Chapter 3 cash flows and cost terminology Solutions Review Questions 3. 1 Product costs are the costs associated with getting products and services for sale, whereas period costs are not directly related to readying products and services for sale. 3. 2Revenues less product costs = revenues less cost of goods sold or cost of providing services. 3. 3The matching principle. 3. 4The products service firms offer are not tangible or storable. 3. 5Merchandising firms buy goods from suppliers and resell substantially the same products to customers. . 6Cost of goods sold = cost of beginning inventory + cost of goods purchased during the period – cost of ending inventory. 3. 7Manufacturing firms use labor and equipment to transform inputs such as raw materials and components into outputs (finished goods). 3. 8Because they vary proportionally with production volume and can be traced directly to products. 3. 9Variable manufacturing overhead varies proportionally with production volume, whereas fixed manufacturing overhead does not change as production volume changes. . 10Prime costs equal the sum of direct materials and direct labor; conversion costs equal the sum of direct labor and manufacturing overhead. 3. 11Cost pools, cost objects, cost driver (allocation basis), and allocation volume (denominator volume). 3. 12Determine the allocation rate (overhead rate), and allocate the cost. 3. 13They are equal. Discussion Questions 14. For long-term software and consultancy projects, typically one of two methods is followed. The first is the completed contract method.
Under this method, the company accumulates the expenses incurred in the project in an “inventory” account, and states this inventory at cost in the balance sheet as of the balance sheet date. In the year in which the project is completed, this cost is then charged to the income statement against the revenues earned from the project (like cost of goods sold for a manufacturing firm). The second method is the percentage completion method. Under this method, expenses for each period are charged directly to the income statement each year, and a proportional amount of the total project revenue is also recognized as income in that year.
In this case, there is no inventory account for the project. 15. Yes, a restaurant would typically be classified as a service firm because the benefit from the “product” is not received by the customer over a period of time in the future. There is no transfer of ownership of an “asset” as it were. Restaurant patrons receive the benefit of the eating experience while being served at the restaurant site—this benefit cannot be bought and stored for future use (the exception of course is “take-outs,” but we are not considering take-outs here). 6. We would classify U-Haul as a service firm as well for the same reason we consider restaurants and hotels as service firms. Customers are essentially purchasing the right to use the U-Haul truck for a specific period of time. This benefit is not storable and used at some future point in time. As mentioned in the text, the products service firms offer are not tangible or storable like they are for merchandising and manufacturing firms. U-Haul is a good example. 17.
Merchandising firms hold inventories for the following reasons: • To make products readily available whenever customers need them and shop for them. If an item is not in stock, ordering, receiving and delivering it to the customer takes time, and the product may reach the customer too late (think of grocery store items such as milk, vegetables, and meat). • Some items are available only in certain seasons, but there is demand throughout the year. By stocking up when supply is available, merchandising firms can meet the demand at other times. Often ordering and receiving in bulk quantities is a lot more cost effective for merchandising firms than ordering in small quantities. Planning, handling and transportation activities are a lot easier. For this reason, many suppliers offer bulk discounts to induce merchandising firms to buy in large quantities and maintain inventories at their own sites. 18. Yes, inventory is an asset, and the cost of an asset includes not just the purchase price but all other expenses incurred to ready the asset for its intended purpose. Inventories are no exception.
Thus, the cost of inventory must include the cost of receiving and stocking goods. However, including the cost of receiving and stocking goods poses an allocation problem for merchandizing firms because these firms often purchase many different products in large quantities from the same vendor. Any reasonable and equitable allocation procedure is acceptable. 19. Some merchandising firms have very fast moving inventories because of the nature of the business and the products involved. Grocery stores are a good example because they sell numerous products with very short shelf lives.
Allocating transportation and receiving costs to individual products — if done properly — may result in accurate cost numbers for each product, but for such firms, charging these costs directly to cost of goods sold is not likely to result in material distortions. 20. Research development expenditures typically provide benefits to companies at some future in point in time. They are not part of the costs incurred to produce units in the inventory. Hence they are not included in inventoriable costs. In general, GAAP requires that the costs of research and development activities be expensed in the period in which they are incurred.
The logic is that it is difficult to ascertain future benefits that these expenditures may generate. So GAAP advocates a “conservative” approach by advocating expensing of all research and development costs, and not allowing any recognition of expected benefits. 21. Generally speaking, operating cash flows and income differ from each other because of non-cash flows charges to income. One such non-cash item is depreciation. Depreciation is significant in magnitude for manufacturing firms because these firms are capital incentive with property, plant and equipment accounting for a major percentage of total assets.
On the other hand, service firms such as consulting firms, software and IT firms, are far more dependent on human resources. As we know, human resources are not reported as assets under GAAP; the costs of human resources are expensed as period costs in the periods in which they are incurred. Consequently, the depreciation charge is much lower for service firms compared to manufacturing firms, and income and cash flows tend to be closer to each other. 22. A noticeable trend in the last fifty years is the increase in the level of automation in almost every sector of manufacturing.
The direct labor content has decreased appreciably. This trend has dramatically increased manufacturing overhead as a percentage of total costs because much of the costs of automation get reflected in the increase in depreciation associated with property, plant and equipment; and depreciation is included in the manufacturing overhead. Later, in Chapter 10, we will learn that machine and equipments costs are better viewed as direct costs rather than overhead from a decision making perspective. 23. Ship building and custom boat building require significant labor input.
Another example would be custom home building. Automobile manufacturing – once an extremely labor intensive operation – is now highly automated, with very little labor content. Motorcycle manufacturing, Harley-Davidson in particular, is highly automated. 24. In general, any two drivers would yield the same allocations if they are perfectly correlated with one another. For example, suppose a company is producing two products, A and B. Product A requires two hours of labor per unit, and one hour of machining per unit.
Product B requires four hours of labor per unit, and two hours of machining per unit. Let us say that the company expects to produce 200 units of A and 100 units of B in a month, requiring 800 hours of labor and 400 hours of machine time. Assume that the expected overhead costs are $8,000. If we use labor hour as the cost driver, the overhead rate is $10 per labor hour (= $8,000/ 800 labor hours), and we would charge $20 of overhead to a unit of A, and $40 to a unit of B. Suppose instead that we use machine hour as the cost driver. In this case, the overhead rate is $20 (= $8,000/400 machine hours).
Notice that the overhead charged per unit of A is again $20, and the overhead charged per unit of B is $40. The reason we get the same allocations is that both products use labor and machine time in the same proportion (two to one). 25. Yes, depreciation is a cost allocation procedure that allocates the purchase price of an asset (e. g. , a machine) over its life. The cost pool is the depreciation cost. If the objective of the allocation is to compute product costs (either for inventory valuation or for decision making), the cost object would be the product that the asset helps produce.
The cost driver is time, and allocation volume would be the useful life of the asset measured in number of years or number of hours. 26. The most important resource for a professional services firm such as a consultancy firm is human resource in the form of the professional or the consultant providing the service. A reasonable basis for allocating a consultant’s cost to a project or a job is to measure the amount of the time individual spends on the job, and allocate his/her cost (e. g. , salary, direct support and overhead costs) in proportion to the time spend.
For example, if a consultant is paid $400,000 in annual salary, and works, on average, 2,000 hours a year, the application rate will be $200 per hour. Therefore, if this individual spends 20 hours on an assignment, that assignment will be charged $4,000. 27. Sometimes, situations do arise when revenues have to be allocated to different components of a product offering that a company makes. Often, companies bundle products and services in order to increase demand. Xerox is known to bundle sales of copiers with service agreements it offers to maintain the copiers at the customers’ sites.
Yet, from an organizational perspective, making copiers and servicing them maybe be viewed as two distinct sets of activities for Xerox. It is important for the company to know how profitable copiers themselves are, and how profitable is servicing the copiers. Therefore, revenues from bundling these two aspects have to be allocated in a reasonable way to help Xerox plan and manage their operations well. Exercises 3. 28 The following table provides the required classifications (with product costs listed first, followed by period costs). Salary paid to consultants |Product cost. This is a cost of providing the service. | |Travel to client site |Product cost. This is a cost of providing the service. | |Cost of general purpose software |Product/period cost. This is an ambiguous item. We can| | |make a stronger case for product cost if it pertains | | |to a specific service.
A general purpose software like| | |Microsoft Office probably would be a period cost. | |Fee for attending training seminar |Period cost. This is part of the firm’s expenses for | | |maintaining skill, much like recruiting new | | |consultants. | |Salary to office administrator |Period cost. Pertains to administration. |Corporate office rent |Period cost. Administrative support. | As this problem illustrates, we can classify many costs unambiguously as being product or period costs. However, there is no bright line test. Some costs could be classified either way, with the specifics determining the actual bucket. 3. 29The following is the GAAP margin statement for Boyd Associates. Revenues$1,600,450 Cost of delivering service1,150,450 Gross margin450,000 Marketing & administration174,600 Profit before taxes275,400
We can readily obtain the answers by noting that revenue – cost of services = gross margin and gross margin – marketing and administration costs = profit before taxes. 3. 30The following is the gross margin statement for Skogg Consulting. Revenues9,000 hours ? $350/hour$3,150,000 Cost of delivering service9,000 hours ? $300/hour2,700,000 Gross margin$450,000 Marketing & administrationPlug figure220,000 Profit before taxesGiven $230,000 We can readily obtain the answers by noting that revenue – cost of services = gross margin and gross margin – marketing and administration costs = profit before taxes.
Notice that we ignored the reimbursement of actual costs in this statement. If we included the amounts, it would increase revenue and costs by identically. 3. 31a. |Brad Timberlake | |GAAP Income Statement | |Item |Detail |Amount | |Seminar Revenue | |$1,750,000 | | |35 seminars ? 25 persons ? $400 per person| | |Cost of supplies | |328,125 | | |35 seminars ? 125 persons ? $75 per person | | |Set up costs per seminar | |700,000 | | |35 seminars ? 20,000 per seminar | | |Gross margin | |$ 721,875 | |Office administrator | |50,000 | |Other expenses | |250,000 | |Profit before taxes | |$421,875 | b. Item |Classification |Rationale | |Cost of supplies |Unit level |Proportional to the number of persons | | | |attending Brad’s seminars | |Set up costs per seminar |Batch level |Proportional to the number of seminars only | |Office administrator |Product level |This amount is traceable to the seminar | | | |product.
This classification makes more sense| | | |if Brad also offers other products such as | | | |books, video tapes, and DVDs. | |Other expenses |Facility level |This amount is independent of the number of | | | |persons per seminar or the number of | | | |seminars. | c. By inspection, it appears that unit- and batch-level costs make up product costs, while product and facility level costs comprise period costs. However, this equivalence is not usually true. For instance, the cost of a dedicated machine is a product level cost. The cost of factory rental is a facility level cost.
However, both costs are product costs as they are manufacturing costs. Likewise, sales commissions are unit level costs, and the cost of transporting items to the customer’s site is a batch level costs. Both of these selling expenses are period costs. In sum, there is no obvious correspondence between costs per the cost hierarchy and product / period costs. These cost classifications are useful for different purposes, underscoring the maxim, “different costs for different purposes. ” 3. 32The following table provides the required classifications (with product costs listed first, followed by period costs). |Cost of merchandise sold |Product cost.
This is a cost of getting the goods | | |ready for sale. | |Transportation in |Product cost. Required for getting goods ready for | | |sale. | |Cost of display cases |Product/period cost. This is an ambiguous item. We can| | |make a stronger case for product cost if it pertains | | |to a specific item. | |Stocking goods on shelves |Period cost.
This is part of the firm’s expenses for | | |maintaining its facilities. | |Store rental |Period cost. Pertains to administration. | |Store manager’s salary |Period cost. Administrative support. | As this problem illustrates, we can classify many costs unambiguously as being product or period costs. However, there is no bright line test. Some costs could be classified either way, with the specifics determining the actual bucket the cost falls into. 3. 33The following is the GAAP income statement for MegaLo Mart. We learn that profit before taxes for the year is $644,691. MegaLo Mart | |GAAP Income Statement | |Item | |Amount | |Revenues | |$14,568,800 | |Beginning inventory, 1/1 |$245,600 | | |Purchases |10,950,325 | | |Ending inventory, 12/31 |260,400 |$10,935,525 | |Transportation in | |102,500 | |Gross margin | |$3,530,775 | |Sales commissions | |437,064 | |Store rent | |1,435,000 | |Store utilities | |134,675 | |Other administration | |879,345 | |Profit before taxes | |$644,691 | Notice that all costs related to getting the goods ready for sale go above the line for gross margin. All period costs such as selling and administration expenses appear below the line. 3. 34The following is the GAAP income statement for Sweets & Treats. We first fill in COGS and then use the inventory equation to fill in purchases. We learn that purchases total $1,598,645 and that costs of sales and administration were $435,500. Sweets & Treats | |GAAP Income Statement | |Item | |Amount | |Revenues | |$2,250,300 | |Beginning inventory, 1/1 |$ 125,000 | | |+ Purchases |1,598,645 | | |- Ending inventory, 12/31 |112,400 | | |= Cost of goods sold | |1,611,245 | |Gross margin | |$ 639,055 | |- Sales and administration | |435,500 | |Profit before taxes | |$ 203,555 | Notice that all costs related to getting the goods ready for sale go above the line for gross margin. All selling and administration expenses appear below the line. . 35 The following table provides the required classifications. |Item |Classification |Comments | |Connectors used to make a product |Direct materials |These items form a part of the product and vary with the | | | |volume of production. | |Labor to machine product components|Direct labor |Some refer to this as “touch labor” because the workers | | | |physically touch the product. |Steel used to make components |Direct materials |The steel becomes an integral part of the product and varies | | | |with the volume of production. | |Drill bits, saw blades, and other |Variable manufacturing overhead|These items are used to make many units of the product and/or| |tools | |many products. We would classify their cost as variable, as | | | |making more units would require more tools. | |Salary paid to the factory manager |Fixed manufacturing overhead |This item is a fixed cost; it is not directly traceable to | | | |units of any product. |Factory maintenance costs |Partly fixed manufacturing |Some items, such as the salary to the maintenance manager, | | |overhead and partly variable |are fixed. Other items, such as the supplies used to maintain| | |manufacturing overhead |equipment, might vary with usage and the number of units | | | |made. | |Depreciation on materials handling |Fixed manufacturing overhead |The amount does not vary with any obvious volume-related cost| |equipment | |driver. | |Holiday pay paid to assembly |Direct labor/ variable |This item likely varies with labor cost. Some firms include | |workers. manufacturing overhead |it as a part of direct labor. Others treat the item as | | | |variable overhead, allocating it by using labor hours or | | | |labor cost as the allocation basis. | 3. 36 The following table provides the required classification (with variable, product costs listed first, followed by fixed, product costs, variable, period costs and fixed, period costs) |Item |Product / Period |Variable / Fixed | |Product components Product |Variable | |Direct manufacturing labor |Product |Variable | |Supplies used in manufacturing |Product |Variable | |Production supervisor |Product |Fixed | |Factory rent |Product |Fixed | |Plant manager salary |Product |Fixed | |Sales commissions |Period |Variable | |Distribution costs |Period |Mixed (has both variable & fixed | | | |portions) | |Sales manager salary |Period |Fixed | |Corporate office expenses |Period |Fixed | As the classification indicates, product/period costs correspond to business function. All manufacturing costs are product costs while non-manufacturing costs are period costs.
This classification is useful for financial reporting. Product costs flow through the firm’s inventory accounts. In contrast, we expense period costs during the accounting period. Variability does not relate to function but is a cost characteristic. Thus, both manufacturing and non-manufacturing costs could be variable or fixed. 3. 37 a. Inventoriable costs are another term for product cost. As you know, only manufacturing costs can be inventoried. Thus, we have: Direct materials cost$2,400,000 Direct labor cost720,000 Factory overhead1,008,000 (140% x $720,000 labor cost) Total costs4,128,000 Number of units120,000 Cost per unit$34. 40 ($4,128,000 / 120,000) b. No.
We have to consider all controllable costs, regardless of business function, when evaluating a product’s profit. We need to do this because changing a product’s volume will change other costs. For example, we need to consider sales commission when evaluating profitability. The product/period cost classification (which leads to inventoriable costs) is useful from a financial accounting purpose. But it often is NOT useful from a decision making perspective. 3. 38a. We can express cost flows through the materials inventory account using the following accounting equation: Ending balance = Beginning balance + Purchases – Issued out to WIP. Plugging in the numbers, we find: $25,000 = $24,000 + $82,000 – Issued out to WIP Issued out to WIP = $81,000. b.
We can express cost flows through the work-in-process account using the following accounting equation: Ending balance = Beginning balance + Costs charged to operations – Cost of goods manufactured. We can, therefore, compute cost of goods manufactured as: $180,000 = $220,000 + $800,000 – Cost of goods manufactured Cost of goods manufactured = $840,000. c. We can express cost flows through the finished goods account using the following accounting equation: Ending balance = Beginning balance + Cost of goods manufactured – Cost of goods sold. We can therefore compute cost of goods sold as: $85,000 = $40,000 + $840,000 – Cost of goods sold Cost of goods sold = $795,000. 3. 39Considering the work in process (WIP) account, we know that:
Beginning balance + Costs charged to operations – Ending balance = Cost of goods manufactured. However, we do not know the costs charged to operations. We do know that such costs include the cost of materials, labor, and manufacturing overhead. For materials, we have: Beginning balance + Purchases – Ending balance = Cost of materials issued to WIP. Plugging in the numbers, we find: $14,000 + $86,450 – $13,750 = $86,700 = Cost of materials issued to WIP. Thus, the total costs charged to operations (i. e. , to WIP) are: $86,700 (materials) + $134,500 (labor) + $67,250 (overhead) = $288,450 Plugging this total into the inventory equation for WIP, we have: 28,200 + $288,450 – $25,400 = $291,250 = Cost of goods manufactured. Next, we know that manufactured goods would be physically moved to the finished goods inventory. The associated cost would be moved to the finished goods inventory account as well. Applying the inventory equation to the finished goods account, we have: Beginning balance + cost of goods manufactured – ending balance = Cost of goods sold Plugging in the numbers, we have: $8,200 + $291,250 – $10,300 = $289,150. 3. 40 a. It is straightforward to trace the materials and labor consumed by any given job. For this particular job, Kim and Tim’s cost sheet might look like the following:
MaterialsEstimated based on gallons, quality etc$250 LaborEstimate based on job features ($12 per hour ? 45 hours)540 Brushes, etc. Included in markup– Mgmt TimeEstimate (4 hours ? $20 per hour)80 Total cost$870 Markup40% of total cost348 Bid $1,218 Notice that Kim and Tim do not include an amount specifically for their use of brushes, scaffolding, and other materials. Such costs are part of the firm’s overhead expenses. Indeed, many painting contractors do not even include a specific charge for the “management time” that Kim and Tim include in their estimate. The markup covers these costs. b. Under the approach in part (a), the overhead charge is co-mingled with the profit markup.
Explicitly charging for overhead allows a manager to separate the charge for overhead from that for profit. For instance, Then, their cost sheet might look as follows: MaterialsEstimated based on gallons, quality, etc. $250 Materials overhead20% of materials cost50 LaborEstimate based on job features540 Labor overhead 50% of labor cost 270 Mgmt time Estimate (4 hours ? $20 per hour)80 Total cost$1,190 Kim and Tim might then add, say a 10% markup to total cost, to arrive at their bid. Notice that this markup is substantially lower than that in part (a). The reason is that the markup in part (b) is for profit only while the markup in part (a) includes overhead costs. 3. 41 a. The following table provides the required computations: |Allocation Basis | | |Head count |Revenue |Profit | |Step 1: Determine the allocation rate | | | |Total cost pool |$3,200,000 |$3,200,000 |$3,200,000 | |Denominator volume |800 persons |$160,000,000 |$5,000,000 | |Rate per unit of the cost driver |$4,000/person |$0. 020/ |$0. 64/profit $ | | | |revenue $ | | | | | | | |Step 2: Determine the cost allocated to each division | |Northwest division |$1,000,0001 |$1,000,0002 |$1,280,0003 | |Midwest division |1,200,000 |1,200,000 |1,152,000 | |Southern division |1,000,000 |1,000,000 |768,000 | | | | | | |Total allocated |$3,200,000 |$3,200,000 |$3,200,000 | | | | | | 1: $1,000,000 = 250 persons ? $4,000; $1,200,000 = 300 persons ? $4,000; $1,000,000 = 250 persons ? $4,000. : $1,000,000 = $50,000,000 in revenue ? $0. 02; $1,200,000 = $60,000,000 in revenue ? $0. 02; $1,000,000 = $50,000,000 in revenue ? $0. 02. 3: $1,280,000 = $2,000,000 in profit ? $0. 64; $1,152,000 = $1,800,000 in profit ? $0. 64; $768,000 = $1,200,000 in profit ? $0. 64. b. As shown in part [a], the distribution of costs among the three divisions is the same whether we use head count or revenue as the allocation basis. As discussed in the text, the proportion of cost allocated to a cost object equals the proportion of driver units in that cost object. Comparing the three divisions, the proportions of driver volumes for head count are 250:300:250, or 5:6:5.
This equals the proportions for revenue, which is $50,000,000:$60,000,000:$50,000,000, or 5:6:5 for the three divisions. Because the proportions are equal, the allocated costs also are equal. In contrast, the proportion of profit contributed by the three divisions is $2,000,000: $1,800,000: $1,200,000, or 10:9:6. Because this proportion differs from 5:6:5, the proportion of head count among the three divisions, the allocated costs also differ. 3. 42 a. There are several methods the friends could use, including: 1. Equal split because each person gets to use the house. This mechanism is simple and easy to implement. However, it assumes all persons get the same utility even though the desirability of rooms varies. 2. By the desirability of each room.
Desirability is a subjective concept, although we assume that features such as an attached bath, room size, view, and the amount of sunlight would factor into assessing desirability. 3. Allocate the cost in proportion to the area of each bedroom. This method assumes that area occupied is the sole driver of the rental cost. 4. Institute some kind of a market mechanism in which each friend “bids” for each room, and the bids determine who gets which room and each person’s share of the total cost. Designing such a mechanism and implementing it may, however, involve more work than the friends are willing to do. b. We would argue for differing allocation bases for the different expenses.
The differences stem from two sources: (1) the ease of measuring each person’s consumption of the joint resource, and (2) perceptions of equity. We suggest the following allocations, although alternate solutions clearly exist. . Rent: An equal split with an ad hoc adjustment for the desirability of each room. Utilities: An equal split for electricity, water and cable TV because it is practically impossible to measure each friends’ consumption accurately. Direct tracing may be more defensible if, for instance, one of the friends wants to watch a pay-per-view event (and the others have no interest). Similar logic may apply to add on packages acquired for the benefit of only a sub-group of the friends.
Food: This is often a contentious issue among roommates. One method that works well is to partition the food into two groups (or cost pools). The first pool contains generic items such as milk, juice, bread, and eggs, whose consumption is hard to measure and which are often purchased in large (e. g. , gallon) quantities. The cost of this generic-items cost pool would be shared equally by the friends. The other cost pool comprises items such as steaks and ice cream, where we can easily keep the items separate. For each specialty food item, each person pays for the items he buys and consumes. The grouping is arbitrary to some degree and depends on the mutual trust among the friends. Problems 3. 43 Shawn’s Lawn Mowing Service | |GAAP Income Statement | |Revenues from lawn mowing | | 525,200 | |Revenue from fertilizing services | | 640,000 | |Miscellaneous revenue | | 76,450 | |Total Revenue | |1,241,650 | |Beginning inventory of fertilizer & supplies | 34,350 | | |+ Purchases of fertilizer & supplies | 395,400 | | |- Ending inventory of fertilizer & supplies | 29,460 | | |Cost of goods used | |400,290 | |Depreciation of lawn mowing equipment | | 45,000 | |Equipment repair and maintenance | | 78,000 | |Fuel and other costs | | 54,000 | |Crew salaries (lawn mowing & fertilizing) | | 285,600 | |Gross Margin | 378,760 | |Office rent | | 82,000 | |Advertising | | 128,000 | |Accounting | | 45,000 | |Depreciation of Shawn’s truck | |4,000 | |Profit | | 119,760 | The statement, while adequate for external reporting, is inadequate from a decision making perspective. For instance, the relative profit from mowing versus fertilizing, and other services, is not clear. The statement also does not help Shawn with his decision regarding whether to expand into snow removal services. Shawn might benefit from detail that broke out major cost items along various product dimensions. He also might wish to have costs delineated by their variability so that he could more easily determine cost controllability for specific decisions. 3. 44The difficulty in this problem lies in computing revenue.
Let us do this in two steps. First, use the inventory equation to compute the cost of goods sold. Beginning inventory of goods$238,600 + Purchases for the year879,830 – Ending inventory178,450 = Cost of goods sold$939,980 Now, we can use the sales break up to determine the total revenue. Consider an item purchased for $50, which will have a list price of $100. The following table shows that Natalie expects to receive $66 for such an item (on average): |Percent of sales |List |Discount |Actual |Expected revenue | | |price | |price | | |10% |$100 |$0 |$100 |$10. 0 | |60% |100 |25 |75 |45. 00 | |20% |100 |50 |50 |10. 00 | |5% |100 |80 |20 |1. 00 | |5% |100 |100 |0 |0. 00 | | | | | |$66. 00 | On average, Natalie expects sales of $66 for each $50 item, or $1. 32 for each $1 of purchase ($66/$50). Thus, for total purchases of $939,980, she expects sales of 939,980 * 1. 32 = $1,240,773. 60. With this data in hand, we can now construct an income statement: Natalie’s Knick Knacks | |GAAP Income Statement | |Item |Detail |Amount | |Revenue |As computed above |$1,240,773. 60 | |Cost of goods sold |As computed above |939. 980. 00 | |Gross margin | |$300,793. 0 | |Store rental and utilities | |136,800. 00 | |Staff salaries | |64,500. 00 | |Profit before taxes | |$99,493. 60 | An alternate presentation is to show the discounts as a separate line item, as follows: |Natalie’s Knick Knacks | |Income Statement for year ended 12/31/xx | |Item Detail |Amount | |Gross revenue (= cost of goods sold ? | |$1,879,960. 00 | |2) | | | |Discounts & rebates | |639,186. 40 | |Net revenue | |$1,240,773. 60 | |Cost of goods sold |As computed above |939. 980. 00 | |Gross margin | |$300,793. 0 | |Store rental and utilities | |136,800. 00 | |Staff salaries | |64,500. 00 | |Profit | |$99,493. 60 | 3. 45 a. We could use the inventory equation to determine COGS. (As instructed, we ignore the cost of transportation in for this computation. ) Beginning inventory$2,450,000 + Purchases23,125,000 = Total available for sale$25,575,000 – Ending inventory2,225,000 = Cost of Goods Sold$23,350,000 b.
Here, we need to allocate $179,050 between the COGS account with a value of $23,350,000 and the ending inventory with a value of $2,225,000. As always, let us do this in two steps: Step 1: Calculate the rate $179,750/($23,350,000 + $2,225,000) = 0. 007028/$ (rounded). Step 2: Allocate the costs (using the exact # from step 1) To COGS: $23,350,000 * 0. 007028 = $164,111. 93 To ending inventory: $2,225,000 * 0. 007028 = $15,638. 07. Thus, the total COGS (after adjusting for the cost of transport in) is: Unadjusted COGS$23,350,000. 00 Allocation for transportation in164,111. 93 Adjusted COGS$23,514,111. 93 c. Ideally, we should allocate transportation costs to individual units and track the costs through the inventory account.
However, this is a tedious and cumbersome procedure for what is often a small cost. Most firms allocate the cost, using end-of-year balances as the allocation basis. Some firms (like Serene used to do) allocate the entire cost to the COGS account. This method could be justified because the amount is not significant (e. g. , is less than 1% of the total cost) and because in a typical firm, COGS would dwarf the ending inventory. Thus, even an allocation would push most of the cost into the COGS account. In Serene’s case, the allocation resulted in income increasing by $15,577. 17 for this year. However, next year, the change is likely even smaller. (Why?
The effect on income is the change in the allocation for transportation expense between beginning and ending inventory accounts! ) 3. 46 It would seem prudent to compute the cost of goods sold separately for the two product lines. We can do that separation as follows: Wine Groceries Total Beginning inventory $284,600$145,600 + Purchases$1,450,240$2,168,400 (c) – Ending inventory395,340128,900 = COGS1,339,500 (a)$2,185,100 (b)$3,524,600 We can compute (a) by applying the inventory equation to wine. We can then back out (b) as the remaining COGS. We can then apply the inventory equation to calculate (c) as $2,168,400. With this data in hand, we present the following: |Wine |Groceries |Total | |Sales |$2,265,800 |$2,080,000 |$4,345,800 | |COGS |1,339,500 |2,185,100 |$3,524,600 | |Gross margin |926,300 |(105,100) |821,200 | |Traceable salaries |230,000 |180,000 |410,000 | |Segment margin |696,300 |(285,100) |$411,200 | |Common salaries | | |235,320 | |Store rent | | |145,290 | |Other costs | | |97,000 | |Profit before taxes | | |($66,410) | Such a statement is useful to the board as we find that wine sales are the key driver for profits. We appear to be subsidizing groceries with wine sales. This has several strategic implications for what the cooperative might wish to do. 3. 47
We can apply the inventory equation to determine the value of ending inventory. Beginning inventory + Costs added – COGM = Ending inventory. However, costs added include materials, labor and overhead. We only have overhead in total, meaning that we need to allocate it between the two products. Let’s do the allocation first. Step 1: Determine rate Total overhead cost$1,358,500 Total raw materials cost$1,235,000($690,000 + $545,000) Rate$1. 1/material$ ($1,358,000/$1,235,000) Step 2: Allocate costs Raw material cost in R-750$690,000 Allocated cost$759,000($690,000 * 1. 1) Similarly, we calculate $599,500 as the overhead allocated to D-800. We can plug these numbers into the inventory equation |R-750 |D-800 | |Beginning inventory (WIP) |$280,000 |$147,500 | |+Raw materials used |690,000 |545,000 | |+Labor used |985,000 |1,342,600 | |+Overhead allocated |759,000 |599,500 | |=Total costs in account |2,714,000 |2,634,600 | |-Cost of goods manufactured |2,250,000 |2,346,900 | |= Ending inventory |$464,000 |$287,700 | 3. 48 a. Ly might be more sympathetic if he considers the contractor’s cost structure. The cost of the labor and materials represent the contactor’s variable costs. In addition, the contractor has overhead expenses, such as the cost of maintaining an office, operating trucks, and buying and maintaining tools. The contractor is entitled to recover these legitimate costs of running the business.
Like other businesses, the contractor adds an overhead charge to the variable costs to cover fixed costs and contribute to profit. Much like retail stores mark up an item to convert the wholesale price to a retail price, contractors add markups to their services. Naturally, competition and other market pressures dictate the magnitude of the markup. b. Many contractors see “free” bids as a way to increase the volume of business. One way to think about this practice is to consider the time and effort spent in assembling “lost” bids as overhead expenses. The benefit from not charging potential clients for this overhead is to increase the number of bids solicited.
If contractors charge to provide an estimate, consumers may not price many jobs and get fewer bids per job. Often, getting a cost estimate is an integral part of the consumer’s decision process and increasing the cost of this step may stop the consumer from pursuing the job altogether. The cost of submitting free quotes is that it encourages consumers to obtain multiple bids and play contractors off against each other. Thus, contractors will “lose” more bids and perhaps receive a lower price on the bids that they “win. ” Market forces dictate the nature and extent of “free” bids. For example, during the summer months, when they are in high demand, many air conditioning repair shops will charge to provide a bid.
Similarly, some contractors will often ask for an advance or significant assurances of obtaining the job, if providing the bid involves significant time and effort. For example, most homebuilders will provide rough estimates only until such time the homeowner has essentially selected the builder. 3. 49 The problem’s wording suggests that this is a short-term decision that only affects the firm for the next six months. Examining controllable costs, we would argue that fixed overhead is probably not controllable over this timeframe. This conclusion relies on the nature of the fixed costs, and does not rely on the fact that an allocation makes a fixed cost appear like a variable cost. We also note that the opportunity cost for the firm’s capacity is zero.
The firm has plenty of capacity available (utilization is only 40%), meaning that the decision to make or buy A-103 would have no effect on the firm’s other products and components. With this correction for fixed costs, we have the controllable costs for making the component as: Materials$12. 00 per unit Direct Labor9. 00 Variable overhead4. 5050% of labor cost Total$25. 50 per unit. This amount is smaller than the controllable cost ($32 per unit) associated with purchasing the units from the supplier. Thus, the firm should continue making the units. 3. 50 Many firms perform the kinds of analysis like that done by the consulting firm. Such analyses consider all costs, and allocate them to individual activities.
For instance, the consultant would have considered the cost of the technician’s salaries, equipment, training, transportation, office support and so on in her analysis. For each cost item (there could be hundreds of these), the consultant would choose an appropriate driver and determine the total cost of field service calls. Dividing the total by the number of service calls yields the “cost” per call. It is often the case that many, if not most, of the costs considered are fixed over the short-term. Thus, while it might be useful for long-range planning decisions (we visit this issue in Chapter 11), the number is usually meaningless for short-term decisions.
Grace is making her decision as if the $495 is a variable cost; that is, she is acting as if she is writing a check for $495 each time she dispatches a technician. In reality, her cost would change little whether she accommodated more calls or not. Thus, she is not saving costs in the short-term by her decision. More important, she appears to be hurting revenue. A reputation for poor after-sales service would lower the firm’s sales. Grace’s decision might set the firm down a disastrous path! 3. 51 a. Under GAAP, inventoriable cost comprises variable manufacturing costs (e. g. , materials and labor) plus an allocation for fixed manufacturing costs.
Inventoriable cost does not include any selling or administrative costs – these costs are treated as period expenses. Pringle allocates fixed manufacturing costs to products using units produced as the allocation basis. Thus, we have: Step 1: We first calculate the allocation rate by dividing the cost pool by the denominator volume. $11,750,000/58,750 units = $200 per unit. Step 2: With this rate in hand, we can determine inventoriable cost for each kind of canoe: ModelModelModel X-5XV-10XV-20 Materials cost$100$175$300 Labor cost300400700 Allocated overhead200200200 Inventoriable cost$600$775$1,200 Again, we emphasize that selling and administrative costs are not included in inventoriable costs. b.
This change in the allocation basis will change the overhead rate that we use to allocate fixed manufacturing costs. Step 1: Compute the allocation rate Plugging in the numbers from the problem, $11,750,000/$23,500,000 = $0. 50 per labor $. Step 2: Allocate costs With this rate in hand, we can determine inventoriable cost of each canoe: ModelModelModel X-5XV-10XV-20 Materials cost$100$175$300 Labor cost300400700 Allocated overhead150200350 Inventoriable cost$550$775$1,350 In each case, we compute the allocated overhead as the labor cost of each canoe ? rate per labor $. As before, we do not allocate fixed SG&A costs to determine inventoriable costs. c.
We find that the inventoriable cost for X-5 has decreased, the cost for XV-20 has increased, and there is no change in the cost for XV-10. To understand the difference, notice that when Pringle allocates fixed manufacturing costs using units, each canoe gets an equal share of overhead. However, when Pringle allocates by labor cost, allocated overhead is proportional to the canoes’ labor cost. The “average canoe” consumes $400 of labor (= $23,500,000/58,750 canoes). There will be no change due to the change in the allocation basis only if each kind of canoe actually did consume $400 per canoe in labor costs. However, this equivalence is not true.
Thus, canoes with lower than average labor cost (e. g. , X-5) will experience a reduction in reported cost if Pringle changes it allocation basis from units to labor cost. Conversely, canoes with higher than average labor cost (e. g. , XV-20) will experience an increase. Note: Although the inventoriable cost of each individual canoe changes depending on the allocation basis chosen, the total fixed manufacturing costs allocated to all canoes will be $11,750,000 regardless of the allocation basis chosen. 3. 52 a. Let us first calculate the overhead rates (step 1 in the allocation process). We have: Material related overhead = $39,000/$260,000 = 15%, where $260,000 is the total materials cost.
Labor related overhead = $486,200/$374,000 = 130% where $374,000 is the total of labor costs. Machine related overhead = $784,687. 50/104,625 hours = $7. 50/hour where 104,625 is the total number of machine hours. With these data in hand, we are now ready to compute inventoriable cost per unit. |Product |A-104 |RJ-95 |XL-435 |Detail | |Units |10,000 |15,000 |12,500 | | | | | | | | |Materials | $5. 00 | $6. 0 | $9. 00 | | |Labor | $7. 50 | $9. 60 | $12. 40 | | |Materials related overhead | $0. 75 | $0. 98 | $1. 35 |15% of materials cost | |Labor related overhead | $9. 75 | $ 12. 48 | $16. 12 |130% of labor cost | |Machine related overhead | $ 18. 75 | $ 19. 50 | $24. 38 |$7. 50 per machine hour | |Inventoriable cost per unit | $ 41. 75 | $ 49. 06 | $63. 5 | | b. No, the managers’ assertion is not correct. The central issue is that much of the overhead might be fixed. The allocation, however, makes such fixed costs appear like variable costs by expressing the costs on a per unit basis. Nevertheless, these costs are not controllable in the short-term. Thus, these costs are not relevant for short-term decisions. As we will learn in Chapters 4-6, allocated fixed costs are not relevant for short-term decisions. 3. 53 a. The following table lists the costs that could be allocated and our rationale for whether they should be included in the allocation scheme.
Note that we do not include the cost of the raw timber as the friends pay Boomer the prevailing market rate for the raw timber they consume. |Cost Item |Rationale | |Rent for splitter |We believe that this cost of $200 should be allocated among the friends. The cost is | | |measured well, has a specific purpose, and is a common cost. In addition, the cost is | | |sufficiently large – not allocating it in some way could potentially lead to resentment. | |Helping Dale split logs |This cost must be subjectively measured, and is likely not large in magnitude.
Further, | | |any charge is a transfer from Dale to his friends. Attempting to estimate this cost and | | |including it in the scheme would likely create animosity (e. g. , cost sharing for other | | |favors the friends did for each other). It is likely that such cost sharing is implicitly | | |done by, for example, Dale buying a round for his friends one evening. | |Cost of using Bill’s trailer |This is a common cost, arguing for its allocation. However, the cost must be subjectively | | |measured. Further, the cost is likely to be small in magnitude.
We believe that the latter| | |two factors outweigh the potential benefits from allocating the common cost. We would not | | |include this cost in the costs to be allocated. | b. The following two allocation schemes seem appropriate for allocating the cost of the log splitter. Allocate Based on Use. Among themselves, the friends split 4 cords of wood for the day (? for Hank, 1 each from Bill and Dale, and 1? for Boomer). Thus, this scheme would allocate $50 (= $200/4 cords) for each cord of wood. Hank would therefore contribute $25, Bill and Dale would contribute $50 each, and Boomer would contribute $75 toward the cost of the splitter.
This scheme is equitable and is easy to implement. The allocation basis also appears to be easy to measure (within some margin of error). However, the scheme can easily go awry. For instance, what if Bill or Boomer believes that Hank has really used the machine for ? of a cord rather than ? a cord? How do we measure the amount of wood cut with the required precision? What if one of the friends uses the spare capacity to split some wood for his parent’s use? Overall, this mechanism could drive a wedge among the friends (pun intended)! Equal Split. This mechanism would allocate $50 of cost to each of the four friends. This scheme does not alter the cost allocated to Bill or Dale.
However, Boomer would be charged $25 less and Hank would be charged $25 more than under the “based on use” scheme. The scheme is easy to implement and poses no measurement issue. The only problem is a perception of equity for Hank and Boomer’s share. However, we believe that this is a small price to pay. After all, the friends use Boomer’s timber and it is likely that the quantity was estimated rather than measured as it would be in a lumberyard. Further, the friends are likely to cooperate in many such joint ventures and the roles may be reversed in some other situation. In the interest of creating least potential for acrimony, we believe that an equal split is the best mechanism in this situation. 3. 54 a.
Let’s use the two-step procedure to determine the cost allocated to each product. Step 1: Calculate the allocation rate. Here, the cost driver is the number of setups per year, which totals 10, and the total cost is $40,000. Thus, we calculate the rate as: Rate per setup = $40,000/10 = $4,000 per setup. Step 2: Use the rate to determine allocated costs. The following table has the required computations. | | | |% of cost allocated = % of | | |Number of setups |Allocated cost (= number of |driver units from the | | |per year |setups ? ate per setup) |product line | |Product | | | | |24” Two-suiter |7 |$28,000 |70% | |26” Three-suiter |2 |8,000 |20% | |30” Jumbo Wheeler |1 |4,000 |10% | |Total |10 |$40,000 |100% | Notice that the percent of cost allocated to each product line is the same as the percent of driver units contributed by the product line. b. This requirement changes the cost driver. Replicating the two steps, we have: Step 1: Calculate the allocation rate.
The total cost is still $40,000 but the cost driver is the total number of setup hours, which equals 160. Thus, we calculate the rate as: Rate per setup = $40,000/160 = $250 per setup hour. Notice that when computing the rate we use the total number of setup hours, not the number of hours per setup. The magnitude of resources consumed by a product line is a function of both its volume (number of setups) and the time per setup. Step 2: Use the rate to determine allocated costs. The following table has the required computations. | |Number of setups|Allocated cost (= number of setup |% of cost allocated = % of driver | | |per year |hours ? ate per setup hour) |units from the product line | |Product | | | | |24” Two-suiter |7 |$24,500 = 98 setup hours ? $250 per |61. 25% | | | |setup hour. | | |26” Three-suiter |2 |$9,000 = 36 setup hours ? $250 per |22. 50% | | | |setup hour. | | |30” Jumbo Wheeler |1 |$6,500 = 26 hours ? $250 per setup |16. 25% | | | |hour. | |Total |10 |$40,000 |100% | c. As reported in the above tables, the percent of driver units contributed by each product equals the percent cost allocated to it. This equivalence is a fundamental property of all allocations. The answers differ because the setups for the different products take different amounts of time, causing the percentage of setups to differ from the percent of time used. The answers will coincide if it takes the same time to perform the setup for any product. In this case, the proportion of setup hours across products will equal the proportion of the number of setups across products. 3. 55
This a “non-standard” problem in that we are dealing with a not-for-profit. Thus, the notions of a gross margin or other margin do not apply. What the board needs to know (at a minimum) is how much money has been raised, how it has been spent, and how much is in reserve for future years. The following might be a typical statement. Operating Cash Flow Program receipts:$25,459. 93 In kind donations (program related)2,450. 00 Total program receipts$27,909. 93 Program costs: Cash expenses$14,345. 55 In kind expenses*2,450. 00 Total program costs$16,795. 55 Net receipts from programs$11,114. 38 Interest income2,396. 48 Total operating inflows$13,510. 86 Administration expenses:
Office expenses$2,440. 00 Postage and printing845. 00 Board meetings143. 50 Total administration expenses3,428. 50 Funds available from operations$10,082. 36 Source and Use of funds Funds available from operations$10,082. 36 Cash donations14,000. 00 Total available for scholarsh