Unit 7.3)
· Customer-level activity (Unit 7.1)
· First-stage allocation (Unit 7.2)
· Non-value-added activity (Unit 7.3)
· Organization-level activity (Unit 7.1)
· Process improvement (Unit 7.3)
· Product-level activity (Unit 7.1)
· Unit-level activity (Unit 7.1)
· Value-added activity (Unit 7.3)
EXERCISES
7-1 Classifying activities (LO 1) Using the table on the next page, place an “X” in the column that corresponds to the type of activity level referred to in each scenario.
7-2 Classifying activities (LO 1) Mitchell Manufacturing’s single finished goods warehouse is located across the street from its manufacturing facility. A recent study of product sales showed that most product lines are sold primarily in a single geographical region. For instance, the Willamette line is sold primarily in the Northwest, while the Neuse line is sold primarily in the Southeast. To reduce delivery time to customers, the company has decided to close the existing warehouse and lease five smaller regional warehouses that will each serve a single product line.
Required
0. Classify the warehouse costs under the current single-warehouse scenario as unit-level, batch-level, product-level, customer-level, or organization-level.
1. Classify the warehouse costs under the proposed multiple-warehouse scenario as unit-level, batch-level, product-level, customer-level, or organization-level.
2. Under an activity-based accounting system, what effect will the change in warehouse strategy have on product costs?
7-3 Determining cost drivers (LO 2) Grimes Grocery operates a chain of convenience stores in the Northwest. As a result of a recent consultant’s visit, the company is in the beginning stages of implementing an activity-based costing system. The following activity cost pools have been identified:
· Stocking shelves
· Managing stockroom inventory
· Maintaining refrigeration units
· Processing lottery tickets
· Maintaining employee records
Required
Identify at least one possible cost driver for each activity cost pool.
7-4 Selecting a cost driver (LO 2) Brett Graham has been working on Hiltech’s activity-based cost implementation team. One of his assignments is to study the information services department. One activity cost pool in the department is providing support for computer users by providing a help desk that users can call and ask questions. Brett has identified two possible cost drivers for this activity cost pool: number of calls and length of call in minutes.
Required
0. Identify some of the costs that will be included in this activity cost pool.
1. Which of the proposed cost drivers would be best for this activity cost pool? Why?
7-5 Calculating traditional and ABC overhead rates (LO 2) Smith Machining makes three products. The company’s 2012 budget includes $1,000,000 of overhead. In the past, the company allocated overhead based on expected capacity of 40,000 direct labor hours. The company recently implemented an activity-based costing system and has determined that overhead costs can be broken into four overhead pools: order processing, setups, milling, and shipping. The following is a summary of company information:
Required
0. Calculate the company’s overhead rate based on direct labor hours.
1. Calculate the company’s overhead rates using the activity-based costing pools.
7-6 Allocating overhead to products using activity-based costing (LO 2) Lylewood Data Solutions provides data processing services to small businesses in the Northeast. For years, the company has allocated the cost of the data storage department using the number of tape mounts (how many times a data tape is loaded onto the computer’s tape drive). This rate was tied closely to direct labor usage, since the more tapes that were mounted, the more operators that were needed to mount them. Under the current system, a customer is charged $1.25 each time a tape is mounted.
Three months ago the company implemented a new data storage system that uses an automated tape library. As a result, operators are no longer needed to mount the tapes. Some data that is used only temporarily is stored on a computer disk and never transferred to tape. With the new system, the department’s payroll has dropped from 20 operators to 3.
Debbie Lewis, manager of the data center, believes that the new system’s costs are more the result of data storage than of number of tape mounts. She has gathered the following information on the operation of the storage system, which is expected to cost $284,015 per month to operate.
Required
0. Calculate the activity cost rate for the data storage department using the number of tape mounts as the activity driver. Using this rate, determine the data storage costs that should be allocated to each customer.
1. Calculate the activity cost rate for the data storage department using gigabytes of data storage as the activity driver. Using this rate, determine the data storage costs that should be allocated to each customer.
2. Which activity measure will customers prefer? Why?
3. Is the number of tape mounts still a good cost driver for the data storage department? Why or why not?
7-7 Comparing product costs under traditional and activity-based costing (LO 3) Adams, Inc., is a book publisher that reissues old titles. The company offers these books with either a standard machine-glued hard cover or a deluxe, hand-embossed, hand-stitched, leather cover. Adams currently allocates overhead to the books based on direct labor hours.
A recent activity analysis conducted by the controller revealed the following information.
Required
0. Calculate the following for each product:
0. Direct labor hours per unit
1. Printing press hours per unit
2. Sales orders per unit
1. What do your calculations above reveal about how standard edition books and deluxe edition books consume activities?
2. If Adams, Inc., implements an activity-based costing system, what will likely happen to the cost of a standard edition book and a deluxe edition book?
7-8 Explaining the differences between traditional and activity-based product costs (LO 3) “You’re killing me!” exclaimed Myles Werntz, product manager for Premium products. “All along I’ve been told that the Premium line costs the company $125; we charge $225 and make a $100 profit. Now you’re saying that costs have increased to $200. That’s crazy.”
Required
As the company controller you were part of the team that implemented an activity-based costing (ABC) system. Explain to Myles what typically happens to the cost of premium products under ABC. Consider what kinds of cost were included in the $125 amount and what kinds of cost are likely to be included in the $200 amount.
7-9 Calculating product costs using traditional and activity-based costing (LO 2, 3) Jay Krue makes two products, Simple and Complex. As their names suggest, Simple is the more basic product, and Complex comes with all the bells and whistles. The company has always allocated overhead costs to products based on machine hours. Last year, the company implemented an activity-based costing system, and managers determined the following activity pools and rates based on total overhead of $1,599,000:
Only the Complex product requires bonding, so all the costs of bonding should be allocated to Complex. The following data relate to both products.
Required
0. Using the traditional method of allocating overhead costs,
0. allocate overhead cost to the products.
1. show that the overhead assigned to each product sums to the total company overhead.
2. determine the overhead cost per unit for each product.
1. Using the activity-based costing rates,
0. allocate overhead cost to the products.
1. show that the overhead assigned to each product sums to the total company overhead.
2. determine the overhead cost per unit for each product.
2. Explain why overhead costs differ under the two costing methods. Refer specifically to the characteristics of the two products.
7-10 Value-added and non-value-added activities (LO 4) The following list includes activities that are performed in a physician’s office. Classify each activity as value-added or non-value-added. For each non-value-added activity, state whether it can be eliminated without jeopardizing the office’s operations.
0. Patient checks in.
1. Medical records clerk pulls patient’s medical records.
2. Patient waits in reception area to be called to exam room.
3. Nurse takes vital signs (temperature, blood pressure, height, weight).
4. Patient waits in exam room.
5. Doctor completes examination.
6. Billing clerk files insurance claim.
7. Accounting clerk processes patient payments.
8. Accounting clerk resolves billing errors.
7-11 Value-added and non-value-added activities (LO 4) The following list includes activities that are performed in a clothing store. Classify each activity as value-added or non-value-added. For each non-value-added activity, state whether it can be eliminated without jeopardizing the store’s operations.
0. Unpacking shipments.
1. Stocking shelves.
2. Changing clothing on mannequins.
3. Taking items to the dressing room for the customer.
4. Ringing up sales.
5. Cleaning dressing rooms.
6. Restocking shelves after customers try on items.
7. Closing the register at the end of the day (balancing sales totals with cash, checks, and credit card slips).
8. Cleaning the store.
9. Depositing daily receipts at the bank.
7-12 Managing activities (LO 5) Clive Franks was reviewing the product costs for his line of artist’s oil paints. The current production schedule calls for the paints to be produced in batches of 1,000 tubes. Between each batch, the mixing and packaging lines must be completely cleaned to remove all remnants of color before changing to the next batch.
Currently, Clive makes 50 colors in 50,000 batches. Under the company’s activity-based costing system, each batch incurs setup and cleaning charges of $50, for a total charge of $2,500,000 in setup costs. To reduce his costs in the coming year, Clive plans to increase the batch size to 2,000 tubes, which will reduce the number of required setups to 25,000.
Required
0. What effect will Clive’s decision to increase the batch size have on his total setup costs?
1. What effect will Clive’s decision to increase the batch size have on the cost of a tube of paint?
2. What effect will Clive’s decision to increase the batch size have on other costs incurred by the company?
3. What negative effects should Clive consider before increasing the batch size?
7-13 Managing activities (LO 5) In the Reality Check: At the center of activity (see page 360), you read that the U.S. Postal Service recently altered its pricing strategy based on the results of an activity-based costing analysis. Specifically, the new rates are designed to encourage customers to use computer-readable mailing labels, which eliminate the need for human sorting, and to drop off magazines at a location closer to their final destination, which consumes fewer delivery resources. Customers who don’t alter their behavior when bringing items to the post office will pay higher rates.
Required
0. What risk does the U.S. Postal Service assume when changing its pricing strategy based on activity-based costing? In general, what kinds of organizations are likely to benefit from such a strategy and what kinds are not?
1. If all customers changed their behavior, would the U.S. Postal Service experience immediate savings? What kinds of costs do you think are incurred for “human sorting” and “magazine delivery”? What actions would the U.S. Postal Service need to take to save money?
PROBLEMS
7-14 Allocating overhead cost to products in a service industry (LO 2) The Trust Department of First National Bank offers two types of service, Basic and Premier. Trust customers with basic service do not grant trust officers any discretion in managing their accounts. The trust officers or their assistants merely execute the actions prescribed by the customer and send monthly statements. Premier customers grant the trust officers broad discretion in managing their accounts, including the buying, selling, and distribution of trust assets.
For years, the Trust Department’s vice president assumed that the cost of these services was based on the amount of time the trust officers spent working on the accounts. But after some ebbs and flows in the market and the advent of various software packages for executing transactions, the vice president has begun to suspect that the costs of the services may have shifted. He has gathered the following information about the activities required by each service:
Other information is as follows:
Required
0. How many trust officer hours does each type of account consume, on average?
1. How many transactions does each type of service generate, on average?
2. Using the traditional method of allocating Trust Department costs, which is based on trust officer labor hours, compute the cost per account to provide services to Basic and Premier customers.
3. Using activity-based costing, compute the cost per account to provide services to Basic and Premier customers.
7-15 Determining product costs using traditional and activity-based costing (LO 2) Claire Company produces Tablets and Books. Total overhead costs traditionally have been allocated on the basis of direct labor hours. After implementing activity-based costing, managers determined the following cost pools and cost drivers. They also decided that general costs should no longer be allocated to products.
Other information is as follows:
Required
0. Determine the unit product cost for Tablets and Books using the traditional costing system.
1. Determine the unit product cost for Tablets and Books using the activity-based costing system.
2. Show that General cost is the difference between the total overhead costs allocated to products under the traditional system and the total cost allocated to products under the activity-based costing system.
7-16 Comparing traditional and ABC costs (LO 2, 3) Ellis Perry is an electronics components manufacturer. Information about the company’s two products follows:
The company incurs $899,000 in overhead per year and has traditionally applied overhead on the basis of direct labor hours.
Required
0. How much overhead will be allocated to each product using the traditional direct labor hours allocation base? What overhead cost per unit will be allocated to each product?
1. Assume that Ellis Perry has identified three activity cost pools.
Given these activity pools and cost drivers, how much overhead should be allocated to each product? What overhead cost per unit will be allocated to each product?
2. Explain the change in overhead costs per unit.
7-17 Allocating selling expenses to products using activity-based costing, activity management (LO 2, 5) Refer to the information about Claire Company in Problem 7-15. Claire’s managers have gathered the following information about selling and administrative costs.
Required
0. Using the information given here and in Problem 7-15, calculate the product margin per unit for Tablets and Books using the traditional costing system.
1. Prepare a report like the one in
Exhibit 7-12
, Panel A.
2. Using the information given here and in Problem 7-15, calculate the product margin per unit for Tablets and Books using the activity-based costing system. Be sure to include selling and administrative costs.
3. Prepare a report like the one in
Exhibit 7-12
, Panel B.
4. Based on your analysis, what actions might the managers consider taking to improve the profitability of Books and of the company overall?
7-18 Activity-based costing in a service setting (LO 2, 5) Patrick Payroll Services provides weekly payroll processing for a number of small businesses. Patrick Talbert, the company’s owner, has been using an activity-based costing system for several years. He used the following information in preparing this year’s budget.
Required
0. Calculate the cost rates for each activity cost pool.
1. Patrick is preparing a proposal for a prospective client, Nelly’s Nectar Bar. The client has 20 employees. What is the estimated cost of providing weekly payroll services to this client for the first year?
2. How can Patrick use the estimated cost information you have calculated to price the service it will provide to Nelly’s Nectar Bar?
7-19 Allocating overhead to products using activity-based costing (CMA adapted) (LO 2, 5) Nancy’s Nut House is a processor and distributor of a variety of different nuts. The company buys nuts from around the world and roasts, seasons, and packages them for resale. Nancy’s Nut House currently offers 15 different types of nuts in one-pound bags through catalogs and gourmet shops. The company’s major cost is that of the raw nuts; however, the predominantly automated roasting and packing processes consume a substantial amount of manufacturing overhead cost. The company uses relatively little direct labor.
Some of Nancy’s nuts are very popular and sell in large volumes, but a few of the newer types sell in very low sales volumes. Nancy’s prices its nuts at cost (including overhead) plus a markup of 40%. If the resulting prices of certain nuts are significantly higher than the market price, adjustments are made. Although the company competes primarily on the quality of its products, customers are price conscious.
Data for the 2011 budget include manufacturing overhead of $6,000,000, allocated on the basis of each product’s direct labor cost. The budgeted direct labor cost for 2011 totals $1,200,000. Based on the sales budget and raw materials standards, purchases and use of raw materials are expected to total $9,000,000 for the year.
The unit costs of a one-pound bag of two of the company’s products follows.
Nancy’s controller believes that the traditional costing system may be providing misleading cost information, so she has developed the following analysis of the 2011 budgeted manufacturing costs.
Data regarding the 2011 production of cashews and chestnuts follow. There will be no Raw Materials Inventory for either type of nuts at the beginning of the year.
Required
0. Using the current costing system, calculate the cost and selling price of one pound of cashews and one pound of chestnuts.
1. Using an activity-based costing approach and the information provided, calculate the cost and selling price of one pound of cashews and one pound of chestnuts.
2. Given the activity-based costing information you have just calculated, what action do you suggest Nancy’s Nut House should take regarding cashews and chestnuts?
7-20 Activity-based costing and activity-based management in a service industry (CMA adapted) (LO 2, 5) Best Test Laboratories was founded 25 years ago to evaluate the reaction of materials to extreme increases in temperature. Much of the company’s early growth was attributable to government contracts to test the suitability of weapons, transportation equipment, and clothing for use in arid desert regions. Recent growth has come from diversification and expansion into commercial markets. Environmental testing at Best Test now includes:
· heat testing (HTT).
· air turbulence testing (ATT).
· stress testing (SST).
· arctic condition testing (ACT).
· aquatic testing (AQT).
Currently, all the company’s budgeted operating costs are collected in a common overhead pool. All of the estimated testing hours are collected in another common pool. One rate per test hour is used to estimate the cost of all five types of testing. In determining the sales price, this hourly rate is marked up by 45% to cover administrative expenses, taxes, and profit.
Rick Shaw, Best Test’s operations engineer, believes that there is enough variation in the test procedures and cost structure to establish separate costing and billing rates. After analyzing the following data, he has recommended that new rates be put into effect at the beginning of Best Test’s fiscal year.
The budgeted total costs for the coming year are as follows:
The following chart reports Shaw’s analysis of resource usage by test type.
Required
0. Compute the common pool hourly cost and hourly billing rate for Best Test Laboratories.
1. Compute the activity-based hourly cost for each of the five tests performed by Best Test Laboratories.
2. Calculate the activity-based hourly billing rate for each of the five tests performed by Best Test Laboratories.
3. Based on the new hourly cost data, what recommendations would you make to Rick Shaw on the pricing of the company’s five tests?
7-21 Calculating activity-based product costs; activity-based management (CMA adapted) (LO 2, 3, 5) Efferson Electronics manufactures two large-screen television models. The 32-inch fl at-panel LCD model has been in production since 2003 and sells for $900. The company introduced a 42-inch plasma HDTV in 2006; it sells for $1,140.
The company’s income statement for 2011 follows. Based on these results, management has decided to concentrate the company’s marketing efforts on the plasma HDTV model and begin to phase out the LCD model.
The unit costs for the two television models are as follows:
Jon Daniel, Efferson’s controller, just attended a seminar on activity-based costing and believes the company should implement such a system. He has gathered the following information for 2011 to explore the possibility.
Required
0. Calculate the activity rate for each activity cost pool.
1. Allocate overhead costs to each of the products using activity-based costing.
2. Calculate the total product cost of each product using activity-based costing.
3. Are the product costs you calculated in part (c) the total costs of the two products? Why or why not?
4. Evaluate Efferson’s decision to focus on the 42-inch plasma television and phase out the 32-inch LCD television.
5. In what other ways could Efferson Electronics use the activity-based cost information calculated in part c?
7-22 Calculating activity-based product costs; activity-based management (CMA adapted) (LO 2, 3, 5) Highland Manufacturing produces two products in its Saratoga plant, balzene and galvene. Since it opened its doors in 1965, Highland has been using a single manufacturing overhead pool to accumulate overhead costs. Overhead has been allocated to products based on direct labor hours.
Until recently, Highland was the sole producer of galvene in the country and was therefore able to dictate the selling price. However, last year Marcella Products began marketing a comparable product at $37 per unit—a price that is below Highland’s product cost. Highland’s market share of galvene has declined rapidly as a result. The company’s managers must now decide whether to meet the competitive price or discontinue the product. Highland’s cost accountant has suggested that the company do an activity-based cost analysis before managers make the decision.
The two main indirect costs of manufacturing balzene and galvene are power usage and setup costs. Most of the power usage occurs in the fabricating department; most of the setup costs are incurred in the assembly department. Setup costs are incurred predominantly in the production of balzene. The fabricating department has identified machine hours as the appropriate cost driver; the assembly department has identified setups as the appropriate cost driver. Direct labor rates are the same in both departments.
The combined budget for manufacturing is as follows.
The cost accountant has prepared the following estimates of overhead usage by the two departments:
Required
0. Calculate the unit costs of balzene and galvene using the current overhead allocation basis of direct labor hours.
1. Calculate the amount of overhead cost assigned to the Fabricating and Assembly activity cost pools using the cost accountant’s estimates. Determine the overhead rate for each cost pool.
2. Calculate the unit costs of balzene and galvene using activity-based costing. Round your answer to two decimal places.
3. Did the switch to activity-based costing change the actual cost to produce galvene? Why or why not?
4. What action should Highland’s managers take regarding the production of galvene? Why?
CASE
7-23 Activity-based costing and ethics (CMA adapted) (LO 2) Thomas-Britt Industries was founded by Matt Thomas in 1950 as a small machine shop that produced parts for the aircraft industry. The Korean War brought rapid growth to Thomas-Britt. By the end of the war, the company’s annual sales had reached $15 million, almost exclusively from government contracts. The next 40years brought slow but steady growth. Cost-reimbursement contracts from the government continued to be the main source of revenue.
In the early-1990s, president Will Thomas, son of the founder, realized that Thomas-Britt could not depend on government contracts for long-term growth and stability. Consequently, he began planning for diversified commercial growth. By the end of 2003, Thomas-Britt had succeeded in reducing government contract sales to 50% of total sales.
Traditionally, the costs of the Materials Handling Department have been allocated to other departments as a percentage of the dollar value of direct materials. Peter Anderson, manager of the government contracts unit, has been complaining about this allocation for several months. He believes that since his unit’s materials costs are high and materials handling activities are low relative to the commercial unit, he is absorbing more than his fair share of this overhead. He wants to find a way to transfer some of these charges to another unit, thereby increasing the government contracts unit’s profitability and his year-end performance bonus.
Peter shared his views in a recent meeting with Sarah Lindley, the newly hired cost accounting manager, and Reese Mason, manager of the commercial unit. After a heated discussion, Sarah agreed to investigate the current allocation method and, if appropriate, recommend an alternative method.
After doing some research, Sarah learned the following:
· The majority of the direct materials purchases for government contracts are high-dollar, low-volume purchases. Direct materials purchases for commercial contracts are mostly low-dollar, high-volume purchases.
· There are other departments that use the services of the Materials Handling Department on a limited basis, but they have never been charged for materials handling costs.
· One purchasing agent with a direct phone line is assigned exclusively to purchasing high-dollar, low-volume materials for government contracts, at an annual salary of $36,000. His employee benefits are estimated to amount to 20% of his annual salary. The dedicated phone line costs $2,800 a year.
The Materials Handling Department’s budget for 2011, as proposed by Sarah Lindley’s predecessor, follows.
After reviewing the situation, Lindley has recommended that allocating materials handling costs based on the number of purchase orders issued is preferable to the current allocation based on direct materials cost. She estimated the number of purchase orders to be processed in 2011 as follows:
Using the 2011 estimates, she provided the following analysis to Anderson and Mason.
When Mason saw the projected increase in the commercial unit’s costs, he exploded. He was not going to lose any of his year-end performance bonus just because Lindley wanted to change the way she calculated the numbers. He marched into Lindley’s office and reminded her that he had been with the company for 25 years and had “plenty of pull” with Thomas as a member of the senior management team. He then told her to “adjust” her numbers and modify her recommendation so that the results would be more favorable to the commercial unit. He added that since materials handling costs were only allocated to the government contract and commercial units, she could just hide some of the commercial unit’s purchase order volume in those other units.
Given her new position, Lindley is not sure how to proceed. She questions his motivation. To complicate matters, Thomas has asked her to prepare a three-year forecast of the two units’ results, for which she believes the new allocation method would provide the most accurate data. Using the new method would put her in direct opposition to Mason’s directives, however.
Lindley has assembled the following forecasted data to project the units’ direct materials handling costs.
Required
0. Using the forecasted information, calculate the materials handling costs that would be allocated to each unit under both allocation methods. Show the cumulative dollar impact over the three-year period 2011-2013.
1. Why might the number of purchase orders be a better cost driver for materials handling costs than direct materials cost?
2. Are there other factors in the allocation that Lindley should consider?
3. In a recent meeting between Sarah Lindley and Reese Mason, Mason said that there is nothing in any accounting pronouncement that requires the use of activity-based costing. Therefore, there is no reason to make Lindley’s recommended change in allocation methods. Do you agree with Mason? Why or why not?
4. What ethical conflict does Sarah Lindley face? What specific steps should she take to resolve it? Refer to the IMA Statement of Ethical Professional Practice (
Exhibit 1-8
), in developing your answer.
ENDNOTES
1
. Mark Albert, “The ABCs of Activities Based Costing,” Modern Machine Shop,
www.mmsonline.com
,
http://www.mmsonline.com/articles/the-abcs-of-activities-based-costing.aspx
(accessed September 13, 2008).
2
. Introduction to Activity-Based Cost Management, Armstrong Laing Group, 2004,
http://www.fds.hu/pdf/introduction%20to%20activity%20based%20cost%20management
(accessed May 28, 2007; site now discontinued).
3
. Michael Heaney, “Easy as ABC? Activity-Based Costing in Oxford University Library Services,” The Bottom Line: Managing Library Finances, 17, no. 3 (2004): 93-97.
4
. Tad Leahy, “Where are You on the ABC Learning Curve?” BusinessFinance, December 2004,
http://businessfinancemag.com/print/5988
(accessed November 21, 2009).
5
. For a more complete history of the development of activity-based costing, see Steve Player and Carol Cobble, Cornerstones of Decision Making: Profiles of Enterprise ABM (Greensboro, NC: Oakhill Press 1999) from which this information is taken.
6
. Peter F. Drucker, The Practice of Management (New York: Harper, 1954), 195.
7
. Robin Cooper and Robert S. Kaplan, “How Cost Accounting Systematically Distorts Product Costs,” in William J. Bruns, Jr. and Robert S. Kaplan (eds.), Accounting and Management: Field Study Perspectives (Boston: Harvard Business Publishing, 1987).
8
. Activity Based Costing: How ABC Is Used in the Organization, BetterManagement,
http://www.bettermanagement.com/images/Library/pdf/Activity_Based_Costing_Survey_Result
(accessed June 2, 2007).
9
. Miles Free, “Is Your Order Book Telling You to Consider Activity-Based Costing?” Production Machining, April 17, 2007,
http://www.productionmachining.com/articles/is-your-order-book-telling-you-to-consider-activity-based-costing.aspx
(accessed September 13, 2008).
10
. In this chapter, we will illustrate the development of activity-based costs using only manufacturing overhead. A similar analysis may be completed for selling and administrative costs to develop a truer ABC product cost.
11
. This step is sometimes referred to as “second-stage allocation.”
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2
COST BEHAVIOR AND COST ESTIMATION
After studying this chapter, you should be able to meet the following learning objectives (LO).
1. Identify basic cost behavior patterns and explain how changes in activity level affect total cost and unit cost. (Unit 2.1)
2. Estimate a cost equation from a set of cost data and predict future total cost from that equation. (Unit 2.2)
3. Prepare a contribution format income statement. (Unit 2.3)
The Pitch
Martin Keck, vice president for sales at Universal Sports Exchange, one of C&C Sports’ customers, was reviewing the latest corporate income statement prior to meeting with Judy Elmore, the company’s chief financial officer.
“I don’t understand these numbers,” Martin thought. “We fell short of our projected sales volume of jerseys by 10%, so I was anticipating net income to be 10% lower than expected as well. But that’s not what the numbers are showing. How can I use this information to help me plan for the coming year? I just placed an order for jerseys with C&C Sports last week thinking I knew what we needed, and now I’m not so sure I did the right thing.&
Martin’s thoughts were interrupted by the telephone’s ringing. He answered, and heard Jonathan Smith, C&C Sports’ vice president of marketing, on the other end.
“Hi Martin,” Jonathan said. “I’m calling to check on your last order of jerseys—it’s smaller than I expected.”
“I was just thinking about that order, Jonathan,” said Martin. “I told our purchasing manager to cut the order this month because we sold 10% fewer jerseys than we expected to last year. That means we have left over jerseys in inventory, and we don’t need as many as we originally thought we would.”
“Ouch,” commented Jonathan. “That had to hurt Universal’s bottom line last year.”
“It did,” replied Martin. “Although for the life of me I can’t figure out how much money we lost from the lower sales volume.”
Martin faces a problem that is common in companies that rely on financial statements prepared according to GAAP to make business decisions. GAAP-based income statements categorize expenses based on business function—product, selling, or administrative. To predict what the company’s income might have been under certain scenarios, we need to know how those costs behave—that is, how they change with changes in the company’s activity level.
UNIT 2.1 Cost Behavior Patterns
GUIDED UNIT PREPARATION
Answering the following questions while you read this unit will guide your understanding of the key concepts found in the unit. The questions are linked to the learning objectives presented at the beginning of the chapter.
1. Why is it important for managers to understand cost behavior patterns? LO 1
2. What is a variable cost? If the activity level increases, what happens to the total cost incurred? Give three examples of a variable cost. LO 1
3. What is a fixed cost? If the activity level increases, what happens to the total cost incurred? Give three examples of a fixed cost. LO 1
4. Distinguish between committed and discretionary fixed costs. LO 1
5. What is a mixed cost? If the activity level increases, what happens to the total cost incurred? Give three examples of a mixed cost. LO 1
6. What is a step cost? If the activity level increases, what happens to the total cost incurred? Give three examples of a step cost. LO 1
In evaluating a business decision, it is important to understand how the costs associated with a given course of action will change over a range of activity levels. When managers talk about cost behavior, they are referring to the way in which total costs change in response to changes in the level of activity. This unit introduces four common cost behavior patterns that serve as the foundation for cost–volume–profit analysis (
Chapter 3
), and you’ll learn how to use these cost behavior patterns to estimate total cost.
Variable Costs
Let’s assume that you are shopping for a new cell phone plan. The carrier has offered you a plan based on the number of minutes you talk on your phone. For each minute you talk, the carrier will charge you $0.05. If you talk 10 minutes you will be charged $0.50 (10 minutes × $0.05 per minute); if you talk 1,000 minutes, you will be charged $50 (1,000 minutes × $0.05 per minute).
This hypothetical phone plan is an everyday example of a variable cost. Any total cost that varies in proportion to a business activity is a variable cost. The activity can be any repetitive event that serves as a measure of output or usage, such as units sold, units produced, minutes talked, or miles driven. As the level of activity increases, the total cost increases by the same proportion. Conversely, as the level of activity decreases, the total cost decreases by the same proportion. So a 10% increase in volume results in a 10% increase in total variable cost, and a 10% decrease in volume results in a 10% decrease in total variable cost.
Variable costs have two main characteristics:
· The total cost varies in proportion to changes in the level of activity.
· The cost per unit remains constant, regardless of the level of activity.
These characteristics are illustrated in
Exhibit 2-1
, representing your hypothetical cell phone plan. As the number of minutes you talk increases, so does your phone bill. Notice that if you talk for zero minutes, the total cost is $0. This pattern is true of all variable costs: If there is no activity, no cost is incurred. But while the total bill changes with the number of minutes used, the cost per minute remains constant at $0.05 per minute. Notice that the slope of the total cost line equals the cost per minute, $0.05. The following table illustrates the relationship between minutes used, total cost, and cost per minute at various levels of activity.
EXHIBIT 2-1 Variable cost of cell phone service.
Total variable cost is easy to estimate if you know the cost per unit of activity. Suppose you have talked on your phone for 375 minutes. How much is your phone bill going to be? The answer is $18.75:
Think About It 2.1
For each of the following companies, identify at least one cost that you think is variable. What is the unit of activity that makes that cost variable?
Fixed Costs
Now assume you are in the market for an apartment. You have found your dream living quarters for only $900 per month. If you decide to share it with a roommate, the total rent for the apartment remains $900, but each of you will pay only $450 ($900 ÷ 2). If you decide to share it with two roommates, the total rent will remain $900, but the cost per person will fall to $300 ($900 ÷ 3). Regardless of the number of people living in the apartment, the total rent for the apartment remains $900. Only the cost per person changes.
Your hypothetical apartment rent is an everyday example of a fixed cost. In contrast to a variable cost, the total amount of a fixed cost does not change with the activity level. However, the cost per unit does change. The higher the level of activity, the lower the fixed cost per unit. It’s just like dividing a pie: The more people who want to eat the pie, the smaller each piece becomes.
Fixed costs have two main characteristics:
· The total cost remains fixed, regardless of changes in the level of activity.
· The cost per unit varies inversely with changes in the level of activity.
Exhibit 2-2
illustrates these characteristics. As the number of roommates increases, the total rent remains constant. But while the total rent remains constant as the number of roommates changes, the cost per person varies. The following table illustrates the relationship between the number of occupants, the total cost, and the cost per person at various levels of activity:
EXHIBIT 2-2 Fixed cost of an apartment rental.
Discretionary versus Committed Fixed Costs
One important distinction between different types of fixed costs is the period over which they can be changed. Discretionary fixed costs are fixed costs that can be changed over the short run. For instance, the cost of an annual contract for television advertising is a fixed cost. In times of falling profits, however, a company may choose to cut such advertising costs to improve profits. Committed fixed costs, on the other hand, cannot be changed over the short run. For instance, a company may have signed a 10-year lease on an office building. Until the lease period ends, nothing can be done to change the amount of rent the company pays.
WATCH OUT!
Most students are very good at defining variable and fixed costs, but they often make mistakes in recalculating costs when the activity level changes. To avoid mistakes, keep the costs in their “constant” form. For example, if you are calculating variable costs, use the cost per unit because you know that number won’t change (remember $0.05 per minute?). Then calculate the new total by multiplying the constant—in this case, the cost per unit—by the number of units. If you are calculating fixed costs, use the total cost (remember $900 per month for rent?), even if someone has given you the cost per unit. You know that a fixed cost per unit applies to only one activity level, so don’t use it to predict fixed cost at any other level of activity.
Companies should be careful about reducing their discretionary fixed costs during times of falling profits. Consider the cost of television advertising. Reducing advertising is likely to reduce sales further, exacerbating the problem of falling profits.
Step Costs
Suppose your cell phone company offers a plan under which you can buy airtime in blocks of 500 minutes. Every block of 500 minutes costs $40. If you use between 1 and 500 minutes, you will pay $40; if you use 501 minutes, you will pay $80.
This phone plan is an example of a step cost. Step costs are fixed over only a small range of activity. Once that level of activity has been exceeded, total cost increases and remains constant over another small range of activity.
With step costs, total cost remains constant over the step range, but unit cost decreases as usage within the step range increases. So while the total cost of both 100 minutes and 500 minutes would be $40, the cost per minute of airtime would be $0.40 and $0.08, respectively.
Exhibit 2-3
illustrates step costs.
EXHIBIT 2-3 Step cost of cell phone service.
Mixed Costs
At this point, you may be thinking that all costs are either fixed or variable. That isn’t quite the case, however. Some costs have both a fixed and a variable component. These costs are referred to as mixed costs. Since a mixed cost has both a fixed and a variable component, both the total cost and the unit cost will vary with changes in the level of activity.
Think about the natural gas bill you might receive for heating your apartment. To receive service, you pay a base charge of $10 per month, regardless of how much gas you use. Then you pay an additional charge of $0.06 per cubic foot for the gas you use. The $10 monthly charge is the fixed component, and the $0.06 charge per cubic foot is the variable component. So the total cost can be expressed as:
Exhibit 2-4
illustrates the concept of a mixed cost. Notice that the total cost line intersects the y-axis at $10, representing the fixed component of the mixed cost. The slope of the line is $0.06, representing the variable component of the mixed cost. As the following table shows, both the total cost and the unit cost change with changes in the level of activity.
EXHIBIT 2-4 Mixed cost of natural gas service.
Reality Check—If it looks like a variable cost…
This total cost translates into $346 per new customer—slightly above the Yankee Group’s 2004 average.
The Yankee Group, a Boston-based consulting firm (
www.yankeegroup.com
), reported in 2004 that as wireless telephone companies increase in size, they experience an increase in customer acquisition cost. At that time, wireless companies incurred an estimated average cost of $334 to sign up a new customer. With every 1 million new customers, this cost increased by $1.15.
What kind of costs are these? The $1.15 represents a total cost of $1,150,000 for every 1 million new customers. This cost is an example of a step cost because it is fixed over a relatively small level of activity. What about the $334 average cost? At first glance, it appears to be a variable cost. That is, for each new customer that signs up for service, the company should incur an additional cost of $334. Let’s look more closely at this cost, however, using information from Alltel Corporation’s financial statements.
For the year ended December 31, 2006, Alltel reported a total cost of $1,144,548,000 to acquire 3,303,907 new wireless customers, as follows:
This total cost translates into $346 per new customer—slightly above the Yankee Group’s 2004 average. Does this mean that if Alltel signed up one more wireless customer, total cost would have increased by $346? Probably not. Consider Alltel’s selling and marketing expenses. More than likely, much of that expense represented the cost of television or billboard advertising, which does not increase with the addition of a new customer. Because one more customer will not increase the total cost incurred for advertising, this cost is fixed. Therefore, the $346 customer acquisition cost reported by Alltel is really a mixed cost—part variable and part fixed. Can you think of examples of the variable components of this mixed cost?
Sources: Shawn Young, “As Wireless Firms Grow, So Can Costs,” The Wall Street Journal, April 29, 2004; Alltel Corporation 4th Quarter 2006 Highlights,
http://media.corporateir.net/media_files/irol/74/74159/4Q06_results/4q06_highlights
(accessed March 11, 2008).
Think About It 2.2
What causes a mixed cost to increase with activity? What causes the cost per unit of a mixed cost to decrease with activity?
UNIT 2.1 REVIEW
KEY TERMS
Activity p. 48
Committed fixed cost p. 51
Cost behavior p. 48
Discretionary fixed cost p. 51
Fixed cost p. 50
Mixed cost p. 52
Step cost p. 51
Variable cost p. 48
SELF STUDY QUESTIONS
1. LO 1 A variable cost remains constant in total with changes in activity level. True or False?
2. LO 1 Macintosh Corporation leases a copy machine for a monthly fee of $100 plus a charge of $0.01 per copy. Macintosh’s copy cost would be considered a
2. variable cost.
2. fixed cost.
2. step variable cost.
2. mixed cost.
1. LO 1 Meg Thomas maintains a membership at Woodridge Health and Fitness that costs her $120 per month. The membership fee would be considered a
3. variable cost.
3. fixed cost.
3. step variable cost.
3. mixed cost.
UNIT 2.1 PRACTICE EXERCISE
Complete the following table, identifying the following costs as fixed, variable, or mixed.
SELECTED UNIT 2.1 ANSWERS
Think About It 2.1
All companies have some type of variable cost. For each of the following companies, identify at least one cost that you think is variable. What is the unit of activity that makes this cost variable?
Think About It 2.2
The variable component of the mixed cost increases as activity increases, so the total cost increases. The fixed component of the mixed cost causes the cost per unit to think is variable. What is the unit of activity that makes this cost variable? decrease with activity, since those fixed costs are spread over more units.
Self Study Questions
1. False
2. D
3. B
Unit 2.1 Practice Exercise
Costs 1 and 4 are easy to identify because they match the “constant” definition of fixed and variable costs. Cost 1 is constant in total over all activity levels, so it must be a fixed cost. Cost 4 is constant per unit over all activity levels, so it must be a variable cost. The other costs cannot be classified just by looking at them.
Costs 2 and 3 both change with the activity level, but that doesn’t make these costs variable. Variable costs vary directly with activity, meaning that there is a linear relationship between the cost and the activity. To determine whether such a relationship exists, compute the cost per unit (total cost ÷ activity level). For cost 2, the per unit amounts are $5.10, $2.60, and $1.77. For cost 3, the per unit amounts are $4.30, $4.30, and $4.30. Notice that cost 3 has a direct relationship to the activity level—that is, for every additional unit of activity, a cost of $4.30 is incurred. Because this unit cost is constant over all activity levels, it must be a variable cost. For cost 2, on the other hand, the per unit cost decreases with activity, which means it can’t be variable. We know that cost 2 is not fixed because it changes with activity. If it is neither fixed nor variable, it must be mixed.
Costs 5 and 6 both decrease on a per unit basis as the activity level increases, which is a characteristic of both fixed and mixed costs. To determine whether these costs are fixed or mixed, compute the total cost (cost per unit × activity level). For cost 5, the total cost is $600,000, $600,000, and $600,000, indicating that it is a fixed cost. For cost 6, the total cost is $151,000, $152,000, and $153,000. Since cost 6 has characteristics of both fixed costs (the cost per unit decreases as the activity level increases) and variable costs (the total cost increases as the activity level increases), it is a mixed cost.
UNIT 2.2 Cost Estimation
GUIDED UNIT PREPARATION
Answering the following questions while you read this unit will guide your understanding of the key concepts found in the unit. The questions are linked to the learning objectives presented at the beginning of the chapter.
1. Express the relationship between total cost (TC), variable cost per unit (VC), volume (x), and fixed cost (FC) in equation form. LO 2
2. Explain how a scattergraph is used to separate a mixed cost into its fixed and variable components. LO 2
3. Explain how the high-low method is used to separate a mixed cost into its fixed and variable components for cost estimation. LO 2
4. Given a choice between the high-low method, a scattergraph, or regression analysis, which method would you prefer for separating a mixed cost into its fixed and variable components? Why? LO 2
5. Explain the concept of the relevant range. How does a company’s relevant range differ from the steps found in a step cost? LO 2
A large part of analyzing a business decision is predicting the level of cost that will be incurred. Once you know how a particular cost behaves, estimating the total cost is relatively simple. In this unit, we will learn how to use several techniques for making these estimates.
Total cost is a combination of fixed and variable costs.
1
It can be predicted using the standard algebraic equation
where:
y = total cost;
m = the variable cost per unit;
x = the level of activity (such as number of units); and
b = total fixed cost.
Think back to the cost of natural gas which we examined in Unit 2.1. This mixed cost included a fixed charge of $10 per month and a variable charge of $0.06 per cubic foot. The total cost of service at any level of usage can be estimated using the following equation:
So for 100 cubic feet of gas, the estimated total cost would be
While using this equation to predict the total cost is a simple task, we don’t always know the total fixed cost and variable cost per unit. So we need to determine those costs before we can predict future costs. Let’s look at three methods of estimating costs: scattergraphs, the high-low method, and regression analysis.
Scattergraphs
Scattergraphs are the simplest method for estimating the fixed and variable components of a mixed cost. A scattergraph is simply a graph that shows total costs in relation to volume or activity level. The data needed to create a scattergraph can be gathered from weekly or monthly reports. Once you have plotted the individual points, draw a line through them to estimate the cost relationship.
2
The following table shows the delivery costs that Universal Sports Exchange incurred last year with its outside delivery service.
Exhibit 2-5
shows the same information in the form of a scattergraph. Notice that the level of activity—number of deliveries in this case—is plotted on the horizontal axis and the total delivery cost is plotted on the vertical axis. This is the customary format for a scattergraph. Based on a visual inspection of the scattergraph, a linear relationship appears to exist between the number of deliveries and delivery cost.
EXHIBIT 2-5 Scattergraph of delivery costs.
To estimate the fixed and variable cost components using a scattergraph, it is necessary to visually “fit” a line to the plotted points. You need to draw the line so that it appears to fit the data well, minimizing the distance between the line and the data points. Once you have drawn the line, you can calculate the fixed and variable costs using basic algebra.
Exhibit 2-6
shows one possible line fitted to the plotted points. Notice that it crosses the y-axis (where the level of activity is 0) at $500. Thus, the estimate for fixed delivery cost is $500.
EXHIBIT 2-6 Scattergraph of delivery costs with fitted line.
You can calculate the variable cost of a delivery as the slope of the line using any visually identified point on the line. Using the point representing 1,500 deliveries and $2,600 of total delivery cost,
Thus, total delivery cost can be estimated using the equation
The estimated delivery cost for 1,000 deliveries would be
The scattergraph method of estimating costs is subject to some limitations. Most importantly, the choice of the line used to estimate the cost components is subjective. Using a different line will produce different estimates of the fixed and variable costs.
High-Low Method
Another “quick and dirty” approach to estimating the fixed and variable components of a mixed cost is the high-low method. This method is similar to the scattergraph in that you begin by examining the cost data from a number of periods. Unlike the scattergraph, the high-low method requires only two data points—the lowest point of activity and the highest point of activity.
To estimate total cost using the high-low method:
1. Identify the highest and lowest levels of activity
2. Compute the variable cost per unit (the slope of the line):
3. Calculate the fixed cost using either the high point or the low point such that:
4. Complete the cost equation by showing that
WATCH OUT!
Always select the high and low points based on level of activity, not total cost.
Let’s return to the data on delivery cost that we used in the scattergraph example.
Step 1: The highest level of activity, 2,800 deliveries, occurred in July at a total cost of $4,800. The lowest level of activity, 600 deliveries, occurred in June at a total cost of $1,500.
Step 2:
Step 3: Using the high point,
Or, using the low point,
WATCH OUT!
In using the high-low method to separate a mixed cost into its fixed and variable components, students often stop after Step 2, forgetting half the solution. Remember to insert either the high point or the low point into the total cost equation to calculate the fixed cost component of the mixed cost (Step 3). Then write out the total cost estimation equation (Step 4). Use only the high point or the low point to complete Step 3, since those were the only two points used to estimate the variable cost per unit.
Step 4:
We can now use our equation to estimate the delivery cost at any level of activity. For example, at 1,000 deliveries, estimated total delivery cost would be:
Like the scattergraph, the high-low method does have some limitations. Because it is based on only two extreme points, the high and low activity levels, the cost equation may not be truly representative of the cost relationship. Be careful not to use an obvious outlier as either the high or the low point, or it will greatly skew your cost estimate.
Regression Analysis
A more precise approach to separating a mixed cost is regression analysis, a statistical technique that identifies the line of best fit for the points plotted in a scattergraph. As shown in
Exhibit 2-7
, spreadsheet software such as Microsoft Excel makes regression analysis easy. After entering the data points in the spreadsheet, use the INTERCEPT and SLOPE functions to determine the fixed cost and variable cost per unit, respectively.
EXHIBIT 2-7 Regression using Microsoft Excel.
Using the same data represented in our scattergraph (
Exhibit 2-5
), regression analysis results in a total fixed cost of $388.94 and a variable cost of $1.49 per delivery. Thus, the equation to estimate total delivery cost would be
Using this equation, the estimated delivery cost for 1,000 deliveries would be
You have now learned three ways to estimate the fixed and variable components of a mixed cost: the scattergraph, the high-low method, and regression analysis. Let’s compare the results of the three methods:
Reality Check—Where does the relevant range end?
Growth of this magnitude will definitely move BMW’s production costs into a new relevant range.
How wide is the relevant range of activity? When does a company leave one relevant range and enter another one with a different cost function? The answers to these questions are company-specific and can greatly affect the cost estimates used in decision making.
Consider an announcement by the BMW Group that it will spend $750 million to expand its plant in Spartanburg, South Carolina. When the three-year expansion is complete, the plant will be 60% larger and employ 500 more workers, and production capacity will increase from 160,000 to 240,000 cars. Growth of this magnitude will definitely move BMW’s production costs into a new relevant range.
Sources: BMW Group, “BMW Group Invests US $750 Million in US Plant,” news release, March 10, 2008; PR-inside.com, “BMW Announces Plant Expansion,” news release, March 10, 2008,
http://www.pr-inside.com/bmw-announces-plant-expansion-r478681.htm
(accessed March 11, 2008).
Why go through all these estimations? Remember, we started the chapter by asking what Universal’s income would be if sales volume increased by 10%. But we can’t estimate how income will change when the activity level changes until we can estimate how costs will change with the activity level.
Think About It 2.3
Why do these three estimation techniques result in different predictions for delivery cost? Which one is right?
Cost Estimation and the Relevant Range
A final word of caution about cost behavior and estimation: Cost behaviors and estimates are valid only within the relevant range, or the normal level of operating activity. Beyond the relevant range, cost relationships are likely to change, and with them, cost estimates. (For more about relevant range see the box at top of this page.)
Consider the graph shown in
Exhibit 2-8
, which represents a cost relationship that is often encountered in business. Note that the cost relationships on either side of the shaded relevant range differ markedly from the highlighted portion of the curves. While these graphs represent curvilinear cost relationships, within the relevant range the cost relationships approximate a linear relationship. Thus, the estimation techniques you have learned, which are based on a linear relationship, are valid, but only over the relevant range.
EXHIBIT 2-8 Cost relationship within the relevant range.
UNIT 2.2 REVIEW
KEY TERMS
High-low method p. 58
Relevant range p. 61
Regression analysis p. 60
Scattergraph p. 56
SELF STUDY QUESTIONS
1. LO 2 The scattergraph method provides the most accurate cost function estimates. True or False?
2. LO 2 Bargain Booksellers sold 40,000 books in April and 65,000 books in December. Shipping costs for the two months were $150,000 and $200,000, respectively. Using these two months’ data, the shipping cost function is best estimated as
2. ($2.00 × number of books sold) + $70,000
2. ($0.50 × number of books sold) + $167,500
2. ($3.33 × number of books sold)
2. ($2.00 × number of books sold) + $50,000
1. LO 2 Mike Morriss conducted a regression analysis on Morriss Medical Supplies’ catalog printing costs for last year, which resulted in the following equation: $5x + $750. If Morriss plans to print 500 catalogs in 2011, what are the printing costs expected to be?
3. $755
3. $2,500
3. $3,250
3. $5,000
UNIT 2.2 PRACTICE EXERCISE
This exercise extends the work you did for the
Unit 2-1
exercise. This time, complete the table by estimating the cost formula. For mixed costs, use the high-low method.
SELECTED UNIT 2.2 ANSWERS
Think About It 2.3
The three estimation techniques use different combinations of data points to arrive at a cost equation for deliveries. As a result, their estimated costs differ. Although none of the three techniques yields a correct answer (remember, they are estimations), most statisticians would agree that regression gives the best estimate because it calculates the line of best fit for all data points, not just one or two.
Self Study Questions
1. False
2. A
3. C
Unit 2.2 Practice Exercise
Determining the cost formulas for costs 5 and 6 might seem a little confusing at first because those costs are represented per unit instead of in total. You can easily convert them to totals, however, by multiplying the per unit amounts by the appropriate number of units. For cost 5, the total costs are $600,000, $600,000, and $600,000. For cost 6, the total costs are $151,000, $152,000, and $153,000. Applying the high-low method to these total costs is easy.
UNIT 2.3 Contribution Margin Analysis
GUIDED UNIT PREPARATION
Answering the following questions while you read this unit will guide your understanding of the key concepts found in the unit. The questions are linked to the learning objectives presented at the beginning of the chapter.
1. Define the term contribution margin. LO 3
2. What is the contribution margin ratio? How is it related to the variable cost ratio? LO 3
3. If a product’s variable cost per unit increases while the selling price and fixed cost decrease, what will happen to the contribution margin per unit? LO 3
4. How can a company increase a product’s contribution margin? LO 3
Once you understand cost behavior, you can begin to use that knowledge in making business decisions. One of the basic tools for making such decisions is the contribution margin. In this unit you will learn how to calculate the contribution margin and how to construct a contribution format income statement to support business decision making.
Contribution Margin
If an organization wants to make a profit, it must generate more sales revenue than the expenses it incurs. This relation can be expressed using the following profit equation:
Let’s expand this profit equation based on our knowledge of cost behavior. Since variable cost per unit remains constant, we can express total variable expense as a function of the number of units sold. Likewise, we can express total sales revenue as a function of the number of units sold, resulting in the following expanded profit equation.
WATCH OUT!
You will notice that sometimes we refer to variable and fixed costs and at other times to variable and fixed expenses. A cost is the cash or other value given up to obtain goods or services in the expectation that they will generate future benefits. A cost can be capitalized as an asset on the balance sheet, as in the purchase of inventory for resale. Once the future benefits have been received, however, the cost becomes an expense on the income statement. So an expense is an expired, or used up, cost.
In the inventory example, when inventory is sold, the future benefit—sales revenue—has been realized, so the original capitalized cost is expensed on the income statement as the cost of goods sold. At the same time, the inventory asset on the balance sheet is reduced. Some costs, such as salaries and wages, are expensed in the same period in which they are incurred and are never reported on the balance sheet.
Applying some basic algebra to this equation, we can express operating income in the following way:
The above equation highlights the contribution margin, an important relationship between sales and variable cost. The contribution margin is the difference between sales revenue and variable expenses. In other words, it is the amount that remains to cover fixed expenses and provide a profit. The contribution margin can be expressed in unit terms, as the sales price per unit minus the variable cost per unit, or as a total:
Using the definition of contribution margin, we can rewrite the profit equation as
This version of the profit equation should help you understand an important relation between contribution margin and profit. As the number of units sold increases, total contribution margin increases, but fixed expenses remain the same. Thus, as the number of units sold rises, profit increases by the additional contribution margin per unit.
Suppose Universal Sports Exchange pays C&C Sports $14.80 for each baseball jersey and sells the jerseys to customers for $20. Let’s assume the only other variable expense Universal incurs is the 6% sales commission it pays each sales-person ($20 × 6% = $1.20 per jersey). Therefore, the jersey has a $4 contribution margin ($20 − $14.80 − $1.20). For each jersey sold, Universal earns $4 to cover its total fixed expenses and provide some profit.
Reality Check—The contribution margin recipe
An estimated 30% of all new restaurants fail within their first year of business.
Technological advances have made vital information more readily available to restaurant managers than it was in the past. Before restaurants had “back-office” computer systems to provide vital operating information, managers would look at a recipe, develop a best-guess estimate of the cost to prepare the item and then increase it by 300 to 400% to arrive at the menu price. With today’s systems, however, guessing is no longer necessary. Based on a recipe and the prices of its ingredients, these systems can calculate the contribution margin of a menu item. Armed with this information, restaurant owners can quickly perform menu engineering and identify dishes that aren’t selling or aren’t making money.
What’s the bottom-line result? Using such a system, Chip Motley, the owner of four restaurants in the Washington, DC area, was able to identify a rib-eye steak special that was selling well but wasn’t making much money. He decided to raise the price and increase the contribution margin. Because the increased price did little to change the sales volume, the result was a bottom-line improvement from the increased contribution margin.
An estimated 30% of all new restaurants fail within their first year of business. Perhaps if more restaurant owners understood the concept of the contribution margin, the failure rate would be lower.
Sources: “Back-Office Bonanza,” Nation’s Restaurant News, October 27, 2003, 8–12; John Nessell, “Is Your Menu Working For or Against You?” Restaurant Resource Group,
http://www.rrgconsulting.com/menu_engineering.htm
(accessed March 12, 2008); “Restaurant Management Tips: Sell the Big Contributors,” Chef2Chef Culinary Portal,
http://foodservice.chef2chef.net/restaurant-management/chapters/tip01.shtml
(accessed March 12, 2008); Chana R. Schoenberger, “A Burger with a Side of Losses,”Forbes, December 9, 2002, 168, available online at
http://www.forbes.com/free_forbes/2002/1209/168.html
(accessed March 12, 2008).
In assessing business opportunities, the contribution margin ratio is sometimes a useful tool. The contribution margin ratio is the ratio of the contribution margin to sales.
The contribution margin ratio for Universal’s baseball jersey is 20%:
The contribution margin ratio can be used to determine the increase in profits from a given dollar increase in sales revenue. With a 20% contribution margin ratio, each dollar in baseball jersey sales generates $0.20 ($1.00 × 20%) in contribution margin for Universal. So an additional $100 in jersey sales will generate $20 in additional contribution margin.
Contribution Format Income Statement
Recall from the chapter opener that Universal missed its target sales goal by 10% and Martin Keck, vice president for sales, was trying to understand how the lower sales volume affected income.
Exhibit 2-9
presents Universal Sports Exchange’s income statement that raised Martin’s questions.
3
EXHIBIT 2-9 Universal Sports Exchange’s functional income statement.
This format, which is consistent with GAAP, does not help managers predict the financial results of their decisions. This shortcoming is due to the format of GAAP statements, which is based on cost function (product, sales, administration) rather than on cost behavior.
What Martin needs to answer his questions is an income statement that classifies expenses by behavior. Such a statement will allow him to easily assess the impact of sales volume on operating income. This type of income statement is called a contribution format income statement, and it presents expenses by behavior, as follows:
For the purposes of illustration, let’s assume that Universal sells only one product, baseball jerseys. Universal buys each jersey from C&C for $14.80 and sells it for $20. That means that both the sales revenue and cost of goods sold vary with the number of jerseys sold. Selling and administrative expenses are made up of $179,500 in selling expenses and $51,500 in administrative expenses. The selling expenses include a 6% sales commission paid to the sales staff. That is, for every dollar of sales made by a sales representative, Universal pays a $0.06 commission. Since sales revenue varies with activity, total sales commissions also vary with activity. The rest of the selling expenses are fixed, as are all the administrative expenses.
Using this information, we can prepare an income statement in the contribution format, as shown in
Exhibit 2-10
. Notice that we arrived at the same operating income as in the original income statement in
Exhibit 2-9
. Changing from a traditional functional income statement to a contribution format income statement does not change the amount of income. Rather, it just rearranges the individual components. If you notice that operating income has changed after you convert from one format of the income statement to the other, you have made an error; you should recheck your work.
EXHIBIT 2-10 Universal Sports Exchange’s contribution format income statement.
We are not quite ready to predict how much income Universal lost by failing to meet its sales targets because we don’t have the information in “constant” form. (Recall from the WATCH OUT! box on page 51 that you should always put your information in constant form before you begin to estimate the results of a change in activity.) So what do we need to do? Fixed expenses are in the correct format because they are in their “constant” form—that is, in total. Variable expenses, however, need to be converted to a per unit basis, as shown in
Exhibit 2-11
.
EXHIBIT 2-11 Universal Sports Exchange’s contribution format income statement with unit data.
Notice that in the “Ratio” column, variable amounts are shown as a percentage of sales. The contribution margin ratio is 20%; the variable cost ratio is 80%, or 1 minus the contribution margin ratio.
If Universal were to increase its sales volume (the number of jerseys sold) by 10%, how many more jerseys would that be? First, we need to know the current sales volume, and we can calculate that amount by dividing total sales dollars by sales price per unit:
Increasing sales volume by 10% would mean selling 5,250 additional jerseys (52,500 × 0.10). So how much more income would these 5,250 additional jerseys generate? Each jersey generates $4 in contribution margin, so the total increase in operating income would be $21,000 ($4 × 5,250). Net income would increase by $14,700 after taxes ($21,000 × (1 − 0.30)). We could have obtained the same result using the contribution margin ratio:
Exhibit 2-12
shows how the contribution format income statement would have looked had the expected level of sales been achieved. Notice that the variable items—sales, variable expenses, and contribution margin—would have varied in total, whereas the fixed expenses would have remained fixed.
EXHIBIT 2-12 Universal Sports Exchange comparison of actual and expected results.
Think About It 2.4
If the managers at Universal Sports Exchange had decided to lower the sales prices of jerseys to increase sales volume, what would have been the effect on the following?
·
Cost of goods sold per unit
·
Commission per jersey sold
·
Contribution margin per unit
If the strategy had worked as planned, what would have been the change in the following?
·
Total sales revenue
·
Total cost of goods sold
·
Total commissions paid
·
Total contribution margin
UNIT 2.3 REVIEW
KEY TERMS
Contribution format income statement p. 66
Contribution margin p. 64
Contribution margin ratio p. 65
Cost p. 64
Expense p. 64
Variable cost ratio p. 67
SELF STUDY QUESTIONS
1. LO 3 A contribution format income statement presents all expenses by behavior rather than by function. True or False?
2. LO 3 The contribution margin is calculated as
2. Sales revenue – Cost of goods sold.
2. Sales revenue – Variable cost of goods sold.
2. Sales revenue – Total variable expenses.
2. Sales revenue – Total fixed expenses.
1. LO 3 The amount of net income presented on a functional income statement will be different from the amount of net income presented on a contribution format income statement. True or False?
1. LO 3 Jenkins Jewelers operates with a 30% contribution margin. If Jenkins’s sales increase by $20,000, operating income will increase by
4. $6,000.
4. $10,000.
4. $14,000.
4. $20,000.
UNIT 2.3 PRACTICE EXERCISE
Restate the following income statement in contribution margin format.
SELECTED UNIT 2.3 ANSWERS
Think About It 2.4
| Cost of goods sold per unit | no change | |||
| Commission per jersey sold | decrease | |||
| Contribution margin per unit | ||||
| Total sales revenue | increase | |||
| Total cost of goods sold | ||||
| Total commissions paid | ||||
| Total contribution margin |
Self Study Questions
1. True
2. C
3. False
4. A
Unit 2.3 Practice Exercise
The Wrap-up
In the chapter opener, Martin Keck wondered how much additional income Universal would have earned if the company had met its sales target. Recall that the sales target was 10% higher than actual sales. The answer to this question requires an understanding of Universal’s cost behavior patterns.
We’ve seen that to achieve the additional 10% of sales, Universal would have sold 5,250 more baseball jerseys. Those additional jerseys would have generated an additional contribution margin of $21,000. After the income taxes on this additional income had been deducted, the bottom line would have increased by 50% to $44,100.
To be able to predict the difference in income, Martin needed to know cost behavior patterns and needed information in constant form—variable costs per unit and fixed expenses in total.
CHAPTER SUMMARY
In this chapter you learned some important terms and techniques that will be relevant throughout the rest of this book. Specifically, you should be able to meet the learning objectives set out at the beginning of the chapter:
1.
Identify basic cost behavior patterns and explain how changes in activity level affect total cost and unit cost. (Unit 2.1)
The two basic cost behavior patterns are variable and fixed. Costs that are a combination of these two basic patterns are referred to as mixed. The following table shows how these costs change with changes in activity:
2.
Estimate a cost equation from a set of cost data and predict future total cost from that equation. (Unit 2.2)
Total cost can be expressed in the form y = mx + b, where y is the total cost, m is the variable cost per unit, x is the number of units, and b is the total fixed cost. Given a set of costs and activity levels, you can estimate a cost equation using one of the following methods: scattergraph, high-low, or regression.
3.
Prepare a contribution format income statement. (Unit 2.3)
A contribution format income statement is an income statement that categorizes expenses by their behavior. It follows the structure:
Besides showing total sales revenue and expenses, the contribution format statement should also show per unit amounts for sales revenue, variable expenses, and contribution margin.
KEY TERMS
Activity (Unit 2.1)
Committed fixed cost (Unit 2.1)
Contribution format income statement (Unit 2.3)
Contribution margin (Unit 2.3)
Contribution margin ratio (Unit 2.3)
Cost (Unit 2.3)
Cost behavior (Unit 2.1)
Discretionary fixed cost (Unit 2.1)
Expense (Unit 2.3)
Fixed cost (Unit 2.1)
High-low method (Unit 2.2)
Mixed cost (Unit 2.1)
Regression analysis (Unit 2.2)
Relevant range (Unit 2.2)
Scattergraph (Unit 2.2)
Step cost (Unit 2.1)
Variable cost (Unit 2.1)
Variable cost ratio (Unit 2.3)
EXERCISES
2-1 Identify cost behavior (LO 1) Macon Vitamins sells a variety of vitamins and herbal supplements to small health food stores. Macon purchases the vitamins and supplements from leading manufacturers. Identify each of the following costs incurred by Macon Vitamins in terms of its cost behavior—variable, fixed, mixed, or step.
0. Vitamin C tablets
1. President’s salary
2. Sales commissions ($1.00 per case)
3. Straight line depreciation on office equipment
4. Shipping (billed in 100-pound increments)
5. Advertising
6. Telephone charges (monthly fee of $35 plus long distance charges)
2-2 Identify cost behavior (LO 1) Identify each of the following costs in terms of its cost behavior—variable, fixed, mixed, or step.
0. The cost of coffee beans at a Starbucks shop
1. Depreciation of airplanes at Southwest Airlines
2. Nurses’ wages at M. D. Anderson Cancer Center, assuming a ratio of one nurse to every five patients
3. Electricity cost at a Krispy Kreme Doughnuts store
4. The cost of hard drives installed in computers built by Dell
5. Store managers’ salaries at Barnes and Noble bookstores
6. Actors’ wages and salaries at Paramount Studios, when the star is paid a base amount plus a percentage of box office receipts
7. The cost of fabric used in making shirts at Lands’ End
8. The cost of cookies provided to guests at check-in at Doubletree Hotels
9. The cost of a national advertising campaign for Burger King
2-3 Estimate unit and total costs (LO 1) Will Jones, LLP is a small CPA firm that focuses primarily on preparing tax returns for small businesses. The company pays a $500 annual fee plus $10 per tax return for a license to use Mega Tax software.
Required
0. What is the company’s total annual cost for the Mega Tax software if 300 returns are filed? If 400 returns are filed? If 500 returns are filed?
1. What is the company’s cost per return for the Mega Tax software if 300 returns are filed? If 400 returns are filed? If 500 returns are filed?
2. Why does the cost per return differ at each of the three volume levels?
2-4 Cost behavior (LO 1) Identify each of the following costs, incurred monthly by Baylor Balloon Bouquets, as fixed, variable, or mixed. Explain your reasoning.
2-5 Cost behavior (LO 1) To calculate the unit cost of the MP3 players that he sells at his mall kiosk, Joel Lawson added up all his costs and divided by the number of units he sold during the year. He then used this unit cost to estimate total costs for the coming year.
Required
Explain to Joel why this unit cost is not useful in predicting total costs for the coming year.
2-6 Cost behavior (LO 1) The Boeing Company produces commercial aircraft. The following passage is taken from Management’s Discussion and Analysis, included in Boeing’s 2005 Annual Report.
“Commercial aircraft production costs include a significant amount of infrastructure costs, a portion of which do not vary with production rates.”
As part of its accounting practices, Boeing spreads the fixed infrastructure costs over the “accounting quantity” for each type of airplane. The accounting quantity is the estimated number of planes that will eventually be produced. At the end of 2005, Boeing’s accounting quantity for the 737 Next-Generation plane was 2,800. At the end of 2008, the accounting quantity for this plane had risen to 4,200.
Required
0. What effect would this change in accounting quantity have on the total fixed infrastructure cost of the 737 Next-Generation plane?
1. What effect would this change in accounting quantity have on the unit cost of the 737 Next-Generation plane?
2-7 Scattergraphs (LO 2) Usonic, Inc., has collected the following information on its cost of electricity:
Required
0. Prepare a scattergraph of Usonic’s electricity costs for the year. Plot the total electricity cost on the y-axis. Draw a line that you think best represents the electricity cost function. Be sure that the line runs through at least one of the data points.
1. What is the equation of the line you drew in part (a)?
2. What is the expected electricity cost when 425 machine hours are used?
3. Why does your answer to part (c) differ from the actual cost for the month of April, when 425 machine hours were used?
2-8 High-low method (LO 2) Refer to the data in Exercise 2.7.
Required
0. Using the high-low method, compute the variable cost of electricity per machine hour.
1. Compute the total fixed cost of electricity.
2. Represent the electricity cost function in equation form.
3. What is the expected electricity cost when 425 machine hours are used?
4. Why does your answer to part (d) differ from the actual cost for the month of April, when 425 machine hours were used?
2-9 Estimated cost equation (LO 2) Refer to the data in Exercise 2.4. Using the form y = mx + b, estimate the cost formula for each cost incurred by Baylor Balloon Bouquets.
2-10 Cost estimation (LO 2) Managers of Tom Brown Distributors are evaluating the compensation system for the company’s sales personnel. Currently, the two salespeople have a combined salary of $60,000 per year and earn a 3% sales commission.
The company is considering two alternatives to the current compensation system. The first alternative is to reduce total salaries to $50,000 and increase the sales commission to 5%. The second alternative is to eliminate the salaries and pay a 12% sales commission.
Sales projections under each of the compensation systems are as follows:
Required
0. Write the cost equations for the current compensation system and both alternative compensation structures.
1. Given Tom Brown’s sales projections, and assuming that the cost of goods sold is equal to 30% of sales, which pay system would be the most profitable one for the company? Ignore all other costs and show your calculations.
2-11 Contribution format income statement (LO 3) Restate the following income statement in contribution format.
2-12 Contribution format income statement: missing values (LO 3) Complete each of the following contribution format income statements by supplying the missing numbers.
2-13 Contribution format income statement (LO 3) The Robinson Company sells sports decals that can be personalized with a player’s name, team name, and jersey number for $5 each. Robinson buys the decals from a supplier for $1.50 each and spends an additional $0.50 in variable operating costs per decal. The results of last month’s operations are as follows:
Required
Prepare a contribution format income statement for the Robinson Company.
2-14 Contribution format income statement (LO 5) Mary Smith sells gourmet chocolate chip cookies. The results of her last month of operations are as follows:
Required
0. Prepare a contribution format income statement for Mary.
1. If Mary sells her cookies for $1.60 each, how many cookies did she sell during the month?
2. What is the contribution margin per cookie?
3. What is Mary’s contribution margin ratio?
PROBLEMS
2-15 Calculate changes in cost; decision making (LO 1) Southwest Phone Services offers a cellular phone plan for $50 per month. Under this plan, you can make an unlimited number of phone calls and talk as long as you like.
Required
0. Prepare a table that shows the cost per minute of airtime and the total amount of the phone bill at the following usage levels: 10 minutes, 100 minutes, 250 minutes, and 500 minutes.
1. What type of cost behavior does Southwest’s phone plan illustrate? Why?
2. Assume that your current cell phone plan costs you $0.02 per minute. If you use 1,000 minutes of airtime per month, which plan would you prefer, $50 per month or $0.02 per minute? What if you used 3,000 minutes per month? At what level of airtime usage would you become indifferent between the two plans?
3. How would you decide which phone plan to buy?
2-16 Scattergraph; high-low method; cost estimation (LO 2) The Salinas Corporation has gathered the following data on its copy machine costs for the first eight months of the year.
Required
0. Prepare a scattergraph of the cost information and then choose a line that you believe best represents the cost function. Represent your chosen line with a cost equation of the form y = mx + b. Show your calculations.
1. Using the high-low method, what is the variable cost per copy?
2. Using the high-low method, what is the fixed cost per month?
3. Using the high-low method, represent the cost function with a cost equation of the form y = mx + b.
4. Using your cost equation from part (d), provide your best estimate of the copy costs for September if 70,000 copies will be made. Why does your estimate differ from the $7,000 cost incurred in March?
2-17 High-low method; cost estimation (CMA adapted) (LO 2) Bob Jones owns a catering company that stages banquets and parties for both individuals and companies. The business is seasonal, with heavy demand during the summer months and year-end holidays and light demand at other times. Bob has gathered the following cost information from the past year:
Required
0. Using the high-low method, compute the overhead cost per labor hour and the fixed overhead cost per month.
1. Bob has booked 2,800 labor hours for the coming month. How much overhead should he expect to incur?
2. If Bob books one more catering job for the month, requiring 200 labor hours, how much additional overhead should he expect to incur?
3. Bob recently attended a meeting of the local Chamber of Commerce, at which he heard an accounting professor discuss regression analysis and its business applications. After the meeting, Bob enlisted the professor’s assistance in preparing a regression analysis of the overhead data he collected. This analysis yielded an estimated fixed cost of $48,000 per month and a variable cost of $4 per labor hour. Why do these estimates differ from your high-low estimates, calculated in part (a)?
2-18 High-low method (LO 2) Harlan Gravity Grips produces spike sets for track shoes. CEO Brittany Harlan has gathered the following information about the company’s sales volume and marketing cost for the past six months.
Required
0. Using the high-low method, compute the variable marketing cost per spike set.
1. Compute the total fixed marketing cost.
2. Represent the marketing cost function in equation form.
3. Examine the data and identify the potential outlier.
4. Recalculate the marketing cost function, removing the potential outlier.
5. Which of the two cost functions you calculated would be appropriate to use in estimating future marketing costs? Why?
2-19 Cost estimation (LO 2) Thomas, Ltd., provides nationwide passenger train service on 21,000 miles of routes. Selected operating data for fiscal 2010 are shown below.
Required
0. The above data provide three possible activity measures that could influence fuel expense. Use the high-low method to develop a cost formula for fuel expense for each of the three measures.
1. Do any of the cost formulas you developed in (a) appear to be a poor choice for estimating future train operations expense? Why?
2. Which formula do you think will make the most accurate predictions? Why?
2-20 Cost behavior identification; contribution format income statement (LO 1, 3) Mighty Bright Window Cleaners’ monthly income statement at several levels of activity is as follows:
Required
0. Identify each expense as fixed, variable, or mixed.
1. Prepare a contribution margin income statement based on a volume of 5,000 windows.
2-21 Cost estimation; contribution format income statement (LO 2, 3) J Bryant, Ltd., is a local coat retailer. The store’s accountant prepared the following income statement for the month ended January 31.
Bryant sells its coats for $250 each. Selling expenses consist of fixed costs plus a commission of $6.50 per coat. Administrative expenses consist of fixed costs plus a variable component equal to 5% of sales.
Required
0. Prepare a contribution format income statement for January.
1. Using the format y = mx + b, develop a cost formula for the operating expenses.
2. If 2,700 coats are sold next month, what is the expected total contribution margin?
2-22 Contribution format income statement; decision making (LO 3) Henley Horticulture provides and maintains live plants in office buildings. The company’s 850 customers are charged $30 per month for this service, which includes weekly watering visits. The variable cost to service a customer’s location is $17 per month. The company incurs $2,000 each month to maintain its fleet of four service vans and $3,000 each month in salaries. Henley pays a bookkeeping service $2 per customer each month to handle all invoicing and accounting functions.
Required
0. Prepare Henley’s contribution format income statement for the month.
1. What is the expected monthly operating income if 150 customers are added?
2. Mr. Henley is exploring options to reduce the annual bookkeeping costs.
Option 1: Renegotiate the current contract with the bookkeeping service to pay a flat fee of $10,200 per year plus $1 per customer per month.
Option 2: Hire a part-time bookkeeper for $18,000 per year to handle the invoicing and simple accounting. He would need to pay $5,000 per year to have taxes and year-end financial statements prepared.
Compare the current bookkeeping cost with the two options at customer levels of 850, 1,000, and 1,100.
3. Besides the bookkeeping costs incurred, what should Mr. Henley consider before he makes a change in bookkeeping services?
CASES
2-23 Calculate expected costs (LO 1) Helios Botanicals develops hybrid tearoses. A relative newcomer to the field, Helios is looking for innovative ways to advertise its products to potential customers. Rose Mayfield, sales manager and avid online shopper, wonders about advertising the company’s roses on various gardening websites. She has contacted Kimland Media, Inc., an advertising firm specializing in Internet advertising campaigns, to explore some options.
After meeting with Rose, Sami Landon, regional sales coordinator, has suggested that Helios use a targeted marketing strategy by placing banner ads on a few gardening websites. Helios would pay for the service based primarily on the number of ad impressions (the number of times the ads are shown). Using past campaigns as a guide, Sami has prepared the following quarterly estimate for Helios.
From past experience, Kimland Media estimates that 10% of all viewers will “click through” the banner ad to Helios’s website. Of those viewers who click through, Kimland estimates that 5% will actually make a purchase.
Required
0. What is the expected total cost per quarter of Helios’s Internet advertising campaign?
1. Given Sami’s cost estimates, what is Helios’s expected cost of acquiring a new customer through the campaign?
2. Using the information you just calculated, what is the estimated cost to get one more person to click through and make a purchase?
2-24 Ethics (This is a continuation of Case 2-23) On March 15, Jeff Blake, Kimland Media’s sales director, stopped by Sami Landon’s cubicle. “Sami, I’ve been reviewing your accounts, and they aren’t generating as much revenue as we had hoped. If you want to achieve your quota for the quarter, you’re going to have to bump it up a bit.”
Sami thought for a few minutes about how she might increase her revenue pool. She could sign some new customers, but she didn’t have any strong leads, and developing the ones she had would take too much time. She couldn’t create new banner ads for her current customers. Then it dawned on her: She could increase her variable revenue through increased click-through counts on her existing banner ads.
Sami got on the phone and called her friends and family members. “I need a small favor. Would you go to
www.tearosegarden.com
and look for the Helios ad? Then just click through the ad as many times as you can.”
Required
0. Was it ethical for Sami to enlist the help of friends and family to drive up the number of click-throughs to Helios’s website? Why or why not?
1. Would your answer to part (a) change if Sami’s friends and family members actually made a purchase from Helios? Why or why not?
2. What impact did Sami’s actions have on Helios Botanicals?
ENDNOTES
1
. You may be wondering about how mixed costs fit into this equation. Remember that a mixed cost has both a fixed and variable component. Therefore, we separate the mixed cost into its fixed and variable components and then add these amounts to the other fixed and variable costs.
2
. You can use the chart function in Microsoft Excel or a similar package to easily plot points on a scattergraph.
3
. Notice that the financial statements do not use the traditional December 31 date. This is because most retailers use the 4–5–4 calendar that divides the year into months using a 4 weeks/5 weeks/4 weeks pattern, with each week beginning on a Sunday. You can learn more about the 4–5–4 calendar at
http://www.nrf.com/modules.php?name=Pages&sp_id=392
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On Sheet 1: Table 2 should use Fixed cost per month “$3 million (instead of $10) per month” because Project 2->Tab 2->Question #3 states that “The variable cost per unit is $10 and the fixed costs are $3 million per month.” Please correct the related numbers on Question 2 accordingly. Question #2: “Marginal Contribution = Revenue – Variable Costs” is the correct formula you should use. Question #2: You should use the formula “Profit % = Profit / Revenue” when calculating Profit % for Total (in cell D70). Do not use ‘sum’ function at here. On Sheet 2: Sheet 3: For Question #1, Total Allocated costs (row 14) for Cost of Standard Boxes (Column H) should be the sum of the computed results in column H (=16.84). Your calculations for the Allocated cost per box are incorrect. For example, for Standard boxes, Allocated Cost per box = Total Allocated costs (16.84) / Number of boxes per year (108) = 0.16. Please correct your related calculations for both standard boxes and Deluxe boxes. On Sheet 4: |
|
Feedback Date |
|
Feb 15, 2022 2:57 PM |
|
Assignment |
|
Project 3 |
>Sheet Maximization has been populated in Cells A to H of Q 1. Assuming the company operates months of the year convert the information from Project 2 to annual information for both Standard and Deluxe Boxes.
22
( obtain from Project 2)
12 Boxes sold per month in millions
/unit
VC Costs (FC+VC)
(millions)
0.00
.00
00.00
4.00
0
.80
$ 10.00 $ 3.00 $ 36.00 6.00
0
$ 10.00 $ 3.00 $ 36.00 5.20
$ 10.00 $ 3.00 $ 36.00 2.80
$ 10.00 $ 3.00 $ 36.00 0.00
$ 10.00 $ 3.00 .00
$ 36.00 $ 10.00 $ 3.00 $ 36.00 $ 10.00 $ 3.00 $ 36.00 $ 10.00 $ 3.00 $ 36.00 $ 10.00 $ 3.00 $ 36.00 $ 10.00 $ 3.00 .00
$ 36.00 $ 10.00 $ 3.00 .00
$ 76.80 $ 36.00 $ 921.60 $ 10.00 $ 3.00 $ 76.20 $ 1,320.00 $ 36.00 $ 914.40 $ 10.00 $ 3.00 $ 75.20 $ 36.00 $ 902.40 $ 10.00 $ 3.00 $ 73.80 $ 36.00 $ 885.60 $ 10.00 $ 3.00 $ 72.00 .00
$ 36.00 $ 864.00 $ 10.00 $ 3.00 $ 69.80 $ 36.00 $ 837.60 $ 10.00 $ 3.00 $ 67.20 $ 36.00 $ 806.40 $ 10.00 $ 3.00 $ 64.20 $ 36.00 $ 770.40 $ 98.00 12 Price Annual Revenue (millions) Annual VC (millions) Annual FC (millions) Annual Total Costs (millions) $ 30.00 $ 10.00 $ 10.00 $ 3.00 $ 120.00 $ 36.00 $ 10.00 $ 3.00 00
$ 20.40 $ 36.00 $ 180.00 $ 10.00 $ 3.00 00
$ 36.00 0
$ 10.00 $ 15.00 $ 3.00 $ 180.00 $ 36.00 $ 10.00 $ 3.00 00
$ 36.00 $ 10.00 $ 16.00 $ 3.00 00
$ 36.00 $ 10.00 $ 16.50 $ 3.00 00
$ 198.00 $ 36.00 $ 10.00 $ 17.00 $ 3.00 $ 25.05 $ 204.00 $ 36.00 $ 300.60 $ 10.00 $ 3.00 00
$ 25.00 $ 36.00 $ 300.00 $ 10.00 $ 18.00 $ 3.00 00
$ 24.90 $ 216.00 $ 36.00 $ 298.80 $ 25.00 $ 10.00 $ 18.50 $ 3.00 00
$ 24.75 $ 222.00 $ 36.00 $ 297.00 $ 10.00 $ 19.00 $ 3.00 $ 228.00 $ 36.00 $ 10.00 $ 19.50 $ 3.00 00
$ 234.00 $ 36.00 $ 10.00 $ 20.00 $ 3.00 00
$ 24.00 $ 240.00 $ 36.00 $ 23.00 $ 10.00 $ 20.50 $ 3.00 $ 246.00 $ 36.00 $ 22.50 $ 10.00 $ 21.00 $ 3.00 $ 252.00 $ 36.00 $ 288.00 $ 22.00 $ 10.00 $ 21.50 $ 3.00 $ 258.00 $ 36.00 $ 21.50 $ 47.30 $ 10.00 $ 22.00 $ 3.00 $ 567.60 $ 264.00 $ 36.00 $ 300.00 $ 21.00 $ 47.25 $ 10.00 $ 22.50 $ 3.00 $ 567.00 $ 36.00 and 1.5 Million Deluxe Boxes per month. With environmental concerns over the use of the materials and techniques to make the Deluxe Boxes the company director is concerned over its longterm feasibility. The marketing manager is convinced that under the current cost allocation Deluxe boxes is the highest contributor to company gross profit. How much profit is made on each product ? Also calculate the Gross Profit percentage for each product. HINT Use the annual information calculated in to complete Question 2. Complete the grey spaces
per month )
9 10.5 108 18 $ (in millions) $ (in millions) $ 1,080.00 $ 1,260.00 $ 120.00 $ 36.00 $ 297.00 9 1.5 10.5 108 18 126 120.00 36.00 156.00 Millions Millions $ 2,030.40 $ 513.00 $ 1,080.00 $180 $ 950.40 $ 333.00 below. How much overhead would be allocated to Standard and Deluxe Boxes ( in total and per unit) using this method? Show all supporting calculations. Complete the grey spaces
of Drivers
$ 47.00 $ 50.00 500 1,000 7,000 Labour Hours $ 5.00 200 800 1,000.00 9,000.00 10,000.00 6.00
N/A $ 18.00 $ 156.00 108 18 N/A Question 1 $ 2,030.40 $ 513.00 Box.
$ 18.80 15 Question 2 40.22% 18.21% 18.21% $ 139.16 $ 270.00 18 $ 15.00 Total $ 90.00 $15 $ 180.00 Contribution $ 90.00 Fixed Costs $ 139.161
In this Project you will analyse managerial and costing information to improve the company’s EBITDA. You will use what you have learned about cost behavior and apply activity-based costing and cost-volume-profit analysis to make recommendations about LGI’s operational productivity. Use Information you calculated in project 2 Tab 3
Profit
12
1
10
Question 1
Profit Maximization
Standard Boxes
Quantity
Price
Revenue
VC
FC / per month (millions)
Total
Daily profit (revenue -all costs)
Annual Revenue (millions)
Annual VC (millions)
Annual FC (millions)
Annual
Total Costs
Annual Profit
5
$ 22.00
$
11
$ 10.00
$ 50.00
$ 3.00
$ 53.00
$ 5
7
$ 1,3
20.00
$
6
$
36.00
$ 636.00
$ 6
8
5.5
$ 2
1.6
$ 1
18
$ 55.00
$ 58.00
$ 60.80
$ 1,425.60
$ 660.00
$ 6
9
$ 729.60
6
$ 2
1.2
$ 127.20
$ 60.00
$ 63.00
$ 64.20
$ 1,526.40
$ 720.00
$ 756.00
$ 770.40
6.5
$ 20.80
$
13
$ 65.00
$ 68.00
$ 67.20
$ 1,622.40
$ 780.00
$ 816.00
$ 806.40
7
$ 20.40
$
14
$ 70.00
$ 73.00
$ 69.80
$ 1,713.60
$ 840.00
$ 876.00
$ 837.60
7.5
$ 20.00
$
15
$ 75.00
$ 78.00
$ 72.00
$ 1,
800
$ 900.00
$ 936.00
$ 864.00
8
$ 19.60
$ 156.80
$ 80.00
$ 83.00
$ 73.80
$ 1,881.60
$ 960.00
$ 996.00
$ 885.60
8.5
$ 19.20
$ 163.20
$ 85.00
$ 88.00
$ 75.20
$ 1,958.40
$ 1,020.00
$ 1,056.00
$ 902.40
9
$ 18.80
$ 169.20
$ 90.00
$ 93.00
$ 76.20
$ 2,030.40
$ 1,080.00
$ 1,116.00
$ 914.40
9.5
$ 18.40
$ 174.80
$ 95.00
$ 98.00
$ 76.80
$ 2,097.60
$ 1,140.00
$ 1,176.00
$ 921.60
10
$
18.00
$ 180.00
$ 100.00
$ 103.00
$ 77.00
$ 2,160.00
$ 1,
200
$ 1,236.00
$ 924.00
10.5
$ 17.60
$ 184.80
$ 105.00
$
108
$ 2,217.60
$ 1,260.00
$ 1,296.00
11
$ 17.20
$ 189.20
$ 110.00
$ 113.00
$ 2,270.40
$ 1,356.00
1
1.5
$ 16.80
$ 193.20
$ 115.00
$ 118.00
$ 2,318.40
$ 1,380.00
$ 1,416.00
12
$ 16.40
$ 196.80
$
120.00
$ 123.00
$ 2,361.60
$ 1,440.00
$ 1,476.00
12.5
$ 16.00
$ 200.00
$ 125.00
$ 128.00
$ 2,400.00
$ 1,
500
$ 1,536.00
13
$ 15.60
$ 202.80
$ 130.00
$ 133.00
$ 2,433.60
$ 1,560.00
$ 1,596.00
13.5
$ 15.20
$ 205.20
$ 135.00
$ 138.00
$ 2,462.40
$ 1,620.00
$ 1,656.00
14
$ 14.80
$ 207.20
$ 140.00
$ 143.00
$ 2,486.40
$ 1,680.00
$ 1,716.00
$ 168.80
$ 70.80
$ 2,025.60
Profit Maximization
Deluxe Boxes
Deluxe boxes sold per month (millions)
Revenue (price x volume)
Variable Cost per standard box
Variable Cost (cost per unit x volume)
Fixed cost per month (millions)
Total Cost (Fixed + Variable)
Daily Profit (revenue – all costs)
Annual Profit (millions)
1
$ 30.00
$ 13.0000
$ 17.00
$ 360.00
$
156.00
$ 204.00
1.2
$ 29.50
$ 35.40
$ 12.00
$ 15.00
$ 424.80
$ 144.00
$ 244.80
1.35
$ 29.00
$ 39.15
$ 13.50
$ 16.50
$ 22.65
$ 469.80
$ 162.00
$ 198.00
$ 27
1.8
1.5
$ 28.50
$ 42.75
$ 18.0000
$ 24.75
$ 513.00
$ 216.00
$ 297.00
1.55
$ 28.00
$ 43.40
$ 15.50
$ 18.50
$ 24.90
$ 520.80
$ 186.00
$ 222.00
$ 298.80
1.6
$ 27.50
$ 44.00
$ 19.00
$ 25.00
$ 528.00
$ 192.00
$ 228.00
$ 300.00
1.65
$ 27.00
$ 44.55
$ 19.50
$ 25.05
$ 534.60
$ 234.00
$ 300.60
1.7
$ 26.50
$ 45.05
$ 20.0000
$ 540.60
$ 240.00
1.75
$ 26.00
$ 45.50
$ 17.50
$ 20.50
$ 546.00
$ 210.00
$ 246.00
1.8
$ 25.50
$ 45.90
$ 21.00
$ 550.80
$ 252.00
1.85
$ 46.25
$ 21.50
$ 555.00
$ 258.00
1.9
$ 24.50
$ 46.55
$ 22.0000
$ 24.55
$ 558.60
$ 264.00
$ 294.60
1.95
$ 24.00
$ 46.80
$ 22.50
$ 24.30
$ 561.60
$
270.00
$ 291.60
2
$ 23.50
$ 47.00
$ 23.00
$ 564.00
$ 276.00
$ 288.00
2.05
$ 47.15
$ 23.5000
$ 23.65
$ 565.80
$ 282.00
$ 283.80
2.1
$ 47.25
$ 24.0000
$ 23.25
$ 567.00
$ 279.00
2.15
$ 47.30
$ 24.5000
$ 22.80
$ 567.60
$ 294.00
$ 273.60
2.2
$ 25.0000
$ 22.30
$ 267.60
2.25
$ 25.5000
$ 21.75
$ 270.00
$ 306.00
$ 261.00
$ 44.13
$ 20.66
$ 23.48
Question 2
The Company currently operates by selling 9 Million
Standard Boxes
Question 1
37.5
Standard Boxes Deluxe Boxes Total
Number Of Boxes (in
Millions
1,5
Volume per year ( millions)
126
$ (in millions)
Revenue $ 2,030.40 $ 513.00
$ 2,543.40
Less:
Variable Costs
$180
Marginal
Contribution
$ 950.40
$ 333.00
$ 1,283.40
Less:
Fixed Costs
$ 156.00
Profit
$ 830.40
$ 1,127.40
Profit
%
40.90%
57.89%
44.33%
Sheet2
Question 1
A new intern at the company believes that fixed cost based and allocated on a daily basis is incorrect and suggests allocating the Fixed Costs between Standard and Deluxe Boxes Based on the number of boxes sold. How much costs are allocated to each product based on the method suggested by the intern? To prove s/he point the intern also calculated the profit percentage. Complete the grey spaces
Standard Boxes Deluxe Boxes Total
Volumes (per Month)
Volumes per year ( millions)
Total Fixed Costs (Millions- from Tab1)
New Profit
Sales
Less VC
Contribution Margin
Less Fixed Costs
$ 133.71
$ 22.29
Operting Profit
$ 816.69
$ 60.57
Profit %
40.22%
11.81%
Sheet3
Question 1
LGI’s production managers recently attended a course at UMGC where they learned about ABC costing. They propose allocating the total fixed costs between Standard and Deluxe boxes based on this method . They collected information about the cost drivers and the break up of the total costs in
Table 1
Table 1
Manufacturing overhead
$ Amount
Cost driver
Standard Box
Deluxe Box
Totals
Cost of
Deluxe Boxes
Cost of Standard Boxes
Total Cost Check (must agree to Column B7:B14)
Depreciation
$47.00
Square feet
7,000
80,000
87,000
$ 43.22
$ 3.78
Maintenance
$50.00
Direct
Labour Hours
1,000
9,000
10,000
$ 45.00
$ 5.00
Purchase order processing
$9
Number of purchases orders
4,500
5,000
$ 8.10
$ 0.90
$ 9.00
Inspection
$34
Number of employees
6000
$ 29.14
$ 4.86
$ 34.00
Indirect Materials
$5.00
1,000.00
9,000.00
10,000.00
$ 4.50
$ 0.50
Supervision
$7.00
#of inspections
1000
$ 5.60
$ 1.40
$ 7.00
Supplies
$4.00
Units manufactured
$ 139.16
$ 16.84
$ 4.00
Total Allocated costs
$15
N/A
$
108.00
Number of boxes per year
$
126.00
Allocated Cost per Box
$ 7.73
$ 0.16
Deluxe Boxes Deluxe Boxes Total
Sales
Less: Variable Costs $ 1,080.00 $180
Contribution $ 950.40 $ 90.00
Less: Fixed Costs $ 16.84 $ 139.16
Profit
$ 933.56
$ 193.84
Profit % 40.22%
37.79%
Sheet4
Question 1
The sustainability manager is concerned about the long term sustainability implications of Deluxe boxes on the environment and suggest changing to sustainable materials for the production of a
Sustainable Deluxe
If the company switches to their current quantity of Deluxe Boxes sold to Sustainable Deluxe Boxes there will be some cost implications.
The Sustainable Deluxe Boxes could be made cheaper, and the sustianability manager believes that the company could bring down the selling price to $15 per box which would entice current Deluxe Box customers to accept the switch over. The new Sustainable Deluxe Boxes will attract 60% of total fixed costs calculated for the Deluxe Boxes under the ABC method. The number of boxes sold will not be affected by this new selling price, as the company will in future have to do marketing to sell more boxes at the lower price. Calculate the new Gross profit and profit percentage. Complete the grey spaces
Standard Boxes Sustainable Deluxe Total
Quantity 108.00 18.00 126.00
Sellin price per unit
$ 33.80
Sales $ 2,030.40 270.00
$ 2,300.40
VC $ 1,080.00 $180 20.00
Contribution $ 950.40 $ 90.00
$ 1,040.40
Fixed Costs $ 16.84 $ 139.16 $ 156.00
Profit $ 933.56
– 49.16
$ 884.40
GP %
45.99%
18.21%
The manager is concerned about the massive reduction in profit from the Sustainable Deluxe Boxes but realizes that because of the change in materials, they will no longer be able to charge the price of $18 per box. The manager wants to achieve at least the same profit percentage for the deluxe boxes as they have on standard boxes. How much additional profit are they requiring? Complete the grey spaces.
Required profit
See Tab 3
Less: Existing profit
See Q 1 above
Equals: Difference in additional profit required
22.01%
Question 3
Work out the percentage that they should mark up on the costs to achieve the same profit % as for the standard boxes. Complete the grey spaces
%
Sales $ 2,030.40
Less Required GP%
Equals: Mark up percentage on cost
$ 2,030.22
Question 4
Use the percentage calculated in Question 3 to determine how much the company should charge per product to reach the same profit percentage as for the standard boxes . Assume the company can still sell the same quantity of the Sustainable Deluxe Boxes as for the Deluxe Boxes. Complete the grey spaces
Totals
Variable Costs $ 180.00
Fixed Cost
Total Costs
$ 319.16
Sales
Units sold
Sales Price per unit
Question 5
Prove that your calculation in Q 4 is correct. Complete the grey boxes.
Proof:
Per Unit
Sales $ 270.00 $ 15.00
Less VC $ 180.00 12
Contribution $ 90.00
Fixed Costs $ 139.16
Net Profit
Profit %
33.00%
Question 5
The marketing manger is concerned that the change could havea significant impact on sales as ciustomers may see the sustaiable boxes as an inferiror product for which they still have to pay only a little bit less than the orginal price of the Deluxe Boxes. How many boxes would the company have to sell to break even on the new Sustainabale Deluxe Boxes based on the new selling price? Complete the grey boxes.
$ Totals
Selling price
Less: Variable costs
Breakeven Quantity
– 0.73
BreakEven Value
$ 8.89
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